A recent thread at the Lindauerheads board sets forth evidence that stocks are approaching fair-value price levels, according to the Tobin’s Q valuation assessment tool. Is stock investing safe again?
I say “no.” But we’re getting there.
Tobin’s Q is a valuations assessment tool with a sound theoretical basis and a good track record. I view the drop in the Tobin’s Q numbers as a significant development. There are smart people who today believe that stocks are no longer terribly overvalued.
Even the P/E10 valuation assessment tool, which I prefer, reports far better numbers than those that applied a few years back. The fair-value P/E10 number is 14 or 15. At the top of the bubble, we were at 44. Today we are at 23. We are not at the price levels at which informed long-term stock investors feel comfortable going with a high stock allocation. But we have made lots of progress.
The Tobin’s Q tool and the P/E10 tool are telling somewhat different stories. It’s worth taking note of that. But I don’t view it as a big huge deal. We are still in the early stages of developing the Rational Investing approach. We still have a lot to learn. It would not be reasonable to expect all of the analytically valid valuation-assessment tools to provide identical findings. I’m not even sure that it would be a good thing if they did. We need to take into consideration a variety of perspectives. The healthy thing is for some Rational Investors to point to the Tobin’s Q indicator, some to point to the P/E10 indicator, some to point to other indicators, and all to take a variety of perspectives into account in developing their own particular takes.
More important than the question of the differences between the two valuation-assessment tools is the question of whether it is reasonable to expect stocks to begin performing well once we get to fair-value price levels. The historical reality is that stocks always drop to price levels far below fair value in the wake of out-of-control bull markets. We saw the most out-of-control bull in history in the 1990s. Can we really feel safe betting our retirements on a hope that this time it will all turn out different, that this time we should expect stocks to begin a long-term upward move as soon as they touch fair-value price levels?
I don’t see that as being even a remotely safe way to proceed. It wouldn’t be a good idea to hold off on buying any stocks until we get to a P/E10 value below 10, as we usually do in the huge bear following a huge bull. But there’s a real risk that, if you buy heavily at fair value, you will see a 50 percent price drop before the emotional pain that will hit investors upon learning that Passive Investing has failed once again to work for the long term comes to an end. Even if we really are today at fair value, it is not necessarily a good idea to buy heavily into stocks just yet.
The other side of the story is that, if you got entirely out of stocks when prices went to la-la land, you probably should be inching your way back in today and planning a move to a significant stock allocation sometime over the next few years. I believe that P/E10 offers a better read of the realities than Tobin’s Q. But I am not sure. If it is Tobin’s Q giving the better read, it would be a mistake for most investors to stay entirely out of stocks too much longer. Stocks offer a strong long-term value proposition when purchased at fair-value price levels.
Perhaps the most important consideration is the emotional makeup of the investor making the allocation decision. If you have been following the Passive Investing model for some time, you are likely emotionally drained today and may need some time away from stocks to get your head straight and to start learning about more realistic investing strategies. I doubt that you’re missing a once-in-a-lifetime chance to get into stocks at good prices even if we really are at fair-value price levels today. The odds strongly favor a drop to price levels well below fair value in the wake of the sort of bull we experienced in the 1990s. So take your time before making a decision. Don’t make decisions in a panic. Work on feeling comfortable with valuation-informed strategies before making any dramatic moves.
If, on the other hand, you have long been a valuation-informed investor who has been longing for a chance to see prices good enough to justify purchasing stocks for the long term, and if you prefer Tobin’s Q to P/E10, you should be buying today. How about shifting to a stock allocation of 30 percent, or 40 percent, or 50 percent? You don’t need to jump from 0 percent to 70 percent in one fell swoop. Ease into things, continue to watch valuations, and move to a higher stock allocation when prices improve a bit more.
Personally, I want to see a likely 10-year return on stocks of at least 2 percentage points better than what I am getting from my TIPS and IBonds before moving into stocks. I view stocks as a risky choice until we see large numbers of investors giving up their attachment to the Passive Investing model. Can we really say that emotion has left the market until we see that happen? I am okay with taking on that risk if I am compensated for it. But for so long as stocks are offering a 10-year return no better than what is available to me from the super-safe asset classes, I don’t see the rational case for putting my retirement savings in jeopardy. We are still in the red-alert-danger-zone, according to the P/E10 tool. We still should be anticipating a price drop of 50 percent or more.
Things are changing, however. That’s the news that I take from the encouraging Tobin’s Q numbers. Stocks are still overvalued or at best fairly valued. But we are on our way to price levels at which stocks will again offer a very appealing long-term payoff. We all should be planning to up our stock allocations over the next few years. The smart investor avoids panic moves by using the historical data to anticipate what is likely coming in the next few years.
We still need a significant price drop for stocks to become an appealing long-term buy. But we no longer require two or three or four significant price drops to get to that magic place. We are closer to reasonable stock prices than we have been at any time since the mid-1990s. That’s good news indeed.
Today’s Passion: I argued in a recent blog entry that Stocks Might Be About to Take Off. How many times have the doom-and-gloomers been proven wrong in recent years?
Remember that Tobin’s q predicts returns ten years from now fairly well. So does P/E10.
Tobin’s q does not do a good job at five years. P/E10 does an adequate job, but nothing to brag about.
If people are looking for short term timing tools, they need to look elsewhere.
If people are looking to invest 100% or 0% and nothing in between, they need to start looking at reality.
Have fun.
John Walter Russell
Personally, I want to see a likely 10-year return on stocks of at least 2 percentage points better than what I am getting from my TIPS and IBonds before moving into stocks.
This corresponds to P/E10=18, a good choice.
Have fun.
John Walter Russell
One thing that is lacking in the referenced discussion board thread is any mention of confidence limits. There are a few comments about probabilities. But single point forecasts leave much too much to be desired.
Place confidence limits about a forecast and you are beginning to say something meaningful.
Identifying time frames and confidence intervals is NOT that difficult (for numbers types).
Have fun.
John Walter Russell
For new money or for money in recently purchased CDs, it comes to a P/E10 of 18. For me to sell any of the IBonds that I have paying 3.5 percent real, I would like to see a P/E10 of 15. At that price level, the most likely 10-year return on stocks is 5.6 real.
Rob