I read John Bogle’s book Common Sense on Mutual Funds in the Spring of 1996. It was by reading that book that I learned that the idea that the safe withdrawal rate is the same number at all times is in error. Bogle states in the book that Reversion to the Mean of stock prices is an “iron law” of investing.
If prices always revert to the mean, going-forward returns are higher starting from times of low prices than they are starting from times of high prices. Since the safe withdrawal rate is determined largely by the return obtained on one’s stock portfolio, the safe withdrawal rate must be higher at times of low prices and lower at times of high prices.
I took money out of stocks as a result of what I learned from reading Bogle’s book. I was planning to leave my corporate employment and make a living building a business on the internet in the not-too-distant future. I imagined that the new business would not produce much in the way of earnings in the early years. So I wanted my savings to be secure. What Bogle’s book told me about the risks of owning stocks at times of high valuations told me that stocks were not the right place for most of my money at the sorts of valuation levels that applied at the time.
Investor emotions determine stock prices
The CAPE level is even worse today. There was a brief time-period when the CAPE dropped to a bit below fair-value levels in the wake of the 2008 Buy-and-Hold Crisis. But prices have been high for that 27-year time-period other than during that brief time-period. Shiller’s research shows that it is primarily investor emotion that determines stock prices. We have been living through the longest and strongest period of out-of-control irrational exuberance in our nation’s history. Not good! Has anything changed?
I believe that the next Buy-and-Hold Crisis is on the not-too-distant horizon. I worry that it will begin before I complete the book that I am writing on the far-reaching how-to implications of Shiller’s research.
But I would, wouldn’t I?
I have a horrible track record when it comes to predictions re these matters. I thought that Shiller’s prediction in 1996 that the Buy-and-Holders would within 10 years come to regret sticking with their high stock allocations was perfectly reasonable. We are now 27 years down the line and the Buy-and-Holders who I know are not evidencing feelings of regret. Satisfaction is more like it. Not regret.
But just wait!
I am joking around.
I don’t know what is going to happen. That’s the obvious truth of the matter.
I still believe that prices are headed sharply downward. I haven’t given up on that one. I possess a strong confidence in the irrational exuberance concept. If today’s stock price is nearly 50 percent the product of investor emotions, prices will be going down sharply. But when? That’s what everyone wants to know. When?
The question becomes a bit maddening over time. The when of the matter depends on investor emotion. Only you know when. I don’t mean you personally. I mean you collectively. All of the stock investors out there will determine when it will happen by at some point losing confidence in the crazy Buy-and-Hold stuff and running for the hills to protect what portion of their life savings they believe can still be saved. Do you want to tell me when?
To determine when in advance, we would need to possess much better tools for deciphering investor emotion than we possess today. CAPE is an amazing tool. But it has its limits. A CAPE of 17 could apply for a market that is a rocket ship about to take off after years of being stuck at 8 or 10 or it could apply for a market that has been wandering in the 20s for many years and is about to send us all into a Great Recession or – gulp! – a Great Depression. The number itself doesn’t give you a precise fix on the emotion that applies. You need to know the context in which the number appears.
And that’s tricky too. Shiller viewed the “25” that applied in 1996 as a bad omen for a perfectly good reason. The historical return data available to him at that time suggested that a CAPE of “25” was bad news. I still believe that it is bad news. But we have seen a lot of numbers in the neighborhood of 25 in recent years and still no long-lasting crash. Perhaps “25” needs to be reinterpreted.
Or perhaps not, you know? It could be that, the longer prices remain insanely high, the stronger is the emotional turn in the other direction when it finally comes. That’s a scary thought for those of us alive in the United States today. But it would make emotional sense. The end of a 30-year marriage causes more emotional pain than the end of a six-month fling. I think we would have been better off listening to Shiller in 1996, I’ll say that much.
People’s belief in buy-and-hold
But I refuse to be too negative re this stuff. Say that we do suffer a devastating crash and a deep economic downturn as a result. I believe that that might be the thing that causes us as a nation of people to take a more serious look at Shiller’s work. And that would change everything! If the CAPE hits 8, the last thing in the world we will want is for people to maintain their belief in Buy-and-Hold. Buy-and-Hold posits that stock prices reflect the economic realities.
According to the Buy-and-Hold way of thinking about these matters, a CAPE of 8 signals an economy that is a dog who has chased his last frisbee. The Valuation-Informed Indexing thought is that a CAPE of 8 is nutso, that the irrational depression that causes that number is just as off-base as the irrational exuberance that brought us to today’s 30. Valuation-Informed Indexing posits that, when the CAPE reaches 8, we should all vote ourselves raises by pushing the CAPE up to 17 and that those raises are economically legitimate.
I don’t believe that investors are as confident in their irrational exuberance today as they were in their irrational exuberance of 1996. I can’t point to anything objectiver to prove that that’s so. I just believe (looking at that darn historical return data) that irrational exuberance runs out of steam over time. At times of high CAPE values, investors are always looking over their shoulders worrying that the boogeyman is going to jump out of the bushes.
The fact that he has been a long time coming on this go-around does not persuade me that he has died and his body has been buried deep in the ground. He’s out there. You (and all of the millions of other you’s out there somewhere) are not as aware of him as I am because you do not write about this stuff for a living. But you are aware of him. He feels closer now than he did in 1996 because he has been too close for so very long. One day too close will become too too close and then….
I hope we make it through to the other side. I believe we will. I cannot say that I am not afraid. But I sincerely believe that things could turn out very well indeed if we don’t lose it and if we wise up just a bit. For the past 27 years, it has been good stuff on the outside and bad stuff lurking within. Soon that will be transformed into lots of bad stuff being visible and lots of good stuff being hidden underneath. I will enjoy being able to explain to people why things are so much better than they seem rather than telling this upsetting story that it has been my job to tell for such an awfully long time now.
Rob’s bio is here.
