Bull Markets Increase The Odds Of 2 Outcomes - Very High Return Years And Very Low Return Years

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Includes: DIA, QQQ, SPY
by: ValueWalk

By Rob Bennett

By January of 1996, stock prices had reached truly crazy levels. The P/E10 level had shot up to 25, a number so high that it always leads to collective stock-market losses big enough to bring on an economic crisis. So investors should have been expecting poor returns for the next few years. No?

No.

We saw a return of 19 percent in 1996. We saw a return of 31 percent in 1997. We saw a return of 27 percent in 1998. We saw a return of 18 percent in 1999.

Those are amazing returns. Maybe out-of-control stock prices signal not low future returns but high future returns.

But wait.

The return from the beginning of 2000 until the end of 2015 was 1.8 percent. That's a very poor return for an asset class that delivers an average return of 6.5 percent. The return from the beginning of 1996 through the end of 2015 was 5.9 percent. That's good. But it's a bit less than the average return. Given the amazing return obtained in the first four years of that 20-year time period, it is certainly a disappointing number.

These numbers tell the story of how stock investing works in the real world.

We would expect stocks to offer a poor value proposition at times of high prices. Our common sense tells us that investors should have been going with low stock allocations in 1996.

But it is not just common sense that influences our thinking. We are greatly influenced by what the experts in the field tell us about a particular subject matter. Most of the experts in the stock investing field tell us not to time the market, not to lower our stock allocations when stock prices reach insanely dangerous levels. So most of us didn't lower our stock allocations in 1996. Most of us tuned out the voice of common sense that told us that stock prices had gone too high to justify more purchases of this usually outstanding investing option.

Common sense has been proven largely right. The return for the following 20 years was not at all bad. But it was not great either. It was slightly sub-par. But of course, stocks are still priced insanely high today. Today's P/E10 is 26, just a tad up from what it was in 1996. So the return for the next 20 years is likely to be worse than what it was for the past 20 years, which itself was slightly sub-par.

And we are likely to see a great deal more volatility other the next 20 years because prices always work their way down to one-half of fair value in the wake of huge bull markets. That's saying something given that the past 20 years included one of the worst price crashes ever seen in history, one that scared millions of investors and one that brought on an economic crisis that continues to cause political stress on both the left and the right to this day.

And none of this is even a tiny bit new. The stock market has been operating in this manner for as far back as we have records. High prices always signal poor long-term returns going forward. There has never been a single exception to the rule. All of the evidence available to us tells the same story. The stock market is just like every other market that has ever existed. The thing being purchased offers a great value proposition when sold at good prices and a poor value proposition when sold at wildly inflated prices. It all makes sense.

Except for one thing. What the experts do doesn't make sense. Shouldn't the experts have been telling us all to lower our stock allocations in 1996?

To understand why they didn't, you have to look at those returns from 1996 through 1999 and consider what it would have done to the business prospects of those experts to have told the true story.

Yes, the odds of poor returns shot to high levels when the P/E10 level hit 25. The P/E10 level measures investor emotion. Investors were insanely emotional in 1996. That meant that stock prices might fall hard.

But it also meant that prices might shoot up very high. Emotional investors don't make rational decisions. Emotion might prompt investors to crash prices. But it also might prompt them to send prices to levels never seen before in history. Stock prices are predictable in the long term because the economic fundamentals control in the long term. But in the short term, it is investor emotions that control and emotions are not predictable. Bull-market prices increase the odds both of big price drops and of big price increases.

There were a small number of investing analysts who advised their clients or readers to lower their stock allocations in early 1996. Imagine what their clients thought of them when a return of 19 percent was delivered for 1996. And then a return of 31 percent was delivered for 1997. And then a return of 27 percent was delivered for 1998. And then a return of 18 percent was delivered for 1999.

Investing experts need to eat too. Investing experts prefer to have their clients like them rather than hate them. Valuation-Informed Indexing works. Buy-and-Hold sells.

We all want to obtain higher returns at lower risk. Valuation-Informed Indexing always delivers higher returns at lower risk. It should be more popular than Buy-and-Hold.

But the human mind focuses on what happens in the short term rather than what happens in the long term. The stock market delivers feedback in a way that messes with our minds.

Disclosure: None