A Rich Life

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

Valuation-Informed Indexing #135 — My Response to the Seeking Alpha Article Saying P/E10 Doesn’t Work

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I’ve posted Entry #135 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s titled My Response to the Seeking Alpha Article Saying P/E10 Doesn’t Work.

Juicy Excerpt: I don’t agree with most of the points made in the article. But the appearance of the article is encouraging. I believe that we need to convert the entire world to Valuation-Informed Indexing. That won’t happen as a result of me posting articles praising the concept. It can only happen as the result of a national debate in which people who support the concept argue to the best of their ability in support of it and in which people who see flaws in the concept argue to the best of their ability to opposition to it. Canavale is advancing the debate by trying to shoot the concept down. For that we all owe him our gratitude.

A second reason why we should all be happy to see this article is that it shows that the Buy-and-Holders are getting nervous. I was around in the day when the Buy-and-Holders were so sure of themselves that they wouldn’t go to the bother of shooting down Shiller’s ideas. They just ignored them. The appearance of this article is evidence that at least some Buy-and-Holders are opening up their minds a wee bit. Arguing against Valuation-Informed Indexing is the first step in a long journey that ends with people like Chuck Carnevale becoming big-time advocates. He (and lots of others) has to got to work through his objections before he will permit his mind to be won over by the new ideas. By airing his reservations he is giving those of us who support the concept an opening to try to win him over.

Beyond Buy-and-Hold #105 — Forget the S&P 500 Level, It’s the P/E10 Value That Really Counts

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I’ve posted Entry #105 to my weekly Beyond Buy-and-Hold column at the Out of Your Rut site. It’s called Forget the S&P 500 Level, It’s the P/E10 Value That Really Counts.

Juicy Excerpt: I was having a discussion with some Valuation-Informed Indexing skeptics when the words popped out of my head — “An S&P 500 priced at 1,000 when the P/E10 value is 30 is the same as an S&P 500 priced at 500 when the P/E10 value is 15.”

That’s a pretty darn simple way of making the essential point. Is it so? It’s so. The evidence showing it to be so is at this point a mountain. Don’t take my word for it. Check it out yourself. But, if you are interested in knowing my opinion, please understand that, yes, I very much believe it is so.

“Not Considering Which End of the Cycle the P/E10 Level Appears on Causes Confusion for Newcomers Who Feel That Each P/E10 Level Should Dictate a Single Stock Allocation”

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Yesterday’s blog entry reported on an e-mail that I sent to academic research Wade Pfau on January 16, 2011. He responded later the same day.

Wade’s e-mail further discussed the Fisher and Statman study. He explained that for purposes of the paper he was writing he thought it would be proper to rebalance the tested portfolios each year. He asked whether I viewed annual rebalancing as a violation of the tenets of Valuation-Informed Indexing. My response is set forth below.

Wade:

I agree that rebalancing is the theoretically proper way to do things. I don’t think it is required as a practical matter. But rebalancing is theoretically better and more appropriate.

I’ll tell you the biggest problem that I aware of in testing this. There are four major cycles in the historical record (one producing a major bear in the early 1900s, one in the 1930s, one in the 1970s and one today). Each of the P/E10 levels should be (and my sense is that the data generally shows this to be so) producing worse results during the years following a bull market top than it does in the years leading up to a bull market top. For example, we are now in the low 20s. It was not a bad time to be in the low 20s when we hit the low 20s in the early 1990s. Investing heavily in stocks at the low 20s today is probably going to turn out much worse because we are probably on the way to 7 or 8 in the not too distant future.

The downside of reporting different results for the different ends of a major cycle is that you cut an already too small data set in half. So I don’t say that this should be done. But it does affect the result and not considering which end of the cycle the P/E10 level appears on causes confusion for newcomers who feel that each P/E10 level should dictate a single stock allocation.

John and I (really John — he did all the statistical work, I just asked questions and made suggestions as we went along) did not consider the effect of what stage of the cycle the P/E10 level appeared in when we developed The Stock-Return Predictor (which gives the likely return for each P/E10 level). We developed The Investor’s Scenario Surfer (which lets the investor go through a realistic, random 30-year returns sequence and see whether his choices of valuation-informed allocation levels beats a Buy-and-Hold allocation strategy) later and we did include an adjustment for the stage of the cycle in which the P/E10 level appears in that one. I don’t know how John did it but it might be possible to figure this out by looking at old articles and discussions and e-mails (he stored all his work materials on a Yahoo Finance site that was shut down, causing the materials to be lost!). The calculator forces the user to choose not only a starting-point P/E10 level but whether the P/E10 level is occurring in a “Normal” market or a “Bear” market. John applied some sort of filter so that the return sequences that pop up in the early years of the bear market scenarios are a bit more likely to be bad ones (as is true in the record, of course).

The reason why this happens is not important in terms of the statistical analysis but is highly important in terms of the big picture questions. Bull markets cause massive misallocation of resources (because all investors make bad spending choices, thinking they possess more lasting wealth than they do in fact possess). What’s really going on is that bull markets are causing economic crises (the Buy-and-Hold theory is that it is economic developments that are causing stock price changes, but it appears to be the other way around — stock price changes are causing economic developments). I think that part of the reason why the general phenomenon is not widely appreciated today is that it requires a reversal of thinking on so many different fundamental points.

I am not trying to cause confusion here. I’m just saying this as a follow-up to your point about the late 1990s being the best time for Buy-and-Hold. The core principle here is that all overvaluation is the product of investor self-deception (in a world of rational investors, prices would always be set properly). So the biggest bull markets are going to be at one and the same time the most dangerous time to invest in stocks and the time when theories that downplay valuations are going to become most popular. We couldn’t have had the huge 1990s bull without Buy-and-Hold having first become the dominant theory. This is one of those cases where the observer is causing the results of his experiment by watching things. Buy-and-Holders saw only half of the story and their inability to see the other half caused millions of others not to believe that the other half matters, which caused data to be generated that for a time seemed to vindicate the findings of the Buy-and-Holders.

To become totally objective about this, someone would have to stand outside of bull and bear markets and do the tests. But we are of course always in one or the other or on our way to one or the other. We are on our way to a time when only
studies taking extreme bear positions will be considered in line with the data (because the data of that moment will make stocks look the worst they have ever looked in history).

Anyway, I think it would be a theoretical plus to have an adjustment for whether the P/E10 level occurred in the bull phase of a secular bull/bear cycle or in the bear phase of it. But I have doubts as to whether such an adjustment can be included as a practical matter (because of the limited data set).

Another statistical problem that John encountered is that the data seemed to behave differently pre-1920 and post-1920. The effect of valuations has generally been stronger in the post-1920 years (John has an article where he discusses
reasons what might be the reasons for this). John’s practice was to use data from 1921 forward when possible and to incorporate the earlier data only when it was needed to generate statistically meaningful results (for example, he needed a larger data set when we made 60-year predictions in The Stock-Return Predictor).

Rob

VII #90 — The Correlation Between P/E10 Values and Long-Term Returns Is Stronger Than Most Realize

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I’ve posted Entry #90 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called The Correlation Between P/E10 Values and Long-Term Returns Is Stronger Than Most Realize.

Juicy Excerpt: The stock price that applies on any given day is a COMBINATION of short-term and long-term effects. If the theory behind the VII model is correct, the short-term effects should always be pulling the data in the direction of showing no correlation and the long-term effects should always be pulling the data in the direction of showing a perfect correlation. The combined effect of the two contrary forces should be data showing a strong but imperfect correlation and one that grows as the time-period lengthens.

That is precisely what we see when we look at the 140 years of data.

If the VII model properly explains how stock investing works, we should not be expecting to see a perfect correlation when we compare the P/E10 value that applies on the day of a purchase and the long-term return produced in the years following that purchase. We should be expecting to see a strong but less than perfect correlation. That’s the correlation that appears on our computer screens when we generate graphics showing to us in pictures the story that the historical stock-return data has been trying to tell us for 140 years now.

Valuation-Informed Indexing #87 — The Fair-Value P/E10 Number Is Somewhere Between 14 and 16

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I’ve posted Entry # 87 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called The Fair-Value P/E10 Number Is Somewhere Between 14 and 16.

Juicy Excerpt: Yale Economics Professor Robert Shiller, the grandfather of the Valuation-Informed Indexing model, puts it at 16. There’s a good case that can be made for that number. But “16” is not the only reasonable answer to the question “What is the fair-value P/E10 number?”

John Walter Russell, former owner of the www.Early-Retirement-Planning-Insights.com site, did the statistical work for development of The Stock-Return Predictor and the other calculators available at my web site. John put the fair-value P/E10 number at 14. He explained why in this article: Typical Values of P/E10.

Invest It Wisely Runs an Article on Valuation-Informed Indexing not Authored by Rob Bennett!

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The  Invest It Wisely blog last week posted an article that is exciting for two reasons. One, it advocates Valuation-Inforemd Indexing. Two, it was not written by Rob Bennett!

This is the sort of thing we need to see to get the ideas we have been talking about and developing in the Retire Early and Indexing discussion-board communities for nine years now into the mainstream. We are beginning to see signs of what I have long dreamed of — a “Normalization” of our discussions of the realities of stock investing.

The article is by Mathieu Bouville and is titled The CAPE: How to Beat Stocks with a 50/50 Portfolio. It’s super stuff.

Juicy Excerpt: Figure 1 shows the annualized real return over the next 20 years as a function of the current CAPE. When the CAPE was below 10, the return of the S&P 500 has never been below 5% p.a. over the next 20 years (i.e. one at least multiplied one’s purchasing power by 2.7). And it has never been above 3% when the CAPE was above 23. (This does not mean that this will never happen, just that it is quite unlikely.) With the 1999–2000 CAPE of more than 40, it is hard to see how one could dream of making money in the long run…. If the CAPE has some predictive power, it can be used to improve the efficiency of one’s asset allocation.

Beyond Buy-and-Hold #53 — This Is the Best Time in History to be a Stock Investor

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I’ve posted Entry #53 to my weekly Beyond Buy-and-Hold column at the Out of Your Rut site. It’s called This Is the Best Time in History to be a Stock Investor.

Juicy Excerpt:  Please use Shiller’s data to choose any month from 1870 forward and look at the P/E10 level that applied to determine what stock allocation you should have been going with at that time. Then move ahead 10 years to see what return applied. Shiller’s data doesn’t identify the precise return. But, if the P/E10 level stayed the same or rose or fell only a bit, the return was solid or at least acceptable. If the P/E10 level fell hard, the return was poor or perhaps downright panic-inducing. Please complete this exercise for as many cases as you need to to convince yourself that you should always look at the P/E10 level of stocks before buying them.

How To Use Valuation-Informed Indexing — Part Two

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I recently posted a Guest Blog Entry at the Balance Junkie site titled How to Use Valuation-Informed Indexing — Part Two.

Juicy Excerpt: The smart Valuation-Informed Indexer prepares not only for the most likely outcome but for all other realistic possibilities. And the smart Valuation-Informed Indexer takes into consideration the emotional hit he will feel if he shifts to a low stock allocation because prices are high and stocks perform well for a few years or if he shifts to a high stock allocation because prices are low and stocks perform poorly for a few years.

He does this by avoiding dramatic valuation shifts. It is generally better to maintain at least a small stock allocation (perhaps 20 percent or 30 percent) even when stocks are selling at the insanely high prices that applied from 1996 through 2008. And it is generally better to avoid going with a stock allocation above 90 percent even when stocks are selling at prices so low that it is impossible to imagine a bad long-term outcome (perhaps your imagination is too limited!).

The idea behind Valuation-Informed Indexing is to shift the probabilities in your favor. Start thinking that our ability to predict stock returns is greater than it is and you will almost surely hurt yourself. Moderate allocation shifts always work. Extreme valuation shifts rarely do.

Investing Online AI Blog: “PE/10 Tells Us Whether the Market Is Priced Too High & Eventually Will Fall”

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George, the blogger at the Investing Online AI blog, has written a post advocating the use of P/E10 to know when it is dangerous to own stocks. George learned about Valuation-Informed Indexing from a Guest Blog Entry that I wrote at another site and we had a long telephone conversation the other night in which we discussed the wonders of the P/E10 stock valuation metric. His blog entry is titled P/E10 — A Tool for Investing.

Juicy Excerpt: If there were a way to know if the market was overvalued, that would definitely help. We could buy stocks or the index when it was cheap, and sell when it was expensive. This is the notion of value investing, and the strategy that Warren Buffett used to become the wealthiest person in the world.

The best measurement that I have found so far of whether an index is overvalued or undervalued is the P/E10. I read about it over at Passion Saving.com. Most people measure the value of a stock or index by the P/E ratio. This is the price of the stock (or index) divided by the annual earnings. The problem with the P/E ratio is that it fluctuates wildly as earnings change from year to year, or even quarter to quarter.

The P/E10 solves this problem because it averages 10 years of earnings. This makes it smoother and more useful. In fact, it makes it an accurate predictor of future index values. I think the real value to investors is that it tells us whether the market is too high and eventually going to fall.

“The P/E10 Tool Could Drastically Change How the Entire Investment Industry Operates & Measures Risk”

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I’ve had extensive e-mail correspondence and one long telephone conversation with a community members named “Larry” about the need for us to get political leaders involved in speeding up the transition from Buy-and-Hold to Valuation-Informed Indexing. I will be setting forth the text of some of those e-mails here at the blog in days to come.

Set forth below is the text of an e-mail that Larry sent me on November 2, 2009, after a long telephone call on which we conversed about these matters in depth. Larry spent several weeks going over all the materials at my site and at John Walter Russell’s site prior to the telephone call.

Rob,

Thanks for talking with me on the phone.

I get how big this really is after talking with you yesterday. I think the P/E 10 is an incredible risk management tool that large institutional investors, actuaries, economic forecasters, individual investors, mutual fund managers, and financial planners should all use.  Risk management is the one area that the people in these professions understand. The P/E 10 tool has the ability to drastically change how the entire investment industry operates and measures risk.

However, I still believe you need to include the qualitative analysis to back up the numbers in this tool to gain credibility. In my view, overcoming this “last missing link” will  take the P/E 10 into the mainstream of the investing world. I could not sleep last night because I believe this tool combined with quality macro economic analysis will change the course of investing in this country.

I am working on a conceptual model of how to take this mainstream.  I also think that venture capitalist or angel funding is a very real possibility to fund a business that will promote this tool to the masses. I am more than happy to contact key venture capitalists and even Mr. Perot himself if we can package this properly.

Mr. Perot does not have any money in the market  (or very little) presumably because of the risk involved. He has invested in bonds for many years. Suzy Orman takes the same approach as Mr. Perot. Almost all of her personal money is in bonds due to the risk in the  market. There is a reason why banks don’t loan money to invest in the stock market!

Larry