I was having a discussion with some Valuation-Informed Indexing skeptics when the words popped out of my head — ?An S&P 500 priced at 1,000 when the PE10 value is 30 is the same as an S&P 500 priced at 500 when the PE10 value is 15.?
That?s a pretty darn simple way of making the essential point. Is it so? It?s so. The evidence showing it to be so is at this point a mountain. Don?t take my word for it. Check it out yourself. But, if you are interested in knowing my opinion, please understand that, yes, I very much believe it is so.
The implications are far-reaching
And of course the point applies with even greater force when stocks become as overpriced as they became in the late 1990s. At the top of the bubble, stocks were priced not at two times their fair value but at three times their fair value. So the way to say it then was that an S&P 500 priced at 1,000 when the PE10 value is 45 is the same as an S&P priced at 350 when the PE10 value is 15.
It?s so simple an insight.
And so powerful an insight.
They say that stocks are risky. Are they?
This insight suggests that the risk may be nothing more than perception. We all look at the S&P value to gain a sense of how stocks are doing at a given moment. What if the S&P value alone does not give the full story? What if you must make a valuation adjustment to know the true value of the market (and of your portfolio!)?
If that were so, that would explain why stocks seem so risky. If most of us have a wildly improper view of how stocks are doing at all times, we would naturally stand to be surprised a lot. When we notice ourselves getting surprised by stocks all the time. we come to think of them as risky. Would the risk go away if we took the 30 seconds it would take to include a valuation adjustment when reporting the S&P value?
It would.
The only way I know to check this is to check whether stocks have over the years offered the same number of surprises to those who made valuation adjustments as they have to those who have not. Do you want to know how many surprises there have been in the 140 years for which we have records for those who make valuation adjustments?
None. Nada. Zilch.
In reality, stocks move in patterns that are completely predictable
Stocks perform in highly predictable ways for those who make valuation adjustments. Stocks are not risky for those who make valuation adjustments. That?s what I think.
But it can?t be! If taking the risk out of stock investing were so easy, everyone would do it!
If you are going to believe what I am saying here, I need to offer an explanation of why everyone doesn?t tap into this magic of correcting the S&P price for the effect of overvaluation or undervaluation.
Index funds didn?t exist until 1976.
That?s my explanation.
This magic trick wasn?t possible until recent years. Once it became possible, we were in a wild bull market and no one wanted to know the real numbers. People have only in the past few years become slightly interested in learning about a better way to invest in stocks and the idea of making valuation adjustments has indeed been catching on among a small but growing percentage of the population.
It?s not true that everyone will immediately do something just because it is a good idea. It takes time for everyone to hear about the good idea. Then it takes some more time for everyone to overcome the inertia that makes bad old ideas seem more comforting than good new ideas for a time. Everyone will become Valuation-Informed Indexers. Give is a break! We?re working on it!
Hey! You could be the first on your block!
Could it really be so simple?
I think it is.
We can all know what our stock return is going to be in advance. We can turn stocks into a virtually risk-free asset class. We can make stocks far more appealing to the millions of middle-class people who need to invest in this asset class to finance their retirements but who until now have been afraid to do so.
It?s so simple an insight! And so profound an insight!
The S&P value is not what they say it is on television or on the radio or in the newspaper. It is the number they say it is adjusted for the amount of overvaluation or undervaluation that applies at the time. For something to be overvalued is for it to be mispriced. To know the real price, you need to make an adjustment. Of course!
We live in exciting times. Our old understanding of how stock investing works is some kind of messed up. We?re dummies!
But we are getting smarter. Things are looking up.
Rob Bennett believes that we all need to adopt a new vision of retirement purpose. His bio is here.
Rob Bennett believes that we all need to adopt a new vision of retirement purpose. His bio is here.
I am very leery about all of the market indices breaking new highs. But, I’ve recently been able to buy Cisco, HP and other great stocks at a P/E under 10. I figure we are due for some kind of a correction, after the amazing run-up. But, most of my stocks are fairly valued.
Hi Bret – I’m with you about these highs. But I think they’ll stay with us as long as interest rates remain low (there’s no competition for stocks in a low rate environment). Valuations are the key, but a general market decline will likely pull down even the strongest of stocks.
Hi Rob, AGree that valuations matter! Higher relative pe (or pe 10)>>>> lower future returns and vice versa.
Disagree that; “It works in the other direction, of course. An S&P priced at 1,000 when the PE10 value is 7 is the same thing as an S&P 500 priced at 2,000 when the PE10 value is 15.” All that means is that in both cases the earnings are 33. A PE 10 7 illustrates a much lower valuation than a pE 10 15.
Am I missing something Rob?
It’s always great to hear your voice, Barbara.
You are right and I am wrong. Thanks so much for being kind enough to take time out of your day to point out this error.
Numbers are not my strong point. I am forced to deal with them to do writing in this field. But I really need people to check my numbers. I am grateful to you for doing that here.
Here is the way I think I should have made the point I was trying to make:
“It works in the other direction, of course. An S&P 500 priced at 1,000 when the P/E10 value is 15 is the same thing as an S&P 500 priced at 2,000 when the P/E10 value is 30.”
Does that sound right?
I look forward to seeing you are FinCon14. Thanks again for setting a fellow blogger straight!
Rob
Hi Rob, Try this, an S& P 500 with a value of $1,000 (assumes earnings of $100 and price of $1,000) would have a PE 10 of 10. That would be an equivalent valuation to an S & P 500 with a value of $500 (assumes earnings of $50 and price of $500) also sporting a 10 for the PE 10.
Thus what matters is not the absolute value of the index, but the relationship between the price and earnings of the index. Greater earnings relative to the price will give you a lower and more desirable PE 10. 🙂