A Rich Life

The Old Ideas on Saving & Investing Don't Work -- Here's What Does

“In 23 Years, There Has Not Been One Post Arguing That Shiller Got Something Wrong.”

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

Disagreeing with you is not abusive or criminal

I pointed out the error in the Greaney retirement study (it lacks a valuation adjustment) on May 13, 2002. It has not been corrected to this day. 23 years.

If there had been claims that Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns is not legitimate research, that would be fine. People can listen to both sides and decide for themselves what to do with their retirement money. We haven’t seen that. In 23 years, there has not been one post arguing that Shiller got something wrong. What we have seen are death threats and demands for unjustified board bannings and acts of defamation and extortion. Not kosher.

I don’t believe that Buy-and-Hold can stand long-term if that’s the best that its advocates can offer. There needs to be open discussion so that people can make up their own minds. The problem with open discussion is that we have all seen that, when there is open discussion, Valuation-Informed Indexing grows and Buy-and-Hold diminishes. I don’t see any other way that things can play out. The abusive stuff just delays the inevitable.

I believe that the next Buy-and-Hold Crisis will be a turning point. But we’ll see, you know? I know for certain that I don’t want to be on the side telling people that the safe withdrawal rate is the same number at all possible valuation levels. That never should have been a thing in the first place. It’s a marketing gimmick, a money-making thing.

Is it possible that people really believed that the market was efficient back in the days when Buy-and-Hold was being developed? I think it’s possible. Shiller’s research was not available to us at that time. But that’s no excuse for letting 44 years pass without opening every site to honest posting re the peer-reviewed research.

I sincerely believe that the Greaney study lacks a valuation adjustment. So I say that. There should be zero controversy on the question of whether I should feel 100 percent free to state my honest views. The issue today is that, if people are permitted to post honestly (even Bill Bernstein said that the safe withdrawal rate was 2 percent at the top of the bubble), the 44-year cover-up is exposed. We are arguing over whether the biggest act of financial fraud in the history of the United States should come to an end or should be permitted to continue destroying people’s live. I vote enthusiastically for bringing it to an end.

Rob

ValueWalk.com Article #1 — The Stock-Return Predictor

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I recently authored a Guest Blog Entry posted at the ValueWalk.com site. It is entitled The Stock-Return Predictor.

Juicy Excerpt #1: Could it be that the price that the market is trying to tell us is the true market price is the nominal market price as adjusted for the effect of overvaluation or undervaluation? The market generates the P/E10 figure as much as it does the nominal market price. Perhaps all the confusion over whether the market is efficient or not, and if not, why not, stems from a failure to appreciate that the market is reporting the true market price in two steps.

Juicy Excerpt #2: The suggestion here is that the only thing that has been keeping us from enjoying an efficient market is the insistence of the believers in the efficient market theory that market timing is not needed for the market to become efficient. Markets in which investors do not change their stock allocations in response to big valuation shifts cannot achieve efficiency because valuations affect long-term returns and it is irrational for investors to ignore this reality when setting their stock allocations. The market is not automatically efficient. But investors can make it efficient if they are willing to change their stock allocations in response to valuation shifts.

“It’s Informative, It’s Based on Solid Data and It Provides Useful Results”

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The blog Political Calculations has written a review of The Stock-Return Predictor. We won the “Silver Standard” designation. This is a whole big bunch better than winning the “Outright Awful” designation, assigned to online tools “that actually Make You Stupider.” I am naturally relieved.

In all seriousness, the review is an intelligent and nicely balanced write-up. I am grateful that the owner of the blog was willing to take the time to look at the calculator and to report on it to his readership.

Juicy Excerpt: “While not cutting-edge where stock market theory is concerned (that’s our bailiwick!), The Stock-Return Predictor will provide a reasonably good rule-of-thumb for informing a potential user’s stock market investing decisions. The tool provides a neat approach for delivering high quality information to the tool’s intended audience. What’s more, we really like the valuation-based approach since this helps communicate some of the risk that an investor may be taking on when making a new investment. The user-interface could use some serious refreshing, but overall, we find this tool satisfies our requirements for earning our Silver Standard. It’s informative, it’s based on solid data and it provides useful results.”

And best of all — it doesn’t make you stupider!

Is Stock Investing Safe Again?

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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?

“The Future Cannot Be Predicted
Based on Historical Empirical Observations”

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Frank Voisin, author of the frankly speaking blog, has written a review of The Stock-Return Predictor. It is entitled Prediction Madness. Oh, phooey!

I’m just joking around. Here is some of what Frank has to say about my favorite investing calculator in the whole wide world, the one that changes everything forevermore.

Juicy Excerpt: Taleb provides compelling evidence why the future cannot be predicted based on historical empirical observations. The reasoning is that the majority of that which impacts our world is the result of Black Swans which are inherently unpredictable…. When Rob runs his regression algorithms, he is not taking into account the billions of variables that had an effect on the markets in the past that may not exist in the future….

Frank is bringing something important to the table. Anyone who thinks that he or she can use the Return Predictor as his or her only source of investing guidance is a fool. That’s my take. And I think it would be fair to say that Frank agrees.

Where I part company with Frank is re his suggestion that someone who does not use the Predictor or some similar tool is not also a fool. I think that it would be just as much a mistake to fail to take into consideration how stocks have always performed in the past as it would be to consider only how stocks have always performed in the past. How stocks have always performed in the past is not the only thing that matters. But how stocks have always performed in the past does matter.

Is it possible that we will see something worse than what we have ever seen before? It is possible. But how likely is it? Black swan scenarios are by definition uncommon. They can turn up and people need to know that they can turn up. People need to consider the possibility of black swan scenarios in their planning. It makes all the sense in the world for someone to say “I am going to put a bit less into stocks than the Predictor indicates is wise because the data used to construct the Predictor covers a time in which there were no black swan events and yet these are a real possibility.”

What I don’t think makes sense is to be paralyzed by the possibility that a black swan scenario may turn up. It is true that this may happen. But what are we to do about it? What are the practical implications of an acceptance of the possibility of a black swan scenario? Are we to avoid stocks altogether? Is that a realistic way to go? I don’t see it.

Things would have to get pretty darn bad for us to see stocks perform worse than they ever have in the past. In the wake of the bull market of the 1920s, we saw a drop in stock prices of 89 percent. Anything less than that is something less than a black swan event, a possibility that is taken into consideration by those using the historical stock-return data as guidance re what may happen in the future. I don’t rule out the possibility that we could see something worse than that. I don’t let it paralyze me, however. I view the possibility of a black swan event as something that we just need to live with, like we live with the possibility that lightening might strike us dead someday.

The purpose of the Predictor is not to persuade people that black swan events will not turn up. It is to persuade people that, when they look to the historical data for guidance re how stocks may perform in the future, they should examine the data in analytically valid ways. We all consider what has happened in the past when investing, whether we acknowledge it or not. How can a stock investor not consider how stocks have always performed in the past? The point of the Return Predictor is to encourage people not to fall for the idea that always becomes popular when prices are where they are today, that this might be the first time in history when valuations will not affect future returns. The danger of falling for that one is a high-probability danger, one that has been causing the ruin of investors since the day the first stock market opened for business.

Please do consider the black swan possibilities. They are real. But please don’t get so worked up over black swan scenarios that you fall victim to the far greater risk that this will be the first time in history when following the Passive Investing model will work out in the long run. The historical data says it isn’t going to be that way. The smart bet is that things will probably turn out this time at least somewhat as they always have before.

Long shots sometimes come in. People are always amazed when they do but the reality is that from time to time they do. That said, it’s not a smart idea to bet all your retirement money on a long shot. You should be taking into consideration how stocks have always performed in the past when deciding how to invest today.

Today’s Passion: Felix Salmon, author of the Market Movers blog, said of the Predictor that: “For People Who Like to Take a 30,000-Foot View of Investing, This Is a Handy Little Tool.”

Stocks Might Be About to Take Off

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Could stock prices begin going up soon and then continue going up for a good bit of time?

Yes, that could happen.

The Stock-Return Predictor tells us that the most likely annualized 10-year return today is 1.8 percent real (the numbers that apply when this blog entry appears may not be precisely the same as those that applied when it was written). That’s not so hot. It becomes especially unexciting when you take into consideration how high the odds are that we may see a price crash in the not-too-distant future. If I am going to take those sorts of chances with my retirement money, I want to see a likely return of a good bit more than 1.8 percent.

But “most likely” is not the same thing as “definite.” If those going with high stock allocations today are lucky, they could see returns a good bit higher than 1.8 percent real. How does an annualized 10-year return of 4.8 real sound? There’s a 20 percent chance that we’ll see a return that high or higher.

Should you take a chance on stocks then? At least stocks give you a chance of earning a real return of 4.8 percent real. You don’t stand any chance whatsoever of earning a return that high today in TIPS or IBonds or CDs. Stocks have more potential.

I think you should take a chance on stocks. With a small portion of your portfolio.

Where I take issue with the conventional advice is that I say that you should not take as much of a chance with stocks as you would at a time when prices were at reasonable levels.

Stocks do indeed possess the potential to provide a nice return over the next 10 years. In that sense they are more appealing than TIPS or IBonds or CDs. Stocks also possess the potential to provide an absolutely horrible return over the next 10 years. There’s also a 20 percent chance that the annualized 10-year return will be a negative 1.20 percent real or something worse than that. The super-safe asset classes are providing low returns today but they aren’t providing negative returns.

Everyone agrees that stocks are the more volatile asset class. Everyone agrees that the distance between the potential up for stocks in 10 years and the potential down for stocks in 10 years is considerable. On those two points my thinking and the conventional thinking are in line.

The problem with the conventional advice is that it does not point out the extent to which the potential ups and downs of stocks change with changes in the valuation level. The conventional view is that stocks always offer a better deal than the super-safe asset classes and that you thus don’t need to pay much attention to the effect of valuations.

The historical data does not back up that claim. The historical data shows us that there are times when stocks offer a deal so much more compelling than the super-safe asset classes that it is hard to make a reasoned argument for not going primarily with stocks and there are other times when it is a close call and there are yet other times when the super-safe asset classes offer the better deal. My take is that the super-safe asset classes generally offer the better deal today.

If you believe that stock returns are going to be on the lucky side of the spectrum of possibilities, you should invest accordingly. We are not able to see into the future to the extent needed to know with precision what return stocks will provide over the next 10 years. My goal in encouraging use of the Return Predictor is to educate you about the odds. If you know what the historical data says about the odds of the various outcomes, you are investing in an informed way.

Combine that with a little bit of luck and you’re on your way!

Today’s Passion: Find out what they said at the Vanguard Diehards board about the Predictor by checking out the article entitled Community Comments on Predicting Stock Returns.

About That 68 Percent Price Drop

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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.

“No One Can Predict the Future”

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A community member named “Chipmunk” makes an important, common-sense point in Community Comment #84 in the article entitled Investing Discussion Boards Ban Honest Posting on Valuations!. Here is what Chip tells us:

“I’ll venture a regular guy opinion. I will say that Rob’s explanation does make sense. However, no one can predict the future. Just when someone uses history to try to backtest, create a model, and then predict the future, the factors change or new factors emerge, thus making the model useless for predicting the future.”

Is he right?

Yes, to a large degree he is right. There is no backtest that can tell you what stocks are going to do in the future. It’s dangerous to think that there could be such a thing. Chip’s common sense has generated for us a warning that we all need to keep in mind.

But what about the Return Predictor? Isn’t that the product of backtesting? When I agree with Chip, aren’t I rejecting my own tool for learning how to invest successfully?

I don’t think so.

Chip is absolutely right that we are going to see new factors emerge in coming years that will affect how stocks perform. The Return Predictor looks only at how stocks have always performed in the past. It cannot look into the future. It cannot anticipate factors that have not emerged yet.

Where Chip goes wrong is in saying that, when new factors emerge, it will render the Rational Investing model (the Rational Investing model posits that valuations will always affect long-term returns) “useless.” When new factors emerge, it may be that we will need to make adjustments to the Predictor. It may someday even mean that we will need to develop an entirely new tool. It will not mean that we will need to reject the model by which today’s tool was developed. If it is true today that valuations affect long-term returns (I strongly believe this to be the case), then this will always remain true.

The question of whether valuations affect long-term returns is fundamental. We need to be able to answer that question correctly to come to possess any reasonable understanding at all of how stocks work. This always has been and always will be a critical question. Lots of new factors have come to our attention in the past and our process of learning about these new factors did not affect the importance of the critical factor. The emergence of new factors in the future will not affect this core matter either.

The Predictor is like a weather report. A weather report does not tell you for certain whether it is going to rain tomorrow or not. It tells you the odds. It lets you know whether you need to carry an umbrella or not. A weather report does not tell you everything you could possibly want to know about the weather. But it does offer valuable information bits. The same is true of the Predictor. It informs you as to how stocks work. It does not tell you all there is to know and it cannot tell you all there is to know because we fallen humans are not capable of knowing all there is to know.

Can we predict tomorrow’s weather? Not perfectly. But we are capable of providing valuable information bits about tomorrow’s weather. Those planning an outdoor event for tomorrow afternoon would be foolish not to take a look at the weather report. Those investing in stocks to finance their retirements would be foolish not to look at the Predictor as one tool for use in determining whether their current stock allocation is appropriate or not.

I don’t know what goes into the development of a weather report. But I am confident that there have been changes over time in the process by which weather reports are developed. The people who study the weather learn new things over time. As they learn things, they need to incorporate what they learn into their models. We’re always making small changes in how we go about predicting the weather and over time the effect of the accumulated changes can be significant.

It is going to be the same with our development of tools to predict stock returns. There is today no other tool on the internet that does what the Predictor does (my guess is that other such tools have been developed that are not publicly available, but that is just a guess). I believe that there will come a day when there will be hundreds of web sites that will offer such tools. There will be grand debates about how such tools should best be constructed. Over time we will learn new things and it will become possible to predict stock returns more effectively than we can today.

The Return Predictor is state of the art today. It is not always going to be state of the art. Chip is right that there are going to be new factors or that we are going to discover factors that were always there but that we do not know about today. That’s just the way life is. I don’t think we have to see it as a bad thing. It does indeed follow from a belief that life gets better that life is not perfect today but the positive way to look at it is that it is today’s imperfections that make it possible for life to get better.

Chip is living in the black-and-white world. He is thinking that, if the best tool available to us today is not perfect, we should not make use of any tool, we should give up on the idea of predicting returns. I see that as a dangerous mistake.

The reality is that we all predict returns. Those who never look at the historical data have some idea of what return they are going to obtain from their stock investments. If they didn’t have any idea whatsoever what to expect, they wouldn’t be able to bring themselves to put money down on stocks.

The difference is that those who use what the historical data tells us about how stocks have always performed in the past are basing their predictions on something rational, something objective, something solid. They are not just taking guesses, they are not permitting the emotions of the moment to exert too powerful an influence over their investing choices.

No one can predict the future perfectly. That’s so. But we all can make an effort. We all can learn what is available for us to learn. We all can try to invest more successfully in the future than we have in the past. The reality that we can never do this perfectly is no excuse for abandoning reason. To fail even to take into consideration what the historical data says is to abandon reason. That’s Passive Investing.

Today’s Passion: A recent moderator’s decision at the Early Retirement Forum shows how the ban on honest posting on SWRs and other valuation-related topics has remained in place despite the widespread community support for a lifting of the ban. The moderator closed a thread on “Tomorrow’s Market” that showed promise of helping lots of early retirees get a better fix on the realities of investing in stocks at today’s prices. Why did he do this? Because two Goons showed up on the scene and made every community member present uncomfortable with their ugliness. Why weren’t the two Goons removed so that the rest of us could have the discussions which we intended the forum to facilitate when we built it? Only the moderator who made the improper decision knows the answer to that one. What the two Goons learned is that they can get any promising discussion shut down by engaging in highly abusive behavior. They won’t forget the lesson taught them by the board moderator anytime real soon. And neither will the community members who put time and effort into taking the thread in a postive direction. Boo, baby!

“For People Who Like to Take a 30,000-Foot View
of Investing, This Is a Very Handy Little Tool”

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Felix Salmon posted a nicely balanced write-up of The Stock-Return Predictor at his Market Movers blog earlier this week. His blog entry is entitled: “A Look at Long-Term Stock Valuations.”

Juicy Excerpt: Think of Rob as a buy-and-hold kinda guy with very infrequent reallocations, just like most sensible financial advisers. But Rob’s reallocations are really infrequent: only once a decade or so…. This plan isn’t really about market timing: it would have had you underweight equities for pretty much all of the big 1990s boom…. I think Rob’s approach has a lot to be said for it, but I do have a few problems with it.

Set forth below are my responses to several of Felix’s comments re the Predictor (Felix’s words are in italic):

I just don’t think that many investors have anything like the requisite amount of patience needed – where you can happily sit back for a decade or two waiting for the P/E10 to come down to the mid-teens before going overweight equities.

There is no question whatsoever that this is so today. Most investors have had the Passive Investing model drilled into their heads for so long that the idea of taking the price at which stocks are being offered into account when making allocation decisions sounds exceedingly strange. Given what we have heard from most investing “experts” over the past two or three decades, our finding (see The Scenario Surfer) that long-term timing has throughout history always beat rebalancing strikes many as counter-intutive.

The reality, however, is that it is Passive Investing that is strange, it is Passive Investing that is counter-intutive. We take prices into account when buying houses, cars, comic books and bananas. How could it be possible that stocks are the only asset class on the face of Planet Earth that operate according to an entirely opposite set of rules? Passive Investing simply does not make sense.

That’s a problem for those who try to practice Passive Investing during a secular bear. People need to possess deep confidence in an investing strategy to stick with it during hard times. It’s not possible to possess deep confidence in Passive Investing; the idea that prices don’t matter can never ring true to middle-class investors who have found that prices matter a great deal when making all of the hundreds of other types of purchases they routinely make.

Rational Investing (investing with an acceptance of the obvious reality that stock prices matter) is something new (speaking more precisely, it is something old than has been rediscovered after having been “forgotten” for the length of the most out-of-control bull market in U.S. history). It is going to take people some time to get used to the idea. This process cannot be rushed because long-term timing will not work any better than Passive Investing for those who do not possess deep confidence in it. The difference is that it is possible over time to develop a deep confidence in Rational Investing while this is not so with Passive Investing (investing as if stock prices did not matter).

I don’t believe that the stock-market asset class has rules which govern its long-term behavior

I like this statement because it is a clear and plain and direct and bold expression of a view that is held by many investors. We need to get these things out in the open and this statement does a good job of putting a topic that is too often evaded face-out on the table for discussion.

I do not share this view. I believe that there are indeed rules that govern how stocks perform and that it is very important that we do all that we can to discover these rules and to share what we learn with our fellow investors. My sense is that progress on this front has been held up for a long time because of the popularity won by Passive Investing during the huge bull and that we need to put confidence in this discredited model behind us to get about the business of learning the realities.

Rob Arnott has said that be believes we are on the threshold of a “revolution” in our understanding of how stock investing works in the real world. That’s my take as well.

I can easily believe that we will never again see the S&P 500 trading on a P/E10 of less than 15. (It’s already been 20 years…)

Again, this view is widely shared. Again, I take the minority viewpoint.

It’s not at all uncommon for secular bulls to last 20 years. So it shouldn’t be so surprising that it has been a long time since stocks have been undervalued. The big benefit I see in using the historical data as a guide to how stocks may perform in the future is that it gets us beyond the subjective impressions that we cannot help but adopt from watching stocks perform in one way for so long. For most humans, the way in which something works for 20 years is the way it works, period. For stocks, that rule does not hold. Stocks have been going through wild up and down cycles sometimes lasting for decades ever since the first stock market opened for business.

for people who like to take a 30,000-foot view of investing, this is a very handy little tool.

It cheers me to hear the Predictor described as a tool for use by those seeking “a 30,000-foot view of investing.” That’s a perfect way of describing it. Anyone who uses only the Predictor to inform her investing decisions is a fool. Anyone who does not use either the Predictor or some tool like it is also a fool, in my opinion. The Predictor obviously does not answer every question and obviously does not aim to. What it does, though, is to provide an historical perspective on how stock investing works that it is very hard to tap into though any means other than a review of the historical data.

The Predictor grounds you in an understanding of how stocks have always performed in the past not for the purpose of persuading you to accept that there can never be changes in how stocks perform, but to develop in you a healthy skepticism of the commonly voiced truisms that just happened to have become accepted as true during the most out-of-control bull market in the history of the United States.

I have seen many people react to the Predictor as if the only possible responses were 100 percent acceptance or 100 percent rejection. There are all others sorts of far more moderate and generally more interesting possibilities. It could be that the calculator gets some things right and some things wrong. There’s value in that if you possess the insight needed to distinguish what things it gets right from what things it gets wrong.

That sort of insight comes only from exploring the implications of the findings generated by the tool with both a healthy desire to learn and a healthy skepticism. The “it’s all good” and “it’s all bad” reactions tend to be conversation stoppers. We need to avoid dead ends and find ways to encourage lots of smart people to talk more about the questions brought to the table by the Predictor.

it gives me pause, too: I’ve worried for a while that stocks aren’t an attractive asset class any more.

That sounds real. And encouraging. I take these words as a sign that there are people opening up to the idea of looking at stocks in a new light. I view that as being good news indeed (stock investors could use some right about now, eh?).

The problem, of course, is that there’s not very much in the way of alternatives.

This is a very widespread belief that I do not share. The alternative to investing in overpriced stocks is — investing in fairly priced stocks! Fair prices always return. The returns earned on stocks purchased at fair prices are so great that they are well worth waiting for. It bugs me when people call me a bear because the primary reason why I avoid investing in stocks when they are selling at sky-high prices is that I love stocks and like the idea of being able to own so much more of them just by taking a little something off the table for a few years.

I don’t invest in TIPS at times of high stock prices because I love TIPS. I invest in TIPS at times of high stock prices because I love stocks and owning TIPS for a time permits me to come into ownership of more stocks down the road a stretch.

in any case, according to Rob, if I put all my money in stocks today, I can expect a real return of 5.65% over the next 30 years; 4.65% would be unlucky. I’d be happy with that, I think.

Stocks are a good deal even when purchased at today’s prices for those who hold for 30 years. I wish, though, that we saw more discussion of what is involved in holding stocks purchased at today’s prices for 30 years. My guess is that it is going to be a big bunch tougher to pull off than most of the investors who think of themselves as buy-and-holders realize today.

I am grateful for Felix’s blog entry. He made a good number of helpful observations on a good number of important points. I think he has pushed our debate over how stocks work in the real world forward in a significant way. Thanks, Felix!

Note: The statistical research that drives the Predictor was done by John Walter Russell, owner of the www.Early-Retirement-Planning-Insights.com site. Those interested in knowing more about where the numbers come from should check out John’s site.

Today’s Passion: I outlined some of the uses to which the Predictor can be put in an article entitled Benefits of Using the Historical Return Data for Predicting Stock Returns.