By Rob Bennett
An exceedingly helpful paper on the topic of this column (the merit of valuations-based market timing) was recently published by Valentin Dimitrov of Rutgers Business School and Prem C. Jain of the McDonough School of Business at Georgetown University. It is titled: Shiller’s CAPE: Market Timing and Risk.
The paper states that: “We find that even when CAPE is in its ninth decile, future 10-year stock returns, on average, are higher than future returns on 10-year Treasurys. Thus, the results are largely consistent with market efficiency. Only when CAPE is very high, say, CAPE is in the upper half of the tenth decile (CAPE higher than 27.6), future 10-year stock returns, on average, are lower than those on 10-year U.S. Treasurys.” So the paper is not generally supportive of the Valuation-Informed Indexing concept. However, it provides a wealth of data and analysis that I believe should be reviewed by all with an interest in coming to a better understanding of many questions raised by Robert Shiller’s “revolutionary” (his word) 1981 research showing that valuations affect long-term stock returns.
I find it amazing that Valuation-Informed Indexers and Buy-and-Holders look at the same historical return data and come to wildly different conclusions re what it signifies. I’ll describe one way in which this is so in the words below.
Let’s say that for purposes of discussion we agree valuations-based market timing only works when the P/E10 value is higher than 27.6. Rarely is the P/E10 value that high. So investors should forget about valuations-based market timing, right?
The paper reports that: “For the extreme CAPE deciles, most observations come from a limited number of years. This is expected as very high or very low CAPE levels have been infrequent. For example, for Decile 10 (CAPE from 23.4 to 44.2), 2 observations occur in 1901, 17 occur in the 1928 to 1930 period, 7 occur in the 1965-1966 period, and the remaining 124 are concentrated in the 1995 to 2006 period. The 45 highest CAPE values all occur in the short period between 1997 and 2001.”
The paper’s conclusion - that there’s not much benefit to be had by engaging in valuations-based market timing - is rooted in an examination of many years of stock market history in which valuations rarely travelled to insanely dangerous levels. But valuations have remained at insanely dangerous levels for most of the past two decades. There were 26 cases in which valuations reached insanely dangerous levels in all of U.S. stock market history prior to 1996. Then there were 124 cases in the following 10 years. Valuations dropped hard in the economic crisis of 2008 but they have been at insanely dangerous levels for much of the past 10 years as well.
Is this good news for today’s investors? Or very, very bad news?
If you draw the conclusion reached by the authors of this paper - that valuations don’t matter all that much, that stocks are always at least a reasonably good investment choice - it is good news.
But it seems to me that an alarming conclusion can quite reasonably be drawn from the data that Dimitrov and Jain examined to develop their sanguine assessment. Could it be that the data is telling us that, while stocks are generally a great investment choice, the one exception is when valuations reach truly insane levels and that there has never before in U.S. history been a time period in which stocks constituted so bad an investment choice as they have for the past 20 years?
I’ll go another step down the logic chain. Could it be that it is so critical that investors exercise price discipline that the only way that this wonderful asset class can turn bad is for large numbers of investors to become persuaded that it is not necessary to do so, that stocks are always best for the long run, that investors can turn off their common sense and pretty much ignore valuations when buying stocks because it will all somehow work out okay anyway? Could it be that excessive valuations were rarely able to destroy the value of stocks in the past because most investors understood how dangerous it would be to ignore price when buying stocks but that the relentless promotion of Buy-and-Hold strategies in recent decades has brought about a new reality?
I believe in looking at stock market history to develop an informed take on how stocks may perform in the future. But the lesson that I draw from the data cited in the paper is that stocks really do become a dubious choice when valuations reach the high 20s - which is where they have stood for most of the past 20 years. I don’t take comfort in the fact that this has happened so rarely in the past. I become alarmed when I realize how out to sea we have travelled in the Buy-and-Hold Era.
The historical data is telling us never to let valuations get out of hand and we have drawn the conclusion that it is okay for us to let valuations get out of hand because things worked out well for earlier generations of investors who did not let valuations get out of hand. I am not at all sure that that follows.