Reactions to Pfau Silencing

Economics Professor Valeriy Zakamulin: “I Do Believe That Stock Returns Are to Some Extent Predictable, Both in the Short- and Long-Term. But I Do Not Accept that Stock Returns Are Highly Predictable. My Model Predicted Better Than the Shiller P/E10 Model Post-1960.”

May 14, 2013 by Rob

I have been letting lots of people know about my article reporting on The Silencing of Academic Researcher Wade Pfau by The Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of Valeriy’s response to the e-mail of mine detailed in the earlier blog entry:

Rob:

First of all, you forget that I do believe that the stock returns are to some extent predictable, both in the short- and long-term. But I do not accept that the stock returns are highly predictable. Just read my paper about the secular mean reversion and long-run predictability of stock returns. In this paper I actually show that my model predicted better than the Shiller’s PE10 model post-1960.

Second, when it comes to the fixed interest rate securities like CDs and bonds, you need to understand that for an investor who holds them till maturity the return is positive and known in advance. Hence, in this case CDs and bonds are completely risk-free. If you bought a CD or a bond in 1980-82, this security would provided you 12-15% annual fixed return till maturity. That is why many investors switched to fixed income securities at that time.

Third, Shiller in 1981 wrote a paper about excessive stock volatility (compared to some particular rational model). As far as I know he wrote a paper (co-authored by Campbell?) about his model that uses PE ratio only in 1998. In this paper they warned about a huge overvaluation in the stock market.

Finally my comment on the following: I would not be inclined to set my bond allocation by “the current secular trend in the bond market.” I would compare the long-term value proposition available from bonds with the long-term value proposition available from other asset classes and go with the asset class offering the better deal. My view is that all investors should be seeking the asset classes that offer the best returns at the lowest risk.

I believe this is a huge mistake if we agree that the stock and bond returns are predictable. If you believed that stocks would provide you with 6.5% annual average return (computed using 140 years of data) and use this estimate to invest in 2000 for about 10 years, you would be way off your expectations. If, on the other hand, in 2000 you used last 20 years to compute the average stock return and supposed that during the next 10 years the stocks provided the same average return, again you would be way off your expectations. The same examples can be constructed for the bond investing. A more wiser approach to stock and bond investing is to take into account the model that use the predictability of stock and bond returns.

Valeri

Economics Professor Valeriy Zakamulin: “In 1982 the Yield on 10-Year Government Bonds Approached 15% Annual. This Was Much More Than One Could Get From Risky Stocks, the Prices of Which Has Been Decreasing From About 1966. No Wonder the P/E10 Dropped to About 7 at That Time.”

May 13, 2013 by Rob

I’ve been letting lots of people know about my article reporting on The Silencing of Academic Researcher Wade Pfau by The Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of the e-mail sent by Valeriy in response to the e-mail of mine detailed in the earlier blog entry:
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Rob:

My comment on the following:

“Which would you say were riskier in the early 1980s, stocks or CDs? I would say that CDs were far riskier. Inflation could have wiped out your returns. Stocks are virtually risk-free when they are selling at the prices that applied at that time. The likelihood was that valuations would rise dramatically over the next 10 years and the investor would obtain a return of something in the neighborhood of 15 percent real per year. In a worst case scenario, valuations would remain at insanely low levels and the return would be “only” 6.5 percent real. The only risk that I can see is the risk that the economy could have collapsed. But, if that happened, CDs would not pay off either. So the risk of stocks was certainly less than the risk of CDs at that time.”

First of all, we know about this only a-posteriori.

Second, about year 1980, you probably forget that at that time the short and long interest rates were sky-rocketing. You could get about 10% annual completely risk-free return from CDs. In 1982 the yield on 10-year government bonds approached 15% annual. This was much more than one could get from risky stocks, the prices of which had been decreasing from about 1966. No wonder that the PE10 dropped to about 7 at that time: investors sold stocks and bought bonds instead. And note that it was completely rational!

Third, when you talk about stock risk, you’d better mention that you are talking about long-run risk, not short-run. If you bought stocks in 1980 and held them till 1982, you would lose. Of course, if you bought stocks and held them for about 10-20 years, you would greatly multiply your initial investment.

I see that you focus mainly on stocks and forget about secular trends in bonds. Bonds, as stocks, also have secular bull and bear markets, and stock returns depend on whether it is a secular bull or a secular bear market in bonds. How much to allocate to bonds also depends on the current secular trend in the bond market.

Valeri

I replied:

Valeri:

On point after point, the same basic dynamic applies. If you ASSUME investor rationality, Buy-and-Hold and all the conventional investing wisdom makes perfect sense. If you ASSUME that investor emotions are the dominant influence on stock prices, Buy-and-Hold is the most dangerous strategy ever concocted by the human mind. It is the fundamental assumption that determines where your logic leads. Experts in this field spend all of their time debating the end points of their analyses. They need to examine the fundamentals. That’s where the action is (in my view!).

Did you ever look at how the people posting at liberal web sites respond to political developments in contrast to how people posting at conservative web sites respond to them? You would think these two groups of people were living in different worlds or seeing different fact patterns play out. They view the world from fundamentally different perspectives. Both sets of people are entirely sincere. It is the starting-point world view that determines what they see when they look at the world. So it is with Buy-and-Holders and Valuation-Informed Indexers.

You say “we know about this only a-posteriori.” That’s a Buy-and-Hold mindset speaking, Valeri (I mean no offense, please understand that I have the greatest respect in the world for all of my many Buy-and-Hold friends). You find it hard to accept that long-term stock returns are highly predictable and that investors could be so irrational as not to take advantage of this reality. So, when stocks perform in highly predictable ways, you look for reasons why investors did not act as they “should” have. The reason is that investors are not rational! They want to be. They could be a lot more rational than they are today. But to become more rational, they need more experts encouraging them to learn about what the last 30 years of academic research shows and to take advantage of tools that help them make practical use of this research and all this sort of thing. Investors cannot learn about these findings in the absence of hearing about them. We need to tell people about them and we need to encourage people to talk the findings over. Then investors will gradually become more capable of rational choices, to everyone’s benefit.

All of the key things we “know” today about how stock investing works, we “knew” in the early 1980s. We now have 140 years of historical data available to us . In 1982, we had only 110 years of historical data available to us. But the message was precisely the same. Shiller didn’t publish his research showing that valuations affect long-term returns in 2011. He published it in 1981. The research and the data said the same thing then that it says now. It said that long-term timing is absolutely required, that any investor who fails to engage in long-term timing has zero chance of seeing his investing strategy work out well in the long term. Why? Because practicing long-term timing is nothing more or less than exercising price discipline and no market participant can do well without exercising price discipline. That’s Lesson #1. Nor can any market work if the majority of participants in it fail to exercise price discipline. Price discipline is the thing that makes markets work. Take price discipline out of the equation and you have a dysfunctional market and the price crashes and the economic crises that follow from that.

I very much disagree that 10 percent returns were available risk-free from CDs in the early 1980s. Do you know of any peer-reviewed academic research that tells us how to predict long-term CD returns? I do not. So you are always taking on inflation risk when investing in CDs. This is not so with stocks. The U.S. economy has for 140 years been sufficiently productive to support returns of 6.5 percent PLUS inflation and, at times of insanely low prices, the return naturally goes up to 15 percent real. It is not possible to obtain similar returns from CDs on a risk-free basis. Stocks offered a far better long-term value proposition than CDs in the early 1980s, according to the academic research (in my assessment!).

You say “no wonder that the P/E10 dropped to about 7 at that time,” suggesting that the reason was the price drops we were seeing from 1965 forward. You are ignoring the effect of the relentless promotion of Buy-and-Hold strategies by the “experts” in this field! Say that Shiller has published his research in 1971 instead of 1981 and that we all had been promoting Valuation-Informed Indexing all along. In that case, investors would have responded to the lower stock prices in the same way they respond to lower prices for any other good or service they buy in this consumer wonderland of ours. They would have gotten excited about the lower prices and increased their darned stock allocations! That would have brought those insanely low stock prices back up to reasonable levels in no time flat. It is the relentless promotion of Get Rich Quick/Buy-and-Hold strategies that causes insane price levels like that (and all the human misery that goes with the unemployment rates we see at times when we permit the heavy promotion of such doomed strategies). Had we all been telling people all along what we learned from Shiller’s research, none of this would have posed any problem whatsoever.

I of course disagree that it was “completely rational” for millions of investors to sell their stocks at a time when the most likely 10-year annualized return was 15 percent real. I see it just the other way around. I see it as rational for investors to increases their stock allocations when the long-term value proposition is outstanding and to decrease them when the long-term value proposition for stocks is worse than it is for no-risk asset classes.

You are 100 percent correct that I am talking about long-term strategies, not short-term strategies. Shiller’s research confirms the Buy-and-Hold finding that short-term timing never works. I view that insight as the second most powerful investing insight in history. None of what I am talking about works in the short term. In fact, in the short term, Valuation-Informed Indexing is often a total disaster (look at what happened from 1996 through 1999 for a recent, real-life illustration of the point). This stuff does not work in the short term. That point cannot be emphasized enough. I believe that much of the confusion re these points is that investors have a natural but unfortunate inclination to focus on the short term and there is so much money to be made in this field by appealing to this unfortunate inclination that most “experts” in the field feel pressured to rationalize the promotion of strategies that are precisely the opposite of the strategies they would recommend if they used the last 30 years of peer-reviewed academic research as their guide.

You say that an investor who bought stocks in 1982 and then held for 10 to 20 years would do very well. This is so. But is it because the investor followed a Buy-and-Hold strategy or is it because stocks were priced to deliver outstanding long-term returns in 1982? I say that it is the latter. Buy-and-Hold can APPEAR to work for a time. But it only works when stocks are priced to deliver a strong long-term value proposition. Buy-and-Holders don’t sell when the long-term value proposition turns bad. So they eventually give up most of the gains they enjoyed in earlier years. It is because Valuation-Informed Indexers don’t do this that they are able to retire so many years earlier. The Valuation-Informed Indexers go with the same high stock allocations as the Buy-and-Holders during the years when stocks offer a strong long-term value proposition. But they lower their stock allocations when the long-term value proposition for stocks is no longer there. So they never experience the portfolio wipeouts that are eventually experienced by EVERY Buy-and-Holder (there has never yet been an investor who followed a Buy-and-Hold strategy for an investing lifetime and did not see most of the accumulated gains of a lifetime wiped out at one point — this has never once happened to any Valuation-Informed Indexer). The only difference between the two strategies is that the Valuation-Informed Indexers retain a far higher percentage of their gains and thus feel a far greater emotional peace about the investing experience than the Buy-and-Holders, who pretend for a time that their bull market gains are real and then suffer great emotional angst as the phony gains disappear into thin air in the secular bear brought on by the relentless promotion of Buy-and-Hold strategies.

Finally, I would not be inclined to set my bond allocation by “the current secular trend in the bond market.” I would compare the long-term value proposition available from bonds with the long-term value proposition available from other asset classes and go with the asset class offering the better deal. My view is that all investors should be seeking the asset classes that offer the best returns at the lowest risk. If all investors did this, the investing markets would work as well as other markets, in which market participants do precisely this. It is this idea that investors should follow entirely different sets of rules that cause all the trouble. Investors need to be informed about what works to be able to invest effectively and investors need to invest effectively for our markets to stabilize and remain healthy.

It all makes sense — But only from the perspective of someone who has rejected the conventional idea that investors can invest rationally without taking price into consideration when making purchase decisions. If you ASSUME that rationality is possible without price discipline, you will end up in a very different place. My question to you is — Is that because the other place is the right place or is it because your starting-point ASSUMPTION could never permit you to arrive at any other destination?

Please do not take any of this personally. I like you and I respect you just as I like and respect all of my many Buy-and-Hold friends. I interpret your questioning as a sincere desire to figure out where I am coming from and so I am trying my best to be as frank as possible while also being as polite and warm and respectful as is obviously appropriate. I hope you will hear these words in the spirit in which I am sending them your way, my new friend.

Rob

Economics Professor Valeriy Zakamulin: “What You Basically Say Is That an Index Portfolio Should Eliminate All RIsk. This Is Somewhat Related to the Old Markowitz Idea of Diversification — When You Put Together Lots of Stocks, the Risk Decreases.”

May 10, 2013 by Rob

I have been letting lots of people know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Rob:

My comment on the following: I don’t agree that the thing that stock investors are being paid for is a willingness to take on risk. I believe that this idea became popular in the days before index funds. Then there really was risk — the investor was sharing in the fortunes or lack thereof of the company in which he bought shares of ownership. Indexing changes all that. When you buy an index fund, you are buying a share in the productivity of the U.S. economy. That economy has been sufficiently productive to produce an annual return of 6.5 percent real for 140 years now.

What you basically say in this paragraph is that an index portfolio should eliminate all risk. This is somewhat related to the old Markowitz’ idea of diversification: when you put together lots of stocks, the risk decreases. If the stock returns were mainly independent of each others, in this case all risk could be eliminated and a large portfolio of stocks would be effectively riskless. However, this does not happen in reality. No matter how many stocks you put together, the risk decreases to some particular level only.

Last but not least, what about bond investing? Often one advocates for a portfolio of 60% in stocks and 40% in bonds. Roughly 50-50. What are your thoughts on bond investing? Do you also have similar ideas on how to educate investors about the dangers of bond investing?

Valeri

I replied:

Valeri:

Thanks for raising more intelligent challenges!

Yes, I certainly agree that diversification reduces risk. It drives me crazy when Buy-and-Holders say that there is no such thing as a free lunch. The diversification achieved through indexing is the ultimate free lunch. And Bogle is the guy who championed index funds. So it seems to me that Bogleheads should be celebrating free lunches on a daily basis. Yet many express skepticism about them. It is my belief that free lunches are wonderful and that we should all gobble them down when we discover them!

You say “this doesn’t happen in reality.” I say it DOES happen in reality. Wade’s research shows that Valuation-Informed Indexing reduces the risk of stock investing by close to 70 percent (the Maximum Portfolio Drawdown Percentages drops from 60 percent to 20 percent). That’s huge. And we are still in the early years of the transition. Once all investors have been educated about the implications of Shiller’s findings, the volatility of stock prices will be dramatically reduced from what it was during the time-period examined by Wade. That will bring stock risk down further. I don’t believe that we will ever get to zero risk. But I don’t think it is fair to say that there is zero risk for CD investors either. I see no reason why it would not be possible to bring stock risk down to something only a bit greater than the risk that applies for CDs.

Which would you say were riskier in the early 1980s, stocks or CDs? I would say that CDs were far riskier. Inflation could have wiped out your returns. Stocks are virtually risk-free when they are selling at the prices that applied at that time. The likelihood was that valuations would rise dramatically over the next 10 years and the investor would obtain a return of something in the neighborhood of 15 percent real per year. In a worst case scenario, valuations would remain at insanely low levels and the return would be “only” 6.5 percent real. The only risk that I can see is the risk that the economy could have collapsed. But, if that happened, CDs would not pay off either. So the risk of stocks was certainly less than the risk of CDs at that time.

The 60/40 stuff is the the product of the conventional model for understanding how stock investing works. This is the sort of thing that was discredited by Shiller’s research. Please note that the subtitle of his book refers to his findings as “revolutionary.” That means that these old ideas get pulled up by the roots. If valuations affect long-term returns, there is no one stock/bond allocation percentage that makes sense in all valuation scenarios. There are some valuation levels at which it makes sense to be 80 percent in stocks and there are other valuation levels at which it makes sense to be 20 percent in stocks. There never can be any one rule-of-thumb allocation percentage because the #1 goal is for the investor to keep his risk profile constant and, if valuations affect long-term returns, risk VARIES with changes in valuation levels. Shiller’s finding that valuations affect long-term returns turned the conventional wisdom on its head. We are today only in the early stages of coming to terms with the implications of his findings. That’s why this stuff is so “controversial” today.

I believe that the most important thing is that investors limit themselves to investment choices that they understand well. The reason why this is so important is that even the best investing strategies often pay off only in the long run, so investors MUST have enough confidence in their strategies to stick with them for the long term. Investors who have the time and skill and inclination to study bonds can invest in them successfully. The asset class has a place. But most middle-class people know little about bonds. Thus, they should not be invested in bonds, in my assessment.

I like stocks as a growth-oriented asset class. I think that 80 percent of investors should invest only in index funds. At times of high valuations, investors need an alternate asset class that counters stocks effectively. I see TIPS and IBonds as better choices than conventional bonds for the alternate asset class. The reason is that bonds are subject to inflation risk while TIPS and IBonds are not. People worry that there are times (like today) when TIPS and IBonds pay low returns. That’s not a problem because stocks pay high-enough returns when purchased in a valuation-informed way to finance a middle-class retirement. The investor should use the P/E10 metric as a guide to know how much to shift his allocation from stocks to TIPS or IBonds as valuations rise. Then, when stocks are again offering a strong long-term value proposition, he should return to his high stock allocation.

This calculator (The Investor’s Scenario Surfer) permits the investor to see how this strategy has worked over a 30-year time-period throughout history:

http://www.passionsaving.com/portfolio-allocation.html

I have zero problem with bonds or real estate or any other asset class for those investors who are willing to study alternate asset classes enough to understand well how they operate. But I believe that the typical middle-class person needs a smart, safe, simple strategy. This is why I rank Bogle as the second most important investing analyst of all time (second only to Shiller). Bogle aims to serve this middle-class need, which most others have ignored. His only mistake, in my view, was his failure to take valuations into consideration. That is critical. But, with that exception, I am a Boglehead all the way.

A simple way to think of Valuation-Informed Indexing is that it is the investing strategy that combines Shiller’s key insights with Bogle’s key insights. I like to argue that Shiller and Bogle go together like chocolate and peanut butter!

Rob

Economics Professor Valeriy Zakamulin: “If Stocks Are No Longer Risky, They Should Provide the Same Return As Money Markets.” Rob Bennett: “You Are Touching on the White-Hot Core of the Dispute.”

May 9, 2013 by Rob

I have been contacting numerous people to let them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by The Buy-and-Hold Mafia.

Yesterday’s blog entry reported on the correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of the e-mail sent to me by Valeriy in response to the e-mail of mine detailed in the earlier blog entry:

Rob:

My comment on the following: “My view is that we are on the verge of a huge breakthrough. We now know how to assess risk effectively (look at the P/E10 value!). Once we know how to assess risk effectively, we know how to eliminate risk. There is no reason why stocks need to be a risky asset class. We made them a risky asset class for many years because of our ignorance of the realities. “

You see, the basic postulate in finance, and it is completely rational, is that “no reward without risk”. Since stocks are risky, then they need to provide a higher (expected) rate of return than money markets. This is what we actually see looking back at the history, namely, stocks provided higher returns than bonds and money markets. Without any risk, if stocks are no longer risky, they should provide the same return as money markets. What is the point to invest in stocks in this case?

Valeri

I replied:

Valeri:

You are touching on the white-hot core of the dispute with this one.

I don’t agree that the thing that stock investors are being paid for is a willingness to take on risk. I believe that this idea became popular in the days before index funds. Then there really was risk — the investor was sharing in the fortunes or lack thereof of the company in which he bought shares of ownership. Indexing changes all that. When you buy an index fund, you are buying a share in the productivity of the U.S. economy. That economy has been sufficiently productive to produce an annual return of 6.5 percent real for 140 years now. So in all likelihood that’s roughly what you are going to get (provided you don’t overpay or underpay for your shares). The number could change a small bit in either direction. But with an advanced economy dramatic changes in either direction are unlikely. The investor is being paid for the use of his money, which is put to productive uses. His money is essentially being rented and his return is the rental fee. You give up control over the money for a period of time and in return you get an annual return of 6.5 percent real, plus or minus whatever adjustment is needed to reflect the fact that the shares were overpriced or underpriced at the time you made the purchase.

It’s true that, when investors come to realize that index funds purchased in a valuation-informed way are not significantly more risky than Certificates of Deposit (CDs), the disparity in return on stocks and on CDs will need to tighten. But this doesn’t necessarily mean that the return on stocks will drop; the tightening can be achieved by a rise in the return on CDs. The return on stocks is set by the productivity of the U.S. economy. The return on CDs is set by the need of the banks offering them for sale to offer a return high enough to attract the investors needed to purchase their offerings. Here it is the PERCEIVED risk (NOT the actual risk) of stocks that matters. Stocks have never in history been as risky as they were in 2000 (when prices are at three times fair value, prices are certain to fall hard in coming years). So, according to the conventional theory, stocks should have been offering amazing returns at the time to compensate for the insane level of risk being taken on by investors. The reality is that the most likely annualized return 10-year return on U.S. stocks at the time (as determined by a regression analysis of the historical return data) was a negative 1 percent real (See The Stock-Return Predictor). TIPS and IBonds and CDs were at the time offering a return of 4 percent real. That’s a differential of 5 points real of return each year for 10 years running, a total penalty for the stock investor of 50 percent of his starting-point portfolio value. Where’s the compensation for buying stocks at the riskiest time to own them in U.S. history?

The reason why we had an equity risk PENALTY at the time is that the PERCEIVED risk of stocks was low. Buy-and-Hold was being pushed relentlessly at the time and millions of investors had become convinced that there was no need to consider price when setting their stock allocations. In fact, many investors had come to believe that the only possible risk in stock investing was the risk associated with a lowering of one’s stock allocation! Investors act on perceived risk, not real risk. In 1982, when risk was nil (prices cannot drop lower when they are already at one-half of fair value and the investor obtains a return of 6.5 percent real when prices remain at fair-value levels), the most likely annualized 10-year return was 15 percent real. There was no need to compensate stock investors for taking on actual risk at this time. But there was a great need to compensate them for taking on perceived risk. Perceived risk is always greatest when real risk is lowest (because it is low prices that cause investors to fear stocks).

If we educate investors to the realities and stock valuations stabilize, the risks of stock ownership will drop to levels not much higher than the risks of owning CDs. Banks will no longer be able to sell CDs providing returns far below the returns available from stocks in an environment in which stocks are no longer perceived as carrying much more in the way of risk (the appeal of CDs today is their low perceived risk). So they will have to increase the returns paid by CDs. They of course can do this since the money obtained by selling CDs can be put to equally productive uses as the money obtained by offering shares of stock. Banks indeed HAVE paid high returns on CDs at times like the late 1990s when the perceived risk of stocks was so low that there was no other way to market the CDs. The reason why CD rates are so low today is that the perceived risk of stocks in the minds of many investors is high and these investors are willing to accept low returns to escape that perceived risk.

It is true that on an overall basis the historical record shows a higher return for stocks and more risk for stocks. This is why many have come to believe that stocks pay higher returns BECAUSE of the higher risk attached to them. But index funds have only been available since 1976. We are still in the early stages of thinking through how this entirely new asset class operates. And the historical record does NOT support the conventional view of risk when you compare risk and return offered at particular times. At particular times, there is a negative correlation. High prices mean high risk and low returns. Low prices mean low risk and high returns.

Again, these are merely the sincere views of a non-expert who has spent a lot of time trying to understand conflicts and weaknesses in the conventional understanding of stock investing. I believe what I am saying here. But I am just one guy who never studied investing in school and who never managed a fund and I of course could be partly or entirely wrong.

I thank you again for your willingness to engage in a back-and-forth discussion that I find highly stimulating.

Rob

“Investors Should ALWAYS Aim to Keep Their Risk Profile Right. Whether the Economic Outlook Is Bright Doesn’t Matter — That Is Cooked Into the Price, So It Doesn’t Need a Separate Analysis.”

May 8, 2013 by Rob

I have been writing many people to let them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of my reply to the e-mail detailed in the earlier blog entry:
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Valeriy:

Re the first point — You’ll get a different result if you factor in whether the fair-value P/E10 number appears on the way up or the way down. When we see a P/E10 of 15 on the way up, the P/E10 that applies 10 years later is always a good bit higher. When we see a P/E10 of 15 on the way down, the P/E10 10 years later is always lower. It’s not the number alone that matters. You need to take into consideration what type of investor emotion it is that produced the number. It’s no failing of P/E10 that it doesn’t produce good predictions from a fair-value start for those who do not take investor emotions into consideration. That’s a failing on the part of those performing the analysis. P/E10 always works for those willing to consider both numbers and emotions, both of which are critical aspects of the stock investing story.

Re your second point — I believe that investors should ALWAYS aim to keep their risk profile right. That’s the key to success. Whether the economic outlook is bright doesn’t matter — that is cooked into the price anyway so it doesn’t need a separate analysis. This all comes down to risk management, in my assessment. The P/E10 value is telling us how risky stocks are. If all investors aimed to keep their risk profiles constant (they would if only we would tell them how to do it), stock prices would always self-correct and all would be well. Fama was right that the market WANTS to be efficient. What makes it inefficient is the Social Taboo that says that we must not tell people about the dangers of going with high stock allocations at times of insanely high P/E10 values. We want to be rational. But we cannot pull it off without access to good information and those of us who understand the realities dare not provide good information in light of the intense social pressures imposed on us not to speak too clearly about these matters.

My view is that we are on the verge of a huge breakthrough. We now know how to assess risk effectively (look at the P/E10 value!). Once we know how to assess risk effectively, we know how to eliminate risk. There is no reason why stocks need to be a risky asset class. We made them a risky asset class for many years because of our ignorance of the realities. But we have overcome our ignorance over the past 50 years. Now we just need to give ourselves permission to talk through and think through all that we have learned and to share the insights we have developed with all interested parties without apology or hesitation.

I don’t think that a wise use of P/E10 ever calls for getting entirely out of stocks. It never predicts short-term results and short-term results matter. P/E10 is a risk-management tool. Should investors have lowered their stock allocations in 1996? Absolutely. Should they have gone to zero stock allocations? No. The aim should have been to keep their risk profiles roughly stable. So an investor who properly went with an 80 percent stock allocation in 1982 might properly have gone with a 20 percent stock allocation from 1996 forward. But not zero.

Please note that those who dropped to 20 percent stocks in 1996 are ahead of the game today. And they will be even more ahead of the game after the next crash. And the differential will grow and grow over the decades of compounding to come. Wade’s research shows this:

http://mpra.ub.uni-muenchen.de/29448/

Please understand that I am only stating my sincere views. I obviously do not know it all. I have been wrong about important things in the past and it could be that it is happening again. I am telling you what I believe because you are asking good questions and I love to be able to share this stuff, which I view as being very important. But I am not trying to say that I know it al. We need to have everyone sharing his or her sincere views if we are to hope that as a society we can advance in our understanding of this stuff. I am certainly grateful for the challenges to my thinking that you have advanced in our e-mail communications. They force me to think and to reconsider points where I may have made mistakes. But you need to know that I am biased. I cannot help it.

Rob

Economics Professor Valeriy Zakamulin: “If the Bubble Occurs, It Is Rational to Participate In It”

May 7, 2013 by Rob

I’ve been e-mailing lots of people to let them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of an e-mail sent by Valeriy in response to the e-mail of mine detailed in the earlier blog entry:

Rob:

First of all I would like to comment the following:

The right way to think about this (in my view!) is that P/E10 tells you the extent of risk in the market. It never identifies the precise return that will apply in 10 years. It always identifies the range of possible returns (the range is 6 points in either direction — when prices are at fair-value levels, the range is from an annualized 10-year return of 0 on the down side to an annualized return of 12 percent real on the up side) and assigns rough probabilities to an actual outcome falling at any point on the range of possibilities (the most likely 10-year outcome starting from a time of fair-value prices is an annualized return of 6 percent real).

What I am telling in this context is that if the PE10 ratio is way too high or way too low, then the precision of your forecast (the range of possible outcomes as measured for example by plus minus one standard deviation) is rather good. If the PE10 ratio is close to its long-run mean, then the range of possible outcomes is too wide to be useful for forecasting.

My comment on the following: If we tell people how stock investing works, we will never see such extreme P/E10 values again. Once we get the word out, stock prices become self-regulating. If people understand that they MUST change their stock allocations in response to big price swings, each swing upward will bring on sales and those sales will pull prices back to fair-value levels again. There can never be another bull market or another bear market once we permit open discussion of Shiller’s findings.

First of all, it seems to me that we agree that people are not fully rational. Second, it will not be correct to say that it is rational that the PE10 ratio should always be about 15. In a rational expectation model the value of PE (hence PE10) depends on some, sometimes unobservable, parameters. For example, the investor’s risk aversion, the derivative of which is the market price of risk. Third, I do believe that the Shiller’s work did its job, now many people understand that it is not rational to have a PE10 value of 44. Forth, despite this, even in a rational expectation framework if the bubble occurs, it is rational to participate in it. As an example, image that you are in 1993 and you see a bubble in the stock market, yet the economic outlook is very bright, the investors’ optimism is high, and it looks like the bull market will continue for a long time. Will you get out of the stocks and miss the bull market till 2001? I doubt.

Valeriy

“We Were at 3x in 2000. We Will Be at 0.5x When This Is Over. That’s a Loss for Every Stock Investor of Five-Sixths of His Accumulated Wealth of a Lifetime.”

May 6, 2013 by Rob

I have been contacting numerous people to let them know about my article on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of my response to the e-mail detailed in the earlier blog entry:

Valeriy:

I get what you are saying here and I agree with most (but not quite all) of it.

I 100 percent agree that excessive P/E10 values over-correct. That is a hugely important point and one that even many who believe in P/E10 do not get.

The important question (in my mind) is — Why?

I believe that P/E10 is reporting to us the state of investor emotions. In 2000, we were insanely in love with stocks. So the nominal price at the time was at three times the true and lasting value (let’s call it 3x). The REASON why prices always over-correct is that the drop from 3x to x is emotionally devastating. The drop from 3x to x causes a loss of $12 trillion of buying power in our economy. That loss causes tens of thousands of businesses to fold and puts millions of employees out of work. The economic destruction causes us all to lose hope for the future. Our despair causes us to lose hope that stock prices will ever recover. So the P/E10 value falls not to fair-value (15) but to one-half of fair value (7 or 8). There has never been an exception to this rule. Every secular bull market has produced a secular bear market that put us at 7 or 8.

Please consider what this means in the current context. We were at 3x in 2000. We will be at 0.5x when this is over. That’s a loss for every stock investor of five-sixths of his accumulated wealth of a lifetime (assuming a 100 percent stock allocation — you need to lower the loss to reflect the percentage of a portfolio not in stocks in 2000). This is why it is so imperative that we get word out re all this. To get to a P/E10 of 7 would take another 65 percent price drop over the next few years. That would put us in the Second Great Depression.

But this is 100 percent optional Great Depression! A P/E10 of 7 is as insane as a P/E10 of 44. If we tell people how stock investing works, we will never see such extreme P/E10 values again. Once we get the word out, stock prices become self-regulating. If people understand that they MUST change their stock allocations in response to big price swings, each swing upward will bring on sales and those sales will pull prices back to fair-value levels again. There can never be another bull market or another bear market once we permit open discussion of Shiller’s findings. We want people to invest in a rational way. But people cannot be rational without easy access to good information and the idea that is constantly pushed that timing is in some way a bad thing causes those who understand how important long-term timing is to keep their mouths shut about it. So investors do not today have access to the information they need to make intelligent choices.

Stock prices cannot be precisely predicted at ANY P/E10 level. That is because prices are determined by emotion in the short term (up to ten years) and by economic realities in the long-term (over 10 years). The price that applies at any given time is a combination of short-term and long-term effects. Long-term prices are to a large extent predictable but not fully so because prices are always at least to some extent influenced by the investor emotion that applies at the moment and this is never predictable at all (emotion is irrational and thus cannot be predicted). Some people say that the r-sqaured for P/E10 does not show a large enough correlation. It shows the precise amount of correlation that we should expect if the Shiller model is accurate! We should not expect a perfect correlation because Shiller says that emotion affects prices in the short term and so the short-term aspect of any price should never be predictable. The market behaves exactly as we would expect it to behave in a world in which Shiller’s understanding of how the market works is the right one.

People have a hard time relating to this because we are all accustomed to focusing on the short-term, what will happen in the next year or so. The Buy-and-Holders showed that that is a waste of time (I believe they are right that short-term timing never works and I believe that this was a major advance). What the Buy-and-Holders missed is that long-term outcomes are nothing at all like short-term outcomes. Long-term outcomes are HIGHLY predictable. Buy-and-Holders advise against all forms of timing because they believe that risk is stable and thus the best bet is to maintain a constant allocation. Valuation-Informed Indexers believe that risk is variable and that the key strategy imperative is to keep one’s personal risk profile constant and this REQUIRES long-term timing. If long-term timing works, staying at the same allocation at all times is an insanely risky choice. It is ALWAYS going to produce a wipeout sooner or later. And, indeed, in the historical record we see just this. Those who remain at a high stock allocation ALWAYS experience at least one wipeout at some point in their investing lifetimes (which delays their retirements by years or in some cases by decades).

A fair-value P/E10 on the way up is a very different thing than a fair-value P/E10 on the way down. It’s not the number alone that matters. You need to take into consideration what CAUSES the fair-value P/E10 number. A fair-value P/E10 on the way up is caused by POSITIVE investor emotions — people are getting over the panic they felt during the preceding crash and slowly gaining confidence in the stock market again. A fair-value P/E10 on the way down is caused by NEGATIVE investor emotions — people are terror-struck at the prospect of losing all their money but not able yet to fully process the damage they did to their portfolios by following Buy-and-Hold strategies during a bull market.

One of Shiller’s most important lessons is that stock investing is NOT purely a numbers exercise. We can use numbers to generate insights. But the numbers must always be considered in light of the reality that investing is done by humans, who are emotional creatures. Strictly numbers-based analyses leave out an important part of the equation. This is why much of the research in this field has gotten off track (n my view!).

Thanks again for the stimulating back-and-forth and for caring enough to at least take a look at some of my thoughts re these matters.

Rob

Economics Professor Valeriy Zakamulin: “If the Current P/E10 Ratio Is Near the Long-Run Mean, the Shiller Model Cannot Predict Anything.”

May 3, 2013 by Rob

I have been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of his next e-mail to me:
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Hi Rob,

I looked at your blog, you advocate the Shiller’s PE10 model. It can indeed predict returns to some extent, and this model is very popular among practitioners.

Yet the majority of people do not understand correctly the implications of this model.

The correct implication that everyone understands: if the current PE10 ratio is way too far from its long-run mean, then there is something extremely wrong with the valuation. In this case the model predicts that sooner or later there will be a big correction.

The incorrect implication: the majority of people believe that the Shiller’s model implies that if the current PE10 ratio is near the long-run mean, then the market valuation is correct and one should expect the returns equal to the long-run mean returns. The problem is that people do not really understand the nature of mean reversion. The mean reversion is not just returning back to the mean. What the Shiller’s model really implies is that “an excess in one direction will lead to an excess in the opposite direction”. So if the market was highly overvalued in 2000, then the PE10 ratio should first decrease to the mean, then move further down so that the market will be undervalued. Every secular bull market starts at a PE10 value which is way below the long-run mean.

You need to understand the following: IF THE CURRENT VALUE OF PE10 RATIO IS NEAR THE LONG-RUN MEAN, THE SHILLER’S MODEL CANNOT PREDICT ANYTHING!

To understand, just look at the chart of PE10

http://en.wikipedia.org/wiki/File:S_and_P_500_pe_ratio_to_mid2012.png

For example, at about 1970 and 1990 the PE10 ratio was at the long-run mean. Did it mean that the 10-year return would be “average”? On the contrary, during 1970s the stock market return was way below average whereas during 1990s the return was way above average.

Valeriy

Economics Professor Valeriy Zakamulin: “I Can Understand Why Robert Shiller Cannot Tell People About All His Ideas on How Stock Investing Works. He Must Act Very Professionally. He Can Only Tell Those That Are Supported by Scientific Research.”

May 2, 2013 by Rob

I’ve been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my correspondence with Economics Professor Valeriy Zakamulin. Set forth below is the text of the e-mail that Valeriy sent me in response to the e-mail detailed in the earlier report:

Dear Rob,

I apologize for not being able to respond to all points in your mail, I just do not have so much time.

When it comes to the paper of Arnott, co-authored by Nobel Laureate H. Markowitz, I am familiar with the paper. First, if a Nobel Laureate co-authors a paper, this does not automatically means that this paper is an excellent paper (if you are interested in the flaws of other Nobel Laureates, read about the collapse of the Long Term Capital Management http://en.wikipedia.org/wiki/Long-Term_Capital_Management). This paper does have some weaknesses. For example, the size effect is mainly due to the January effect, the value effect is also partly due to the January effect. This paper, which supposedly explains both the size and value effects, cannot account for the January effect.

I can understand why Robert Shiller cannot tell people about all his ideas on how stock investing works. Being a recognized Yale Professor, he must act very professionally, he can only tell those that are supported by scientific research.

It seems to me that you do not really understand how the market timing strategy works and a possible total collapse of the stock market. From the long-term perspective, the period of 1990s was a period of a great stock market bubble according to the PE10 model. But was it rational to withdraw money from stocks in 1990 and put them into bonds? Not at all, if you used Shiller’s model you would miss the great return over 1990s. Market timing strategy implied selling the stocks in about 2001 and place money in bonds. But what if all investor pursued this strategy? I am sure that all the stock prices would dropped to zero. You disagree with the assumption that investors are rational, but at the same time you actually believe that investors are rational and the mass sale of stocks ends when the PE10 ratio approaches its long-term average. This will never happen if the investors are irrational. As a proof of my point, read about the stock market crash of 1987 (see for examplehttp://hnn.us/articles/895.html). One of the main causes was the popularity of the portfolio insurance strategy which requires selling stocks when prices drops. When everyone implements this quite sensible strategy, then the stock market crashes.

I am not familiar with the papers by W. Pfau, if they were critisized, maybe the critique was well grounded?

I believe that if people knew about PE10 model in 1970, then the period afterwards would be a period of only good economic times. Here you are wrong. The stock market is only a barometer of the state of economy. I believe that for a capitalism economy it is natural to have periodic boom-bust cycles.

Valeriy

“The Problem We Have Is a Circular One. The Experts Say That Buy-and-Hold Can Work Because This Is What People Want to Hear. And the People Want to Hear It Because in an Earlier Time They Were Persuaded by the Experts that Buy-and-Hold Could Work and Now Their Retirements Are Riding On It.”

May 1, 2013 by Rob

I’ve been sending e-mails to numerous people letting them know about my article reporting on The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia.

Yesterday’s blog entry reported on my e-mail correspondence with Economics Professor Valeriy Zakamulin. Set forth below is my response to the e-mail detailed in yesterday’s report:
>
Valeriy:

You are making great points and asking important questions. Thanks for being willing to get down to the nitty gritty of all this.

What I believe in might be termed a “Conspiracy of Ignorance.” I believe that the humans gradually acquire knowledge over the years. We start out not knowing and then over time we come to know. I don’t think that people are meeting in a dark room and crafting plans to trick everybody. I believe that people misunderstand how stock investing works and pass along their misunderstandings when they share what they think they know with others.

I believe that the Efficient Market Hypothesis was an advance over what we had before. It was a tool that helped us advance. But I also believe that belief in it has become dogmatic and the dogmas are holding us back.

I understand the point you make about the default belief (the “presumption of innocence”). Ideally, there would be no default belief. We would just tell people what we know for sure and let people make decisions based on that. The trouble is, it is the most fundamental question of all (how markets work) that causes the most uncertainty. Buy-and-Holders believe that the market is efficient. If that’s so, stock investing risk is stable and staying at the same stock allocation at all times is the ideal strategy. But what if this is not so, what if valuations affect long-term returns? If that is so, then risk is variable and Buy-and-Hold is the most dangerous strategy imaginable (if millions of investors elect to remain at the same stock allocation when they should be lowering their stock allocations to keep their risk profiles constant, the collective losses will be in the many trillions of dollars and will cause an economic crisis and in time a Second Great Depression).

So which is it? As a society, we do not know. My belief is that valuations affect long-term returns, that the market is NOT efficient. But there are millions of good and smart people who believe just the opposite, who believe that Buy-and-Hold is a 100 percent sensible and responsible strategy. So, in the practical realm what do we do? We cannot tell people to hold off on investing for retirement until we all agree on which approach is best. Given that we do not all agree what is best, what should we tell investors to do?

It seems to me that the presumption should be that valuations affect long-term returns. All that long-term timing is is paying attention to price. There is no other good or service that we can buy for which price does not matter. Why presume that stocks are the one exception? Plus, we have the fact that for the 140 years of historical data available to us, price always HAS mattered; the data confirms what common sense tells us must be so. In contrast, Buy-and-Hold has never worked in the long-term. Those who stay at the same stock allocation always face a wipeout sooner or later; prices gradually rise higher and higher and higher (because so few are paying attention to price!) and eventually the market crashes and we all lose (even those not invested in stocks suffer in the economic crisis brought on by the huge loss of collective wealth experienced in a stock crash).

I believe that the Efficient Market Hypothesis was a powerful insight containing one huge flaw that is now in the process of killing us. The hypothesis ASSUMES investor rationality. Shiller’s research shows that investors are NOT rational. What fools people is that the irrationality of investors does not do us much harm in the short-term. From 1982 through 1996, stocks were priced to provide a strong long-term value proposition. Buy-and-Holders were going with high stock allocations for different reasons than Valuation-Informed Indexers but the practical effect (good returns) was the same for both groups of investors. It was only with the 2008 crash that Buy-and-Holders were able to see in a concrete sense the danger of staying with the same stock allocation at all times (and of course the next crash — Shiller’s work suggests that prices will drop another 65 percent over the next few years — will bring the point home in a truly terrifying way).

The Buy-and-Hold Model (rooted in a belief in the Efficient Market Hypothesis) permits researchers to study all aspects of the investing experience that can be examined through the use of logic. But the the most important thing we need to study is RISK and the risk of stock investing is rooted in the human inclination to let emotion influence one’s allocation choices. We need to give ourselves permission to discuss RISK in a frank way and that requires that we talk about things not acknowledged by the Efficient Market Hypothesis. The P/E10 metric is a tool that lets us reduce investor emotion (risk) to a number. Stocks were priced at three times fair value in 2000, according to the P/E10 metric. This means that the investor who thought that he had a portfolio value of $600,000 in reality had a portfolio value of $200,000. Big difference! That investor’s illusions caused him to make all sorts of bad financial planning decisions. Those illusions caused him to ruin his life. But the researchers in this field never talk about that aspect of the question! They talk about numbers. To understand investing, they need to talk about human emotions. It is the human desire for self-deception that is the driving force behind all bull markets and it is bull markets that make stock investing risky (there has never been a price crash of long-term significance starting from a time when stocks were selling at low or moderate prices).

The problem we have is a circular one. The experts say that Buy-and-Hold can work because this is what people want to hear. And the people want to hear it because in an earlier time they were persuaded by the experts that Buy-and-Hold could work and now their retirements are riding on it. How do we break the circle? The researchers should be warning people of the dangers of Buy-and-Hold in a world in which the Efficient Market Hypothesis has been discredited (if Shiller is right, the Efficient Market Hypothesis is wrong). Most are not doing this. When researchers fail to point out the dangers, people assume that the advice they are hearing from the experts must be more or less okay. In reality, it is as dangerous as all get-out. The researchers are not paying attention to how their research is being used — it is being used to prop up long-discredited (even if once promising) ideas.

Here is a blog post in which I report on an e-mail I received from Rob Arnott:

http://arichlife.passionsaving.com/2012/12/11/former-financial-analysts-review-editor-rob-arnott-to-rob-bennett-ive-had-similar-experiences-to-those-you-describe-my-work-has-often-triggered-overt-hostility-from-the-guardians-of-the-status-q/

I find it a scandal that researchers were intimidated into not doing research they believed was important. How can we advance knowledge if we are afraid to look at the most important questions? Who is it that is sending the hate mail to these journals? Scientists? Is the sending of hate mail part of the scientific process?

These sorts of things don’t happen only to Rob Arnott. When I was working with Wade Pfau, he was like a kid in a candy store, discovering new insights on a daily basis and getting more and more excited about where he could go with them. Now he feels that he dare not explore any of those insights. Please look at the quotes at the bottom of this article (the longer version of the article I linked to in my first e-mail to you)

http://arichlife.passionsaving.com/the-buy-and-hold-crisis/academic-researcher-silenced-by-threats-to-get-him-fired-from-his-job-after-showing-dangers-of-buy-and-hold-investing-strategies/

and see what Wade said about the work he was doing at the time. He was AMAZED that no other researchers had engaged in these sorts of explorations. He couldn’t make sense of it. Now he knows. Other researchers don’t look at these questions because it is a career-limiting move to do so.

Even Robert Shiller has experienced intimdation. Shiller has said in interviews that he has never told us all that he knows about how stock investing works because he knows that he would be branded “unprofessional” if he were to do so. Huh? An economics professor at Yale doesn’t feel comfortable sharing what he knows about a critically important subject that he has studied for decades? How could that possibly be a good thing? How could such intimidation tactics be part of a valid scientific endeavor? Intimidation tactics are not science. Intimidation tactics are the antithesis of science.

I believe that this article

http://www.passionsaving.com/investing-discussion-boards.html

is one of the most important “studies” even done in this field. Most people in this field won’t even refer to it as a “study” because it does not contain numbers and charts and tables. I say it is important because it tells the true story of the EMOTIONS of the Buy-and-Holders. That’s what we need to know about to advance our knowledge. That’s the missing piece. The market really does want to be efficient. Fama was close to getting it right. What he missed is that investors can behave rationally only if they have access to all the information they need to make good decisions. And, once we get into a bull market, as a society we formulate a SOCIAL TABOO that blocks us from engaging in discussion of the problems of overvaluation. We “know” that the inflated prices are real at the same time that we also “know” on another level of consciousness that they are not. The conflict between the two things we “know” drives us crazy and we evidence our craziness in the sorts of comments you see recorded in that article.

I hope that I am making at least a little bit of sense, Valeriy. I am grateful to you for giving me an opportunity to at least take a stab at making sense to a kind and intelligent person who is well-informed about these issues.

I do believe in a sort of conspiracy. But it is not the sort of conspiracy in which bad people meet in a smoke-filled room to craft plans by which to screw people over. It is a Conspiracy of Ignorance in which millions of people who deep in their hearts very much want to move on to a better place hold back from doing so because they are afraid of what they will find on the other side of The Big Black Mountain. I have been to the other side and I am here to report back that there are wonderful things to be found on the other side. My problem is that it is hard to convince people who have never seen these things how much we are able to advance our understanding of how stock investing works today. We now know how to make stock investing a virtually risk-free endeavor. Wade’s research shows that the Maximum Portfolio Drawdown Percentage drops all the way down from 60 percent to 20 percent (with no loss of return!) for those investors open to taking valuations into consideration when setting their stock allocations. We are on the verge of experiencing the greatest advance in our understanding of how stock investing works ever experienced in history.

All we need is for people to calm down and let in all the good stuff. But people are afraid of the new. I can comfort them and reassure them and inspire them if I can talk to them. But the Buy-and-Hold dogmatics go crazy with fear whenever and wherever I try. And they use the studies of the academic researchers to justify their use of their intimidation tactics. So I need to report to the people affected by this (that’s every last one of us!) how the academic research is being used. It is being used today not to advance knowledge but to hold it back from advancing! I need to say that not because I do not like the researchers (I like them very much) but because it is so and because the intimidation tactics have brought on an economic crisis and because we must address this problem if our free market economic system is to survive.

That’s where I am coming from, in any event. I hope that my venting has made at least a tiny bit of sense. Please do not think that in any way, shape or form I am aiming to criticize you personally. We are all (including me!) little parts in a big Machine. My job is to get that big Machine back on the right track so that all our work becomes productive and positive and meaningful and life-affirming and fun again. It’s a very hard job but it very much needs to be done and through a strange twist of events it seems that I was elected to take this one on.

Please let me know of any thoughts that these words inspire. If I am off-base, I very much need to know how.

Rob

ADDENDUM A:

On reading these words back, I see that I did not address your final point, that a move to money markets would cause a collapse. It’s true that a move out of stocks would cause prices to fall to fair-value levels and that that would be a significant drop from where we are today. The good news is that, once we let people learn how stock investing really works, we will never again see a drop below fair-value levels. In a rational world in which knowledge can be shared freely, stock prices are self-adjusting. High prices cause the value proposition of stocks to fall, which causes people to want to lower their stock allocations, which causes prices to return to fair-value levels. There never again will be bull markets or bear markets once we open the internet to honest posting on the implications of Shiller’s findings.

The emotional approach (Buy-and-Hold), however, eventually causes prices to fall to levels far BELOW fair-value levels. Every secular bull in history has eventually brought us to a P/E10 level of 7 or 8, a 65 percent price drop from where we are today. Insane emotionalism in one direction always brings on insane emotionalism in the other direction. What we want is emotional (and market) stability and that can only be brought on by addressing the emotional conflict that I referred to up above. People will feel at ease about stock investing when they understand how it works and people will understand how it works when we produce lots of research showing that buying stocks is just like buying any other good or service, the price you pay ALWAYS, ALWAYS, ALWAYS matters. It is emotion that causes risk. And it is the belief that it is possible to invest in stocks successfully without taking price into consideration that causes emotion (no human is capable of having confidence in a strategy that ignores price because it defies common sense to believe that price might not matter).

We WILL see a price drop if we open the internet to honest posting but it will be limited. The huge price drop we will see if we continue the cover-up will bring on the Second Great Depression. We can recover from a relatively small price drop and our new knowledge of how to make stocks a virtually risk-free investing class will then bring on an economic boom as millions of middle-class people learn for the first time how to finance their retirements in a truly smart, simple and safe way.

ADDENDUM B:

What I am suggesting re the “How Science Works” question is that the default belief be that price DOES matter, that long-term timing IS required. Price matters with every other good or service offered for sale. Why ASSUME that it works the other way around with stocks? If that were the assumption, people could still publish research trying to show that Buy-and-Hold works, but the default belief would be the opposite of what it is today. If people concluded that there was good evidence in both directions, they would go with a belief that the case for Buy-and-Hold (or the case for market efficiency) had not yet been made and that thus it was not appropriate to suggest that such a strategy could work. The root of all our troubles is this crazy assumption. There has never been a single study showing that long-term timing doesn’t work and common sense tells us that it MUST work. Why assume the opposite of what both common sense and the entire record of historical data tell us and then become dogmatically opposed to challenges to the crazy assumption?

To make sense of this, I think we need to go back to the days when the Efficient Market Hypothesis was developed and examine why the mistake was made. My sense is that the problem is that index funds were not available at the time (Bogle formed Vanguard in 1976). Long-term timing only works with indexes. Since indexes were not available when the work was being done to see whether timing works or not, the researchers tested only short-term timing. When they learned that short-term timing doesn’t work, they jumped to a hasty conclusion that both forms of timing do not work (because in a practical sense there really was only one form at that time). It is my belief that, had Shiller published his “revolutionary” (his word) findings in 1971 rather than 1981, the name of the 1974 book would have been “A Valuation-Informed Walk Down Wall Street” and we today would be living in the greatest period of economic growth in our history instead of in the early years of the Second Great Depression. You see concern expressed about the national budget deficit all the time. But if you compare the numbers, the Buy-and-Hold problem is the far more serious one (the market was overpriced by $12 trillion in 2000 and even Bogle acknowledges that prices always return to fair-value levels with the passage of about 10 years of time — it is obviously not possible for any economy that loses $12 trillion of buying power in 10 years to avoid collapse).

ADDENDUM C:

My bottom line is that we all need to work together to launch a national debate on these questions. I obviously do not know it all. I obviously am one of the flawed humans. So anyone who goes solely by what I say is a darned fool. But what if there were thousands of people coming from all sorts of different perspectives and from all sorts of sets of life experiences addressing these questions with clear and frank and honest words? I think that would turn all this negative energy into positive energy. Say that Buy-and-Hold prevailed. That would be wonderful! By permitting the debate, the Buy-and-Holders would end up for the first time feeling a true confidence in their ideas. We should all want to see that happen if the reality is that Buy-and-Hold works.

I don’t believe that it is even possible for people to know something that they do not feel free to talk about. We learn through discussion. So we MUST talk openly about these matters. It is this assumption that the market is efficient despite the 30 years of academic research showing otherwise that keeps people from talking openly. So I believe that that assumption must be challenged. I believe that we should give Fama full credit for his contribution, which was huge. But I also believe that Fama himself wants his ideas to bear good fruit and so on some level of consciousness Fama himself (and all those who follow his ideas) wants learning to advance. If Fama and Bogle and all the others on “that side” of things wants learning to advance, we ALL want learning to advance. So let’s do it! Let’s get about the business of learning together what really works! We should put an end to The Debate About Having a Debate and proceed to the actual debate that matters, the debate about how stock investing works in the real world.

Rob

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