“Ironically, It Is the Promotion of Buy-and-Hold Strategies That Causes Prices to Get So Out of Whack As to Make Buy-and-Hold Dangerous. If Investors Were Encouraged to Practice Price Discipline, Prices Would Never Stray So Far From the Fair-Value CAPE Value and Investors Would Rarely Need to Change Their Stock Allocations. It Is a Widespread Belief That Buy-and-Hold Can Work That Makes Buy-and-Hold Dangerous.”

Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:

“The CAPE value of 16 is the long-term CAPE value. ”

You tell us repeatedly that the SWR is not always the same number but you seem to think that the fair value CAPE number is always the same.

Yes. That’s very good. I like that comment a lot.

The Buy-and-Holders and the Valuation-Informed Indexers have different ideas as to what is stable and as to what changes.

Buy-and-Holders and Valuation-Informed Indexers agree that the average long-term return is 6.5 percent real. There’s no dispute re that one.

The Buy-and-Holders believe that risk is constant. This is why they believe that stocks are always worth buying. Stocks are generally an amazing asset class. If stocks are generally an amazing asset class and if risk is stable, then you should always go with a high stock allocation. The logic follows. And that of course if why Buy-and-Holders believe that the safe withdrawal rate is always the same number. The safe withdrawal rate is a risk-assessment tool. If risk is stable, the safe withdrawal rate is indeed always the same number.

Valuation-Informed Indexers believe that risk VARIES. So we of course believe that the safe withdrawal rate varies.

Identifying the fair-value CAPE number is just a math exercise. 16 is the median of all the CAPE values we have seen. Sometimes it goes higher and sometimes it goes lower. It always ends up at 16.

You are suggesting that there might be some economic circumstances in which the CAPE value would change. If our economic system became more productive, the fair-value CAPE value would be higher. That’s certainly fair to say. There’s no law that says that it will always be 16.

But of course there is no way to know in advance whether any portion of today’s scary CAPE value is attributable to increased productivity. It is possible that that is so. I certainly don’t have any problem with someone saying: “I think productivity has increased, so I am going to use a fair-value CAPE value of 18. That’s up to the investor. That’s fine.

But please note that that is subjective. Some investors may think that productivity has increased ans some may think that it has declined. They are all entitled to their opinions. But no one can state definitively that they are right on that question. “16” is my effort at identifying a neutral number. It is the average CAPE in the historical record. I don’t object if someone uses 18 or 14.

I have a problem when someone says that there is no need to make a CAPE adjustment when determining the value of their portfolio. Stock prices increased 126 percent from 1996 through 1999. Huh? What the f? Is there any reasonable person who thinks that all of those gains were the product of economic growth? I sure don’t. I think that the vast majority were the product of a runaway irrational exuberance.

That affects the determination of the safe withdrawal rate. If you believe that that 126 percent price increase was the product of economic growth, then you believe that the safe withdrawal rate in 2000 was 4 percent. If you believe that most of that 126 percent price increase was the product of irrational exuberance, then you believe that the safe withdrawal rate in 2000 was 1.6 percent.

Again, there are two schools of thought. One school believes that the market is efficient and thus risk is constant and there is no need for investors to practice price discipline (long-term timing). The other believes that valuations affect long-term returns and that risk is thus variable and it is essential for investors to practice price discipline (long-term timing) if they are to have any hope whatsoever of keeping their risk profile roughly constant over time.

Ironically, it is the promotion of Buy-and-Hold strategies that causes prices to get so out of whack as to make Buy-and-Hold dangerous. If investors were encouraged to practice price discipline, prices would never stray so far from the fair-value CAPE value and investors would rarely need to change their stock allocations. It is a widespread belief that Buy-and-Hold can work that makes Buy-and-Hold dangerous. Telling investors that it is okay not to exercise price discipline is like ripping the brakes out of a fast-moving car. Valuation-Informed Indexing puts the brakes back in and makes for a much more enjoyable long-term ride.

Rob