Let’s start this week with a guest post at Out Of Your Rut. Written by Rob Bennett, This Is the Best Time in History to Be a Stock Investor is an excellent look at P/E10 (price to earnings , but using an average of the prior 10 years earnings) and why Rob concludes we are in a positive buying environment. While I think there’s always risk in investing, some times appear to be better than others and Rob makes a compelling case.
As we wind down the year, just over three months remaining, it’s time to think about How NOT to Lose Your FSA Money. This article was published some time ago, but came to my attention this week through a tweet. Keep in mind, starting in 2011, over the counter medicine is no longer permitted to be reimbursed without a prescription. Check out your records for the past few years and after you use up your current account balance, start planning for next year.
My favorite Tax Tweep Kay Bell, wrote Solar tax breaks in the wake of Solyndra. I’m a believer in solar power, not that I’m a tree hugger, I just think that there’s a compelling economic case to be made for solar to play a greater role in the mix of power sources we use in this country and especially in third word countries. Time for me to write an article looking at this topic from a dollars and sense standpoint.
At Five Cent Nickel, Is the Home Mortgage Interest Tax Deduction a Good Deal? For many, not so much. The standard deduction may result in your mortgage interest having a smaller effect than you’d think. Check out Nickel’s article, do the math and decide.
At My Money Blog, Jack Bogle Makes Market Prediction For Next Decade. The father of index investing is looking for 7%/yr this decade. Not quite the 12.5% we saw this past 25, but not too shabby for those of us looking to retire 7-10 years from now. Time will tell.
Joe:
Thanks much for your kind words re my article arguing that “This Is the Best Time in History to Be a Stock Investor.”
I don’t actually believe that now is a good time to buy. I believe that this is the best time to be an investor because the research available today (Shiller’s research and the research that has followed from it) tells us when is a good time to buy and when is not a good time to buy. Using that research as my guide, I do not believe that stocks offer a strong long-term value proposition at today’s prices. I am currently going with a zero stock allocation.
Rob
Rob – sorry I misinterpreted. I thought the Shiller numbers showed we are toward the lower end of the range. I need to pull that back up and revisit the data.
I am not wild about the Bennett discussion for the following reasons:
— It refers to the Cyclically Adjusted P/E Ratio (CAPE) for the S&P 500 only. Maybe one should not buy an S&P 500 fund right now, but using CAPE analysis, other stocks likely show promise. (Rob, I know this is not the main point of your article, but the attention given only to the S&P 500 misleads, in my opinion.)
— It leads the reader to believe that CAPE values of around 14 or 15 are the historical fair value for every stock. Not so. Banks for example should have notably lower CAPE values.
— I continue to think, a la Jeremy Siegel and Ben Graham, that some consideration must be given to dividends and the benefit of reinvesting dividends especially when stock prices are low. CAPE values do not take this into account. Consider Pepsi Company (PEP):
Sep. 2001 price & Annual Dividend = $48 and $0.58/share-year
Sep. 2011 ” ” = $60 and $2.06/share-year
The share price change yielded a 2.3% per year annual return. The dividend increased 13.5% each year annually on average. One may run the numbers a few ways (and I am sure Joe will 🙂 ), but the outcome leans towards reinvested dividends having a sizable impact on the overall return.
— Benjamin Graham is mentioned often as having first proposed using CAPE analysis. But his criteria for choosing a stock does not rely solely on CAPE. Indeed the father of value investing considered the dividend as well, among other parameters of a company.
Bennett seems to think CAPE is a great tool. Since I suppose only recently have the CAPE numbers for any one stock started becoming available, this translates to today being a great time to be a stock investor. Next year other tools will likely be available, and it will be an even better year to be a stock investor.
On the other hand, since increasingly people will use CAPE in their decision to buy or sell a stock (or short or whatever a stock), broader guides to market behavior suggest CAPE may become less and less useful.
Elle:
Thanks for sharing your thoughts. There is not one point of view on these questions. There are many. We need to hear them all. I need to say what I believe. But for the discussions to achieve balance we need to have other people advancing other points of view. By raising your caveats and concerns re my message, you are helping us all out.
You are right that I view CAPE (I call it P/E10 — the two terms refer to the same thing) as the best valuation metric. I don’t say this for no reason. There are statistical tests that have been done that show that CAPE works best. But the view that CAPE is best is certainly not universally held. That’s not even close to being the truth. There are lots of good and smart people who see flaws with CAPE or who think that other valuation metrics do a better job.
I believe that I believe. But I don’t for 10 seconds believe that anyone should go by what I say just because I say it. I think that would be foolish. It is my hope that we are going to have more and more people offering a variety of viewpoints on these questions. That’s how we all learn together.
I’ve learned lots of things from people who disagree with me on important points. I am grateful to those people for spending their time and energies trying to help me get back on the right track. I expect to learn lots more in days to come, as these sorts of discussions become more widespread.
Rob
Rob, from your discussion; some reading of Graham; and a bit more reading; I think the CAPE value is worth reviewing prior to any stock purchase, at least as one of several criteria with priority. I would like to start looking CAPE values up. Have you seen them listed for free for individual stocks? I have not done an exhaustive search of the net yet, so any pointers you have would be helpful.
I don’t follow individual stocks, Elle. I am strictly an indexer (and I have had a zero stock allocation for 15 years now in any event). So I don’t know.
I agree with you that the CAPE is worth taking a look at, even when buying individual stocks (however, the predictive power is far less with individual stocks than it is with indexes). There’s no question but that CAPE is getting more attention today than it has in earlier times. So I would think that some of the services that help people examine individual stocks would be providing the information. But I am not able to point you to a source.
Rob
Rob, understood, regarding the predictive power of CAPE, indices and individual stocks. I trust you mean the statistical significance of CAPE reverting to the mean and so on is higher with indices than with individual stocks. At least, the latter makes mathematical sense to me.
I try to test my stock purchasing criteria as to whether they are bordering on numerology or truly reflect good financial analysis practices. “Technical analysis” has long struck me as a misnomer (as I believe it did Graham) and a synonym for financial numerology, and I do not practice it (at least I do not think I do). But the notion that P/E historically has averaged around 14 or 15 for stocks as a whole has long interested me and has long been part of my criteria. Discussion of CAPE certainly embraces this. Thank you.
I trust you mean the statistical significance of CAPE reverting to the mean and so on is higher with indices than with individual stocks. At least, the latter makes mathematical sense to me.
“Technical analysis†has long struck me as a misnomer (as I believe it did Graham) and a synonym for financial numerology
We are in complete agreement, Elle.
I don’t trust technical analysis because I believe it is trying to measure something that cannot be measured.
CAPE is measuring something that can be measured. So we should expect it to have value. Studies showing that it really permits us to predict long-term returns should not be too surprising because these studies merely confirm what common sense tells us must be so.
But our ability to predict future returns of individual stocks is limited because there are so many factors other than valuations that play a role. With index funds, there are only two factors that play a role: (1) the productivity of the overall economy (which in the U.S. has always been sufficient to finance a 6.5 percent real average long-term return); and (2) the valuation level that applies on the day the purchase is made, because this determines how long it will take before that 6.5 percent real return will apply.
There are still great benefits to investing in individual stocks for those willing to put in the effort needed to make intelligent picks. But for the millions of middle-class investors who require a simple investing approach, I don’t see how Valuation-Informed Indexing can be beat. It provides good-enough returns with only a small fraction of the risk that applies for Buy-and-Hold indexers. Investor heaven!
Rob
I agree that no load, low expense ratio index funds are the only appropriate stock-investing choice for those who do not want to examine individual companies.
After this discussion, would I also say to these acquaintances to do as you are doing, namely do not hold any stock index funds, because the stock market as a whole is somewhat overpriced (CAPE value of about 20)?
I am wrestling with this, trying hard to be objective. I look at the period 1993 to mid-2008, when the CAPE values were 20 and higher. As you pointed out, the return was okay for this period, because there was not a large decline in the CAPE. In 1993 (same CAPE value as today), would it have been prudent to tell my acquaintances to stay out of stocks? I cannot say yes or no with confidence.
If today I say not to buy any stocks, do I send them to bonds? Or should they just stay in cash, as I presume you are, waiting for CAPE to drop further?
Bond interest rates are historically the worst they have ever been right now and really cannot go further south. This complicates the decision-making. (Of course the best advice will always be ‘live within one’s means; work like heck; save like heck.’)
I am not even sure about the ‘definitely don’t buy stocks when CAPE is greater than 25’ guideline. The CAPE has been over 25 three times since 1871. Only two of those times (1928-1930 give or take and the past decade+) were for a persistent period. The third was for one month in 1901. I guess it makes sense. When CAPE was over 25for some ten+ years recently, bonds were at least paying decently for much of this time.
At the moment I lean towards saying to my acquaintances to be well-diversified among stocks and (investment grade) bonds, with a 60/40 allocation being fine historically for returns and volatility.
Rob, not trying to tear apart your take on things. Ultimately your piece encourages consideration of valuation and maybe prepares people some for what to expect, bringing a bit of peace of mind. But I am not sure what the run-of-the-mill index investor should take from your piece as far as practical steps for his or her index fund portfolio are concerned.
Aside 1:
Those retired relying on dividend for a large part of their income have a different set of considerations here. I think CAPE analysis is less useful to such folks.
Aside 2:
Let me give a nod to those thinking that the use of options etc. can potentially make better use of CAPE values. Space is precious and I would rather talk about the run-of-the-mill, somewhat passive investor who is in or saving for retirement.
But I am not sure what the run-of-the-mill index investor should take from your piece as far as practical steps for his or her index fund portfolio are concerned.
The comments you are making are 100 percent intelligent and fair, Elle.
I agree with you about what it means to be at at P/E10 of 20. I call that the warning track. There are times when stocks can do well starting from a P/E10 of 20 and there are times when they do not do well. There’s risk at that price level. But not so much risk that I would ordinarily think it would be a good idea to be out of stocks.
The reason why we come to different conclusions about how things look today is that I don’t view a P/E10 of 20 as always signifying the same thing. My view is that it made sense to remain heavily invested in stocks when we hit 20 in the early 1990s but that it does not make sense to do so today.
It’s not only the numbers that matter. You need to look at what is causing the numbers.
If you look at the record of historical returns dating back to 1870, you will see that the same pattern repeats over and over again. Stock valuations start at very low levels (half of fair value), then they go up and up and up and up. Then at some point they crash hard. At that point, everything is reversed. They go down and down and down and down until they are again at half of fair value. Then the cycle starts over again.
To understand stock investing, you need to understand why it always plays out that way.
The reason (I believe) is that humans possess within them both a Get Rich Quick urge and an urge to follow what their common sense tells them. The Get RIch Quick urge is dominant on the way up. There is nothing to stop investors from setting stock prices wherever they want to set them. Since we all naturally want more money, we always bid stocks up and up and up.
Sooner or later, the urge to conform to what common sense tells us must be so (prices must revert to fair-value levels), causes a crash. We lose confidence in the made-up stock prices and prices fall hard. That causes a massive loss of (pretend) wealth. The loss of wealth causes an economic crisis because people no longer have money to spend on goods and services. The crisis eventually causes prices to fall to one-half fair value.
Stocks were overpriced by $12 trillion in 2000. It is the loss of that amount of spending power from our economy that caused the economic crisis. If we are on our way to one-half fair value (a P/E10 of 7), we still have another 65 percent price drop from today’s levels coming up ahead. That sort of price drop will cause enough of an increase in lost spending power to put us in the Second Great Depression. These downward trends usually take about 20 years to play out. So stocks do not appear to me to offer a strong value proposition today.
The good news is that, when we get to one-half of fair value, the value proposition going forward is huge. At those prices, the most likely annualized 10-year return is 15 percent real. So the best strategy today is to preserve capital for the great buying opportunity to come.
Now —
We cannot say that valuations will go to precisely 7 and then turn around. So you don’t want to wait until we get to 7 to start buying. Buying some stocks at 15 would make perfect sense. And then you might want to increase your allocation at 10 and again at 7.
I am just telling you how I think it works, Elle. There obviously is nothing wrong with having a different opinion and going according to that. I don’t say that I know it all. But I do find it hard to believe that the pattern that has applied for 140 years is pure coincidence. There has never since 1900 been a time when we went into a deep recession or depression where we did not first hit 25. And there has never been a time when we hit 25 and did not have a deep recession or depression. When all the pieces fit, I have a hard time ignoring the picture that I see in front of me.
I like it when people offer different viewpoints. I don’t want the responsibility of people going by what I say because I am just saying what one person believes. But I do believe this. I have studied these questions in great depth for a long time and I have never heard anything that persuades me that there are major holes in the basic idea being put forth. I think stock investing is primarily an emotional endeavor and right now psychology is bad and likely to get much worse as the effects of the economic crisis caused by the valuation levels we have seen over the past 15 years play out.
When stock prices rise to insanely high levels, the money is not coming from the sky. It is being borrowed from future investors. We borrowed more money from our future selves in the late 1990s than any group of investors has ever borrowed from its future selves in any earlier period in history. Now we need to pay that money back. My personal view is that it is no more complicated than that.
Things were not nearly as bad in the early 1990s. The amounts we had borrowed from our future selves at that time was small in relative terms. There might have been a short recession had we permitted stocks to return to fair-value levels then. But by pushing off the squaring of accounts we took what would have been a short recession and turned it into a major recession or a depression.
That’s the idea that I am putting forward, in any event.
Rob
My view is that it made sense to remain heavily invested in stocks when we hit 20 in the early 1990s but that it does not make sense to do so today.
I do hear you about today. Like many I am shaken by the ineptness of the banking industry and the many rather un-intelligent, let-me-be-blunt-yet-real faux educated individuals who wreaked havoc on the economy. Here in the thick of things just a few years after a great crash, with seemingly unrelenting belt tightening, it makes me wonder about the future. A tiny bit like you perhaps, I look at history (the Great Depression; Japan since the early 1990s or so; the 1970s; the burst housing bubble of the late 80s in some parts of the country; banks having problems in the early 90s) and think the U.S. economy, and increasingly the world as a whole, is able to correct. Over time, people will make a better mouse trap, and our standard of living will generally rise, even if (or because of) certain socialist tendencies (such as health care for all) that can in fact abet capitalism.
Rob, thanks for all of your articulate, well-written and reasoned commentary. It is getting me thinking and looking at the numbers. I guess Ben Bernanke and the Fed are not going to get their way with you :-), insofar as keeping interest rates low so that, as one consequence, folks tend to keep their money in stocks. Are interest rates this low a feeble shoring up and imprudent, since it is never before explored territory and leaves no cushion? I wonder. Ben Graham gave constant attention to interest rates as he spoke of stock investing, if memory serves. But he saw nothing like today.
I guess I could say to an acquaintance (who does not work with individual stocks) and feel reasonable, “For now, consider as one option something like a 50/50 split between an investment grade long term bond fund and cash. When the CAPE falls to 15 or so, consider buying.” Else I am inclined to state as the other option the commonly accepted asset allocations given at many free financial planning web sites, based on risk tolerance and years to retirement. (Excluded from such counsel are investors in individual stocks; investors in dividend income stocks for retirement; and options type traders.)
Again, I appreciate your well-measured words. Shiller and Bogle are two lions to me as well (with Siegel and Graham).
Joe, thanks for all the space. Re-reading this five years from now should be fun. Meanwhile, I am livin’ cheap but happy enough. 🙂
Rob, thanks for all of your articulate, well-written and reasoned commentary.
Backatcha, Elle.
Else I am inclined to state as the other option the commonly accepted asset allocations given at many free financial planning web sites, based on risk tolerance and years to retirement.
Please understand that I am grateful for the good work these people do. My only complaint is that some have come to believe that some years back we reached the point at which we knew all there was to know about investing and didn’t need to bother trying to learn more. I think we are still in the learning stage re the investing project. I think we can take what these smart and good people have done in the past and build something even more wonderful for the future.
Please take care.
Rob