Discover why buy-and-hold advocates oppose valuation-based market timing despite its proven benefits
It’s a mystery why the buy-and-holders are so opposed to valuation-based market timing. Common sense tells us that it must work — it’s through valuation-based market timing that we exercise price discipline when buying stocks, and we now have 43 years of peer-reviewed research confirming that what common sense says must be so really is so.
But the buy-and-holders have never relented. My best explanation is that the people who developed buy-and-hold did not place sufficient focus on the question.
Robert Shiller’s Nobel Prize-winning research showing that valuations affect long-term returns had not been published at the time. This meant they must have jumped to the unfortunate conclusion that, since the guessing-game approach to market timing doesn’t work, no form of market timing is required. By the time the research was published, the buy-and-holders had been advising investors not to engage in market timing for a number of years, and were unwilling to admit they had been mistaken.
Simplifying stock investing
But there’s another possible explanation. It keeps things simple to leave valuation-based market timing out of the stock investing story. We don’t know when prices will turn. If investors accept that valuations make a big difference, they will get antsy whenever prices get a bit high.
Valuations are a big deal. Investors need to take them into consideration. However, discussions of valuations inevitably lead to discussions of when valuations will change. And we really do not know the answer to that.
Shiller was confident in 1996 that stock prices would drop hard sometime within the next 10 years. We didn’t see a price drop until 2008. When we saw that price drop, Shiller expressed a belief that the CAPE value would fall below 10 before it would turn up again. It never fell below 13. Shiller is the most informed person on the planet about stock valuations, but he has limited abilities to answer the most pressing question in the minds of most investors—when will price shifts take place?
An argument can be made that the most effective marketing strategy is to encourage investors not to worry about valuations. Stocks are an amazing asset class, and prices always return to their former highs after they have fallen hard. Most investors do not want to spend much time and mental energy fussing and fretting about stock investing. Maybe telling them that valuations are not such a big deal is okay.
The long-term risk of ignoring valuations
But I don’t believe that. I think valuations are a big deal, but they are only a big deal when prices crash. When prices remain high for a long time, as they have been since the mid-1990s, investors are happy not to bother with keeping track of valuations or understanding the significance of the various valuation levels.
If valuations were only a minor factor, I could understand downplaying their importance on marketing grounds. The trouble with that approach is that ignoring valuations causes them to become a more important factor. So long as investors react with concern when valuations creep upward, valuations can never get too out of control. Their concern causes them to lower their stock allocation and pull prices back to more reasonable levels. The buy-and-hold insistence that valuations don’t matter has caused most investors to abandon any such concerns. As a result, we have seen the highest valuations in the history of the U.S. market during the buy-and-hold Era.
The CAPE level in January 2000 was 44. That’s more than double the fair-value CAPE level of 17. A regression analysis of the historical return data shows that the most likely 10-year annualized return when valuations get that high is a negative 1% real. In contrast, the most likely annualized 10-year return when prices are where they were in 1982 is 15% real. That’s too big a difference to ignore. In a world in which valuations matter that much, investors need to consider valuations when forming their stock investing strategies.
I am in favor of simple strategies. Buy-and-holders are big on telling investors to “stay the course”. Investors who switch strategies because of a few years of bad results with an initial plan are never able to know whether it was the plan that was flawed or if they just ran into a few years of bad luck. The only way to test whether a strategy is good or not is to stick with it for a considerable length of time.
My objection to the idea of failing to engage in valuation-based timing is that, in a world in which valuations affect long-term returns (that’s the world we live in, according to Shiller’s Nobel-prize-winning research), that’s not staying the course. A world in which valuations affect long-term returns is a world in which stock investment risk is not stable but variable.
A stock investment strategy should be as simple as possible but not any more simple than that. Stock valuations matter too much for investors not to at least occasionally change their stock allocation percentage in response to valuation shifts.
To argue that such changes are not needed because of some marketing edge obtained by doing so is unconscionable. It might produce good results in the short term, but it exposes the investors who buy into the idea to far too much risk in the long term.
