Stock Valuations At First Don’t Matter, Then They Matter a Lot, Then They Don’t Matter Again

Beyond Buy-and-Hold #91

Time is money.

That’s the thought we need to keep in mind to make the transition from the Buy-and-Hold Era to the Valuation-Informed Indexing Era.

Please take a look at The Stock-Return Predictor. This time I want you to ignore the number that is reported as the most likely 10-year annualized return, the most important number identified by the calculator. Let’s look instead at the most likely 30-year annualized return for stocks purchased at today’s prices. That’s 6.2 percent real.

Now let’s see what that number is for investors who are fortunate enough to buy stocks when they are selling at the price levels that applied in 1982, the best time to buy stocks in my lifetime. The 10-year number is much higher for the investors who buy stocks at low prices (15 percent real vs. 2 percent real). The 30-year number is higher too. But the difference is not nearly as stark (10.6 real vs. 6.2 real).

Let’s look at it from the other direction

What sort of 30-year number applies when you purchase stocks at the insanely high prices that applied in January 2000, the worst time in the history of the United States to buy stocks? In that case, the 30-year number is 5.0. That’s a bit less than the 6.2 that applies today. And even 1.2 percent of annualized real return over a 30-year time-period translates into a significant dollar difference because of the power of compounding. Still, the difference between the two 30-year numbers is certainly less dramatic than the difference between the two 10-year numbers ( a negative 1.09 vs. a positive 2.2).

Those seeking to defend Buy-and-Hold often point to these 30-year numbers to justify their unwillingness to change their stock allocations in response to big valuation shifts. It all works out in the very distant long run, they argue. Go out three decades and Buy-and-Hold kinda sorta really does work. Is it so?

It’s not a foolish argument. There is a significant truth being expressed with it.

The game changes when stocks are overpriced

When stocks are overpriced, you need to be thinking about three types of time-periods: (1) the short-term (less than 10 years out); (2) the long-term (10 years out through 30 years out); and the very distant long-term (more than 30 years out). The short-term is unpredictable. So forget about market timing aimed at achieving benefits within the short-term. The long-term is highly predictable. So be sure to practice long-term timing. And the very distant long-term?

The numbers for the very distant long-term throw us a curve. In the very distant long-term, returns are even more predictable than they are at 10
years out or 15 years out or 20 years out. In that sense, they follow the general pattern. What’s odd on first impression is that valuations have less significance in the very distant long-term. Valuations matter even in the distant long-term. But not as much as they do at 10 years out and 20 years out.

Looking long-term

The point is made even more clearly by an examination of the numbers that apply 60 years out. When stocks are priced at one-half of fair value, the most likely annualized 60-year return is 6.8 percent real. When stocks are priced at fair value, the most likely annualized 60-year return is 6.5 percent real. When stocks are priced at three times fair value, the most likely annualized 60-year return is 6.2 percent real.

Valuations matter more and more as you go from five years out to 10 years out and then 15 years out and then 20 years out. But valuations come to matter less when you go from 20 years out to 30 years out and then 40 and 50 and 60 years out. What’s going on here?

What’s going on is that the factors determining the stock price are changing over time. It is investor emotion that determines prices in the short-term. Emotions are inherently irrational and thus unpredictable. That’s why short-term timing never works. It is the economic realities that come to determine stock prices in the long term. Economic realities can be rationally assessed. That’s why long-term timing always works.

In the distant long-term, you are seeing multiple waves of investor irrationality and economic rationality doing battle with each other to set stock prices. It takes a bit over 30 years for a full secular bull/secular bear cycle to play out. We saw market tops in 1901, 1929, 1966 and 2000. Go out 60 years and you are seeing a mix of bullish and bearish influences. The net result is a distant long-term return of something in the neighborhood of 6.5 percent real regardless of the valuation level that applied at the time your stock purchase was made.

Cool, huh?

So can we say that Buy-and-Hold “works” in the distant long-term?

I say “no.”

I’ll explain why in next week’s column.

Rob Bennett often writes about the stock price crash. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.

( Photo from Flickr by Helico )

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