Yesterday’s blog entry reported on an e-mail that I sent to Academic Researcher Wade Pfau on August 12, 2011. He sent a response the same day.
Wade congratulated me for obtaining a monthly column at the Financial Highway site. He said that his university subscribed to a service that provided links to media sources using the university name and that my article was picked up by the service. “So everyone here got to see a link to your article in email and our alumni director made a link to it in the alumni group on Facebook.”
He also said that he had received positive comments from a journal on his Fisher and Statman research. He said that things were looking good re future publication. He said: “I might include about the rolling 30-year periods in it rather than keeping it for a separate article. I’ve been getting so busy and there is not enough time to write all the papers I want to write these days.”
My response, sent later the same day, appears below.
Wade:
It always brings a measure of cheer to my day to receive an e-mail from you. Intelligent discussion of investing is like sunshine to me!
That’s a great story about your university and the e-mail links. The internet works in mysterious ways! It’s so new and different a communications medium that people have not figured it out yet.
One of my dreams is to get one of my calculators picked up at the LifeHacker site. It is a a HUGE site and the calculators are perfect for it because the site is looking to share knowledge of practical tools. So what happens a week or so ago? LifeHacker picks up one of my saving articles! It brought in lots of traffic and I am of course grateful. But it is strange for things to happen that way. My investing work is 20 times more important than my saving work and my saving work is 20 times more popular. I actually think of my investing work as Anti-Marketing. My saving articles pull people into my site and my investing articles drive them right back out again!
I like the idea of adding the rolling 30-material into the Fisher article. You have two A+ articles there. But you are better off with one A+++ article. The engineer for the Beatles said that his greatest career regret was that he let them release Strawberry Fields Forever/Penny Lane as a single rather than saving it for inclusion on Sgt. Peppers. Sgt. Peppers got plenty of attention on its own. But it would have been even bigger with inclusion of those two songs (and the dropping of two inferior songs). One A+++ article can have more impact than a lifetime of solid B+ material. So don’t make any mess-ups in that article! (That’s a joke.)
There’s a point made in one of the Bogleheads threads in which you participated that I think might be worthy of some of your consideration. It was one of the critics who put it forward but it was a strong point. He asked: “What is the THEORY that explains why P/E10 would be able to predict returns?” My strong sense is that people don’t spend enough time thinking that over. I believe that I understand the theory (it is of course possible that I am wrong). My sense is that my understanding of the theory has helped me avoid pitfalls that lots of others have fallen into.
Anyway, you must get that article on the front page of the New York Times before our economic and political system falls! That’s sort of a joke too, but perhaps only 50 percent so. We really do live in times that are both exceedingly scary and exceedingly promising (but perhaps all times seem that way to the poor humans living through them without knowledge of how things turn out on the last page of the story).
Please take care.
Rob
canyon wanderer says
He asked: “What is the THEORY that explains why P/E10 would be able to predict returns?”
and the answer is????
Rob says
Super question, Canyon. Thanks for asking that. My sense is that this is a source of a great deal of confusion.
The Buy-and-Hold Model posits that stock prices are determined by each day’s economic and political developments. This sounds plausible. It certainly APPEARS to be the case that this is what is going on.
There’s a problem, though. The historical return data does not support this plausible explanation of what causes stock price changes. Economic and political developments are random events. If this were what was going on, it would not be possible for the P/E10 level that applied 10 years ago to determine the stock price that applies today. This is why Buy-and-Holders find it so hard to accept Valuation-Informed Indexing.
What is going on?
Investors all possess a Get Rich Quick urge. We all want our portfolios to be worth as much as possible. And collectively we possess total power to set the price of our portfolios. Say that you and I and millions of other investors all are worried about our retirements. Say that we all agree to not say anything if all the rest of us pump up stock prices to double the level that applies today. Who can stop us? Nobody. We can all vote ourselves raises by simply keeping quiet while we pump up prices to double their real value.
Now —
That money cannot be real. We obviously cannot create money out of thin air. We all ALSO possess common sense. So we all know on some level of consciousness that a stock price set artificially high is going to collapse in not too much time.
THe tricky part of this is that we know both things. Some people find this hard to accept. How can the same person believe two opposite things? The reality is that we do this ALL THE TIME. The alcoholic knows that he needs to stop drinking and he also knows that he has his drinking totally under control (or at least so he says — and he really does kinda believe what he says). It’s the same with the gambling addict. And the sex addict. And the guy who eats too many chocolate chop cookies. I know that eating cookies makes me fat. Yet at the time I want one I rationalize to myself that one cookie will not hurt so much. It is pathetic. But it is 100 percent human.
So the human investors bid stock prices up to insanely dangerous levels, all the while knowing that they soon will collapse. This is why Buy-and-Holders are so emotional. They “know” that it doesn’t work. They also “know” that it does. They are conflicted. People who point out the conflict make them angry, just as my boy makes me feel a twinge of anger when he says “Dad, that’s why you’re overweight” when I reach for a chocolate-chip cookie. I TELL him to tell me this. And still I feel a twinge of anger when he does.
Today’s stock prices are determined by the stock prices that applied 10 years ago and by our effort to overcome the emotions that set those earlier prices. We were temporarily insane when we set prices at three times fair value. We are now in the process of coming to terms with that insanity. We can’t do that in a month or a year or two years. That’s why secular bear markets last so long. It takes many years for us to come to terms with how much we messed things up in earlier days.
The good news here is that, when we move to this model, we become able to predict stock prices effectively. If stock prices are set by each day’s economic and political developments, it is impossible to predict prices. The Buy-and-Holders are 100 percent right about that. The logic of the Buy-and-Holders is impeccable.
But, if stock prices are determined by things that happened 10 years ago, they are obviously predictable. We can know in advance when stocks are going to perform well and when they are not and profit from this knowledge.
The Buy-and-Hold Model makes sense. That’s not at issue. The problem is that it does not fit the historical record. The entire 140 year history of stock returns is the OPPOSITE of what you would expect to see if stock prices are determined by daily economic and political developments. Stock returns have ALWAYS been highly predictable in the long term. Stock prices MUST be determined mostly by investor emotions from earlier days (and from the new emotions reacting against those earlier emotions).
Economic and political developments can trigger the emotional reactions. But they do not CAUSE the emotional reactions. If prices have gone so high that a price collapse has become emotionally inevitable, the collapse can be set off by just about ANY economic or political development. An increase in inflation might set it off. Or a drop in inflation might set it off. Or the reelection of the current President might set it off. Or the defeat of the current President might set it off. It is the investor emotions that are the true cause of price changes, NOT the daily economic or political developments (which are just catalysts for the true causes).
I sometimes call this “Emotional Market Theory” to contrast it with “Efficient Market Theory”.
Rob