A Rich Life

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

“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

Investing: The New Rules #11 — Why Can’t Buying Stocks Be More Like Buying Peanut Butter?

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I’ve posted Entry #11 in the Investing: The New Rules column at the Death by 1,000 Papercuts site. It’s called Determining Stock Value Using P/E10 and asks why buying stocks cannot be more like buying peanut butter.

Juicy Excerpt: When you pay $14 for each dollar of annual earnings, it will take 14 years for you to break even on the investment. Once you reach the break-even point, every dollar of earnings generated from that point forward is pure profit. From the break-even point forward, your gains just grow bigger and bigger and bigger. An index fund with a P/E10 of 14 represents a very good deal indeed. Buying into value propositions like that will in time make you rich.

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.

Podcast #139 — Only Valuations Matter: Everything Else Is Priced In

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I’ve posted Podcast #139 to the “RobCasts” section of the site. It’s called Only Valuations Matter — Everything Else Is Priced In.

Say that you knew there was a terrorist attack coming. Would it be a good idea to lower your stock allocation? It would depend on the valuation level. At high valuation levels, a terrorist attack would cause a big price drop. At moderate valuations, it might not or the price drop might not be so steep. At low valuation levels, it might cause a small price increase.

Podcast #67 — Valuations Don’t Matter, Then They Do, Then They Don’t

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I’ve posted Podcast #67 to the “RobCasts” section of the site. It’s called At First Valuations Don’t Matter At All, Then They Matter Big Bunches, Then They Don’t Matter At All Again.

In the short term, stock prices are determined by investor emotions. In the distant long-term, the market is efficient. From about five years out until about 30 years out, valuations tell the story.

Podcast #41 — Bogle and Valuations

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I’ve added Podcast #41 to the “RobCasts” section of the site. It’s called Bogle and Valuations.

Bogle recently pointed out that the market now values U.S. businesses at about $9 trillion less than it did just one year ago and that that’s crazy. He’s right. The market was not valuing things properly one year ago. That means that the market is not efficient. That means that Passive Investing cannot work.

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?

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.