3 Return Scenarios That Applied In The Wake Of The 2008 Crash

by: ValueWalk

By Rob Bennett

Last week's column described the reaction of Buy-and-Holders to the 2008 crash. Most did not panic. A significant minority either panicked or came close to doing so before their feelings of panic subsided as a result of the sharp upward price movement we saw in 2009. I expressed a belief that just about all Buy-and-Holders would have panicked had prices continued to drop or had remained at the levels to which they had dropped in late 2008 for a number of years.

One of the purported benefits of the Buy-and-Hold strategy is that it avoids emotionalism by telling investors that their best bet always is to "stay the course," that is, to stick with the same stock allocation. Valuation-Informed Indexing is rooted in an opposite belief that risk varies with changes in stock valuations and that investors must be willing to adjust their stock allocations in response to big changes in the price of stocks to have any hope of keeping their risk profiles roughly constant.

It's not just the drop in their portfolio values that cause Buy-and-Holders to panic in the wake of price crashes. Another factor is their belief that price changes are caused by unforeseen economic developments. If one believes that price changes are caused by economic developments and prices fall hard, the obvious conclusion is that the economy is in bad shape. It is more than a little troubling for investors whose retirements depend on the smooth operation of the economy to learn suddenly that it is not doing at all well. Buy-and-Holders are hit with a double dose of bad news when stock prices crash.

The Valuation-Informed Indexing strategy helps investors develop a more balanced mindset. It is of course a negative that crashes cause portfolio values to diminish. But the other side of the story is that every drop in valuations causes long-term return expectations to increase. So the investor who is investing for the long term and who follows a Valuation-Informed Indexing strategy does not view a price crash as a negative; he sees it as a negative countered by a positive, an event that has an overall neutral effect on his retirement prospects. No one panics in response to neutral events.

Moreover, Valuation-Informed Indexers do not view a price crash as signaling something wrong with the economy. They understand that, once Buy-and-Hold strategies become popular, there is no rational argument that can be made to return stock prices to fair-value levels. The only way for the market to exercise its basic function of setting prices properly is to crash them. Crashes don't result from negative economic developments, but from the need for irrational exuberance eventually to be overcome by irrational depression. Crashes are emotional events, not economic events, just as bull markets are emotional and not economic events.

To maintain their emotional balance, it is important for Valuation-Informed Indexers to keep in mind that while some price changes are highly predictable, others are not. It is a mistake to think that returns are a random walk and thus not predictable at all; that way of thinking leads to shock when big price swings occur. But it is also a mistake to come to believe that return scenarios are predictable in all their specifics. That mindset inevitably leads to disappointment when expectations are not met.

Valuation-Informed Indexers knew in 2008 that a crash was coming. Prices were insanely high. Prices always crash when prices are insanely high. So it was just a matter of time before one arrived. Thus, when the crash came, there was no cause for panic. The Valuation-Informed Indexer had already lowered his stock allocation in anticipation of the coming price drop. Instead of panicking when it came, his natural course of action was to increase his stock allocation in response to the price drop that made stocks a more appealing long-term investment choice.

The tricky part is avoiding the temptation to extremism. Stock prices were indeed insanely high in early 2008. Investors who were expecting to see a crash could not help but feel vindicated when the big price drop arrived. The natural inclination was to expect prices to continue falling until they hit levels as insanely far on the low side as they had earlier been on the high side. Robert Shiller himself made this mistake, advising investors in early 2009 to stay completely out of stocks until the P/E10 level dropped below 10. Investors who followed that unfortunate advice would still be going with zero percent stock allocations to this day.

Shiller's prediction was not sure to go wrong at the time he made it. His advice was rooted in an important reality - the P/E10 level does indeed always fall below 10 before a secular bear market comes to an end. Shiller's mistake was not to tell investors of that scenario; it was to ignore the possibility of at least two other scenarios that also remained live possibilities at the time he offered his advice.

A second scenario was that prices might remain at fair-value levels for some time before dropping to the insanely low levels that Shiller expected to see them drop to in the near future. A third scenario was that prices might shoot back up to insanely high levels for a time and only after the passage of a few years fall back to a P/E10 level below 10.

When prices are high, we can say with near certainty that they will fall hard. We cannot say when. And we cannot say what return pattern will apply. There are many ways for prices to move from high levels to low levels. Investors must be aware of all the possibilities before making stock allocation choices. Investors who bet too heavily on one scenario over other equally likely ones risk experiencing feelings of panic when the expected option fails to play out.

Disclosure: None

About this article:

Expand
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here