Japan Does not Show That Stocks are Dangerous

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berntson
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Japan Does not Show That Stocks are Dangerous

Post by berntson »

Japan is the best-known example of a market that crashed and never came back. The usual idea is that the same could happen to the US stock market or any other stock market at any time. Some (including me) have used the case of Japan to motivate strong international diversification. Others have used Japan to suggest that investing in stocks is really quite a risky enterprise. Your investments could drop by 75% and they could stay there. Here is the chart for the Nikkei:

Image

The first thing to point out is that the Japan crash followed a bubble the likes of which the US market has never seen. The CAPE 10 for Japan rose from 20 in the mid-eighties to over 90 by the early nineties. This doesn't mean that that the US or any other market couldn't experience such a bubble. What it does mean is that the Japanese crash should not have come as a surprise to anyone. This is not a crash that came "like a thief in the night."

Image

The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90. You might as well just set money on fire. No intelligent investor should buy equities trading at such ratios. It is unclear, to say the least, whether any conclusions can be drawn about the dangers of markets with reasonable valuations.

The second thing to point out is that the Japan crash was a disaster for the market as a whole and a disaster for growth stocks. It was not a disaster for value stocks, since they by and large did not participate in the bubble. Here are the returns for various value strategies during and after the crash.

Image

Investors who bought reasonably priced equities did fine, since doing so game them a margin of safety. Buying equities with extreme valuations, on the other hand, is a recipe for disaster.

The lesson that I have mistakenly drawn in the past is that "a crash like Japan's could happen at any time." I now see no evidence to think that's true. What do you think? Am I missing something?
Last edited by berntson on Tue Apr 15, 2014 9:27 pm, edited 3 times in total.
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Re: Why You Shouldn't Fear Japan

Post by nisiprius »

That's very interesting and new, or certainly new to me.

What was your data source, was it no-cost or do you have access to some subscription service?
Last edited by nisiprius on Tue Apr 15, 2014 9:29 pm, edited 1 time in total.
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berntson
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Re: Why You Shouldn't Fear Japan

Post by berntson »

nisiprius wrote:That's very interesting and new, or certainly new to me.

What was your data source, was it no-cost or do you have access to some subscription service?
Thanks nisi! The links to the data are in the post. I also haven't directly verified the data myself since I don't have access to any of the fancy databases.
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Re: Why You Shouldn't Fear Japan

Post by packer16 »

I think folks err in the comparison to Japan and the US during the Depression by not considering the banking systems (or lack therof) and the ability to deal with bankrupt firms. In Japan, the debt holders rarely take over outleveraged firms, remove the debt and managers that borrowed too much and allow the firm to operate with new management without the debt overhang. In the US we have that ability and that allows a resolution of the debt of leveraged firms and the redeployment of capital in an efficient manner. In Japan, you have alot of capital "stuck" in these firms. This seem obvious to us but is not common outside the Anglophile and Dutch countries.

If you read about the Great Depression, you see that a large part of the banking system in the US stopped working. Folks in some parts of the country had to make up currency to facilitate trade. We have not even come close to this situation today or at any period post Depression. That is why I am skeptical when I hear be prepared for a Great Depression or Japan type of collapse. I am definately in the Charles Ellis' camp when it comes to asset allocation. He even suggests that you look at your salary is a bond and when you retire you want to replace that salary with an income stream from investments.

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Re: Japan Does not Show That Stocks are Dangerous

Post by keanwood »

Also for Japan you have to take Deflation into account. Those 1980 Yen are LESS than 2011 Yen.

If this website is accurate http://www.measuringworth.com/japancompare/result.php

In 2011, 1.00 ¥ from 1980 is worth:

1.29 ¥ using the Consumer Price Index
1.02 ¥ using the GDP deflator
1.58 ¥ using the average monthly wage
1.77 ¥ using the nominal GDP per capita
1.72 ¥ using the real GDP per capita
1.93 ¥ using the nominal GDP

This makes Graphs for Japan look worse than they actually are.

--Keanwood


Note: In relation to my other post http://www.bogleheads.org/forum/viewtop ... 0&t=137438 If anyone has the CPI data for Japan and Japan fund data the program that I am working on would be able to make Deflation adjusted graphs as well.
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Re: Japan Does not Show That Stocks are Dangerous

Post by pkcrafter »

Japan Does not Show That Stocks are Dangerous
Yes, it does. Japan shows that a market crash can last long enough to convert shallow risk into deep risk.

For those looking at Japan and coming up with reasons after the fact is kind of like how black swans are always reasoned out--after the fact. Is anyone actually saying something similar can't ever happen in the U.S.?

Bernston wrote:
The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90. You might as well just set money on fire. No intelligent investor should buy equities trading at such ratios.
Of course, you're right, but when emotions, in this case, greed, take over, investors do things they wouldn't normally do. And yet, CAPE 10 did reach 90. Someone was investing in growth stocks--most everyone was investing in growth stocks. Very similar to the dotcom bubble. This is just another powerful example of what investors do.

Should investors have driven the S&P500 CAPE 10 to 44 when the previous high was 30 in 1929? Remember, "It's different this time." I'm sure the Japanese investor said the same thing while enjoying unprecedented economic expansion.

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Re: Japan Does not Show That Stocks are Dangerous

Post by blueleaf »

Looking at that PE10 data, Nikkei has very high valuations even at its market lows - it's troughs are in the 30's, which is higher than any US market period except the late 1990s.

What confuses me is comparing that to that market's average price/book. At least in the data from the site you referenced, Nikkei's average p/b is 1.7, and current is 1.1. Compare that to 2.5ish for the s&p right now.

What gives? Shouldn't those two metrics track pretty closely over time? Maybe book value is accounted for differently in Japan than in the US? I'd live to hear from someone who could help explain.
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Re: Japan Does not Show That Stocks are Dangerous

Post by plats »

Japan’s stock bubble mirrored the land bubble, as land was used as collateral to buy stocks and vice-versa. What was left out of this discussion is that the Bank of Japan orchestrated the bursting of the bubble with interest rate hikes and excise taxes on land sales. It was a time when everyone was saying the average person couldn’t afford to buy a home and the gov’t was worried the work ethic might suffer as a result. The bursting was steep and severe, with a lot of headaches, suicides, but all in all since they averted a great depression I’d say it was a success. And now the average worker can afford a home again.
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Re: Why You Shouldn't Fear Japan

Post by Erwin »

nisiprius wrote:That's very interesting and new, or certainly new to me.

What was your data source, was it no-cost or do you have access to some subscription service?
I looked around and only found one affordable institution that delivers this data, The Idea Farm (http://www.theideafarm.com/subscriber-archives/). I receive quarterly the PE10s of about 40 countries.
I know that some of you will object but I look closely at the PE10s every quarterly to decide my allocation - more on it if interested. BY the way, given today's Japan PE10 at around 10, one will assume that it finally returned to acceptable values, which to a long term investor may mean that is it time to buy the Japan index.
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Re: Japan Does not Show That Stocks are Dangerous

Post by dl7848 »

berntson wrote:
The lesson that I have mistakenly drawn in the past is that "a crash like Japan's could happen at any time." I now see no evidence to think that's true. What do you think? Am I missing something?


Richard Koo: Lessons from Japan's Decline
Last edited by dl7848 on Wed Apr 16, 2014 11:37 am, edited 1 time in total.
steve_14
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Re: Japan Does not Show That Stocks are Dangerous

Post by steve_14 »

berntson wrote:What it does mean is that the Japanese crash should not have come as a surprise to anyone. This is not a crash that came "like a thief in the night."
You mean with hindsight. Unless you can show me pictures of your private island and your fleet of Bentleys, neither this crash, nor the dozens of crashes that followed were obvious to you at the time. Nor will the next dozen crashes be. As a simple test, ask yourself what's going to crash tomorrow, next week, or next month? Any ideas? The answer will surely "not come as a surprise" looking back.
berntson wrote:The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90. You might as well just set money on fire. No intelligent investor should buy equities trading at such ratios.
Unfortunately taking a look at a ratio and deciding the market (which has 10,000X the information you do) is wrong, while you've got it figured out, is a naive strategy. Are you taking note of all the times when this didn't work? Amazon has a P/E of 535, for example, always has, and has been one of the best performing stocks of the last 20 years. Generally speaking, higher valuations mean lower returns ahead, but that's a long way from "I'll just avoid Amazon and Google and not have to worry about stock risk".
berntson wrote:The second thing to point out is that the Japan crash was a disaster for the market as a whole and a disaster for growth stocks. It was not a disaster for value stocks, since they by and large did not participate in the bubble. Here are the returns for various value strategies during and after the crash.
I wouldn't put much weight on such a casually done, sensational study (note some of the section headings) by an investment firm called "Value Partners". In any case that's cherry picking results. Over the last 20 years, international growth as beaten value, and folks who were investing based on the rear view mirror underperformed.
berntson wrote:The lesson that I have mistakenly drawn in the past is that "a crash like Japan's could happen at any time." I now see no evidence to think that's true. What do you think? Am I missing something?
Yes, to summarize, taking a unique historical event and amplifying it to think you've got the market figured out.
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Re: Japan Does not Show That Stocks are Dangerous

Post by nedsaid »

I am going to come to Bernston's defense here. Whether you disagree with his post or not or if you think there were problems with the data, there are things that emerge from this thread.

First, valuations matter and they matter a whole lot. Or as Warren Buffett said, "Geometric progressions eventually forge their own anchors." Or as others have said, "Trees don't grow to the sky." Or as I like to say, start worrying when the shoe shine boys on Wall Street start bragging about their large stock profits. So investors should pay attention not only to extremes in valuations but also extremes in market sentiment.

Second, the deflation and the appreciation of the YEN mitigated the losses from the Japanese stock market. Still not good but less of a disaster than we thought.

Third, value strategies work better in the aftermath of a bubble than growth strategies. We saw this is in the decade of the 2000's where value strategies did better than growth here in the United States. If Bernston's graph is correct, the same held true after the Japanese bubble.

Fourth, don't put all your money in one country even if it is the United States. The Japanese experience to me is a powerful lesson in International diversification.

I think the original post was a good starting point for good discussion.
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Re: Japan Does not Show That Stocks are Dangerous

Post by grayfox »

berntson wrote: Image

Investors who bought reasonably priced equities did fine, since doing so game them a margin of safety. Buying equities with extreme valuations, on the other hand, is a recipe for disaster.

The lesson that I have mistakenly drawn in the past is that "a crash like Japan's could happen at any time." I now see no evidence to think that's true. What do you think? Am I missing something?
Call me skeptical. This research is saying that all you had to do was screen stocks by P/E and $1 grew to $433.86, compared to total market which grew $1 to $2.76.

If I am to believe this, you would have 157x more money investing in Japanese value stocks than in the Japanese total market? :shock:
$10,000 in value stocks would grow to $4.33 million vs only $27,600 in total market?
Pretty extraordinary result for such a simple screen.

Edit: I went to M* and $10,000 in Vanguard VFINX from 1980 to 2011 grew to $256,918. There is something seriously wrong with their results if they show $1 grew to $433.86 from 1980-2011.

So all the Japan Value funds would show these results. What are there symbols so we can look them up on M*?
If this was the result of an actual mutual fund I would believe it. But it is all hypothetical backtesting using screens chosen after the fact using some research methodology that I really can't verify myself.

And then consider that the research was sponsored by some kind if value investing group. Low and behold, the result comes out showing that value investing is 157x better than total market. What a coincidence!
Last edited by grayfox on Wed Apr 16, 2014 2:20 am, edited 2 times in total.
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Re: Japan Does not Show That Stocks are Dangerous

Post by 3504PIR »

pkcrafter wrote:
Japan Does not Show That Stocks are Dangerous
Yes, it does. Japan shows that a market crash can last long enough to convert shallow risk into deep risk.

For those looking at Japan and coming up with reasons after the fact is kind of like how black swans are always reasoned out--after the fact. Is anyone actually saying something similar can't ever happen in the U.S.?

Bernston wrote:
The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90. You might as well just set money on fire. No intelligent investor should buy equities trading at such ratios.
Of course, you're right, but when emotions, in this case, greed, take over, investors do things they wouldn't normally do. And yet, CAPE 10 did reach 90. Someone was investing in growth stocks--most everyone was investing in growth stocks. Very similar to the dotcom bubble. This is just another powerful example of what investors do.

Should investors have driven the S&P500 CAPE 10 to 44 when the previous high was 30 in 1929? Remember, "It's different this time." I'm sure the Japanese investor said the same thing while enjoying unprecedented economic expansion.

Paul
I think this is absolutely correct. Psycologically, we tend to look at crashes as something that bounce back, which is what has recently happened. In truth, we don't know if that is what will happen or not.

Buy and hold won't allow adjusting stock exposure in varying conditions/valuations.

I have always thought that one definition of testing a worst case scenario would be to take one's AA and plug it in to a spreadsheet overlaying retirement withdrawls using the first chart starting in about 1992 or so. Not perfect, but it is enlightning given the assumptions many have around here like the quote I read yesterday that had a poster 99% sure the market would be higher in 20 years.
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Re: Japan Does not Show That Stocks are Dangerous

Post by MapleHermit »

Your information is not completely unreasonable. However, if we are dismissing market timing and dollar cost averaging, investing in Japan back then would of been a disadvantage. Most average Bogleheads don't time the market and dollar cost average which would of resulted in bad performance if they invested in Japan. Also barely any professional portfolio managers who were managing a Japan equity fund managed to beat its Nikkei index during those years.

Moral of the story: Stocks are dangerous and that's why they give such a high return compared to any other asset class. There's no such thing as a free lunch.
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Re: Japan Does not Show That Stocks are Dangerous

Post by cjking »

steve_14 wrote: Unless you can show me pictures of your private island and your fleet of Bentleys, neither this crash, nor the dozens of crashes that followed were obvious to you at the time. Nor will the next dozen crashes be. As a simple test, ask yourself what's going to crash tomorrow, next week, or next month? Any ideas? The answer will surely "not come as a surprise" looking back.

Your idea that if you "know" there is a bubble, you can make huge speculative profits, is wrong. You are probably thinking that it could be exploited by buying put options, but that's not a sound strategy, as you have no idea how long the bubble will last and easily can lose more buying options every quarter while you wait for it to burst than you make when it actually bursts. And even saying "bursts" is overstating the potential for profiting in this way as for example the 2000 SP500 bubble deflated uncharacteristically slowly (I think because of deliberate government intervention.)

The correct response to Japan circa 1990 or SP500 circa 2000 would have been to invest in something else with higher expected returns. (I entirely agree with the OPs point that Japan measured from 1990 is, for the reasons given, not a useful example of stocks being risky - I have posted the same observation on here before.)

Edited to add: there have been many "bubble" discussion threads, I don't have the energy to repeat old arguments (more than I already have) so I suggest digging one of them out if you are interested.
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Re: Japan Does not Show That Stocks are Dangerous

Post by LH »

nedsaid wrote:I am going to come to Bernston's defense here. Whether you disagree with his post or not or if you think there were problems with the data, there are things that emerge from this thread.

First, valuations matter and they matter a whole lot. Or as Warren Buffett said, "Geometric progressions eventually forge their own anchors." Or as others have said, "Trees don't grow to the sky." Or as I like to say, start worrying when the shoe shine boys on Wall Street start bragging about their large stock profits. So investors should pay attention not only to extremes in valuations but also extremes in market sentiment.

Second, the deflation and the appreciation of the YEN mitigated the losses from the Japanese stock market. Still not good but less of a disaster than we thought.

Third, value strategies work better in the aftermath of a bubble than growth strategies. We saw this is in the decade of the 2000's where value strategies did better than growth here in the United States. If Bernston's graph is correct, the same held true after the Japanese bubble.

Fourth, don't put all your money in one country even if it is the United States. The Japanese experience to me is a powerful lesson in International diversification.

I think the original post was a good starting point for good discussion.


Sounds great.

Make a mutual fund that puts those sentiments to action. Call it the

"valuations matter and they matter a whole lot"

Fund.

With it, you will surely beat a passive market index, that pays zip attention to the valuations that matter a whole lot.

You will fail if you attempt this, the index fund will beat your approach expectantly, because in trackable observable and testable reality, valuations do not matter in any practical sense.

This experiment has been run, and is being run, all the time, it just fails, fails, fails, fails. One can use PE10, PE12, the hofsetter zigzag PE5, whatever valuation approach and cutoff, calculation, methodology you want. Failure.

It sounds good though, but you cant talk the talk, if no one can do a mutual fund walk. : )

Testable objective reality is what matters a whole lot. Empiric reality matters.




LH
Last edited by LH on Wed Apr 16, 2014 4:46 am, edited 1 time in total.
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Re: Japan Does not Show That Stocks are Dangerous

Post by dkturner »

pkcrafter wrote:
Japan Does not Show That Stocks are Dangerous
Yes, it does. Japan shows that a market crash can last long enough to convert shallow risk into deep risk.

For those looking at Japan and coming up with reasons after the fact is kind of like how black swans are always reasoned out--after the fact. Is anyone actually saying something similar can't ever happen in the U.S.?


If you have a mindset that markets are always efficient and one should be a buy and hold investor 24/7 the Japanese example does show that stocks can be dangerous. But I seriously doubt that Jack Bogle would have been caught up in this frenzy. I noticed he wasn't holding the bag in 2000 when U.S. equities began to crater. A little common sense can go a long way. :idea:
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Re: Japan Does not Show That Stocks are Dangerous

Post by LH »

dkturner wrote:
pkcrafter wrote:
Japan Does not Show That Stocks are Dangerous
Yes, it does. Japan shows that a market crash can last long enough to convert shallow risk into deep risk.

For those looking at Japan and coming up with reasons after the fact is kind of like how black swans are always reasoned out--after the fact. Is anyone actually saying something similar can't ever happen in the U.S.?


If you have a mindset that markets are always efficient and one should be a buy and hold investor 24/7 the Japanese example does show that stocks can be dangerous. But I seriously doubt that Jack Bogle would have been caught up in this frenzy. I noticed he wasn't holding the bag in 2000 when U.S. equities began to crater. A little common sense can go a long way. :idea:
If you were a buy and hold Boglehead accumulator, how bad did it really hurt you?

You start off investing first at that peak, yearly, with your first job, then you keep investing as it falls down. At first you have almost zero money in the market in your financial lifecyle. Clearly doesnt matter much here.

you start off investing 15,10,5 years before the peak, yearly or monthly (whatever) then you keep going until present day. Whats your real CAGR?

Its unclear to me what the effect really would be to a Boglehead investor, invest 15 year prior, you rode the rocket up, then rode it down, with deflation present, and dividends being spit out along the way. start 1980 investing 100 a month, ride up to 1990, then go to 2014, include dividends, and calculate real return. Especially if you have some bonds in there, and are rebalancing. It does not feel that bad really gestalt wise just eyeballing it.

Image
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Re: Japan Does not Show That Stocks are Dangerous

Post by magneto »

Thanks Bernston for an informative thoughtful post. The preceding wild excess in Japan must have been a key factor in the subsequent underperformance. Seem to remember at the time of the Japan peak all sorts of good reasons being given by the 'experts' as to why 'Japan was different'. Japan houswives were actively involved buying and selling stocks.

The times of wild excess, be it tulips, gold, housing, stocks, dot-com, etc, seem to re-occur in spite of the widespread wisdom learned from the last wild excess. It is difficult to stand aside and not be swept up with the enthusiasm.

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Re: Japan Does not Show That Stocks are Dangerous

Post by richard »

What is the CAPE at which I should not buy stocks?

Should I sell my stocks if CAPE goes above this level? If so, at what level should I start buying them back?
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Re: Japan Does not Show That Stocks are Dangerous

Post by packer16 »

I think the original posters statement is true. Everyone agrees that stocks are more volatile than bonds but what data have others provided to make there case that large stock declines (greater than 50%) are more frequent than once every 50 to 100 years in a single market. How about stating how large the declines have been and how often they occur then with this statement of fact determine how dangerous stocks are rather than speculation on what stock might/should do. With these facts then a rationale rather than speculative discuss can be had. I know speculation can be fun and you can get your point across but very little learning can take place which is what we are all here for.

The same can be done with trying to understand not only the initial decline (which granted could be a black swan) but the subsequent continuation of the decline caused by fundamental and not only psychological factors. The recent Japan and the Depression are two situations out of the normal cycle of stock market recoveries. Are there reasons why this is? These I think are the relevant questions and the answers many be where we can all learn a thing or two. Just my 2 cents. BTW good topic as it appears to have hit (and hopefully cause folks to question) some of there beliefs about market flucuations.

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Re: Japan Does not Show That Stocks are Dangerous

Post by Call_Me_Op »

Regardless of the specific history of Japan or any other country, the fact remains that stocks are valued based upon what people are willing to pay for them. So my theoretical maximum downside is and will always be 100%.
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Re: Japan Does not Show That Stocks are Dangerous

Post by packer16 »

As to buying a selling based upon a certain level of CAPE, I think it will not work. I have a friend that has tried to find a the right level of CAPE to do this and has found no level using out of sample data where the result of switching to cash a certain level would be better than just buying stocks and holding. The problem is the underlying assumptions of how stocks are valued at a given time are not constant so the CAPE level to sell is not a knowable number a priori.

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Re: Japan Does not Show That Stocks are Dangerous

Post by packer16 »

Call_Me_Op wrote:Regardless of the specific history of Japan or any other country, the fact remains that stocks are valued based upon what people are willing to pay for them. So my theoretical maximum downside is and will always be 100%.
Any asset can theoretically go to zero so the key question is how likely based upon history is this going to happen? That leads to the question about frequency and duration of asset class declines which can help form realistic views about our views on the risk of asset classes.

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Re: Japan Does not Show That Stocks are Dangerous

Post by YDNAL »

berntson » Tue Apr 15, 2014 11:15 pm

Japan is the best-known example of a market that crashed and never came back. The usual idea is that the same could happen to the US stock market or any other stock market at any time. Some (including me) have used the case of Japan to motivate strong international diversification. Others have used Japan to suggest that investing in stocks is really quite a risky enterprise. Your investments could drop by 75% and they could stay there. << snip >>

The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90. You might as well just set money on fire. No intelligent investor should buy equities trading at such ratios. It is unclear, to say the least, whether any conclusions can be drawn about the dangers of markets with reasonable valuations.
Fortunately, we all save *regularly* over time - for the most part - and not at any specific CAPE 10.
The lesson that I have mistakenly drawn in the past is that "a crash like Japan's could happen at any time." I now see no evidence to think that's true. What do you think? Am I missing something?
The lesson from Japan is that accumulating from 1980 to 1990 in the NIKKEI meant you were about to see your savings shrink and not recover for 24 years and counting. Hopefully, you also continued accumulating to average your cost basis to a more reasonable level -- more reasonable as measured against previously levels. The other lesson is that Japan's crash could happen at any time, anywhere. Know this, and deal with it!
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Re: Japan Does not Show That Stocks are Dangerous

Post by Methedras »

richard wrote:What is the CAPE at which I should not buy stocks?

Should I sell my stocks if CAPE goes above this level? If so, at what level should I start buying them back?

Well, there isn't a precise answer for this, but certainly there is a "loose" answer. All things being equal, the expected return from purchasing stocks with CAPE10 of 90 is 1/90, or 1.11%. Obviously this is a simplification since we don't know future returns, but it is the best estimate available. What is clear is that the valuation is very high, or consequently the expected return is very low.

So, compare this rate to available bond rates at the time. If you can purchase a bond yielding 1%, you should buy that instead because the risk is much lower for the same expected return. Hell, at those valuations, I'd probably take a bond yielding 0.3% over the risk of purchasing stocks at a CAPE of 90.

I admit, this "formula" isn't even close to bulletproof. There's a lot of fudging going on. But, in a world where you can invest internationally in both bond and stock markets, I can safely say that I would avoid purchasing these high P/E assets if better valued alternatives were available.
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Re: Japan Does not Show That Stocks are Dangerous

Post by hiddensee »

berntson wrote:The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90. You might as well just set money on fire. No intelligent investor should buy equities trading at such ratios. It is unclear, to say the least, whether any conclusions can be drawn about the dangers of markets with reasonable valuations.
That's fundamental analysis, so what happened to the EMH?

Why should I hold an index fund today that includes a lot of tech stocks with enormous P/E? Why is there a 10 page thread on this very board, an anti-timing and anti-picking board, full of people arguing it's a great idea to sell your possessions to buy Tesla stock (CAPE 10: infinity)?

Are we now saying it is possible to stock pick and time effectively?

I'd see this more as a diversification story than an analysis story - the whole country turned out to be WorldCom - but Japan isn't exactly a small place itself, so I think this does present some problem for EMH.
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Re: Japan Does not Show That Stocks are Dangerous

Post by ajcp »

3504PIR wrote:I think this is absolutely correct. Psycologically, we tend to look at crashes as something that bounce back, which is what has recently happened. In truth, we don't know if that is what will happen or not.
"I'm rooting for the market to drop 50% or better yet, even more. Then I can buy equities on the cheap." :oops:
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Re: Japan Does not Show That Stocks are Dangerous

Post by larryswedroe »

FWIW
I have Japanese small value stock return data (not large unfortunately) for period 1990-Feb 2014
Annualized return 3.9%. Total return 151% SD 24.3

Larry
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Re: Japan Does not Show That Stocks are Dangerous

Post by richard »

Methedras wrote:
richard wrote:What is the CAPE at which I should not buy stocks?

Should I sell my stocks if CAPE goes above this level? If so, at what level should I start buying them back?
Well, there isn't a precise answer for this, but certainly there is a "loose" answer. All things being equal, the expected return from purchasing stocks with CAPE10 of 90 is 1/90, or 1.11%. Obviously this is a simplification since we don't know future returns, but it is the best estimate available. What is clear is that the valuation is very high, or consequently the expected return is very low.

So, compare this rate to available bond rates at the time. If you can purchase a bond yielding 1%, you should buy that instead because the risk is much lower for the same expected return. Hell, at those valuations, I'd probably take a bond yielding 0.3% over the risk of purchasing stocks at a CAPE of 90.

I admit, this "formula" isn't even close to bulletproof. There's a lot of fudging going on. But, in a world where you can invest internationally in both bond and stock markets, I can safely say that I would avoid purchasing these high P/E assets if better valued alternatives were available.
The OP wrote "The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90."

I'm asking very precise questions - what are the numbers at which I should stop buying, sell and resume buying? Is your answer that I should stop buying (sell?) when bond yields (which bonds?) exceed 1/CAPE?
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Re: Japan Does not Show That Stocks are Dangerous

Post by dkturner »

richard wrote:What is the CAPE at which I should not buy stocks?

I'm asking very precise questions - what are the numbers at which I should stop buying, sell and resume buying? Is your answer that I should stop buying (sell?) when bond yields (which bonds?) exceed 1/CAPE?
A precise question about an imprecise situation is unlikely to get you a precise answer. Sometimes you just have to bite the bullet and use your imagination. :confused
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Re: Japan Does not Show That Stocks are Dangerous

Post by berntson »

Thanks everyone for the great feedback! I agree that the stock chart would be more informative if adjusted for inflation. I've tried to find a deflation adjusted version, with no success. This thread has convinced me that the history of the Japan's now two lost decades is complex and interesting, something I should know more about.

Blueleaf pointed out that the CAPE 10 for Japan remained high even after the crash but that price to book looks much better. I'm not sure what's going on here. It could be different international accounting standards. Maybe Japan had a disproportionate number of businesses with large investments in infrastructure and physical assets? This would be interesting to look into.

How should we use valuations to make investment decisions? One good answer is the way Jack Bogle would use them. I really liked what dkturner said.
dkturner wrote:I seriously doubt that Jack Bogle would have been caught up in [the Japanese] frenzy. I noticed he wasn't holding the bag in 2000 when U.S. equities began to crater. A little common sense can go a long way. :idea:
Jack Bogle would never use an elaborate PE10 timing strategy to shuttle in and out of equities. That would involve too much activity, too much market timing, and incur high transaction costs. He also would say that short term market movements are unpredictable. Expensive stocks can perfectly well become absurdly expensive stocks on their way to becoming reasonably priced stocks, and this process can take years. But Jack Bogle just has too much damn common sense to participate in a stock buying mania like the one we saw in Japan. Efficient markets are very good at setting prices, but they are no substitute for having a bit of common sense.

At the height of the tech bubble, Jack noticed that the expected return for bonds was very nearly the expected return for stocks. So he shifted a bit of his allocation from stocks to bonds. This is basically Methedras' suggestion. When stocks are priced to return little more than safe government bonds, the sensible investor should consider holding more bonds. Why take risk that you expect to be unrewarded?

Valuations can also be used to compare long-term global expected returns. A Japanese investor who had a high equity allocation might have noticed that Japanese stocks were somewhere between three and six times as expensive as US stocks. Since there was little reason to think that Japanese companies were three to six times better than American companies, it would have been reasonable to shift resources from Japanese equity to US equity.

In our current context, I see little reason to think that government bonds are priced attractively compared to US stocks. US stocks are expensive, but so are bonds. Thus, I see little reason for investors to shift assets from one to the other. Developed international stocks are generally cheaper than US stocks. VEA is 20%-30% cheaper than VTI by most measurements (price to earnings, cash flow, sales, and dividend yield). As a result, I have been slowly pushing my international allocation from 50% to 60%. If the price of US stocks continues to rise compared to international stocks, I'll push the allocation higher yet.
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Re: Japan Does not Show That Stocks are Dangerous

Post by berntson »

richard wrote: I'm asking very precise questions - what are the numbers at which I should stop buying, sell and resume buying? Is your answer that I should stop buying (sell?) when bond yields (which bonds?) exceed 1/CAPE?
This is a great question and there are bound to be several equally good answer. When it comes to weighting my international allocation, I use fundamental weights instead of capitalization weights. Arnott and Hsu showed that fundamental international weights are less volatile than capitalization weights. Two charts from their book Fundamental Indexing:

Image

Image

A fundamental weighting scheme was skeptical of the rapid rise in Japanese prices. It would increase an investor's allocation to Japan, but only as Japan actually started producing more earnings, more cash flow, more sales, and more dividends. Presently, the US fundamental weighting is still at about 40%, but the market cap weighting is about 50%. I'm going with the fundamental weighting and holding 40% US equity.

It may also be worthwhile to have an arbitrary cutoff at which one simply refused to own stocks from a particular global market. We could pick a nice round number. How about a PE10 of 42? I've always like the number 42. :D

Determining an allocation between stocks and bonds is a bit harder, since the assets are less comparable. If you want an exact number, maybe you could use the Kelly criterion?

If we were to ask Jack why he moved assets from stocks to bonds during the tech bubble and how he knew how much to move, I doubt that he would hand us a precise formula. He would probably say something like: Bonds were priced to return approximately as much as stocks. So an investor could reasonable hold more bonds than she otherwise would. If you are going to hold more bonds, make a change that is big enough to matter, but keep an eye on realized taxes and fees.
Last edited by berntson on Wed Apr 16, 2014 9:53 am, edited 1 time in total.
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Re: Japan Does not Show That Stocks are Dangerous

Post by pkcrafter »

Today in the U.S. we see CAPE 10 at 25. By historical standards that is high, in fact, other than a very recent run to 25, the only other 2 times it was exceeded resulted in run-away rises in CAPE 10, 1929 and 1999. Judging by this, we should be seeing most investors backing off equity allocations, but we don't, we see many more posts with investors asking about going 100% stock. If returns continue to be out of this world, we will see even more investors wanting more equity. It's the nature of the beast.

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When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
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Re: Japan Does not Show That Stocks are Dangerous

Post by richard »

dkturner wrote:
richard wrote:What is the CAPE at which I should not buy stocks?

I'm asking very precise questions - what are the numbers at which I should stop buying, sell and resume buying? Is your answer that I should stop buying (sell?) when bond yields (which bonds?) exceed 1/CAPE?
A precise question about an imprecise situation is unlikely to get you a precise answer. Sometimes you just have to bite the bullet and use your imagination. :confused
If so, the fundamental premise of "The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90" is either wrong or not useful.
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Re: Japan Does not Show That Stocks are Dangerous

Post by berntson »

pkcrafter wrote:Today in the U.S. we see CAPE 10 at 25. By historical standards that is high, in fact, other than a very recent run to 25, the only other 2 times it was exceeded resulted in run-away rises in CAPE 10, 1929 and 1999. Judging by this, we should be seeing most investors backing off equity allocations, but we don't, we see many more posts with investors asking about going 100% stock. If returns continue to be out of this world, we will see even more investors wanting more equity. It's the nature of the beast.
Right. Keep in mind, though, that a US investor need not only invest in US markets. I have no bonds, but I also have most of my portfolio overseas in markets with more reasonable valuations. I just see no reason to favor US companies to English companies or German companies or even Japanese companies. So I'll buy whichever ones are the cheapest.
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Re: Japan Does not Show That Stocks are Dangerous

Post by bpp »

berntson wrote:I agree that the stock chart would be more informative if adjusted for inflation. I've tried to find a deflation adjusted version, with no success.
Image

From a different thread:
Japan, 1989

Some notes on sources in there, too.
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Re: Japan Does not Show That Stocks are Dangerous

Post by richard »

berntson wrote:
richard wrote: I'm asking very precise questions - what are the numbers at which I should stop buying, sell and resume buying? Is your answer that I should stop buying (sell?) when bond yields (which bonds?) exceed 1/CAPE?
This is a great question and there are bound to be several equally good answer. When it comes to weighting my international allocation, I use fundamental weights instead of capitalization weights. Arnott and Hsu showed that fundamental international weights are less volatile than capitalization weights. Two charts from their book Fundamental Indexing:

<snip charts>

A fundamental weighting scheme was skeptical of the rapid rise in Japanese prices. It would increase an investor's allocation to Japan, but only as Japan actually started producing more earnings, more cash flow, more sales, and more dividends. Presently, the US fundamental weighting is still at about 40%, but the market cap weighting is about 50%. I'm going with the fundamental weighting and holding 40% US equity.

It may also be worthwhile to have an arbitrary cutoff at which one simply refused to own stocks from a particular global market. We could pick a nice round number. How about a PE10 of 42? I've always like the number 42. :D

Determining an allocation between stocks and bonds is a bit harder, since the assets are less comparable. If you want an exact number, maybe you could use the Kelly criterion?

If we were to ask Jack why he moved assets from stocks to bonds during the tech bubble and how he knew how much to move, I doubt that he would hand us a precise formula. He would probably say something like: Bonds were priced to return approximately as much as stocks. So an investor could reasonable hold more bonds than she otherwise would. If you are going to hold more bonds, make a change that is big enough to matter, but keep an eye on realized taxes and fees.
If "The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90" is to be actionable advice, there should be a way to specify in advance the level of CAPE at which to stop buying. Is the advice to not buy or is it also to sell?

It is relatively easy to specify a number (or formula) with hindsight. 42 is approximately the high point for US CAPE, so it might have avoided Japan, but wouldn't have mattered much in the US.

I'll admit 42 is a good general answer, although the usual problem is that the question is not clear.

Making it up as you go along leaves one prone to emotions and other factors which are the enemy of disciplined investing.

Anyone, saying valuations matter is one thing, coming up with reasoned actionable advice seems another.
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Re: Japan Does not Show That Stocks are Dangerous

Post by berntson »

richard wrote:Saying valuations matter is one thing, coming up with reasoned actionable advice seems another.
I agree completely.

The issue of valuations is rather like this. I'm 150 pounds. It would be bad news if I were 300 pounds, so it makes sense to have some sort of system in place to ensure that I don't become 300 pounds. Over the holidays I usually gain a few pounds and over the summer, I usually lose a few. So there is no sense worrying about every little shift in weight. But it is good for me to have a general policy: If my weight increases too much, I go on a diet.

Exactly how much does my weight need to increase before I should go on a diet? Five pounds? Ten pounds? Twenty pounds? 25.782 pounds? There is no precise answer, nor should we expect one. As a practical matter, I start slowly cutting back as the number rise. Five pounds overweight? Well, no beer for me until I lose a few pounds. Ten pounds overweight? Nothing but egg whites and tuna and an extra five miles a week of running.

Dealing with high relative valuations is similar. As stocks become relatively more expensive, investors should cutback and either find cheaper stocks or move assets to bonds. Precisely how much and precisely when? There is no precise answer, anymore than there is a precise answer to when a person should start a diet. But whatever policy an investor adopts, it should prevent her from buying stocks with a PE10 of 90. Just like whatever weight-loss strategy I adopt, it should tell me to start a diet before I hit 300 pounds.
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Re: Japan Does not Show That Stocks are Dangerous

Post by NoRoboGuy »

berntson wrote:Efficient markets are very good at setting prices, but they are no substitute for having a bit of common sense.
Markets are efficient and irrational. The logical fallacy is people tend to equate efficiency with rational behavior.
There is no free lunch.
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Re: Japan Does not Show That Stocks are Dangerous

Post by steve_14 »

cjking wrote:
steve_14 wrote: Unless you can show me pictures of your private island and your fleet of Bentleys, neither this crash, nor the dozens of crashes that followed were obvious to you at the time. Nor will the next dozen crashes be. As a simple test, ask yourself what's going to crash tomorrow, next week, or next month? Any ideas? The answer will surely "not come as a surprise" looking back.
Your idea that if you "know" there is a bubble, you can make huge speculative profits, is wrong. You are probably thinking that it could be exploited by buying put options, but that's not a sound strategy, as you have no idea how long the bubble will last and easily can lose more buying options every quarter while you wait for it to burst than you make when it actually bursts.
Sounds like you're calling me "wrong" while proving the point of my post. You never know when stocks are in a bubble, or how long it will last, or when stocks will drop. So looking back at Japan and declaring you've got the market figured out going forward is wrong, at that was my point.

As an analogy, you're about to parachute into the middle of genocidal civil war in Africa. You read that someone was killed there in a helicopter accident. "Great", you think to yourself, "I just won't take any helicopters, and this trip will be risk free!"
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Re: Japan Does not Show That Stocks are Dangerous

Post by steve_14 »

louis c wrote:
berntson wrote:Efficient markets are very good at setting prices, but they are no substitute for having a bit of common sense.
Markets are efficient and irrational. The logical fallacy is people tend to equate efficiency with rational behavior.
Where I come from, money is a rather scarce resource, leading people to behave rationally with it. I don't see many folks leaving $100 bills on the sidewalk, for example.
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Re: Japan Does not Show That Stocks are Dangerous

Post by NoRoboGuy »

steve_14 wrote:
louis c wrote:
berntson wrote:Efficient markets are very good at setting prices, but they are no substitute for having a bit of common sense.
Markets are efficient and irrational. The logical fallacy is people tend to equate efficiency with rational behavior.
Where I come from, money is a rather scarce resource, leading people to behave rationally with it. I don't see many folks leaving $100 bills on the sidewalk, for example.
True, but people do not always view logically what that $100 can realistically buy if you are talking about tulips, dotcoms, etc.
There is no free lunch.
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Re: Japan Does not Show That Stocks are Dangerous

Post by Methedras »

steve_14 wrote: As an analogy, you're about to parachute into the middle of genocidal civil war in Africa. You read that someone was killed there in a helicopter accident. "Great", you think to yourself, "I just won't take any helicopters, and this trip will be risk free!"
There are too many "black and white" style responses in this thread, such as the example above. (Sorry Steve, I don't mean to call you out like that! :beer )

Obviously there's no way to pick the exact moment when you should use divination to find the future of stocks and sell the whole lot. No one here should be claiming anything like that. But, I think most of use here on this board would recognize that as the stocks rose, and the P/Es were going up, we would be prudent to rebalance and take some of the profits off the table. If you start to see such a meteoric rise in valuations as in Japan, while it might be hard to dump all of your stocks and assume a 100% bond position, I know I personally would be cutting down on the stock percentage in my AA. I certainly wouldn't hold a portfolio of 75% stocks (as I do now) if I were wholly invested in stocks with a CAPE of 90.

So sure, I would definitely still have lost some money if I were invested during this event, because maybe I only have the guts to cut back to 50% stocks. And yes, that does have a flavor of market timing/tactical asset allocation, but the KEY difference is the motivation behind the allocation change. I wouldn't be paring back on stocks in order to increase my profits, but to reduce potential risks. It's not about getting filthy rich, it's about getting a good night's sleep. And it's not about finding the precise moment to do it, or getting the timing just right. It's about feeling that you have the right risk level, which can never be quantified anyways. Risk is all in the gut.
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Re: Japan Does not Show That Stocks are Dangerous

Post by ogd »

steve_14 wrote:
berntson wrote:What it does mean is that the Japanese crash should not have come as a surprise to anyone. This is not a crash that came "like a thief in the night."
You mean with hindsight. Unless you can show me pictures of your private island and your fleet of Bentleys, neither this crash, nor the dozens of crashes that followed were obvious to you at the time. Nor will the next dozen crashes be. As a simple test, ask yourself what's going to crash tomorrow, next week, or next month? Any ideas? The answer will surely "not come as a surprise" looking back.
I think this is the key point. Any crisis could have been avoided in hindsight. In fact, it reminds me of the eponymous captain in South Park.

There are few roads more alluring in investing than the proposition that you're going to take a lot of risk, profit from it, then maneuver your way around the risk manifesting. Unfortunately, that road is littered with burning wrecks, of once shiny Bentleys if you will.
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Re: Japan Does not Show That Stocks are Dangerous

Post by garlandwhizzer »

I think berntson's post is insightful and makes two excellent points. First valuations matter, especially at extreme levels. This does not mean that it is an easy market timing decision as to exactly when to lighten up on overpriced equities as an asset bubble inflates, or conversely when to buy equities as a market crash progresses. Most of us do that simply by rebalancing, but I believe that there is a small minority of investors who have some skill at picking entry and exit points over time. Second, although many tout the horrors of the Japan's historical market crash as a reason to fear the current US equity market, those two markets are not analogous at present and have never been since Japan crashed. Crashes of the severity and duration of Japan's which is still going on, are in fact predictable by looking at basic measures of stock valuation. No one can predict exactly when the tide will turn and the market will crash, but one can accurately conclude in these incredibly overvalued situations that risks are extreme and act accordingly. As Buffett says, you don't have to pick the exact bottom of a market crash. All you have to do to be a successful value investor is to pick is an entry point when you're getting good long term value for your dollar and then hold on.

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Re: Japan Does not Show That Stocks are Dangerous

Post by dkturner »

richard wrote:
dkturner wrote:
richard wrote:What is the CAPE at which I should not buy stocks?

I'm asking very precise questions - what are the numbers at which I should stop buying, sell and resume buying? Is your answer that I should stop buying (sell?) when bond yields (which bonds?) exceed 1/CAPE?
A precise question about an imprecise situation is unlikely to get you a precise answer. Sometimes you just have to bite the bullet and use your imagination. :confused
If so, the fundamental premise of "The correct lesson to draw from Japan is: Don't buy stocks with a CAPE 10 of 90" is either wrong or not useful.

That's just plain silly. We are talking about the concept of excessive equity valuation. I doubt that anyone attaches any particular significance to the number 90. Excessive valuation is in the eye of the beholder and will vary from market to market. I doubt Mr. Bogle would have been caught with excessive equity holdings had he lived in Japan in the late 1980s, but based on some of the comments in this thread it looks like a number of his acolytes would have.
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Re: Japan Does not Show That Stocks are Dangerous

Post by berntson »

steve_14 wrote:
louis c wrote:
berntson wrote:Efficient markets are very good at setting prices, but they are no substitute for having a bit of common sense.
Markets are efficient and irrational. The logical fallacy is people tend to equate efficiency with rational behavior.
Where I come from, money is a rather scarce resource, leading people to behave rationally with it. I don't see many folks leaving $100 bills on the sidewalk, for example.
I heard something interesting on NPR yesterday. Suppose you and I are running a convenience store selling chocolate bars for a dollar, not including 10% tax. Apparently, studies show that people spend about 8% more when the shelf-price is $1 and we add 10% tax at the register than they do when the shelf-price is $1.10 and already includes tax. I suppose we could say that people are rational, it's just that they get ten cents worth of happiness when we add tax at the register instead of including it in the shelf-price. I'm inclined to think that we're all disposed to engage in certain subtly irrational behavior.
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Re: Japan Does not Show That Stocks are Dangerous

Post by Clearly_Irrational »

richard wrote:What is the CAPE at which I should not buy stocks?
Values over one standard deviation for the market in question are usually a bad sign.
richard wrote:Should I sell my stocks if CAPE goes above this level?
Probably not completely, but you should really consider changing your AA in response. In this example, the right answer would have been to lower your allocation to Japanese equities and increase your allocation to international markets.
richard wrote:If so, at what level should I start buying them back?
When they come back within the "normal" range and more closely match those of other markets you'd edge your allocation back up to your more usual level, whatever that happens to be.

I'm not advocating a continuous dynamic AA based on relative CAPE values, merely suggesting that at certain times an entire market can get out of whack and require special treatment.
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