SINGAPORE (Jan 22): IF one simply buys the US stock index and holds it for 100 years, one can earn yearly returns of 10%. That is substantial and one can expect to double one’s net worth in seven years, quadruple it in 14, octuple it in 21 and increase it by 16-fold in 28 at a 10% growth rate.
The truth is that 99% of investors fail to achieve yearly returns of 10% despite earnest efforts, and thus miss out on the pleasure of growing their returns by 16-fold.
They try to time the stock market in the quest for better returns, but end up with a poorer result instead. This is owing to our herd instinct — shaped by years of a hunter-gatherer existence. Our success as a species depended on us being able to live and hunt together; it was either the woolly mammoth or us. Stay close together, move together and do not stand out. Unfortunately, this primal instinct works against us in the stock market. If one watches the market too closely and follows the minute-by-minute news, one would succumb to the emotions of the crowd and end up doing the opposite of what a rational investor would do. One would succumb to euphoria and increase one’s positions in a rising market or dump them in a faltering one. For example, as recently as 2006, when valuations were low, investors were afflicted with malaise. But today, in 2018, they are back with animal spirits.
Is it possible to have a market-timing formula to help us guard against ourselves?
The formula should be derived from a fundamental measure. Let’s consider earnings, or specifically the price-earnings ratio. A stock’s price divided by its earnings would give the PE ratio. So, if a PE ratio is high, it means the investment is expensive as one is paying more for earnings. One can apply this ratio to the overall market by taking the total capitalisation of all the stocks and dividing it by total earnings. But as earnings are volatile, especially in boom and bust cycles, one could just take the average of the last 10 years. Earnings 10 years ago are not the same as today because of inflation, so one should adjust for that.
That is exactly what Robert Shiller did in 1983; he called it the cyclically adjusted price-to-earnings (CAPE) ratio. Shiller found that a high CAPE ratio will indicate low returns for the next 10 years and vice versa.
Shiller found that the long-term average of the CAPE ratio for the US market is 15. When the ratio strays upward of 15, it points to overvaluation. Just before Black Tuesday, the CAPE ratio was 30, or twice the historical average, and this was followed by a stock market crash leading to the 1930s Great Depression. In 2000, just before the dotcom crash, the CAPE ratio was 40. The CAPE ratio does seem to have some predictive ability.
Today, the CAPE ratio for the US market is 33! Since 2010, the US market has already been deemed overvalued as measured by the CAPE ratio. Instead of crashing, US stocks have continued to pile on gains and defied the CAPE ratio.
What did Shiller say about this?
In Shiller’s own words in 2012: “I even worry about the 10-year PE, even that relationship could break down.” And in March 2017: “There is no clear message from all of this. Long-term investors shouldn’t be alarmed and shouldn’t avoid stocks altogether.”
Is he caving in?
A bull market can defy all logic and make Nobel prize winners (Shiller) look stupid in the short term. We think he will be proven right, ultimately. There are many reasons peddled why a CAPE ratio of 33 is reasonable. Chiefly, “This time, it is different”, “Interest rates are low” and “The 10-year earnings average is skewed lower by 07/08”.
What is the layman to do without a formula?
The last option is to stay mostly invested and to focus one’s attention on what one is buying and the price one is paying. For example, the investor may occupy himself with examining the assets in the balance sheet and determining whether they are fairly stated. He may decipher whether the cash flow accruing to the business is sustainable. He may want to estimate its dividend policy and capital expenditures going forward.
In other words, just focus on buying a stock without paying too much and the result will take care of itself. You might even multiply your returns by 16-fold sooner than in 28 years.
