Beyond Buy-and-Hold #53
Not many see it that way.
But the case that this is the best time in history to be a stock investor is strong.
You don’t believe me?
Here’s what I suggest. Please spend just a few moments looking at the historical stock-return data to see for yourself what huge advances we have made in our understanding of how stock investing works with the academic research of the past 30 years. Here’s a link.
That link will take you to the Online Data section of Robert Shiller’s web site. Please click on the link there marked “Excel File.” Then please click on the box at the bottom marked “Data.” The Data section of Shiller’s site tells you the P/E10 level that applied for every month of stock market history going back to 1870. It is by knowing this number that you know whether it is a good idea to invest in stocks or not and how high a stock allocation you should choose.
How the P/E 10 level works
The average long-term return for U.S. stocks is 6.5 percent real. So that’s the return that you will earn in any time-period in which the P/E10 level (the price of a broad index over the average of the last 10 years of earnings) remains stable. Say that the P/E10 level on the day you buy stocks is 15. And then 10 years later it is still 15. You will have earned an annualized real return of something in the neighborhood of 6.5 percent real.
Earning 6.5 percent real is great. So anytime you can invest in stocks with a realistic expectation that the P/E10 level will remain steady for 10 years, you should be invested heavily in stocks. It is unlikely that you are going to find an alternative asset class that pays you a return of 6.5 percent real.
What if the P/E10 level drops a bit over the 10 years?
That’s not so bad. If the P/E10 level drops from 15 to 13, the return is still going to be something in the neighborhood of 6.5 percent real. Say that you earn 5.5 percent real. That beats what you would get from certificates of deposit handily. So in these circumstances you are again doing the right thing investing heavily in stocks.
Are there any circumstances in which investing heavily in stocks would not be the right thing?
Yes, there are such circumstances.
The fair-level P/E10 level is 14. Stocks always move to the fair-level P/E10 level over the long term. Think of the P/E10 level of 14 as being a giant magnet pulling any super-high or super-low P/E10 levels back to reasonable levels. When the P/E10 level is 8, as it was in 1982, the long-term direction of stocks is upward in a big way. When the P/E10 level is 44, as it was in January 2000, the long-term direction of stocks is downward in a big way.
Get the idea?
It’s fine to be heavily invested in stocks when the P/E10 level is 8. It’s not at all likely when you buy at those prices that your long-term return will be anything close to 6.5 percent real. You’re going to see returns far higher than that. You won’t complain. How many of the investors who went with a high stock allocation in 1982 regretted having done so?
When the P/E 10 level works against you
It’s a different story when the P/E10 level is insanely high rather than insanely low. When the P/E10 level is insanely high (as it has been since 1996), the P/E10 level has to drop hard to make its way back to reasonable levels. In those circumstances, your long-term return could be very low indeed, even a negative number. It is in those sorts of circumstances that you want to be going with a low stock allocation (regardless of anything the stock-selling experts tell you!).
Here’s my request.
Please use Shiller’s data to choose any month from 1870 forward and look at the P/E10 level that applied to determine what stock allocation you should have been going with at that time. Then move ahead 10 years to see what return applied. Shiller’s data doesn’t identify the precise return. But, if the P/E10 level stayed the same or rose or fell only a bit, the return was solid or at least acceptable. If the P/E10 level fell hard, the return was poor or perhaps downright panic-inducing.
Please complete this exercise for as many cases as you need to to convince yourself that you should always look at the P/E10 level of stocks before buying them. A P/E10 of 15 is the fair value price. A P/E10 below 10 is the insanely low price. A P/E10 of 25 or above is the insanely high price.
It is because we can do this today that this is the best time in history to be a stock investor. Knowing in advance the long-term return you are likely to obtain from stocks takes most of the stress out of the stock-buying experience.
What will they think of next?
Rob Bennett did a seven-minute interview with ABC News about his ten unconventional saving money tips. (Editors note: This interview is brilliant! Take six and a half minutes and give it a listen, there’s a lot of wisdom in it—Kevin M.) Rob’s bio is here.