Tag Archives: valuewalk

It’s Not Possible For A New Understanding Of How Stock Investing Works To Become Popular Without People Losing Confidence In The Old Understanding

By Rob Bennett Valuation-Informed Indexing is the future. Buy-and-Hold is the past. Or at least so I believe. But as of today, Buy-and-Hold is far more popular. About 80 percent of stock investors do not believe it is necessary for them to change their stock allocations in response to big valuation shifts. Another 10 percent see the merit of the idea, but are reluctant to adjust their allocations too much, because few investors do this, and they see risk in going against conventional opinion. About 10 percent follow a Valuation-Informed Indexing strategy. I want to spread the word about the new model, which I view as the first true research-based strategy (because Shiller’s 1981 finding that valuations affect long-term returns discredited the belief rooted in Fama’s research that the market is efficient). So I need to point out the dangers of Buy-and-Hold. I wish it weren’t so. I greatly admire the Buy-and-Hold pioneers. I buy into all of their beliefs except for the one about there being no need for investors to take price into consideration when buying stocks. Moreover, the 80 percent who believe in Buy-and-Hold are offended when I find fault with the strategy. If there were some way to make the case for Valuation-Informed Indexing without criticizing Buy-and-Hold, I would win over a lot more people and encounter a lot less friction as a result of my efforts to do so. It can’t be done. Fama said the market is efficient. That means stocks are always priced properly. Buy-and-Holders often object to that statement. They say an efficient market is just one in which all available information is incorporated into the price, but the price that results is not necessarily the right one. That’s a hyper-technical distinction. If the market price incorporates all known information, the market price is as close to perfect as it could possibly get. Buy-and-Holders are essentially saying the market price is always right. If the market price is always right, indicators of overvaluation and undervaluation are meaningless. Buy-and-Holders don’t consider valuations when buying stocks for a logically sound reason. They don’t believe valuation metrics tell us anything. According to the Buy-and-Hold model, the P/E10 value is noise. Shiller showed the P/E10 value is not noise. It effectively predicts long-term returns. By undermining the foundational belief of the Buy-and-Holders, Shiller turned our understanding of how stock investing works on its head. It’s not true that stocks are risky; the risk largely goes away for investors who take valuations into consideration when buying stocks. It’s not true that the safe withdrawal rate is the same number for all retirees; the safe withdrawal rate is a number that ranges from 1.6 percent when stocks are priced as they were in 2000 to 9 percent when stocks are priced as they were in 1982. It’s not true that bad economic times cause stock crashes; stock crashes become inevitable once overvaluation gets too out of control and the losses experienced in the crashes cause consumer spending power to dry up and the economy to falter. Shiller’s finding is all positive. It’s like the discovery of electricity; it leaves us all big winners. But it represents a big change. Shiller’s finding will eventually take us to a very good place, but starting a national debate regarding the implications of his finding has been a disruptive experience. How people invest to finance their retirements is an important and sensitive matter. Telling people they got it all wrong upsets them. People want to move forward in their understanding. But it hurts them to let in the knowledge that they could have earned higher lifetime returns at less risk had they caught on to the significance of the Shiller revolution earlier in life. The normal way for a new idea to catch on is through exposure in the marketplace of ideas. When the Beatles showed up on the Ed Sullivan show with their long hair, a debate was launched as to whether it was okay for men to wear their hair at that length. Arguments were advanced from both sides of the divide in opinion. Eventually, a resolution was reached in the minds of most people. The Beatles won that one (for the most part, but not entirely). Most people of today find long hair acceptable on men. The big problem in the investing realm is that the debate has not yet been successfully launched. People who believe valuations matter keep quiet about it when they are speaking in the presence of Buy-and-Holders. It is viewed as rude to mention how dangerous Buy-and-Hold will prove to be if it turns out Shiller really is on to something. There’s no way to know for certain that Shiller is right. The historical data supports him. But data from earlier times can be dismissed on the grounds that the economic conditions under which that data was produced no longer apply. And the data from the time of Shiller’s finding until today is inconclusive. From 1981 forward, Buy-and-Hold has performed slightly better than Valuation-Informed Indexing. Valuation-Informed Indexers say that’s because stock prices are high today; Valuation-Informed Indexing will be revealed as the superior strategy with the next price crash, which is inevitable, according to the Shiller model. But that way of thinking about things begs the question: to say Valuation-Informed Indexing will prove superior because today’s valuations will produce another crash is to say Valuation-Informed Indexing will prove superior once again because Valuation-Informed Indexing has always been superior. The crash hasn’t come yet. So we don’t know for certain. To be fair, the Buy-and-Holders are begging the question too. They say we cannot know that another crash is coming soon, because the market is efficient and returns are thus not predictable. All of the beliefs of those following both strategies follow from their core premises. If the market is efficient, Buy-and-Hold is the ideal strategy. If valuations affect long-term returns, Buy-and-Hold is dangerous. I believe I need to point that out to my Buy-and-Hold friends. I don’t want to hurt their feelings. I want them to consider what might happen to their retirement portfolios if it turns out Shiller is right. I criticize their strategy not to upset them, but to alert them to a new way of thinking about how stock investing works that I strongly believe we all need to know about. Disclosure: None.

Our Investing Biases Are Particularly Dangerous Because They Are Time-Based Rather Than Phenomenon-Based

By Rob Bennett I read an article this week that explored the differences between how we have responded as a society to the pushes for limits on smoking and on guns. The push for limits on smoking has been highly successful. The push for limits on guns has not been terribly successful. Why? The article argued that the difference is that smoking is not an ideological or cultural issue; neither conservatives nor liberals see efforts to limit smoking as an attack on their world view. It’s different with guns. Most cities are heavily liberal and most rural areas are heavily conservative. As a result, there are strong ideological and cultural differences between those who own guns and those who do not. Those who have never been around guns have a hard time understanding why anyone would feel a need to own one. But those who have been around guns all their lives cannot understand why those favoring limits on ownership are so troubled by guns. So efforts to change the law in this area produce intense conflicts; the harder one side pushes for limits, the harder the other side opposes those limits and gridlock results. “Bias” is not one thing. There are many varieties of biases, some more problematic than others. In fact, an argument can be made that some biases are good. As a general rule, it is a bad thing to be biased because to possess a bias is to respond unthinkingly to a phenomenon. But acting on the basis of a bias speeds up one’s reaction time and that is not such a bad thing in some cases. I have a strong bias against disco. I have probably missed out on some disco songs from which I would have derived a pleasurable listening experience. But there aren’t many disco songs that fall into that category. And my bias helped me avoid a lot of painful listening experiences too. The biases that many of us hold about investing issues are extremely damaging, in my view. Most biases are phenomenon-based. We favor certain types of food over others. Or we favor certain ways of thinking about issues over others. Or we favor certain ways of doing things over others. These biases can hold us back. But the good thing about phenomenon-based biases is that we can limit the power of the bias by deliberately exposing ourselves to the opposite sort of phenomenon from time to time to check whether the bias is supported by the realities. Liberals are biased against conservative ideas and conservatives are biased against liberal ideas. Is that really such a bad thing? If we reconsidered our philosophical orientation each time a new issue was presented to us for our assessment, it would take much longer for us to figure out where we stand on issues. The reality is that once a person has thought about a few issues hard enough to know where his bias lies, he can save time when assessing new issues by jumping to a quick conclusion that his position will be ideologically consistent with his earlier positions. Being biased is a time-saver. But there are dangers, of course. There are always those few issues regarding which a liberal adopts the conservative take and those few issues regarding which a conservative adopts the liberal take. Those exceptions can achieve great significance over time. If you follow the story of how a liberal becomes a conservative over a number of years or of how a conservative becomes a liberal over a number of years, you will see that it is usually one important exception to a general bias that starts the ball rolling in a new direction. I often seek out views different than my own just to shake up my preconceptions a bit. It’s very very hard to do that in the investing realm. The most important investing biases are time-based rather than phenomenon-based. That means that for long periods of time certain ideas are forgotten by almost the entire population. To tap into the other side of the story, the investor would have to study historical data from a time period many years removed from the current time period. Who does that? Shiller showed that valuations affect long-term returns. What he really was doing when he did that was showing that the stock market is not efficient, that mis-pricing on either the high or low side is a significant reality rather than the illusion that Buy-and-Holders believe it to be. Even during the most out-of-control bull market, there are a small number of people questioning whether the insane prices achieved are real and lasting. But the percentage of the population holding that view can be very small indeed. The percentage of the population that is conservative rather than liberal doesn’t vary dramatically from time to time. The percentage of the population that believes that stocks are the perfect investment choice is dramatically higher when prices are high than it is when prices are low. For a good number of years following the great crash of 1929, investors didn’t expect to see any capital appreciation at all on their stocks. The conventional wisdom of the time was that stocks were worth buying only for their dividends; those that didn’t pay high dividends were not worth owning. In the late 1990s, dividends fell to tiny levels. The very thing that made stocks dangerous (their high price) changed the conventional wisdom on stock ownership to reflect a bias that stocks are always worth owning. Stocks for the Long Run was a popular book in the 1990s. It would not have sold many copies in the 1930s. The book reports on data, facts, objective stuff. The message of the data should not change from times like the 1930s to times like the 1990s. But the ways in which we arrange the data and interpret the data changes when we go from bull markets to bear markets. People will be looking at the same data that was employed in Stocks for the Long Run to sell stocks to make the case against stocks when we are on the other side of the next stock crash. Our stock biases hurt us. But they are hard to see through because just about everyone is on one side of the table for a long stretch of time and then just about everyone is on the other side of the table for the next long stretch of time. Bull markets turn us all into bulls and bear markets turn us all into bears. Investing biases come to be so widely shared for long stretches of time that it is hard for any of us to keep their other point of view even remotely in mind. Disclosure: None

ETFs: Passing Marks For Liquidity, But What About Performance?

By Alliance Bernstein Proponents of credit exchange traded funds (ETFs) claim the last week of market turmoil was a test for these instruments-and that they passed. We think this takes grading on a curve to a new level. The cheerleaders say ETFs succeeded because they traded regularly after a high-yield mutual fund failed and barred investor withdrawals. Here’s what they’re not telling you: in exchange for this liquidity, investors ended up with instruments that have woefully underperformed active mutual funds-recently and over many years. For long-term investors who are saving to pay for college or retirement, that’s an awfully steep price to pay for something they don’t really need. The numbers speak for themselves: Over the first 11 months of this year, the two largest ETFs – HYG and JNK – have sharply underperformed the average active manager, not to mention their own benchmarks. They’ve also trailed the average active manager so far in the fourth quarter ( Display ) and since the start of December, one of the year’s most volatile months so far. ETFs’ longer-term performance falls short, too. In fact, not only have active managers outpaced ETFs over the long run, they’ve done it with lower volatility, as measured by risk-adjusted returns. The Sharpe ratio, which measures return per unit of risk, was 0.45 for JNK and 0.51 for HYG between February 2008, shortly after they began trading, and November of this year. For the top 20% of active high-yield managers, it was 0.71. How Much Liquidity Is Enough? Is the ability to get in or out of an ETF at any point in the day worth the underperformance? For asset managers and traders who need to trade frequently to hedge positions, maybe. After all, they’re not investing in these instruments as long-term income generators. But a large share of the people who own high-yield ETFs aren’t traders. They’re regular folks saving for college, or to buy a new home, or for retirement. In other words, they’re investors, not traders. Most probably aren’t doing any intraday trading at all. If they’re buying ETFs for the liquidity, they’re paying-dearly-for something they don’t need. In our view, an actively managed mutual fund is likely to offer higher potential returns over the long run – and give investors a better chance of meeting their goals. In fact, the data suggest that investors who want long-term exposure to high yield would do better to pick an active manager out of a hat than invest in an ETF. With Mutual Funds, Diversification Is Key All well and good, some investors are no doubt thinking. But what happens when mutual funds fail? That’s a fair question. Liquidity is important for everyone, as the failure of Third Avenue Management’s Focused Credit Fund illustrates. But it’s important to remember that this mutual fund was not a typical high-yield fund. It focused almost exclusively on risky distressed debt issued by highly leveraged companies. These types of assets are relatively illiquid, and that became a problem when large number of investors wanted to sell their shares. In other words, investors were promised “daily liquidity”-the ability to buy or sell shares in the mutual fund at the end of each trading day-but the assets the mutual fund owned could not be bought or sold on a daily basis. These types of strategies are bound to fail eventually. Most high-yield managers follow more diversified strategies that focus on a wide array of higher-quality assets. Of course, investors should still make sure their investment managers have a dynamic, multi-sector approach and are managing their liquidity risk effectively . Those who do a good job will be in position to meet redemptions during downturns and seize opportunities as they arise . That’s something Third Avenue couldn’t do. High-yield ETFs can’t do it, either . The recent turbulence in the high-yield market probably isn’t over. But we don’t think that should concern long-term investors too much. In our view, the best approach at this point is probably to ride out the storm. The intraday liquidity ETFs offer comes at a high price-and if you’re a long-term investor in high yield, you shouldn’t be paying it. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Disclosure: None