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.
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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