Is the stock market going to take off from here, or are we in for another big downturn? I want to provide a framework for thinking about today’s market valuations in their historical context.
In 2003, Ben Stein and I wrote a book titled, Yes, You Can Time the Market. It was a meditation on the valuation of the S&P 500 throughout the 20th century. We investigated the utility of metrics like the price-to-book ratio, price-to-earnings ratio, price-to-dividend ratio, etc. to value and hence time the market. We discovered – unsurprisingly – that if you bought stocks when valuations were low, your long-term returns going forward tended to be much better than if you bought when valuations were high.
Shortly after the book came out, I buttonholed Professor Eugene Fama (who formulated efficient market theory) at a conference, and asked him which metric he thought was the most descriptive. Without hesitation, he replied, “Price – the common numerator of them all.” This made sense. All attempts to discover the value of publicly-traded equity assets are resolved into price by market participants. Price is the meta-valuation metric.
In this context, I would like to present the price of the S&P 500 at the end of October 2008 in relation to its long-term historical price. Here I have used (as Ben Stein and I did in the book) the 15-year moving average. There is nothing magical about this yardstick; we chose it arbitrarily, and any long-term average should provide essentially similar returns.
I have made one transformation of the data: the value of the stock market (in blue), as well as its moving average (in pink), are adjusted for inflation throughout. The results are shown in the graph below (click to enlarge image). Notice how the plunge in stock prices during October 2008 (on the far right) sent the price line steeply below the 15-year moving average. The data is courtesy of Professor Robert Shiller, updated by your author.
What can we infer from this?
First of all, as of the end of October 2008, the real price level of the S&P 500 had fallen to 76 percent of the moving average. Gaps this large below the moving average are comparatively rare, only occurring in 17 percent of the months since 1900.
They include 1917-1924, encompassing the Communist Revolution, World War I, and the postwar inflation and depression. When next valuations were that low, it was in the worst of the Great Depression, 1932-1933. The real market price level fell that far again during the darkest years of World War II, 1940-1943. Finally, the most recent valuations that were this low level occurred 1974-1982, the years of the OPEC oil embargo, high unemployment and rampant inflation.
These were terrible times, to be sure. Nevertheless, they were fruitful years to be buyers of U.S. stocks for long-term investors. On average, over the ensuing twenty years, the S&P 500 had total returns of 597 percent for people who dared to wade into the market on these occasions. This compares with 20-year returns of 353 percent for all years from 1902-1982 (which includes the years of outstanding returns above, obviously). In other words, long-term investors were paid a 69 percent premium to buy and hold stocks when the headlines of the day were scary. Investors are rewarded for their psychological fortitude.
Could the market decline further from here? Of course. Things can always get worse. If history is a guide, there is about a one-in-six chance that the market will improve from the end-of-October levels. By this measure, the lowest the S&P index has been in modern history occurred in 1920, when it fell to 43 percent of its 15-year moving average. If this worst-case scenario were to repeat itself, the S&P 500 would fall to a nominal 552 today.
People are not good at picking market tops or bottoms, but that skill is not essential to good investing. Being approximately right is good enough. Absent unforeseen events that propel us off the pages of market history, this is a good time to buy and hold the S&P 500.