You often hear me talk about questions and how questions determine outcomes. How they determine your life. And it often comes down to how good the questions you’re asking are. I’ve had three conversations this past week with people that have been too conservative [read: out of the market or in too much cash] the past three to eight years all because they’ve been worried about another market fall. Why? A number that has been causing their already conservative investments to be too conservative. And the numbers they are focusing on are because of the questions they are asking.
Let’s talk about dominoes. Specifically is it causal or is it correlation that creates that next domino fall? We’re going to look at the difference between causation and correlation within the market and the questions you’re asking yourself along the way.
Look at the image of Robert Shiller’s data below. It’s the cyclically adjusted P/E Ratio – so basically 40 quarters of P/E Ratios. This is a way to smooth out the data and get the big picture right by filtering out the noise. If Shiller’s P/E ratio is at or above 25 then the expected rate at which the S&P 500 grows over the next five to ten years will be 0.7% to 3.9%. So if you are expecting a 10% to 15% return then you’ll either going to be very disappointed or you are going to have to do something very different. Today the CAPE Ratio is 30! But does that number matter… meaning is it a correlation number or a causation number?
Look at this next chart. This chart will help answer the question of whether or not the CAPE Ratio matters. This chart is a price chart of the CAPE Ratio and you can see the two vertical red bars. Those two bars are basically when things got really bad from a P/E Ratio perspective. As soon as it broke out above 20, the ratio soared to an eventual level of 44. BUT when the P/E ratio broke the 25 number in this chart, there was still another 3 years left of the bull market in the late 1990s. The P/E ratio broke out above 25 before June 1997 and I’m willing to bet A LOT of people got “too conservative”. The problem? This one number kept a lot of people out of the market. Specifically a lot of deep value investors who stayed away from the gains of 1997, 1998, and 1999.
The reason this matters is because I think those people were asking the wrong questions, or as I’ve said before they were fighting the last war. What is most important is price direction. People have often said that there is a huge correlation between P/E ratios and the price. The truth is, is that there is a general or lose corelation. But what’s more important is understanding the casual relationship. When one thing causes something else. And today we’re back in that nose bleed P/E ratio where the CAPE Ration is currently above 30.
I believe that for a “long-term-hold-never-get-out-of-the-market” investor there will be very little growth in their portfolio based on the Shiller’s CAPE Ratio over the next ten years. There will be no growth or negative growth for the long-only investor [read: big-box advisers]. And for those long-term-hold-never-get-out investors who stick it out for the next 10 years and do everything right, they will only see a 4% gain each year. That’s not even including inflation. Got health costs? Got kids in college? You’re in trouble. And that 4% is IF you do everything the right way – which is rarely done.
History lesson: the NASDAQ went up 400% while the CAPE Ratio lived above 30! The S&P 500 doubled in that time period. My point is that I want you to be really careful in what questions you’re asking yourself and what numbers your looking at because valuation kind of just tells you the temperature of the river but not the direction. It’s true that a CAPE ratio will tell you what will happen over the next 5 or 10 years, but that doesn’t mean that the next 2 or 3 years can’t be an amazing time to protect and grow your money.
To make my point even clearer I want to show you a chart of per capita cheese consumption. Look at the chart below. There is a 95% correlation between people who eat cheese and the number of people who die by becoming tangled in their bed sheets. You can see this correlation below.
Another chart shows the correlation between divorce rates and the per capita consumption of margarine. These two have a 99% correlation. It’s so important to make sure that you’re looking at the right information the right way.
It’s not about more information or data. It’s about training. Training your behavior and asking the right questions so that you can be on the right side of the market. You want to look for what causes things to happen. You know what causes your accounts to grow? Being in investments who’s price is rising. Looking at the price charts is an important tool. But price charts are not the answer. They are a tool. The right answer is your training. Your questions. Your filters. You can see what I mean in this weekend’s thoughts below in the video.