Valuation-Informed Investment Strategies Are An Exercise in Time Travel

Valuation-Informed Investment Strategies Are An Exercise in Time Travel
Bru-nO / Pixabay

Valuation-Informed investment strategies are an exercise in time travel.

Today’s CAPE value is 35. That’s double the fair-value CAPE value of 17. Since Shiller’s Nobel-prize-winning research shows that irrational exuberance always disappears in time, I believe that it makes sense to divide the amount listed as the value of my stock portfolio in two to identify its true and lasting value. What I am essentially doing is moving forward to the time when that overvaluation will be gone. Acting like it already doesn’t exist makes financial planning a lot easier.

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An Exercise in Time Travel

It’s an exercise in time travel. Buy-and-Holders don’t like to make that trip. Their attitude is: “Whatever the number is on your portfolio statement, that’s the value of your portfolio. It is what it is.” I had one ask me once: “If you went to the company that holds your funds and asked to have your stock portfolio reduced to cash, how much would you get handed to you?” The answer, of course, is that you would get the full amount listed on the portfolio statement as the value of your holdings. If the company gave you only half of that amount and explained that they believed that that Shiller fellow nailed it, you would call the cops. It’s the portfolio statement number that controls.

Except not really. The portfolio statement number controls today. But Shiller’s research reflects how the market has been working since the day it was founded. Irrational exuberance doesn’t last. It’s not the portfolio statement number that controls tomorrow. It’s the portfolio statement number reduced by the amount of irrational exuberance present in the stock market price that controls tomorrow. Believing that valuations matter is an exercise in time travel.

This is why it is hard to get people to take valuations seriously. We all want to know the true and lasting value of our stock portfolio. So we should all be interested in knowing what the research tells us about the effect of valuations. But taking Shiller seriously leads to strange paradoxes. What would happen if we did take Shiller seriously? We would see that stocks do not offer a strong value proposition at today’s prices. So we would sell some stocks. Which would bring prices down. So stocks would offer a strong value proposition again. So Shiller wouldn’t matter.

Shiller’s research only matters when we ignore it. Which means that we obtain no benefit from it. Once we take it seriously and act on the lessons it teaches us, stock prices return to reasonable levels and Shiller’s research no longer matters. You can’t win.

There’s a benefit in being able to time travel when investing in stocks. Today’s CAPE value will tell you your likely ten-year return. Knowing in advance the returns you are going to obtain from your stock investment takes most of the drama out of this asset class. That’s good, right? You get the same return. But you don’t get elated by the temporary price rises or deflated by the temporary price drops. Taking valuations into consideration makes it possible for investors to “stay the course” in a way that the Buy-and-Holders never imagined was possible. Valuation-informed investors change their stock allocation but keep their risk profile constant over time. That’s staying the course in a meaningful way!

The Crazy CAPE Values

It’s a stress-reduced way to invest. The crazy ups and downs in stock prices that annoy most investors have little effect on those who take valuations seriously. They saw the twists and turns before they happened. By the time they are being talked about in the newspapers and on the internet sites, they are old news. The shocking thing to the valuation-informed investor is not the price jumps and price drops but the crazy CAPE values that ensured that we would be seeing crazy price jumps or price drops in the not-too-distant future.

The thing that is most weird about how the stock market works is that the delay between the time when the CAPE value points to a price change and the time it takes place in the real world can be so stretched out. Shiller warned in 1996 that investors who stuck with their high stock allocations would come to regret doing so within ten years. Few Buy-and-Holders regret having stuck with their high stock allocations over the past 26 years. There were some shaky moments and there were lots of additional warnings by people like me who believe that valuations matter. But the CAPE value is higher today than it was when Shiller published his warning. From the perspective of the Buy-and-Holders, the future foreseen by Shiller has not arrived.

But it will. Unless stocks behave this time in a manner in which they never have before, it will.

It would be good if we could get valuations to have their effect on stock prices more quickly. For that to happen, we would all need to talk about the effect of valuations a lot more than we do today. I think it would be ideal if stock valuations pulled stock prices to where they should be within 24 hours. Then investors really could make rational choices, just as was presumed to be the case by the people who developed the Buy-and-Hold strategy. Then the market really would be efficient at last!

It turns out that market efficiency is not a present-day reality. But it certainly should be a universal aspiration, I like to think that my Buy-and-Hold friends and I could agree on that much.

Rob’s bio is here.

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