I often note that, on the three earlier occasions on which U.S. stock prices went as high as they are today, we experienced an average price drop of 68 percent. There is no one number that tells you all that you need to know about stock investing. So I will today direct a few words to an effort to putting that 68-percent-price-drop number in context.
It is of course possible that we will not see a price drop that big. Today’s P/E10 level is 24 (this blog entry was written in advance, so this number may be slightly out of date when you read these words). In the mid-1960s we saw a P/E10 level of 24, but the subsequent price drop was only 56 percent. That could happen again.
Or it could be that we will not even see a price drop of that magnitude. We have only been to a P/E10 level of 24 three times. The fact that we have never seen a price drop in these circumstances of less than 56 percent is certainly an indication that it is not wise to rule out seeing a price drop of at least that magnitude this time. But three spins of the wheel is not very many spins of the wheel. It could be that this time we will see a price drop of a bit less than 56 percent. Perhaps our small sample of return patterns is biased to the down side. We know that we cannot count on that. But we do not know with certainty that it is not so.
A price drop of 68 percent sounds real, real bad. Think about it a bit and you will see that it is not quite as bad as it first appears to be. The 68 percent price drop does not take place in a single year. It is spread out over time. It might be that you would suffer a loss of something in the neighborhood of 20 percent for four years in succession, or even that there might be some up years mixed in with a greater number of down years in a way that produces an overall loss of 68 percent when all the ups and downs are mixed in together. The loss of wealth is of course still very bad. But a loss that takes place over a good number of years will not be experienced as being nearly as dramatic an event as one that took place quickly. It would not surprise me if many investors will not even be aware that they have suffered a 68 percent hit after they have done so.
The 68 percent hit is the hit that applies at the worst possible moment. At all times other than the worst possible moment, the hit will be less than that. If you go far enough out into the future, there will be no hit at all. If you go far enough out into the future, there will be a big gain. It helps to keep these things in perspective.
Presuming that you are not going with a 100 percent stock allocation, you will not be seeing a 68 percent drop in your overall net worth number. If stocks comprise 90 percent of your portfolio, your overall hit will be about 60 percent. If stocks comprise 60 percent of your portfolio, your overall hit will be about 40 percent. If stocks comprise about 30 percent of your portfolio, your overall hit will be about 20 percent.
The 68 percent number does not incorporate the effect of dividends earned during the time the price of your stocks was falling. Including dividends (which is proper) makes things sound a lot less dramatic. John Walter Russell did research showing that the loss with dividends included might be only 40 percent. In a world in which most investors were better informed about the realities of stock investing, I think the 40 percent number would be the better one to report. The reason why I usually report the 68 percent number (and then add a mention of the 40 percent number if space permits) is that investors have been (improperly, I think) trained to think in terms of stock price changes rather than in terms of real net worth changes (which are more significant, in my assessment).
Stocks are in the Red-Light-Danger Zone today. Stocks are dangerous at today’s la-la land price levels. The potential for a big price rise is small. The risk of a big price drop is big. I believe that most investors (those not possessing strong stock-picking skills) should be limiting their stock allocation to 25 percent or 30 percent until prices return to more reasonable levels.
Still, I don’t think it is at all a good idea to exaggerate the risk that applies. Exaggerations cause emotional reactions. When Passive Investing enthusiasts underplay the risks of owning stocks at these prices levels, they encourage emotional reactions when the price drops come. It’s just as much of a mistake for Rational Investing enthusiasts to overstate the risks.
A 68 percent price drop is a serious thing. The fact that the historical data says that that is the price drop we need to be prepared for today is not a reality to be ignored. But a 68 percent price drop is not the end of the world. Do you know what happened on those three earlier occasions in which we experienced a average price drop of 68 percent? Stock prices shot up from the depressed levels that investors’ negative emotions had taken them. Lots of folks got rich in the aftermath of those earlier price drops.
Middle-class investors as a collective unit are likely going to experience a severe hit in years to come. Those positioned to survive the hit are likely going to amass large amounts of financial freedom quicky indeed in the aftermath.
Today’s Passion: If you’re not prepared for the good times just now beginning to be visible on the distant horizon, read the article entitled Stock Boom Facts and start salivating.
“I often note that, on the three earlier occasions on which U.S. stock prices went as high as they are today, we experienced an average price drop of 68 percent.”
It would be more correct to say that on three of the four earlier occasions in which U.S. stock prices went as high as they are today, we experienced an average price drop of 68 percent.
However, on the fourth and last occassion in which P/E10 valuations were as high as they are today, we experienced a price rise of 83 percent. This price rise occured from 2003 to 2007.
Schroeder
This price rise occured from 2003 to 2007.
We of course do not yet know how large the price drop will be for the time-period going forward from 2003. That is an information bit that will be revealed to us in coming days and weeks and months and years.
Rob
Ed Easterling has complementary articles at his Crestmont Research web site.
http://www.crestmontresearch.com/
http://www.crestmontresearch.com/pdfs/Stock%20Secular%20Chart.pdf
There is more than enough evidence to convince reasonable people, assuming that the market continues to behave as it has in the past (but not identically).
Have fun.
John Walter Russell
John:
Thanks for taking time out of your day to help us all out by providing those links.
Rob
Middle-class investors as a collective unit are likely going to experience a severe hit in years to come. Those positioned to survive the hit are likely going to amass large amounts of financial freedom quicky indeed in the aftermath.
Middle-class investors as a collective unit will only be able to get a total return equal to the market return minus costs. No amount of market timing or other investment games will change that fact.
Middle-class investors as a collective unit will only be able to get a total return equal to the market return minus costs.
I agree, Evidence.
Thanks for stopping by.
Rob
Those [middle class investors] positioned to survive the hit are likely going to amass large amounts of financial freedom quickly indeed in the aftermath.
There are lots of markets. Not everybody has to take a hit.
Cash makes a lot of sense today and there are choices even better than cash.
Have fun.
John Walter Russell
There are lots of markets. Not everybody has to take a hit.
Cash makes a lot of sense today and there are choices even better than cash.
Not every individual has to take a hit but as a collective unit they do.
If one investor reduces their exposure to stocks now, another investor must increase their exposure. You can’t lower your stock exposure unless you find someone else to buy. Someone will take the hit.
It is possible for a small minority of investors to avoid a sever hit, it is not possible for Middle-class investors as a collective unit to avoid the hit.
It is possible for a small minority of investors to avoid a sever hit, it is not possible for Middle-class investors as a collective unit to avoid the hit.
Fair enough, Evidence.
My hope is that it will be the small minority who read the material at this site who will be the ones avoiding the hit. That’s the thought that pops me out of bed in the morning.
Rob
If one investor reduces their exposure to stocks now, another investor must increase their exposure. You can’t lower your stock exposure unless you find someone else to buy. Someone will take the hit.
There are always two sides to a transaction. BUT the price is not determined until the transaction takes place.
Current prices are excessive. Stocks do not deliver the return that they should in a reasonable time frame.
Have fun.
John Walter Russell
Current prices are excessive.
I assume you mean that PE10 is too high. I think it’s about 21 right now. History says that’s high. Not outrageous but still high.
Stocks do not deliver the return that they should in a reasonable time frame.
Here is where I get confused. At M* on 10/10/06, in this message, you wrote that “there was a great buying opportunity in 2002.”
Shiller’s data shows that PE10’s lowest value in the year was 21.95. What you wrote implies that 21.95 in 2002 was low enough to expect great returns. Why should we expect poor returns when PE10 today is lower than that?
you wrote that “there was a great buying opportunity in 2002.”
These words were directed at John. It may be that he will be kind enough to respond on his own. I will put forward a few words here aiming to help people seeking to make sense out of what is being put forward here.
The point being raised by Videotape is valid and important. The long-term value proposition being offered by stocks in 2002 was horrible. The P/E10 value that applied at that time certainly did not represent “a great buying opportunity.”
My guess is that John was speaking in relative terms. When he wrote those words, the P/E10 value was much higher than what it was in 2002. Looking backwards from 2006, one might regret a failure to buy in 2002. Looking forward in an informed way from 2002, there was no buying opportunity. Looking forward in an informed way from 2002, long-term investors holding high stock allocations were looking at a great selling opportunity, not a great buying opportunity.
The world’s understanding of how stock investing works in the real world is at a primitive stage of its development in the year 2008. We have learned during the first six years of our discussions that investing is an intensely emotional endeavor. The work that John and I (and all of the hundreds of community members who have contributed in a constructive way) are engaged in is developing a rational approach to investing. That means going back to the fundamentals and even at times developing a new terminology. So long as we still have people using the old, discredited approach and the old, discredited terminology, there is going to be confusion over some points. The best way for us to deal with that is to do all that we can to encourage all to contribute in a positive and helpful and charitable spirit. Videotape’s basic point is well-taken, but I detect a bit of “Gotcha!” gamesmanship in his post and I have to say that that aspect of it leaves me cold (I am grateful for that aspect of his post in which he raises a legitimate and helpful point, to be sure).
I don’t want to put words in John’s mouth. However, I am confident from having read so much of his wonderful research that he fully appreciates the long-term risk involved in purchasing stocks at the sort of price levels that applied in 2002. John has been learning over the course of the past six years along with all the rest of us. My sense is that it would be fair to say that in the post linked to he spoke a bit carelessly. It is also the case that any fair-minded person trying to make sense of his position would have been able to do a far better job of it than Videotape did with his expression of “confusion.” If you read John’s research with even a tiny bit of care, you would not be suffering from such “confusion” re his views on the implications of a P/E10 level of 22, Videotape.
We all need to be working to get the sort of attitude we see in Videotape’s post diminished. Had the question been posed in a different way, the learning experience that followed from his post could have been greater. It is true that there were a lot of people thinking in 2006 that 2002’s prices looked awfully good in retrospect and we all learn from exploring why that was an illusion of short-term thinking. The attitude makes it harder to bring the community’s focus to that essential point, however. The attitude takes us in a bad direction.
Thanks for seeking clarification of the substantive point, Videotape. Please try harder to craft your posts so as to maximize learning experiences (both for yourself and for others listening in). Yes, you are right that there was no buying opportunity in 2002. You are wrong to suggest that John is required to be the first person in the history of humankind never to speak a bit imprecisely when trying to explain something to a fellow community member on a discussion board. Of the two errors, yours is the one that has caused our community far, far, far, far, far, far more damage over the course of the past six years.
Please think it over, Videotape.
And thank you again for raising the substantive point you raised, which is indeed an important one for all community members to ponder. We are indeed now back where we were in 2002. And today’s buying opportunity is no greater or worse than the one that presented itself to us then. We might shoot to the moon over the course of the next few years, as we did in the years immediately following 2002. Or we might crash hard. The Stock-Return Predictor reveals to us the range of possibilities and assigns rough odds to various points on the range based on an assumption that stocks may perform in the future at least somewhat as they always have in the past. Without John’s research, that tool would not today be available to middle-class investors.
Rob
P/E10 fell below 24, the point at which a person should begin buying stocks (Switching B) if he allows his allocation to go all the way to zero.
More recently, as a result of experience with the Scenario Surfer, I would maintain a minimum stock allocation of 20% at all times. (I now recommend a minimum stock allocation between 20% to 30%.)
Have fun.
John Walter Russell