Yesterday’s blog entry reported on an e-mail sent by academic researcher Wade Pfau to me on December 24, 2010. We exchanged several brief e-mails in the following days. The next substantive one was one that Wade sent me on January 5, 2011, in which he recommend that I read the book “Yes, You Can Time the Market!” by Ben Stein and Phil DeMuth because “it vindicates your views about using valuations to guide long-term conservative investors.” My response is set forth below.
Wade:
It’s always good to hear from you. Things are going well with me.
I have read the book. My favorite part is the introduction. Stein there explains what got him started on the path that led to him writing the book. What got him started was the commonsense observation that timing just had to work — for timing not to work would mean that the price we pay for stocks makes no difference in the results that we obtain and that simply cannot be so.
This is a two-step process. First, one has to be persuaded that timing must work. Then one must go about finding the best approach to timing.
On the first question, I am persuaded that we know the right answer –we know that timing works because it is not possible for the rational human mind to imagine a universe in which the price paid for something does not matter. On the
second question, we need to explore lots of possibilities. It’s not possible for us to know anything with much confidence until there has been extensive public debate on numerous possibilities and we are just not there yet. To get that debate, we need to persuade the Buy-and-Holders to ease up on their dogmatism enough to permit a variety of viewpoints to be widely heard.
The focus on 1984 and 1985 is important. I think that the way the price signals work is indeed the flaw to their particular approach.
There is no one P/E10 level at which stocks turn good or bad. People need to understand that the value proposition gradually changes. Any cliff approach is going to fail in some circumstances.
Say that we were trying to say what the perfect highway driving speed is. Some would say “55,” some “60,” some “70.” Some would say “80”! And, if you tested this, you would find that sometimes driving 80 does not lead to an accident. And sometimes someone driving 55 gets in an accident. There is no one correct driving speed. It does not exist.
It does not follow that we should not have speed limits. We must have a speed limit. We know that the danger of driving increases as speed increases. So we just need to reach a consensus that it is okay to drive 65 but not 70 and go with that even though we understand that there is something artificial in setting the speed limit at any one particular number.
This is how it works with stocks. Stocks are more risky when the P/E10 is 15 than they are when the P/E10 is 10. And 20 is worse. And 25 is still worse. And 30 is still worse again. But there is no one magic number. If you say “Sell all your stocks at 30,” you are going to be proven wrong in the eyes of some when the P/E10 continues up to 44, as it did in January 2000.
We need to separate out the things we know (stocks get increasingly risky as the P/E10 level gets higher) from the things we do not know (the precise P/E10 level at which people should sell stocks). What we really need is a change in the way we talk and think about stock investing. We need to become confident enough to make measured statements.
Buy-and-Hold is inherently dogmatic (it posits that there is never a need to make any allocation change). I think this dogmatism has its roots in fear. Investing is so important to us that we demand a level of precision in our pronouncements that it is impossible for us to achieve today. We need to just relax a bit, let in different viewpoints, and stop feeling a need to come up with perfect answers to every question (Buy-and-Hold does not do this, so we should not demand that alternatives to Buy-and-Hold do it either).
We will never come up with perfect answers. The reason why is that there are always two opposite sorts of factors affecting stock prices. There are economic factors, which are highly predictable. And there are emotional factors, which appear to be almost entirely unpredictable. To not make any predictions at all is foolish because the effect of the economic factors is predictable and being able to predict returns reduces risk while increasing return. But to make precise predictions is ALSO foolish because the emotional factors are almost entirely unpredictable and will cause precise predictions to fail regularly.
What we can do is to identify a RANGE of possible long-term returns and assign ROUGH probabilities to each point on the spectrum of possibilities. This is of HUGE value. The Return Predictor tells us that, for stocks bought when the P/E10 is 10, there is a 50 percent chance that you will be seeing a 10-year annualized return of greater than 10.7 percent real and that, for stocks bought when the P/E10 is 20, there is a 50 percent chance that you will be seeing a 10-year annualized return of less than 3.0 percent real. This tells us a lot about how much risk applies in these two different scenarios.
But it does not tell us everything. With a super good returns sequence, you could buy stocks at a P/E10 of 20 and get a 10-year annualized return of 9 percent real. With a super bad returns sequence, you could buy stocks at a P/E10 of 10 and get a 10-year annualized return of only 4.7 real.
No one knows in advance what returns sequence is going to come up. This is determined by investor emotion, which cannot be predicted. We should be making use of what we do know (that stocks carry more risk at higher valuations) while
not pretending that we can know things we cannot know (things that we would need to know to make precise predictions). We CAN time the market, but only in the long-term and not in such a way as to permit precise knowledge of market
tops and bottoms.
Wade sent a brief response later that day expressing surprise re how few views there were at the Bogleheads board for a thread he put up on the effect of valuations on safe withdrawal rates and saying that, based on the research he was doing, he was giving consideration to going with the following title for his next thread-starter at the Bogleheads Forum: “Yes, Virginia, Valuation-Informed Indexing Works!”
Rob
You are definitely consistent with the bad metaphors.
The safest driving speed is the speed at which other drivers on the road are traveling. There have been several studies that show driving the speed limit when other drivers are traveling 10 MPH higher raises the risk of an accident by a significant margin.
Driving significantly faster than other drivers also raises risk, but not as much as driving slower!
The safest driving speed is the speed at which other drivers on the road are traveling.
I’m with you, What.
I want everyone to lower his or her stock allocation when stock prices rise to insanely dangerous levels. Just as everyone lowers his or her driving speed when the road is covered by ice.
What the Buy-and-Holders are saying is “so long as we broadcast radio reports 24 hours per day warning people that they will be arrested if they ever lower their driving speed when it is icy, we can all pretend that icy road conditions make no difference.” That leads to massive crashes! For what purpose?
The only difference is the length of the feedback loop. Cars driving at high speeds on icy roads cause crashes quickly. So no one denies the effect. Sticking with high stock allocations when prices rise to insanely dangerous levels causes an economic crisis in 10 years or so. The passage of the 10 years confuses people. They look for explanations of the economic crisis that are more recent in time.
That’s why we should be open to considering what the academic research says. Legitimate research looks at the entire 140 years of historical data. All of the legitimate studies show that Get RIch Quick investing strategies never work. This is why I say we should all be permitted to post honestly on safe withdrawal rates and other critically important investment-related topics.
Please take care.
Rob
Buying stocks at lower valuations allows for possibilities not commonly discussed. Sure, it allows one to allocate a greater amount equity and potentially clean-up with higher expected returns. And that’s great.
But it also permits one to allocate a *lesser amount of equity* and have the *same expected return* as if one allocated a greater amount at at higher valuations. This can then free cash for other purposes, like purchasing a home, a car, paying-down a student loan, etc.
So, using the example in the blog entry, a much smaller amount of money invested at PE 10 can produce the same return as a larger amount invested at PE 20. And even when valuations are higher, one can still have the extra cash, just not the higher expected returns.
An understanding of valuations makes cash more flexible.
Buying stocks at lower valuations allows for possibilities not commonly discussed.
Right on, Arty!
There is no end to this.
Once we achieve a consensus that there is nothing to be ashamed about in reporting on academic research honestly and accurately, it’s good stuff piled on top of good stuff piled on top of good stuff.
Rob
An understanding of valuations makes cash more flexible.
This is a huge issue, Arty. You see things others don’t see.
An entire book could be written just on the topic you bring up here.
The good stuff! (And, yes, the Buy-and-Holders deserve a lot of the credit.)
Rob
Yes, it is very liberating. Few realize that a little goes a very long expected way when valuations favor.
Saw Shiller on CNBC the other day . He says he likes stocks now and would not be altogether out. But he is really always pretty wishy washy, and so really, all we need from Shiller we already have–the basic info he provided in his best work. We can take it from there for implementation.
I agree with you about Shiller too, Arty.
He IS wishy washy about implementation. ALL the time. He should be called out on this (by people who also recognize his earth-shaking contributions and praise him for bringing them to us).
My sense is that Shiller either is afraid to address the implementation issue clearly or he feels that he cannot give the short answers needed to be featured on television and so he fogs things up by saying the sorts of things you note above.
He likes stocks “now.” What the heck does that mean?
He thinks they are going to go up over the next few months? What research does he know of that shows us how to engage in short-term timing effectively?
There is nothing to like or not like about stocks in the short term. If we cannot predict short-term returns, liking or not liking is pointless. What matters is whether stocks offer a strong LONG-TERM value proposition or not.
Shiller knows the answer to that one. That’s why he’s not saying that he “likes” stock in the long term when they are selling at today’s prices.
This is the lead guy! This is the fellow who started all this! Heaven help us!
Rob
I think he is afraid that someone listening to him will later blame him for their losing money. I was once bothered by Shiller’s meekishness to actually *say something*. I’m not any more.
It is unrealistic for someone to be all things. He gave us the research–the road map. Those among us who are more willing to speak can do so. And all of us can take his PE/10 concept and run with it. Now, if we could combine Shiller’s research with Bogle’s ability to speak-out publically (or Grantham or Hussman re: valuations), we’d have something more.
It is unrealistic for someone to be all things.
Precisely so!
We all get to contribute one little piece of the huge and beautiful mosaic that we are assembling together.
You are on a roll, my man.
Rob