Do Indexers even need to pay attention to market valuation?

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02nz
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Re: Do Indexers even need to pay attention to market valuation?

Post by 02nz »

Normchad wrote: Sat Jul 17, 2021 7:58 pm I don’t care about valuations. Mostly because there just isn’t anything useful I can do with that information.
Maybe not when it comes to when/whether to invest. But I do think it's wise to consider valuations when projecting future returns, since the relationship between the two is well-established. I see a lot of posts here to the effect of "my/your tax-deferred account will reach X millions in Y years, assuming 10% returns," where the over-optimistic assumption about future returns will likely lead to costly mistakes.
Normchad
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Re: Do Indexers even need to pay attention to market valuation?

Post by Normchad »

02nz wrote: Wed Jul 21, 2021 5:57 pm
Normchad wrote: Sat Jul 17, 2021 7:58 pm I don’t care about valuations. Mostly because there just isn’t anything useful I can do with that information.
Maybe not when it comes to when/whether to invest. But I do think it's wise to consider valuations when projecting future returns, since the relationship between the two is well-established. I see a lot of posts here to the effect of "my/your tax-deferred account will reach X millions in Y years, assuming 10% returns," where the over-optimistic assumption about future returns will likely lead to costly mistakes.
I don’t really make future projections on returns either. But you are right, if I did, I would take that into account.

Based on the CAPE10 of 2016, what should the returns of the last 5 years been?
02nz
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Re: Do Indexers even need to pay attention to market valuation?

Post by 02nz »

Normchad wrote: Wed Jul 21, 2021 6:01 pm
02nz wrote: Wed Jul 21, 2021 5:57 pm
Normchad wrote: Sat Jul 17, 2021 7:58 pm I don’t care about valuations. Mostly because there just isn’t anything useful I can do with that information.
Maybe not when it comes to when/whether to invest. But I do think it's wise to consider valuations when projecting future returns, since the relationship between the two is well-established. I see a lot of posts here to the effect of "my/your tax-deferred account will reach X millions in Y years, assuming 10% returns," where the over-optimistic assumption about future returns will likely lead to costly mistakes.
I don’t really make future projections on returns either. But you are right, if I did, I would take that into account.

Based on the CAPE10 of 2016, what should the returns of the last 5 years been?
My point wasn't about a "correct" projection for a specific time period, but that we should adjust assumptions about forward returns downwards in big-picture planning, rather than assuming the stock market will give us the same returns the next 5, 20, or 100 years that it's given us in the past. I think it's much wiser to assume say 5% returns than 10%, given where valuations are.

BTW projections of portfolio growth are key to retirement planning. It's an essential calculation for the Roth vs traditional decision, for example.
Last edited by 02nz on Wed Jul 21, 2021 6:08 pm, edited 1 time in total.
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

HomerJ wrote: Wed Jul 21, 2021 5:48 pm Valuations today do not tell you anything about "long run" expected returns. They MIGHT tell you something about "short run" expected returns.

I completely ignore valuations and expected returns. I pick an Asset Allocation based purely on risk management. I'm close to retirement, so I have a good chunk in bond/cash so I have safer money for the short-term, and keep the rest of my money in stocks for the long-term.

I get what I get, and I adjust to ACTUAL returns. Don't make plans around "expected" returns.

I consider it foolish to make large adjustments to one's Asset Allocation based on weak predictions with huge error bars.

The market has always moved in cycles. Bad years are followed by good years are followed by bad years are followed by good years.. Will this continue? No guarantees, but probably.

The long-term 10% nominal historical annual return of the stock market INCLUDES all the high valuations years and the crashes and bad decades.

Read that again.

So far, just buying and holding, through the good times and the bad times, still made you rich, because the average return was good even including those bad years.

People talk about 1999-2000, when valuations were the highest in U.S. history... A terrible time to invest, right? No, it turned out fine.

One still made 7.5% a year on money invested at the very top of the dot-com bubble over the past 21 years. And of course, every OTHER year has made even more. When the WORST CASE, in recent years, is 7.5% a year over 21 years, that's pretty good.

Sure short-term, people who invested in 2000 lost money, then gained some, then lost again over the 2000-2010 year period. Long periods of bad years do happen.

But even including those 10 bad years, someone who ignored valuations in 2000, has still made a ton of money investing over the past 21 years.

Another crash or a long sideways market will happen. Maybe even starting tomorrow. But bad years, so far, are followed by good years, and the average will likely still be good enough to make you rich.

Sure, it would be great to be out of the marke during the bad years, and only in the market during the good years, but that's hard... Valuations alone don't tell you that. I talked about 2000. But anyone following valuations would have gotten out of the market in 1996, not 2000. But the market more than doubled from 1996-2000. And even at the bottom of the dot-com crash, in 2003, the market never was as low as it was in 1996.

Buying and holding in 1996, even with valuations at heights no one had seen since right before the Great Depression.... turned out to be a great time to buy.

Valuations predictive power has been terrible since it was discovered in 1988. Ignore them.

Pick an Asset Allocation that you can hold through the long-run even if the market crashes tomorrow, and then you don't have to worry about crashes anymore. We invest for the long run.
Start dates have a very huge impact on long-term returns. So I disagree that we should just ignore them. If I am a Japanese investor I’m not going to blindly follow my AA to be 100% Japanese equities just because “invest we must”…yes, we must invest. Investing a huge concentrated stake in one market that’s historically richly valued is NOT a must

It’s not just a short term decision you are making when investing in heated markets. It very much could have significant long-term impact.
Normchad
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Re: Do Indexers even need to pay attention to market valuation?

Post by Normchad »

02nz wrote: Wed Jul 21, 2021 6:04 pm
Normchad wrote: Wed Jul 21, 2021 6:01 pm
02nz wrote: Wed Jul 21, 2021 5:57 pm
Normchad wrote: Sat Jul 17, 2021 7:58 pm I don’t care about valuations. Mostly because there just isn’t anything useful I can do with that information.
Maybe not when it comes to when/whether to invest. But I do think it's wise to consider valuations when projecting future returns, since the relationship between the two is well-established. I see a lot of posts here to the effect of "my/your tax-deferred account will reach X millions in Y years, assuming 10% returns," where the over-optimistic assumption about future returns will likely lead to costly mistakes.
I don’t really make future projections on returns either. But you are right, if I did, I would take that into account.

Based on the CAPE10 of 2016, what should the returns of the last 5 years been?
The point isn't to have a "correct" projection for a specific time period, but that we should adjust assumptions about forward returns downwards in big-picture planning, rather than assuming the stock market will give us the same returns the next 5, 20, or 100 years that it's given us in the past. I think it's much wiser to assume say 5% returns than 10%, given where valuations are.

BTW projections of portfolio growth are key to retirement planning. It's an essential calculation for the Roth vs traditional decision, for example.
I really have never looked into CAPE10; as I say I just don’t look at valuations. I understand though why other people do. So I’m not trying to be combative, but this is a genuine question. What CAPE10 value would predict a negative return for stocks? Is it 50? A 100? 200?

And my personal very crude retirement planning is a WR of about 3%, and I’m hoping my portfolio returns 1% real, or better. And if it doesn’t, then I’ll need to figure something out.
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

afan wrote: Sun Jul 18, 2021 1:59 pm One might not use valuations to change asset allocation, for the reasons discussed above.

However, for long term planning you do have to assume some rates of return. One could just pick a conservative value and go forward. Or one could project lower returns and adjust expectations going forward.

This might change how much to save to hit asset targets by a certain date. Or how long one might need to work before retiring.

I share the concern that high valuations imply a risk of terrible returns from here. But I cannot think of what to do about this opinion.
The error bars for "expected" returns are too large to be useful. Telling me that "expected" returns are -2% a year to 10% a year doesn't help figure out how much to save each year.

It's just not that exact.

For the first 20 years, you don't even know what final amount you are shooting for... A 30 year old with a new baby and a career path still ahead of him has no idea what his expenses will be in retirement.

Just save a lot, live below your means, invest somewhat aggressively with a large percentage in stocks when young, and you'll get what you get.

As one gets closer to retirement, you can get a better idea of your desired expenses in retirement based on your current lifestyle.

Then I suggest just using a low conservative value for future. You don't change your savings or AA up and down based on valuations. You get what you get and you adjust to ACTUAL returns, not guesses about the future.

Start with a low number (say 2% real or 4% nominal)... If you get more, great, you can adjust by retiring earlier or spending more in retirement. If you get less, you may have to work longer, or spend less in retirement.

But start with low expectations (regardless of valuations), and it will be easier to adjust to low returns.

Just like we do with the 4% rule IN retirement, do the same with accumulation years as well... Plan around poor returns, and then adjust if we (likely) do better.

You don't have to care about people talking loudly about "low expected returns!!", if you always planned around low returns.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

02nz wrote: Wed Jul 21, 2021 5:57 pmI see a lot of posts here to the effect of "my/your tax-deferred account will reach X millions in Y years, assuming 10% returns,"
I'm pretty sure you don't see a lot of posts like that here.

I don't think very many people on THIS board plan around 10% returns.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
GoneOnTilt
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Re: Do Indexers even need to pay attention to market valuation?

Post by GoneOnTilt »

Buy_N_Hold wrote: Sat Jul 17, 2021 7:17 pm Does it make sense to try to risk off a bit when things seem toppy, and adjust your asset allocation of stocks accordingly, or is this kind of thinking essentially just trying to time the market?
All I know is this -- the more I worry about frothy valuations, the higher the market keeps going. So I just keep dumping it in there according to my asset allocation. I focus on my risk tolerance and remind myself I can't predict a darn thing.

Market had a great day today! Cheers! :sharebeer
gougou
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Re: Do Indexers even need to pay attention to market valuation?

Post by gougou »

If you buy at P/E = 40, you should be prepared to only withdraw 2.5% every year from your portfolio if you don't want to be poorer year after year. Otherwise I don't see why an indexer needs to pay attention to the market valuation.

The current SP500 forward P/E is between 20 to 25 so it's not really overvalued if the prediction comes true in the next a few quarters.
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

HomerJ wrote: Wed Jul 21, 2021 6:14 pm
afan wrote: Sun Jul 18, 2021 1:59 pm One might not use valuations to change asset allocation, for the reasons discussed above.

However, for long term planning you do have to assume some rates of return. One could just pick a conservative value and go forward. Or one could project lower returns and adjust expectations going forward.

This might change how much to save to hit asset targets by a certain date. Or how long one might need to work before retiring.

I share the concern that high valuations imply a risk of terrible returns from here. But I cannot think of what to do about this opinion.
The error bars for "expected" returns are too large to be useful. Telling me that "expected" returns are -2% a year to 10% a year doesn't help figure out how much to save each year.

It's just not that exact.

For the first 20 years, you don't even know what final amount you are shooting for... A 30 year old with a new baby and a career path still ahead of him has no idea what his expenses will be in retirement.

Just save a lot, live below your means, invest somewhat aggressively with a large percentage in stocks when young, and you'll get what you get.

As one gets closer to retirement, you can get a better idea of your desired expenses in retirement based on your current lifestyle.

Then I suggest just using a low conservative value for future. You don't change your savings or AA up and down based on valuations. You get what you get and you adjust to ACTUAL returns, not guesses about the future.

Start with a low number (say 2% real or 4% nominal)... If you get more, great, you can adjust by retiring earlier or spending more in retirement. If you get less, you may have to work longer, or spend less in retirement.

But start with low expectations (regardless of valuations), and it will be easier to adjust to low returns.

Just like we do with the 4% rule IN retirement, do the same with accumulation years as well... Plan around poor returns, and then adjust if we (likely) do better.

You don't have to care about people talking loudly about "low expected returns!!", if you always planned around low returns.
There is a clear relationship between PE10 and expected returns.

I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.

If you take the inverse PE10 and are OK with those “rough” expected returns, discount for P/E mean reversion, and are willing to wait out decades of bad performance, then go right ahead and proceed with a fairly undiversified portfolio because you just love large cap US mega caps.
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

Nathan Drake wrote: Wed Jul 21, 2021 6:07 pm
HomerJ wrote: Wed Jul 21, 2021 5:48 pm Valuations today do not tell you anything about "long run" expected returns. They MIGHT tell you something about "short run" expected returns.

I completely ignore valuations and expected returns. I pick an Asset Allocation based purely on risk management. I'm close to retirement, so I have a good chunk in bond/cash so I have safer money for the short-term, and keep the rest of my money in stocks for the long-term.

I get what I get, and I adjust to ACTUAL returns. Don't make plans around "expected" returns.

I consider it foolish to make large adjustments to one's Asset Allocation based on weak predictions with huge error bars.

The market has always moved in cycles. Bad years are followed by good years are followed by bad years are followed by good years.. Will this continue? No guarantees, but probably.

The long-term 10% nominal historical annual return of the stock market INCLUDES all the high valuations years and the crashes and bad decades.

Read that again.

So far, just buying and holding, through the good times and the bad times, still made you rich, because the average return was good even including those bad years.

People talk about 1999-2000, when valuations were the highest in U.S. history... A terrible time to invest, right? No, it turned out fine.

One still made 7.5% a year on money invested at the very top of the dot-com bubble over the past 21 years. And of course, every OTHER year has made even more. When the WORST CASE, in recent years, is 7.5% a year over 21 years, that's pretty good.

Sure short-term, people who invested in 2000 lost money, then gained some, then lost again over the 2000-2010 year period. Long periods of bad years do happen.

But even including those 10 bad years, someone who ignored valuations in 2000, has still made a ton of money investing over the past 21 years.

Another crash or a long sideways market will happen. Maybe even starting tomorrow. But bad years, so far, are followed by good years, and the average will likely still be good enough to make you rich.

Sure, it would be great to be out of the marke during the bad years, and only in the market during the good years, but that's hard... Valuations alone don't tell you that. I talked about 2000. But anyone following valuations would have gotten out of the market in 1996, not 2000. But the market more than doubled from 1996-2000. And even at the bottom of the dot-com crash, in 2003, the market never was as low as it was in 1996.

Buying and holding in 1996, even with valuations at heights no one had seen since right before the Great Depression.... turned out to be a great time to buy.

Valuations predictive power has been terrible since it was discovered in 1988. Ignore them.

Pick an Asset Allocation that you can hold through the long-run even if the market crashes tomorrow, and then you don't have to worry about crashes anymore. We invest for the long run.
Start dates have a very huge impact on long-term returns. So I disagree that we should just ignore them. If I am a Japanese investor I’m not going to blindly follow my AA to be 100% Japanese equities just because “invest we must”…yes, we must invest. Investing a huge concentrated stake in one market that’s historically richly valued is NOT a must

It’s not just a short term decision you are making when investing in heated markets. It very much could have significant long-term impact.
I just showed you that start dates don't matter that much. Even the WORST CASE start-date in the past 50 years returned 7.5% nominal. And of course, money invested in 1998 and 1999 and 2001 and 2002 and 2003 did even better.

It has not been necessary to pay attention to valuations in the past. Completely ignoring valuations, U.S. investors still got rich over the long-run, regardless of start date.

Will this be true in the future? Maybe not. But currently, you have ZERO examples that paying attention to valuations is important for U.S. investors.

I'm not saying you're wrong. But valuation proponents definitely should stop acting so RIGHT when discussing this topic. So far, completely ignoring valuations has worked just fine.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

Nathan Drake wrote: Wed Jul 21, 2021 6:21 pm There is a clear relationship between PE10 and expected returns.
There is a downwards sloping line, but the slope keeps changing. It cannot be used to predict actual returns. PE10 has been absolutely terrible at predicting returns since it was discovered in 1988. PE10 went high in 1992, and has remained high for almost the entire 30 years, yet returns have been decent to good.

Almost every CAPE prediction since 1988 has been wrong.
I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.
Because there are ten thousand other variables. You can't just compare PE in Russia to PE in the U.S. without looking at the other variables.

Timing is important for these bets to increase your returns. You may be right that International will have a good decade going forward, but valuations have been predicting that for the past 8 years, and meanwhile U.S. has made a ton. So the money you put in International following valuations 8 years ago has made far less than it could have if you had just ignored valuations.
[if you] are willing to wait out decades of bad performance, then go right ahead and proceed with a fairly undiversified portfolio because you just love large cap US mega caps.
You have been waiting out a decade of bad performance in International. The pendulum will probably swing the other way at some point, I agree... but no one knows when...

My stocks are 80/20 US/International and have been for 10 years. I just let it sit and rebalance for diversification, knowing that someday International will probably do better than the U.S.

You think you can time WHEN International will do better, and over-weighted International when valuations told you to, and this has cost you. Timing the market is hard and rarely works.

Valuations told a investor to over-weight International 8 years ago, and that investor has less money, AND is probably questioning his decisions.

Far easier to recognize that valuations DON'T predict the future very well... I agree with you that diversification is important, but I would never change my AA based on valuations.

So far, changing one's AA based on valuations has proven itself to be failing investment strategy.

You may be right that changing one's AA based on valuations will work going forward, but you shouldn't be so confident about it, because, so far, in real time, it has failed in the past.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

Normchad wrote: Wed Jul 21, 2021 6:10 pmI really have never looked into CAPE10; as I say I just don’t look at valuations. I understand though why other people do. So I’m not trying to be combative, but this is a genuine question. What CAPE10 value would predict a negative return for stocks? Is it 50? A 100? 200?
It depends on what year you ask the question. The predictions keep being wrong, and they keep changing the equation.

In 1996 at a CAPE of 25, Shiller himself, the guy who won the Nobel prize for CAPE, predicted 0% real return for the next 10 years. Instead we got like 6% real (8% nominal), fairly close to the historical average. (He got to keep the Nobel prize money).

Of course, now a CAPE of 25 predicts decent returns because we have a bunch of data points where CAPE of 25 gives decent returns.

What is deceptive is that valuation proponents will act like the CAPE model has ALWAYS predicted decent returns at CAPE 25.

No, they keep changing the model, which is fine with new data, but they act like the model hasn't been changed and has always been accurate.

Sure, the new model back-tests well. Because it is DERIVED from past data. But then it fails going forward, they add in the new data, and then point to those failed years again as successful predictions because the line on the new model (which now contains data from those years) shows good correlations again.

I'm not sure what the line shows today. Remember it's only predicting 10-year returns. The CAPE of 45 in 2000 did indeed end up with a negative return over 10 years, but a positive annual return of 7.5% nominal over 21 years. So the one data point we have of CAPE over 40 still shows a pretty decent long-term return.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

HomerJ wrote: Wed Jul 21, 2021 6:25 pm
Nathan Drake wrote: Wed Jul 21, 2021 6:07 pm
HomerJ wrote: Wed Jul 21, 2021 5:48 pm Valuations today do not tell you anything about "long run" expected returns. They MIGHT tell you something about "short run" expected returns.

I completely ignore valuations and expected returns. I pick an Asset Allocation based purely on risk management. I'm close to retirement, so I have a good chunk in bond/cash so I have safer money for the short-term, and keep the rest of my money in stocks for the long-term.

I get what I get, and I adjust to ACTUAL returns. Don't make plans around "expected" returns.

I consider it foolish to make large adjustments to one's Asset Allocation based on weak predictions with huge error bars.

The market has always moved in cycles. Bad years are followed by good years are followed by bad years are followed by good years.. Will this continue? No guarantees, but probably.

The long-term 10% nominal historical annual return of the stock market INCLUDES all the high valuations years and the crashes and bad decades.

Read that again.

So far, just buying and holding, through the good times and the bad times, still made you rich, because the average return was good even including those bad years.

People talk about 1999-2000, when valuations were the highest in U.S. history... A terrible time to invest, right? No, it turned out fine.

One still made 7.5% a year on money invested at the very top of the dot-com bubble over the past 21 years. And of course, every OTHER year has made even more. When the WORST CASE, in recent years, is 7.5% a year over 21 years, that's pretty good.

Sure short-term, people who invested in 2000 lost money, then gained some, then lost again over the 2000-2010 year period. Long periods of bad years do happen.

But even including those 10 bad years, someone who ignored valuations in 2000, has still made a ton of money investing over the past 21 years.

Another crash or a long sideways market will happen. Maybe even starting tomorrow. But bad years, so far, are followed by good years, and the average will likely still be good enough to make you rich.

Sure, it would be great to be out of the marke during the bad years, and only in the market during the good years, but that's hard... Valuations alone don't tell you that. I talked about 2000. But anyone following valuations would have gotten out of the market in 1996, not 2000. But the market more than doubled from 1996-2000. And even at the bottom of the dot-com crash, in 2003, the market never was as low as it was in 1996.

Buying and holding in 1996, even with valuations at heights no one had seen since right before the Great Depression.... turned out to be a great time to buy.

Valuations predictive power has been terrible since it was discovered in 1988. Ignore them.

Pick an Asset Allocation that you can hold through the long-run even if the market crashes tomorrow, and then you don't have to worry about crashes anymore. We invest for the long run.
Start dates have a very huge impact on long-term returns. So I disagree that we should just ignore them. If I am a Japanese investor I’m not going to blindly follow my AA to be 100% Japanese equities just because “invest we must”…yes, we must invest. Investing a huge concentrated stake in one market that’s historically richly valued is NOT a must

It’s not just a short term decision you are making when investing in heated markets. It very much could have significant long-term impact.
I just showed you that start dates don't matter that much. Even the WORST CASE start-date in the past 50 years returned 7.5% nominal. And of course, money invested in 1998 and 1999 and 2001 and 2002 and 2003 did even better.

It has not been necessary to pay attention to valuations in the past. Completely ignoring valuations, U.S. investors still got rich over the long-run, regardless of start date.

Will this be true in the future? Maybe not. But currently, you have ZERO examples that paying attention to valuations is important for U.S. investors.

I'm not saying you're wrong. But valuation proponents definitely should stop acting so RIGHT when discussing this topic. So far, completely ignoring valuations has worked just fine.
The problem with your analysis is that valuations have only gotten to the levels we are seeing in the US TSM two times before, the first being the 00 tech bubble, and now. The only way you received those 7.5% nominal returns is that P/E contracted and then expanded to the multiples we see today. The past decade could have simply not had P/E multiple expansion and real returns would have been extremely poor. Or worse - valuations could have become depressed instead.

Increasing P/E multiples over time indicates the market is pricing in decreased risk and decreased expected returns going forward. I do not believe this is static across all markets, however. Many like to argue that low interest rates elevate multiples; and while that's a fantastical narrative, it's actually not as apparent in the historical record that this should be true. So is the P/E multiple really justified for US stocks when it's not nearly as present anywhere else in the world, nor is it present in backtests with lower interest rates in the US historically? Something to wonder about.

My main point isn't to say that "You'll likely be okay anyways". Perhaps. There is a chance, however, you will not. And the valuations DOES give you a sense of what expected returns can be at a baseline level. What's not so obvious, moreso than anything else, is the UNEXPECTED return driven by speculation (i.e., the P/E multiple). But the longer the party goes on, the less likely I am to think that this is some "new normal" of absurdly high P/Es.

You get what you pay for. If you're happy with poor returns and that fits into your risk model for retirement, continue plugging away at your asset allocation without making too many adjustments along the way. Or, if you want higher returns, there's plenty of other places to invest that have higher expected returns. I am NOT suggesting to get out of US LCG completely. But for me personally, the upside is not worth having 80% of my portfolio in the equity portion of my asset class which is a pretty standard allocation.
HomerJ wrote: Wed Jul 21, 2021 6:37 pm
Nathan Drake wrote: Wed Jul 21, 2021 6:21 pm There is a clear relationship between PE10 and expected returns.
There is a downwards sloping line, but the slope keeps changing. It cannot be used to predict actual returns. PE10 has been absolutely terrible at predicting returns since it was discovered in 1988. PE10 went high in 1992, and has remained high for almost the entire 30 years, yet returns have been decent to good.

Almost every CAPE prediction since 1988 has been wrong.
I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.
Because there are ten thousand other variables. You can't just compare PE in Russia to PE in the U.S. without looking at the other variables.

Timing is important for these bets to increase your returns. You may be right that International will have a good decade going forward, but valuations have been predicting that for the past 8 years, and meanwhile U.S. has made a ton. So the money you put in International following valuations 8 years ago has made far less than it could have if you had just ignored valuations.
[if you] are willing to wait out decades of bad performance, then go right ahead and proceed with a fairly undiversified portfolio because you just love large cap US mega caps.
You have been waiting out a decade of bad performance in International. The pendulum will probably swing the other way at some point, I agree... but no one knows when...

My stocks are 80/20 US/International and have been for 10 years. I just let it sit and rebalance for diversification, knowing that someday International will probably do better than the U.S.

You think you can time WHEN International will do better, and over-weighted International when valuations told you to, and this has cost you. Timing the market is hard and rarely works.

Valuations told a investor to over-weight International 8 years ago, and that investor has less money, AND is probably questioning his decisions.

Far easier to recognize that valuations DON'T predict the future very well... I agree with you that diversification is important, but I would never change my AA based on valuations.

So far, changing one's AA based on valuations has proven itself to be failing investment strategy.

You may be right that changing one's AA based on valuations will work going forward, but you shouldn't be so confident about it, because, so far, in real time, it has failed in the past.
CAPE10 has not been wrong. There's a relationship. Yes, it has wide dispersions of outcomes. Nonetheless, the trend exists. However, we have seen a trend of increasing P/E over time. Is the market pricing in less risk? Well, that would indicate less expected returns. Relative CAPE of all assets at any given time HAS been shown to work. In other words, if exUS is looking richly valued, investing in US has indicated better returns going forward. This has been proven out. This is because the increasing trend should manifest in all asset classes to some degree at the same time period. The problem you face is when comparing one asset class's CAPE10 with historical returns of three decades ago. And I agree, that may not be as valuable.

Eight years ago, the relative valuations of US vs exUS was not that high. P/E multiples were basically similar throughout the 90s through 2011 for US vs exUS. Now the spreads are massively wide. Either US has to increase P/E multiples further, or earnings somehow magically outperform dramatically (which isn't indicated in the data to great degree over the 30 year period) for the US to be a better investment. I find this unlikely. It's like a gambler going to the casino and continuing to make the same bet just because it paid off (through luck) in the past.

What you are saying, is that valuation doesn't matter and never matters when it comes to AA models. This is a suboptimal way of framing the discussion, when there are competing assets with higher expected returns. Why shouldn't they be given consideration when you see valuation spreads at the extremes? If all things were equal, there may be no need to have a diversified portfolio of equities. But they are NOT equal, so concentrating most risk into US LCG is very likely to lead to suboptimal long-term returns, poor sequencing risks, etc as we have seen over the 20 year period.
absolute zero
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Re: Do Indexers even need to pay attention to market valuation?

Post by absolute zero »

HomerJ wrote: Wed Jul 21, 2021 6:37 pm
Valuations told a investor to over-weight International 8 years ago, and that investor has less money, AND is probably questioning his decisions.
To be fair, this always always always gets exaggerated by you and by others. There was was no expectation that ex-US equites would outperform US 8 years ago.

From Vanguards 2013 Annual Economic and Investment Outlook:
The projected distribution for international equities shown in Figure 9, on page 13, is not unlike that for U.S. equities, with similarly wide-tail outcomes. The expected return differential between U.S. and non-U.S. equity portfolios is not statistically significant under most VCMM scenarios, in part because valuations across broad geographic areas
of the global equity market are similar as well (see Figure 10, on page 13).
I won’t look up each year, but if I recall it was 2015 when Vanguard started to mention differences between US and ex-US, but even at that time they used super conservative/mild language like “slightly lower valuations for ex-US equities may imply mildly higher expected returns, though the distribution of possible outcomes remains wide.”

Long story short, we have a 10-year forecast for mild outperformance in 2015 by ex-US stocks. Boglehead forum members wait only 6 years, then stamp the forecasts as “wrong.” They don’t even wait the full 10 years to comment on the quality of the forecasts, nor do they pause to consider the fact that the forecasts are probabilistic in nature.
MarkRoulo
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Re: Do Indexers even need to pay attention to market valuation?

Post by MarkRoulo »

ScubaHogg wrote: Tue Jul 20, 2021 12:10 pm
MarkRoulo wrote: Mon Jul 19, 2021 10:15 am Why would you believe anything different than everyone around you? And why would things be different now?

…..
Which leads to the (not horrible) simplification of: Stay the course.

It is hard to know when an irrational market has peaked and when an irrational market still has another double to go!

[Which doesn't mean that some of us don't try :-)]
That’s kinda the point. At some extreme PE you are probably well served by stepping back some. You are just paying so much for a dollar of earnings it would be pretty irrational to expect previous growth to continue. And no, I am not talking about about levels the US saw in the mid to late 90s. I’m talking much higher.

(I’ve seen some charts showing Japan touched some PEs around 90, which seems insane)
I agree with you in theory. I'm just not sure how to operationally use this.

There is the old story (which might be true!) of how Isaac Newton speculated in the South Sea Bubble of 1720, got out with large profits as things got bubbly, watched it continue to rise and ... got back in and got clobbered.

So ... once you've gotten out, then what? If things NEVER drop back to what you consider reasonable, are you out of the market forever?

I'll contribute another historical example. For a long time, bond yields exceeding stock dividend yields was considered a VERY BEARISH sign for stocks because *clearly* risky stocks should have a higher dividend yield than saf(er) bonds. So a pretty good trading rule up until the late-1950s (1958, I think) would be to sell stocks if/when their yields dropped below that of "good" bonds. Except that sometime in the late-1950s stock yields dropped below bond yields ... and didn't revert (they may be reverting now!!!!). So ... what is a prudent investor to do in, say, 1968, having just missed 10 years of excellent stock performance? Get back in? Keep waiting for a pull-back?

It is easy to make a rule when you know how things turned out, but it is much harder to do so (with confidence) when things are playing out.

Obviously, one could be very cautious: "At a P/E of 1,000 and bond yield of 4% or more I'm out of stocks!" But the more obvious the rule is the less likely that you'll ever encounter conditions to trigger it.
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

Nathan Drake wrote: Wed Jul 21, 2021 7:18 pm The problem with your analysis is that valuations have only gotten to the levels we are seeing in the US TSM two times before, the first being the 00 tech bubble, and now. The only way you received those 7.5% nominal returns is that P/E contracted and then expanded to the multiples we see today. The past decade could have simply not had P/E multiple expansion and real returns would have been extremely poor. Or worse - valuations could have become depressed instead.
I agree. There are not enough data points to say anything with confidence. Yourself included.

Note I am NOT saying that returns will be good going forward. When you say returns will likely be bad, I am NOT stating the opposite position that they will be good.

I am stating you don't know. That I don't know. There are only a few data points.

"Nobody knows nothing" is often thrown about here... I prefer "Nobody knows enough".

My point is that it is very hard to predict the future, and I do not believe it is wise to make changes to your Asset Allocation based on predictions from valuations. They have a poor track record.

You get what you pay for. If you're happy with poor returns and that fits into your risk model for retirement, continue plugging away at your asset allocation without making too many adjustments along the way. Or, if you want higher returns, there's plenty of other places to invest that have higher expected returns.
Bad years are followed by good years... So far. I'm investing long-term.

Even if short-term returns are low for U.S. large-cap going forward, the long-term returns should still average out to decent or good. You have no data that proves otherwise. All the data we have shows the exact opposite in fact.

So it's not that "I'm happy with poor returns"... I don't know what returns will be, short-term. I'm expecting decent to good long-term returns. I'm not planning on them. Just in case it doesn't happen. But I have no reason to believe long-term returns will be poor. And neither do you.

There is very little data that supports that argument (Japan is basically it).
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

Nathan Drake wrote: Wed Jul 21, 2021 7:18 pmEight years ago, the relative valuations of US vs exUS was not that high. P/E multiples were basically similar throughout the 90s through 2011 for US vs exUS. Now the spreads are massively wide. Either US has to increase P/E multiples further, or earnings somehow magically outperform dramatically (which isn't indicated in the data to great degree over the 30 year period) for the US to be a better investment. I find this unlikely. It's like a gambler going to the casino and continuing to make the same bet just because it paid off (through luck) in the past.

What you are saying, is that valuation doesn't matter and never matters when it comes to AA models. This is a suboptimal way of framing the discussion, when there are competing assets with higher expected returns. Why shouldn't they be given consideration when you see valuation spreads at the extremes? If all things were equal, there may be no need to have a diversified portfolio of equities. But they are NOT equal, so concentrating most risk into US LCG is very likely to lead to suboptimal long-term returns, poor sequencing risks, etc as we have seen over the 20 year period.
Here's a thread you started in August 2014

viewtopic.php?f=10&t=144482
I currently have 1:1 US to Intl investments, and given the recent turmoil in Europe and abroad as well as the somewhat non-recovery since 2007 for these markets (and as a result, their attractive valuations and dividend yields versus US stocks), I'm inclined to increase my allocation of future investments to tilt more towards international.

Granted, increasing to 60% would be roughly global market cap, but I'm sure many people already think my 50% allocation is way too high...and Bogle for instance wouldn't go higher than 20% (which seems like ridiculous advice to me, but he's still a legend in my eyes).

I just feel that valuations do matter, and that eventually European and Emerging Markets will recover from their funk and outperform US equities (which have already had a nice ride since 2009). International stocks are still nowhere near their 2007 highs, yet in the US we've eclipsed them.

This may sound like market timing to an extent, but I feel comfortable with a global market cap weight for my portfolio.
That was 7 years ago....

Changing your Asset Allocation based on valuations has not worked out for you. You have a lot less money instead of a lot more.

Why are you so strongly advocating others change their AA based on valuations? The last 7 years should have shown you how hard it is to time the market using valuations as a timing method.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

HomerJ wrote: Wed Jul 21, 2021 8:17 pm
Nathan Drake wrote: Wed Jul 21, 2021 7:18 pmEight years ago, the relative valuations of US vs exUS was not that high. P/E multiples were basically similar throughout the 90s through 2011 for US vs exUS. Now the spreads are massively wide. Either US has to increase P/E multiples further, or earnings somehow magically outperform dramatically (which isn't indicated in the data to great degree over the 30 year period) for the US to be a better investment. I find this unlikely. It's like a gambler going to the casino and continuing to make the same bet just because it paid off (through luck) in the past.

What you are saying, is that valuation doesn't matter and never matters when it comes to AA models. This is a suboptimal way of framing the discussion, when there are competing assets with higher expected returns. Why shouldn't they be given consideration when you see valuation spreads at the extremes? If all things were equal, there may be no need to have a diversified portfolio of equities. But they are NOT equal, so concentrating most risk into US LCG is very likely to lead to suboptimal long-term returns, poor sequencing risks, etc as we have seen over the 20 year period.
Here's a thread you started in August 2014

viewtopic.php?f=10&t=144482
I currently have 1:1 US to Intl investments, and given the recent turmoil in Europe and abroad as well as the somewhat non-recovery since 2007 for these markets (and as a result, their attractive valuations and dividend yields versus US stocks), I'm inclined to increase my allocation of future investments to tilt more towards international.

Granted, increasing to 60% would be roughly global market cap, but I'm sure many people already think my 50% allocation is way too high...and Bogle for instance wouldn't go higher than 20% (which seems like ridiculous advice to me, but he's still a legend in my eyes).

I just feel that valuations do matter, and that eventually European and Emerging Markets will recover from their funk and outperform US equities (which have already had a nice ride since 2009). International stocks are still nowhere near their 2007 highs, yet in the US we've eclipsed them.

This may sound like market timing to an extent, but I feel comfortable with a global market cap weight for my portfolio.
That was 7 years ago....

Changing your Asset Allocation based on valuations has not worked out for you. You have a lot less money instead of a lot more.

Why are you so strongly advocating others change their AA based on valuations? The last 7 years should have shown you how hard it is to time the market using valuations as a timing method.
10% annualized returns this decade hasn’t worked out for me? My original allocation target was 50:50. I tilted by 10% gradually towards exUS through new investments to bring it to 60/40. It’s not like I sold out of US, in fact the US portion had better gains despite new investments going purely to exUS, so I really had to invest a lot to bring the allocation to 60/40. Diversification at work, I say.

Let’s see how the next 10 years works for your 50/50 stock/bond portfolio comprised 80% of US LCG going into retirement. Not investing in BTC “hasn’t worked out” either, but I’m perfectly fine because I am happy with my diversified allocation and feel far more comfortable with future returns and downside risk. I’m not worried about having a dead decade or more. I’ll keep investing into assets with lower pricing valuations.

I’m not necessarily advocating anyone change their AA, I’m just asking them to assess the risks given the current valuations and whether their current AA is adequately diversified. There’s a false sense of security with those who just plow most of everything into VTSAX and I think it warrants a more critical look. If you’re fine with the risks, by all means continue what you’re doing. I don’t think there’s anything wrong with making adjustments to your AA over time as the market changes and your understanding of the markets changes. The mistakes most people make are getting out of all equity exposure in general, not tilts towards certain types of equities.
Last edited by Nathan Drake on Wed Jul 21, 2021 9:12 pm, edited 4 times in total.
TheDDC
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Re: Do Indexers even need to pay attention to market valuation?

Post by TheDDC »

No. One does not need to if they are saving investing with Boglehead principles in mind.

A) I am 100% stocks and believe bonds are losers and also wish to WIN with market gains of a historic 8-10% plus.

B) I do generally advocate up to a 25% allocation in international, so for me 75/25 VTSAX/VTIAX is suitable no matter whatever CAPE10 or whatever hocus pocus stuff gets posted to wag a finger about valuations.

Keep saving and building wealth in good quality mutual funds… it’s the key to wealth building.

-TheDDC
Rules to wealth building: 75-80% VTSAX piled high and deep, 20-25% VTIAX, 0% given away to banks, minimize amount given to medical-industrial complex
DangerDad
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Re: Do Indexers even need to pay attention to market valuation?

Post by DangerDad »

>>Do Indexers even need to pay attention to market valuation?<<

I think this question presents a strong argument for Life Strategy or Target Retirement funds because these address BOTH the stocks/bonds AND the US/ex-US aspects of AA and offer the automatic rebalancing mentioned by KlangFool and others. If most or all of your assets are in this type of fund I would suggest there is no practical need to pay attention to market valuation.

Cheers,
DangerDad
TheDDC
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Re: Do Indexers even need to pay attention to market valuation?

Post by TheDDC »

DangerDad wrote: Wed Jul 21, 2021 8:49 pm >>Do Indexers even need to pay attention to market valuation?<<

I think this question presents a strong argument for Life Strategy or Target Retirement funds because these address BOTH the stocks/bonds AND the US/ex-US aspects of AA and offer the automatic rebalancing mentioned by KlangFool and others. If most or all of your assets are in this type of fund I would suggest there is no practical need to pay attention to market valuation.

Cheers,
DangerDad
Bad advice. Pick a fund without bonds. They are losers to inflation long term.

-TheDDC
Rules to wealth building: 75-80% VTSAX piled high and deep, 20-25% VTIAX, 0% given away to banks, minimize amount given to medical-industrial complex
Da5id
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Re: Do Indexers even need to pay attention to market valuation?

Post by Da5id »

TheDDC wrote: Wed Jul 21, 2021 8:51 pm
DangerDad wrote: Wed Jul 21, 2021 8:49 pm >>Do Indexers even need to pay attention to market valuation?<<

I think this question presents a strong argument for Life Strategy or Target Retirement funds because these address BOTH the stocks/bonds AND the US/ex-US aspects of AA and offer the automatic rebalancing mentioned by KlangFool and others. If most or all of your assets are in this type of fund I would suggest there is no practical need to pay attention to market valuation.

Cheers,
DangerDad
Bad advice. Pick a fund without bonds. They are losers to inflation long term.

-TheDDC
Bonds are good for those in retirement or near it IMO. And OK for those of other ages who want a less volatile allocation.
JBTX
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Re: Do Indexers even need to pay attention to market valuation?

Post by JBTX »

You don't have to pay attention to multiples, but I do. It's not that they are very actionable, they aren't, but to a degree they do inform risk awareness.

As multiples get higher, I make modest adjustments, like less in stocks, or more in international. This doesn't mean this strategy will give you highest returns, but it may very well reduce the downside scenario.
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HanSolo
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Re: Do Indexers even need to pay attention to market valuation?

Post by HanSolo »

TheDDC wrote: Wed Jul 21, 2021 8:51 pm
DangerDad wrote: Wed Jul 21, 2021 8:49 pm >>Do Indexers even need to pay attention to market valuation?<<

I think this question presents a strong argument for Life Strategy or Target Retirement funds because these address BOTH the stocks/bonds AND the US/ex-US aspects of AA and offer the automatic rebalancing mentioned by KlangFool and others. If most or all of your assets are in this type of fund I would suggest there is no practical need to pay attention to market valuation.
Bad advice. Pick a fund without bonds. They are losers to inflation long term.
No. It's not bad advice. People like Jack Bogle and Benjamin Graham advocated in favor of including bonds. They had good reasons for that. Many people follow that idea, and are perfectly happy with it.

If you don't like bonds, that's also OK. I'm not seeing a problem either way.
JBTX wrote: Wed Jul 21, 2021 9:41 pm You don't have to pay attention to multiples, but I do. It's not that they are very actionable, they aren't, but to a degree they do inform risk awareness.

As multiples get higher, I make modest adjustments, like less in stocks, or more in international. This doesn't mean this strategy will give you highest returns, but it may very well reduce the downside scenario.
The above is more or less my take.

Different people are comfortable doing different things. Some invest in bonds, some don't. Some adjust for valuations, some don't. I see nothing "wrong" in any of these choices.

Everyone should do what they want to do. Personally, I have no need for others to follow what I do. I'm fine with what I'm doing, and I'm equally happy if others do whatever they want.

Has the OP disappeared? Has the question been answered?
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

Nathan Drake wrote: Wed Jul 21, 2021 8:24 pm
HomerJ wrote: Wed Jul 21, 2021 8:17 pm
Nathan Drake wrote: Wed Jul 21, 2021 7:18 pmEight years ago, the relative valuations of US vs exUS was not that high. P/E multiples were basically similar throughout the 90s through 2011 for US vs exUS. Now the spreads are massively wide. Either US has to increase P/E multiples further, or earnings somehow magically outperform dramatically (which isn't indicated in the data to great degree over the 30 year period) for the US to be a better investment. I find this unlikely. It's like a gambler going to the casino and continuing to make the same bet just because it paid off (through luck) in the past.

What you are saying, is that valuation doesn't matter and never matters when it comes to AA models. This is a suboptimal way of framing the discussion, when there are competing assets with higher expected returns. Why shouldn't they be given consideration when you see valuation spreads at the extremes? If all things were equal, there may be no need to have a diversified portfolio of equities. But they are NOT equal, so concentrating most risk into US LCG is very likely to lead to suboptimal long-term returns, poor sequencing risks, etc as we have seen over the 20 year period.
Here's a thread you started in August 2014

viewtopic.php?f=10&t=144482
I currently have 1:1 US to Intl investments, and given the recent turmoil in Europe and abroad as well as the somewhat non-recovery since 2007 for these markets (and as a result, their attractive valuations and dividend yields versus US stocks), I'm inclined to increase my allocation of future investments to tilt more towards international.

Granted, increasing to 60% would be roughly global market cap, but I'm sure many people already think my 50% allocation is way too high...and Bogle for instance wouldn't go higher than 20% (which seems like ridiculous advice to me, but he's still a legend in my eyes).

I just feel that valuations do matter, and that eventually European and Emerging Markets will recover from their funk and outperform US equities (which have already had a nice ride since 2009). International stocks are still nowhere near their 2007 highs, yet in the US we've eclipsed them.

This may sound like market timing to an extent, but I feel comfortable with a global market cap weight for my portfolio.
That was 7 years ago....

Changing your Asset Allocation based on valuations has not worked out for you. You have a lot less money instead of a lot more.

Why are you so strongly advocating others change their AA based on valuations? The last 7 years should have shown you how hard it is to time the market using valuations as a timing method.
10% annualized returns this decade hasn’t worked out for me? My original allocation target was 50:50. I tilted by 10% gradually towards exUS through new investments to bring it to 60/40. It’s not like I sold out of US, in fact the US portion had better gains despite new investments going purely to exUS, so I really had to invest a lot to bring the allocation to 60/40. Diversification at work, I say.

Let’s see how the next 10 years works for your 50/50 stock/bond portfolio comprised 80% of US LCG going into retirement. Not investing in BTC “hasn’t worked out” either, but I’m perfectly fine because I am happy with my diversified allocation and feel far more comfortable with future returns and downside risk. I’m not worried about having a dead decade or more. I’ll keep investing into assets with lower pricing valuations.
$100,000 invested in VTIAX in August 2014 is worth $147,000 today.
$100,000 invested in VTSAX in August 2014 is worth $254,000 today.

Investing heavily in International because you believe "valuations matter" has definitely cost you money.

Yes, it was all just probabilities around the different "expected" returns. I admit the results do not disprove the valuations theory.

But it certainly doesn't PROVE it. I'm amazed at people who remain absolutely sure valuations are predictive, after watching predictions fail over and over and over. There should be some doubt in the model by this point.

You were sure valuations mattered 7 years ago. You are STILL sure valuations matter today.

Maybe other variables showed up. That's kind of my point. There are far more variables than just valuations, which is why it's hard to predict the future just looking at valuations.
I’m not necessarily advocating anyone change their AA, I’m just asking them to assess the risks given the current valuations and whether their current AA is adequately diversified. There’s a false sense of security with those who just plow most of everything into VTSAX and I think it warrants a more critical look.
This I agree with, but I think that one's AA always requires a critical look, regardless of valuations. The risk is never zero. Diversification and risk management is always important. I just don't think valuations are predictive enough to make risk calculations based on them.
If you’re fine with the risks, by all means continue what you’re doing. I don’t think there’s anything wrong with making adjustments to your AA over time as the market changes and your understanding of the markets changes. The mistakes most people make are getting out of all equity exposure in general, not tilts towards certain types of equities.
I agree small changes are okay. We both agree one should not move completely in and out of the markets based on valuations.

I think the most important thing to always keep a long-term outlook, and not make big changes based on recent market movements.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

HomerJ wrote: Wed Jul 21, 2021 11:54 pm
Nathan Drake wrote: Wed Jul 21, 2021 8:24 pm
HomerJ wrote: Wed Jul 21, 2021 8:17 pm
Nathan Drake wrote: Wed Jul 21, 2021 7:18 pmEight years ago, the relative valuations of US vs exUS was not that high. P/E multiples were basically similar throughout the 90s through 2011 for US vs exUS. Now the spreads are massively wide. Either US has to increase P/E multiples further, or earnings somehow magically outperform dramatically (which isn't indicated in the data to great degree over the 30 year period) for the US to be a better investment. I find this unlikely. It's like a gambler going to the casino and continuing to make the same bet just because it paid off (through luck) in the past.

What you are saying, is that valuation doesn't matter and never matters when it comes to AA models. This is a suboptimal way of framing the discussion, when there are competing assets with higher expected returns. Why shouldn't they be given consideration when you see valuation spreads at the extremes? If all things were equal, there may be no need to have a diversified portfolio of equities. But they are NOT equal, so concentrating most risk into US LCG is very likely to lead to suboptimal long-term returns, poor sequencing risks, etc as we have seen over the 20 year period.
Here's a thread you started in August 2014

viewtopic.php?f=10&t=144482
I currently have 1:1 US to Intl investments, and given the recent turmoil in Europe and abroad as well as the somewhat non-recovery since 2007 for these markets (and as a result, their attractive valuations and dividend yields versus US stocks), I'm inclined to increase my allocation of future investments to tilt more towards international.

Granted, increasing to 60% would be roughly global market cap, but I'm sure many people already think my 50% allocation is way too high...and Bogle for instance wouldn't go higher than 20% (which seems like ridiculous advice to me, but he's still a legend in my eyes).

I just feel that valuations do matter, and that eventually European and Emerging Markets will recover from their funk and outperform US equities (which have already had a nice ride since 2009). International stocks are still nowhere near their 2007 highs, yet in the US we've eclipsed them.

This may sound like market timing to an extent, but I feel comfortable with a global market cap weight for my portfolio.
That was 7 years ago....

Changing your Asset Allocation based on valuations has not worked out for you. You have a lot less money instead of a lot more.

Why are you so strongly advocating others change their AA based on valuations? The last 7 years should have shown you how hard it is to time the market using valuations as a timing method.
10% annualized returns this decade hasn’t worked out for me? My original allocation target was 50:50. I tilted by 10% gradually towards exUS through new investments to bring it to 60/40. It’s not like I sold out of US, in fact the US portion had better gains despite new investments going purely to exUS, so I really had to invest a lot to bring the allocation to 60/40. Diversification at work, I say.

Let’s see how the next 10 years works for your 50/50 stock/bond portfolio comprised 80% of US LCG going into retirement. Not investing in BTC “hasn’t worked out” either, but I’m perfectly fine because I am happy with my diversified allocation and feel far more comfortable with future returns and downside risk. I’m not worried about having a dead decade or more. I’ll keep investing into assets with lower pricing valuations.
$100,000 invested in VTIAX in August 2014 is worth $147,000 today.
$100,000 invested in VTSAX in August 2014 is worth $254,000 today.

Investing heavily in International because you believe "valuations matter" has definitely cost you money.

Yes, it was all just probabilities around the different "expected" returns. I admit the results do not disprove the valuations theory.

But it certainly doesn't PROVE it. I'm amazed at people who remain absolutely sure valuations are predictive, after watching predictions fail over and over and over. There should be some doubt in the model by this point.

You were sure valuations mattered 7 years ago. You are STILL sure valuations matter today.

Maybe other variables showed up. That's kind of my point. There are far more variables than just valuations, which is why it's hard to predict the future just looking at valuations.
Thanks for the history lesson. Here's another:

$100,000 invested in BTC in August 2014 is worth $6.4 Million
$100,000 invested in TSLA in August 2014 is worth $1.4 Million

Investing in VTSAX cost you money. LOTS. So did bonds. Why didn't you invest in these better performers instead? I am amazed that someone on this forum thinks that an early accumulator cares about even 7 years of relative underperformance, when I am investing for the rest of my life. I'm confident my AA will have not only better returns overall than a portfolio like yours, but the sequencing of returns will also be better. I can sleep better at night with my diversified allocation, primarily constructed by an understanding of valuations and a history of the markets and risk premiums. Yours allows you to sleep better even though historically it leaves you more prone to long-term underperformance.

You do you. But valuations do matter and are predictive. They can also be actionable.

Source: https://mebfaber.com/2019/01/06/you-wou ... ood-thing/
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

Nathan Drake wrote: Thu Jul 22, 2021 12:19 am Thanks for the history lesson. Here's another:

$100,000 invested in BTC in August 2014 is worth $6.4 Million
$100,000 invested in TSLA in August 2014 is worth $1.4 Million

Investing in VTSAX cost you money. LOTS. So did bonds. Why didn't you invest in these better performers instead?
You've got this backwards.

A person who came on this board in 2014 and said "you should invest in Bitcoin instead of VTSAX because of xyz" can actually come back today and say "See I told you so!"

We'd still discount it, like we do all single stock purchases, as luck, BUT... we wouldn't be able to tell the guy he was wrong, would we?

You're a guy, who in August 2014, told us "you should maybe invest more in international because valuations matter". and then International did far worse, yet you are still here saying "See, I told you so! Valuations are predictive and they do matter!"

???

This is a real-life example of a valuations prediction that failed. There are thousands of them all over the web. Don't look at a 2020 article that shows what would have happened from 1990-2020 if you did this or that. Look at real-time past predictions where someone makes a prediction, in 1996 or 2004, or 2011 that this or that will happen based on the current model at the time, and they are almost always wrong.

Actual real-time predictions based on CAPE have failed almost every time since it was discovered.
I am amazed that someone on this forum thinks that an early accumulator cares about even 7 years of relative underperformance, when I am investing for the rest of my life.
I agree that 7 years is short-term, and we all invest for the long-term. But remember, the reason I ignore valuations is because they make short 10-year predictions, and I invest for the long-term. You don't care about 7 year underperformance. I don't care about 10-year underperformance. Like I've said over and over, you may be right that U.S. stock market is due for a bad 10 years, but so far, the bad years are followed by good years, and the long-term average, so far, has still been very good. So I don't have to pay attention to valuations. I get rich anyway with just buy and hold over the long run.
Well-written article. His answer to 30 years of good performance is that we just got lucky for 30 years hitting a 19 and getting a 2. But the last 30 years isn't just one backjack hand like he insinuated. The analogy is flawed. It's dozens of blackjack hands.

You hit 19 and get a 2 once, it's luck... It happens over and over, something is wrong with the deck (or CAPE model - the odds obviously aren't what you think they are)

Oh, and that chart of 10-year returns based on CAPE is super-deceptive.. It says its from 1900 but only has 76 data points. It goes CAPE 5-10,10-15,15-20,then lumps 20-45 all together. Most of those really bad 20-45 returns were from 1920s and the 1960s (and CAPE was only in the low 20s).

A chart from 1990-2020 would show a very different story. Pretty much every data point was above CAPE 20, and most would have pretty decent returns instead of mixing them in with the bad returns from 1920s and 1960s.

Yes, the data from 1920 and 1940 and 1960 match the CAPE model pretty well, because the CAPE model was DERIVED from that data.

The trick is to see how the data from 1988-2020 DOES NOT match the model created in 1988. So all the predictions based on the 1988 model turned out incorrect.

I'll bow out now. I've made my points... I'm sorry I can't be more clear. The theory seems correct. It makes sense. I've just seen real-time predictions fail over and over and over and over. And what really makes me mad is then the PhDs change their model based on new data, and then claim the model has always worked.
Last edited by HomerJ on Thu Jul 22, 2021 1:49 am, edited 1 time in total.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

HomerJ wrote: Thu Jul 22, 2021 1:26 am
Nathan Drake wrote: Thu Jul 22, 2021 12:19 am Thanks for the history lesson. Here's another:

$100,000 invested in BTC in August 2014 is worth $6.4 Million
$100,000 invested in TSLA in August 2014 is worth $1.4 Million

Investing in VTSAX cost you money. LOTS. So did bonds. Why didn't you invest in these better performers instead?
You've got this backwards.

A person who came on this board in 2014 and said "you should invest in Bitcoin instead of VTSAX because of xyz" can actually come back today and say "See I told you so!"

We'd still discount it, like we do all single stock purchases, as luck, BUT... we wouldn't be able to tell the guy he was wrong, would we?

You're a guy, who in August 2014, told us "you should maybe invest more in international because valuations matter". and then International did far worse, yet you are still here saying "See, I told you so! Valuations are predictive and they do matter!"

???

This is a real-life example of a valuations prediction that failed. There are thousands of them all over the web. Don't look at a 2020 article that shows what would have happened from 1990-2020 if you did this or that. Look at real-time past predictions where someone makes a prediction, in 1996 or 2004, or 2011 that this or that will happen based on the current model at the time, and they are almost always wrong.

Actual real-time predictions based on CAPE have failed almost every time since it was discovered.
I am amazed that someone on this forum thinks that an early accumulator cares about even 7 years of relative underperformance, when I am investing for the rest of my life.
I agree that 7 years is short-term, and we all invest for the long-term. But remember, the reason I ignore valuations is because they make short 10-year predictions, and I invest for the long-term. You don't care about 7 year underperformance. I don't care about 10-year underperformance. Like I've said over and over, you may be right that U.S. stock market is due for a bad 10 years, but so far, the bad years are followed by good years, and the long-term average, so far, has still been very good. So I don't have to pay attention to valuations. I get rich anyway with just buy and hold over the long run.
Well-written article. His answer to 30 years of good performance is that we just got lucky for 30 years hitting a 19 and getting a 2. But the last 30 years isn't just one backjack hand like he insinuated. The analogy is flawed. It's dozens of blackjack hands.

You hit 19 and get a 2 once, it's luck... It happens over and over, something is wrong with the deck (or CAPE model - the odds obviously aren't what you think they are)

Oh, and that chart of 10-year returns based on CAPE is super-deceptive.. It says its from 1900 but only has 76 data points. It goes CAPE 5-10,10-15,15-20,then lumps 20-45 all together. Most of those really bad 20-45 returns were from 1920s and the 1960s (and CAPE was only in the low 20s)

A chart from 1990-2020 would show a very different story. Pretty much every data point would be red, and most would have pretty decent returns. Yes, the data from 1920 and 1940 and 1960 match the CAPE model pretty well, because the CAPE model was DERIVED from that data.

The trick is to see how the data from 1988 DOES NOT match the model created in 1988. So all the predictions based on the 1988 model turned out incorrect.

I'll bow out now. I've made my points... I'm sorry I can't be more clear. The theory seems correct. It makes sense. I've just seen real-time predictions fail over and over and over and over. And what really makes me mad is then the PhDs change their model based on new data, and then claim the model has always worked.
Saying I’m “wrong” is confusing outcome with strategy. If in 10 years VTIAX skyrockets to the moon and VTSAX goes nowhere and my 2014-2021 VTIAX purchases outperform a theoretical VTSAX purchase, who was right exactly? Well, even in ten years you won’t know. Because I’m holding for longer than that. But my strategy for that timeframe would have resulted in a smoother return profile than one concentrated in either VTSAX or VTIAX alone.

I’m not going to just take your gloating as anything more than a typical fallacious argument that completely misses the point. My original allocation in 2014 was already 50/50, based on a global cap weight premise at the time. My tilt since then has been modest at best. So if you consider that move to be market timing, it certainly didn’t “lose” me much from my original AA. Another straw man argument picked apart.

But continue ignoring evidence that valuations matter. They always have. The article shows that investing in assets with lower CAPES produced significantly higher returns than the S&P500 alone. So in that sense not everything evens out in the long term if you blindly invest in historically overvalued periods when there are cheaper alternatives available. Whether you choose to act on them is certainly your choice. But I’m prepared for another 00-09 or 66-81 and prefer to not suffer through extended periods like that. You seem to not care, and that’s fine. Maybe you’ll be ok if that happens again. Maybe.
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mrspock
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Re: Do Indexers even need to pay attention to market valuation?

Post by mrspock »

Nope. Just rebalance per your IPS. You will naturally buy more in bonds when things get over valued, and more stock when they get cheap.
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Buy_N_Hold
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Re: Do Indexers even need to pay attention to market valuation?

Post by Buy_N_Hold »

HanSolo wrote: Wed Jul 21, 2021 10:48 pm Has the OP disappeared? Has the question been answered?
I have most certainly not disappeared, as far as I can tell. :) I have been reading through these responses carefully, and appreciate all of the input and perspectives. I’m not sure if this is a question that can be “answered” per se, but I have decided to avoid adjusting my asset allocation due to changes in the perceived risk of the market, which was my original intent behind the question. Since I am early in the accumulation phase, it seems to me that even a worst case scenario would provide some great opportunities to average down and DCA at great value.
“To turn $100 into $110 is work. To turn $100 million into $110 million is inevitable.” -Edgar Bronfman
cjking
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Re: Do Indexers even need to pay attention to market valuation?

Post by cjking »

MarkRoulo wrote: Sun Jul 18, 2021 10:45 am If we restrict ourselves to stocks (US and international or just US), bonds and cash, we can start by looking at stock P/E valuations. Currently, we'll note that they are high compared to historical averages. The problem is that there is no obvious action to take.
Many investors on this board restrict themselves to half the worlds equities, a US tracker. CAPE of that is 39. Rest-of-the-world index trackers are also available, CAPE of those is 20. Doubling your expected return by investing in a different half of the world is a potential action.

It's fine to hold the world index and ignore valuations, but lots of people appear to be choosing to hold the more expensive half of the world for reasons that seem a lot less rigorous than the arguments behind a valuation-based approach.

Edited to add: the difference between a 2.6% and 5% return is not going to destroy the retirement finances of anyone who plans to spend down a retirement portfolio. Choosing more risk (less diversification) in order to get a lower return (than 3.6% for world index) seems perverse, but there are a lot of far worse things that people could do.
YRT70
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Re: Do Indexers even need to pay attention to market valuation?

Post by YRT70 »

Nathan Drake wrote: Wed Jul 21, 2021 6:21 pm There is a clear relationship between PE10 and expected returns.

I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.
I don't know much about this topic but going by the quote below it sounds like Ben Felix doesn't have a lot of faith in the predictive power of CAPE. Or am I missing something?
Basically, the predictive power of CAPE goes away if you consider independent samples (non overlapping) instead of rolling periods. It wasn’t this paper that changed my mind (it was a long talk with someone from Dimensional’s research group) but this paper touches the same points.

https://papers.ssrn.com/sol3/papers.cfm ... id=3142575

[...]

My current understanding is that we should treat expected returns as if CAPE has no information because of how weak the evidence of predictability is. We had previously been devising a fancy expected returns model which included CAPE as a predictor but after the aforementioned conversation I think that we will revert back to bootstrapping from the DMS data back to 1900 to estimate expected returns.
HootingSloth
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Re: Do Indexers even need to pay attention to market valuation?

Post by HootingSloth »

YRT70 wrote: Thu Jul 22, 2021 6:33 am
Nathan Drake wrote: Wed Jul 21, 2021 6:21 pm There is a clear relationship between PE10 and expected returns.

I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.
I don't know much about this topic but going by the quote below it sounds like Ben Felix doesn't have a lot of faith in the predictive power of CAPE. Or am I missing something?
Basically, the predictive power of CAPE goes away if you consider independent samples (non overlapping) instead of rolling periods. It wasn’t this paper that changed my mind (it was a long talk with someone from Dimensional’s research group) but this paper touches the same points.

https://papers.ssrn.com/sol3/papers.cfm ... id=3142575

[...]

My current understanding is that we should treat expected returns as if CAPE has no information because of how weak the evidence of predictability is. We had previously been devising a fancy expected returns model which included CAPE as a predictor but after the aforementioned conversation I think that we will revert back to bootstrapping from the DMS data back to 1900 to estimate expected returns.
I don't think you are mistaken. A lot of research is out there questioning the predictive power of CAPE. For example, Vanguard--despite continuing to use valuation-based models to predict 10-year returns--does not seem to believe that CAPE itself has material forward-looking, real time predictive power, much the same as what Ben Felix is saying. After carefully looking at the predictions that a CAPE-based model would have made, in real time and without "peeking" ahead by being trained on future data, here is what Vanguard's research team had to say:
Unfortunately, the Shiller regression’s out-of-sample forecast accuracy has weakened since the mid-1980s. Exhibit 2 illustrates that beginning with the forecasts made in this period, regression-projected stock returns have generally been too bearish, even when one includes the 1999 tech bubble. Put another way, over the last few decades, real-time investors would have been better served by using the historical average returns (Davis et al [2018]).
Global Market Portfolio + modest tilt towards volatility (80/20->60/40 as approach FI) + modest tilt away from exchange rate risk (80% global+20% U.S. stocks; currency-hedge bonds) + tax optimization
cjking
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Re: Do Indexers even need to pay attention to market valuation?

Post by cjking »

CAPE is just a statistic, it doesn't predict anything. There will be a methodology that turns that statistic into a prediction. I disagree with predictions that are based on regression analysis of CAPE relative to its own history, as they contain the implicit assumption that mean reversion should happen.

You can assume less by using 1/CAPE to compare different equity indices, and choose to invest where yields are higher. All you're choosing to believe is that companies that have earned more for a sustained period in the past have a greater than 50% probability of doing so for a while into the future.
YRT70
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Re: Do Indexers even need to pay attention to market valuation?

Post by YRT70 »

HootingSloth wrote: Thu Jul 22, 2021 7:12 am ...
Thanks for the insightful post.
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

YRT70 wrote: Thu Jul 22, 2021 6:33 am
Nathan Drake wrote: Wed Jul 21, 2021 6:21 pm There is a clear relationship between PE10 and expected returns.

I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.
I don't know much about this topic but going by the quote below it sounds like Ben Felix doesn't have a lot of faith in the predictive power of CAPE. Or am I missing something?
Basically, the predictive power of CAPE goes away if you consider independent samples (non overlapping) instead of rolling periods. It wasn’t this paper that changed my mind (it was a long talk with someone from Dimensional’s research group) but this paper touches the same points.

https://papers.ssrn.com/sol3/papers.cfm ... id=3142575

[...]

My current understanding is that we should treat expected returns as if CAPE has no information because of how weak the evidence of predictability is. We had previously been devising a fancy expected returns model which included CAPE as a predictor but after the aforementioned conversation I think that we will revert back to bootstrapping from the DMS data back to 1900 to estimate expected returns.
I agree that using CAPE to forecast exact returns doesn’t have much predictive power. I can’t look at US CAPE and say it will definitively be poor. Valuations could continue to increase.

The idea that Meb points out is that over the long term, the wider the spreads in CAPE are amongst asset classes with similar expected long term returns would allow us to possibly tactically tilt away from those that are much more highly valued than others.

Which is to say, CAPE won’t tell me if US returns 10% next decade, but it does suggest that if US is greatly overpriced relative to EM, that EM is more likely to have stronger returns than US going forward.

I would argue that we are approaching such a time right now. That still may mean that for you personally no changes to your AA are desired, but I think one can look at the data and take reasonable action knowing the risks.
MarkRoulo
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Re: Do Indexers even need to pay attention to market valuation?

Post by MarkRoulo »

Nathan Drake wrote: Thu Jul 22, 2021 8:57 am
YRT70 wrote: Thu Jul 22, 2021 6:33 am
Nathan Drake wrote: Wed Jul 21, 2021 6:21 pm There is a clear relationship between PE10 and expected returns.

I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.
I don't know much about this topic but going by the quote below it sounds like Ben Felix doesn't have a lot of faith in the predictive power of CAPE. Or am I missing something?
Basically, the predictive power of CAPE goes away if you consider independent samples (non overlapping) instead of rolling periods. It wasn’t this paper that changed my mind (it was a long talk with someone from Dimensional’s research group) but this paper touches the same points.

https://papers.ssrn.com/sol3/papers.cfm ... id=3142575

[...]

My current understanding is that we should treat expected returns as if CAPE has no information because of how weak the evidence of predictability is. We had previously been devising a fancy expected returns model which included CAPE as a predictor but after the aforementioned conversation I think that we will revert back to bootstrapping from the DMS data back to 1900 to estimate expected returns.
I agree that using CAPE to forecast exact returns doesn’t have much predictive power. I can’t look at US CAPE and say it will definitively be poor. Valuations could continue to increase.

The idea that Meb points out is that over the long term, the wider the spreads in CAPE are amongst asset classes with similar expected long term returns would allow us to possibly tactically tilt away from those that are much more highly valued than others.
I think the "expected similar long term returns" is the catch.

To pick an example to illustrate (not prove), naively one might think that Europe and the US would have similar-ish returns. European profits might be lower and maybe growth would be lower, but the P/E is lower, too. And, in any event, all of this is news and so should be priced in.

Then one looks at Italy (again, I'm illustrating, so, yes, this is cherry-picked ...) and discover that
  • the US per-capita GDP went from around $44,000/person in 2000 to around $55,000/person in 2019 (before covid).
  • the Italian per-capita GDP went from around $36,000/person in 2000 to around ... $36,000/person in 2019
The Italian economy hasn't grown in per-capita terms for 20 years! It wasn't flat. It went up, then went down a lot, then
went back up over the 20 years, but net-net ... flat. The population is aging. Does Italy have "expected similar long term returns" to the US? I certainly don't know. I expect the Italian companies will do less well, but I don't know if the price reflects this properly. I'd expect growing economies to have higher P/E ratios, but by how much?

Spain did better, but has been net-net flat since 2008. They just got back to 2008 numbers when covid hit.

Greece is, of course, Greece. If one expects the Greek government to go bankrupt again in the next decade, what is the correct P/E ratio for Greek companies?

Japan has a shrinking population and has mostly missed the tech industries of the past 20 years. How does one compare P/E ratios there with here (and, also, Japanese accounting standards are different, so "E" isn't defined the same way)?

China is growing, but it isn't clear how safe investments in China are.

So ... how do you know when two moderately different investments have "expected similar long term returns?" Folks will, of course, sell predictions, but that doesn't mean that they are any good.

I would like to think that this SHOULD work. But then I wonder why if it did work it hasn't been arbitraged away (as the efficient market hypothesis would predict)?
MarkRoulo
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Re: Do Indexers even need to pay attention to market valuation?

Post by MarkRoulo »

cjking wrote: Thu Jul 22, 2021 6:20 am
MarkRoulo wrote: Sun Jul 18, 2021 10:45 am If we restrict ourselves to stocks (US and international or just US), bonds and cash, we can start by looking at stock P/E valuations. Currently, we'll note that they are high compared to historical averages. The problem is that there is no obvious action to take.
Many investors on this board restrict themselves to half the worlds equities, a US tracker. CAPE of that is 39. Rest-of-the-world index trackers are also available, CAPE of those is 20. Doubling your expected return by investing in a different half of the world is a potential action.
...
I'm not trying to address the US vs World argument. For what it is worth, I run 66% US (my expenses are in US dollars) and 33% rest-of-world. But this isn't terribly relevant to the question of whether one can and/or should use PE valuations when making investment decisions.

I'd LIKE to have a useful way to do this, but I don't.

So ... to complicate things. The US economy is much more tech heavy than the rest of the world except China. To illustrate the problem with comparing US vs ex-US, would you expect "fairly valued" tech stocks to have similar PE ratios as, say, J&J or P&G or Ford? It would be great if they did, but they usually don't. So how to compare US P/E ratios to Europe? The economies are different enough that it probably matters. But by how much?
HootingSloth
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Re: Do Indexers even need to pay attention to market valuation?

Post by HootingSloth »

MarkRoulo wrote: Thu Jul 22, 2021 10:49 am
Nathan Drake wrote: Thu Jul 22, 2021 8:57 am
YRT70 wrote: Thu Jul 22, 2021 6:33 am
Nathan Drake wrote: Wed Jul 21, 2021 6:21 pm There is a clear relationship between PE10 and expected returns.

I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.
I don't know much about this topic but going by the quote below it sounds like Ben Felix doesn't have a lot of faith in the predictive power of CAPE. Or am I missing something?
Basically, the predictive power of CAPE goes away if you consider independent samples (non overlapping) instead of rolling periods. It wasn’t this paper that changed my mind (it was a long talk with someone from Dimensional’s research group) but this paper touches the same points.

https://papers.ssrn.com/sol3/papers.cfm ... id=3142575

[...]

My current understanding is that we should treat expected returns as if CAPE has no information because of how weak the evidence of predictability is. We had previously been devising a fancy expected returns model which included CAPE as a predictor but after the aforementioned conversation I think that we will revert back to bootstrapping from the DMS data back to 1900 to estimate expected returns.
I agree that using CAPE to forecast exact returns doesn’t have much predictive power. I can’t look at US CAPE and say it will definitively be poor. Valuations could continue to increase.

The idea that Meb points out is that over the long term, the wider the spreads in CAPE are amongst asset classes with similar expected long term returns would allow us to possibly tactically tilt away from those that are much more highly valued than others.
I think the "expected similar long term returns" is the catch.

To pick an example to illustrate (not prove), naively one might think that Europe and the US would have similar-ish returns. European profits might be lower and maybe growth would be lower, but the P/E is lower, too. And, in any event, all of this is news and so should be priced in.

Then one looks at Italy (again, I'm illustrating, so, yes, this is cherry-picked ...) and discover that
  • the US per-capita GDP went from around $44,000/person in 2000 to around $55,000/person in 2019 (before covid).
  • the Italian per-capita GDP went from around $36,000/person in 2000 to around ... $36,000/person in 2019
The Italian economy hasn't grown in per-capita terms for 20 years! It wasn't flat. It went up, then went down a lot, then
went back up over the 20 years, but net-net ... flat. The population is aging. Does Italy have "expected similar long term returns" to the US? I certainly don't know. I expect the Italian companies will do less well, but I don't know if the price reflects this properly. I'd expect growing economies to have higher P/E ratios, but by how much?

Spain did better, but has been net-net flat since 2008. They just got back to 2008 numbers when covid hit.

Greece is, of course, Greece. If one expects the Greek government to go bankrupt again in the next decade, what is the correct P/E ratio for Greek companies?

Japan has a shrinking population and has mostly missed the tech industries of the past 20 years. How does one compare P/E ratios there with here (and, also, Japanese accounting standards are different, so "E" isn't defined the same way)?

China is growing, but it isn't clear how safe investments in China are.

So ... how do you know when two moderately different investments have "expected similar long term returns?" Folks will, of course, sell predictions, but that doesn't mean that they are any good.

I would like to think that this SHOULD work. But then I wonder why if it did work it hasn't been arbitraged away (as the efficient market hypothesis would predict)?
I think this is right. As the research mentioned above shows, it is hard to compare CAPE across different time frames in a way that allows you to have any predictive value. It seems even harder to compare them across different countries. Accounting standards vary significantly, so that the denominator you are using is not the same. In addition, because of the way that CAPE goes about "smoothing" P/E ratios, it is strongly dependent on the rate of earnings growth. For all the reasons you described above, different countries have different expected rates of earnings growth, and so you cannot just compare CAPE ratios between the two on an apples-to-apples basis.
Global Market Portfolio + modest tilt towards volatility (80/20->60/40 as approach FI) + modest tilt away from exchange rate risk (80% global+20% U.S. stocks; currency-hedge bonds) + tax optimization
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

MarkRoulo wrote: Thu Jul 22, 2021 10:49 am
Nathan Drake wrote: Thu Jul 22, 2021 8:57 am
YRT70 wrote: Thu Jul 22, 2021 6:33 am
Nathan Drake wrote: Wed Jul 21, 2021 6:21 pm There is a clear relationship between PE10 and expected returns.

I do not know why this shouldn’t play a role in one’s equity AA. You can use it to drive decisions on what equities go to EM, DM, SCV, etc on the basis of relative valuations.
I don't know much about this topic but going by the quote below it sounds like Ben Felix doesn't have a lot of faith in the predictive power of CAPE. Or am I missing something?
Basically, the predictive power of CAPE goes away if you consider independent samples (non overlapping) instead of rolling periods. It wasn’t this paper that changed my mind (it was a long talk with someone from Dimensional’s research group) but this paper touches the same points.

https://papers.ssrn.com/sol3/papers.cfm ... id=3142575

[...]

My current understanding is that we should treat expected returns as if CAPE has no information because of how weak the evidence of predictability is. We had previously been devising a fancy expected returns model which included CAPE as a predictor but after the aforementioned conversation I think that we will revert back to bootstrapping from the DMS data back to 1900 to estimate expected returns.
I agree that using CAPE to forecast exact returns doesn’t have much predictive power. I can’t look at US CAPE and say it will definitively be poor. Valuations could continue to increase.

The idea that Meb points out is that over the long term, the wider the spreads in CAPE are amongst asset classes with similar expected long term returns would allow us to possibly tactically tilt away from those that are much more highly valued than others.
I think the "expected similar long term returns" is the catch.

To pick an example to illustrate (not prove), naively one might think that Europe and the US would have similar-ish returns. European profits might be lower and maybe growth would be lower, but the P/E is lower, too. And, in any event, all of this is news and so should be priced in.

Then one looks at Italy (again, I'm illustrating, so, yes, this is cherry-picked ...) and discover that
  • the US per-capita GDP went from around $44,000/person in 2000 to around $55,000/person in 2019 (before covid).
  • the Italian per-capita GDP went from around $36,000/person in 2000 to around ... $36,000/person in 2019
The Italian economy hasn't grown in per-capita terms for 20 years! It wasn't flat. It went up, then went down a lot, then
went back up over the 20 years, but net-net ... flat. The population is aging. Does Italy have "expected similar long term returns" to the US? I certainly don't know. I expect the Italian companies will do less well, but I don't know if the price reflects this properly. I'd expect growing economies to have higher P/E ratios, but by how much?

Spain did better, but has been net-net flat since 2008. They just got back to 2008 numbers when covid hit.

Greece is, of course, Greece. If one expects the Greek government to go bankrupt again in the next decade, what is the correct P/E ratio for Greek companies?

Japan has a shrinking population and has mostly missed the tech industries of the past 20 years. How does one compare P/E ratios there with here (and, also, Japanese accounting standards are different, so "E" isn't defined the same way)?

China is growing, but it isn't clear how safe investments in China are.

So ... how do you know when two moderately different investments have "expected similar long term returns?" Folks will, of course, sell predictions, but that doesn't mean that they are any good.

I would like to think that this SHOULD work. But then I wonder why if it did work it hasn't been arbitraged away (as the efficient market hypothesis would predict)?
There are two theories that answer the question about why it hasn’t been arbitraged away:

1) Higher discount rates (lower valuations), indicates more risk. This isn’t a free lunch. Greece may still be a terrible investment compared to currently priced expectations. Realistically, you are not going to place all your investments into Greece. You will remove the idiosyncratic risk by investing globally into many different countries with various valuations. If a certain basket of countries (DM, EM) collectively has a significant trading discount than US then the market is pricing in that risk. You do not always get rewarded for such risk, but historically it is a proxy for higher expected returns.

2) The behavioral component. Investors tend to overpay for growth over the long term. While in the short term this may appear as though your returns are stronger if growth is going through a period of outperformance, long-term it usually underperforms a value portfolio.

If we believe 1), then this cannot be arbitraged away. If we believe 2), it could be arbitraged away, but you wouldn’t see such wide spreads in valuations if this were the case. Similarly, it’s possible that the behavioral biases are so rooted in human nature that they also don’t get arbitraged away due to how powerful they are.
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nedsaid
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Re: Do Indexers even need to pay attention to market valuation?

Post by nedsaid »

alex_686 wrote: Sun Jul 18, 2021 6:19 pm
ScubaHogg wrote: Sun Jul 18, 2021 5:57 pm My point is there is some logical limit to the claim that we should ignore valuations and stay the course. Maybe we will never see that limit and shouldn’t worry about it (though a Japanese investor would have been well served by worrying about it) but we should probably acknowledge it exists
Well, maybe atypically as a Boglehead, I don’t advocate holding the course.

One should not panic. Trying to time the market is really hard to do. etc.

However, we always say to be calm and write up a ISP. You base your asset allocation based on your market expectations. But the market changes over time. If the market changes shouldn’t you?

MarkRoulo mentioned the 90s where expected real returns of government bonds was 3%. Compare that to now, where it is around 0%. You should come to 2 different conclusions on what your AA should be, right?
Yep, the economy and the markets are dynamic. There are limits to staying the course no matter what. Problem is, I don't know what those limits are. The best we can do is be globally diversified and to take a slice out of our Total Stock Market and Total International Stock Market Index funds and use the proceeds to buy Value Indexes. Maybe take some off the top if markets look too toppy during a time of euphoria.
A fool and his money are good for business.
Marseille07
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Re: Do Indexers even need to pay attention to market valuation?

Post by Marseille07 »

Buy_N_Hold wrote: Thu Jul 22, 2021 5:35 am
HanSolo wrote: Wed Jul 21, 2021 10:48 pm Has the OP disappeared? Has the question been answered?
I have most certainly not disappeared, as far as I can tell. :) I have been reading through these responses carefully, and appreciate all of the input and perspectives. I’m not sure if this is a question that can be “answered” per se, but I have decided to avoid adjusting my asset allocation due to changes in the perceived risk of the market, which was my original intent behind the question. Since I am early in the accumulation phase, it seems to me that even a worst case scenario would provide some great opportunities to average down and DCA at great value.
Correct. Accumulators have little to worry about. A crash is actually a great thing for you get to load up shares on the cheap.
ScubaHogg
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Re: Do Indexers even need to pay attention to market valuation?

Post by ScubaHogg »

HomerJ wrote: Wed Jul 21, 2021 5:56 pm
ScubaHogg wrote: Tue Jul 20, 2021 12:10 pmThat’s kinda the point. At some extreme PE you are probably well served by stepping back some. You are just paying so much for a dollar of earnings it would be pretty irrational to expect previous growth to continue. And no, I am not talking about about levels the US saw in the mid to late 90s. I’m talking much higher.

(I’ve seen some charts showing Japan touched some PEs around 90, which seems insane)
But the problem is that the definition of "extreme" PE keeps changing.

mid to late 90s absolutely was considered "extreme" PE at the time. Shiller himself said in 1996 that the 10-year expected real return was 0%. And based on his data, he was right to do so.

CAPE hit 25 in 1996, and it had never been that high before except in 1929. That was a pretty insane extreme number at the time.

And now you yawn at 25... Heck, you're yawning at 35 or even 40.

"Extreme" is subjective, and if it keeps changing, it's not actionable.
Yes, unfortunately basically everything that involves humans and decision making has a subjective element to it. The future isn’t an engineering problem with known variables and a known range of outcomes. Our knowledge is imperfect and we have to make decisions anyway. But I’m not such a nihilist that I think I should pay zero attention to the world and adjust in outlier events.

I agree in general that we probably shouldn’t make routine adjustments based on valuations. But I also think there are some extremes (which we might not ever see) where we maybe shouldn’t blindly charge ahead in the name of consistency. And yes, I’m yawning at 25. Even 35 or 40. I’m not talking about PEs 10% or 40% above some normal range. I’m talking about PEs 3,4,5,10x above some norm. Or to put it another way, I would really hesitate at paying $100 to get $1 of earnings.

To use a little reductio ad absurdum, if bonds and what-not stayed roughly at their current yields, but the TSM shot up to a PE10 of 200, would you just say “nobody knows enough” and do nothing? Maybe you would. Heck maybe I would. But I don’t know that just the fact I might not do anything would make it a wise decision.

(And a PE of 25 shouldn’t seem extreme in the mid 90s when you could look across the pacific from a few years earlier and see a developed market with a PE almost 4x higher. Maybe 25 felt high, but “extreme” would have been hyperbolic)
“The purpose of the margin of safety is to render the forecast unnecessary.” - Ben Graham
ScubaHogg
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Re: Do Indexers even need to pay attention to market valuation?

Post by ScubaHogg »

nedsaid wrote: Thu Jul 22, 2021 12:01 pm
alex_686 wrote: Sun Jul 18, 2021 6:19 pm
ScubaHogg wrote: Sun Jul 18, 2021 5:57 pm My point is there is some logical limit to the claim that we should ignore valuations and stay the course. Maybe we will never see that limit and shouldn’t worry about it (though a Japanese investor would have been well served by worrying about it) but we should probably acknowledge it exists
Well, maybe atypically as a Boglehead, I don’t advocate holding the course.

One should not panic. Trying to time the market is really hard to do. etc.

However, we always say to be calm and write up a ISP. You base your asset allocation based on your market expectations. But the market changes over time. If the market changes shouldn’t you?

MarkRoulo mentioned the 90s where expected real returns of government bonds was 3%. Compare that to now, where it is around 0%. You should come to 2 different conclusions on what your AA should be, right?
Yep, the economy and the markets are dynamic. There are limits to staying the course no matter what. Problem is, I don't know what those limits are.
Yes, I agree. But even getting people to admit there is some limit is difficult. Personally I’d rather at least ponder the problem in theory so in the tiny chance it occurs I’ve at least put some thought into it.
“The purpose of the margin of safety is to render the forecast unnecessary.” - Ben Graham
minimalistmarc
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Re: Do Indexers even need to pay attention to market valuation?

Post by minimalistmarc »

If there was a boom accompanied by the kind of naive euphoria and ignorance in the general public similar to crypto speculators I would probably start to reduce my allocation.
Nathan Drake
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Re: Do Indexers even need to pay attention to market valuation?

Post by Nathan Drake »

ScubaHogg wrote: Thu Jul 22, 2021 2:52 pm
HomerJ wrote: Wed Jul 21, 2021 5:56 pm
ScubaHogg wrote: Tue Jul 20, 2021 12:10 pmThat’s kinda the point. At some extreme PE you are probably well served by stepping back some. You are just paying so much for a dollar of earnings it would be pretty irrational to expect previous growth to continue. And no, I am not talking about about levels the US saw in the mid to late 90s. I’m talking much higher.

(I’ve seen some charts showing Japan touched some PEs around 90, which seems insane)
But the problem is that the definition of "extreme" PE keeps changing.

mid to late 90s absolutely was considered "extreme" PE at the time. Shiller himself said in 1996 that the 10-year expected real return was 0%. And based on his data, he was right to do so.

CAPE hit 25 in 1996, and it had never been that high before except in 1929. That was a pretty insane extreme number at the time.

And now you yawn at 25... Heck, you're yawning at 35 or even 40.

"Extreme" is subjective, and if it keeps changing, it's not actionable.
Yes, unfortunately basically everything that involves humans and decision making has a subjective element to it. The future isn’t an engineering problem with known variables and a known range of outcomes. Our knowledge is imperfect and we have to make decisions anyway. But I’m not such a nihilist that I think I should pay zero attention to the world and adjust in outlier events.

I agree in general that we probably shouldn’t make routine adjustments based on valuations. But I also think there are some extremes (which we might not ever see) where we maybe shouldn’t blindly charge ahead in the name of consistency. And yes, I’m yawning at 25. Even 35 or 40. I’m not talking about PEs 10% or 40% above some normal range. I’m talking about PEs 3,4,5,10x above some norm. Or to put it another way, I would really hesitate at paying $100 to get $1 of earnings.

To use a little reductio ad absurdum, if bonds and what-not stayed roughly at their current yields, but the TSM shot up to a PE10 of 200, would you just say “nobody knows enough” and do nothing? Maybe you would. Heck maybe I would. But I don’t know that just the fact I might not do anything would make it a wise decision.

(And a PE of 25 shouldn’t seem extreme in the mid 90s when you could look across the pacific from a few years earlier and see a developed market with a PE almost 4x higher. Maybe 25 felt high, but “extreme” would have been hyperbolic)
Everyone has a different threshold. To me a PE above 30 is giving me an estimated return of 3%, maybe less if valuations decrease, maybe more if they continue increasing. As PEs get higher and higher from long term trends, the less likely I am to factor in PE expansion so I will discount for reversion. That leaves an estimate of 1-3%. That’s quite low for having money at risk in equities.

So US stocks are even higher than this at 35-40. At these levels I’m unlikely to add new contributions and may start rebalancing/tilting towards other assets with lower valuations, but I won’t get out completely.

I imagine there would come a point where I reduce exposure completely in favor of other assets, PE50 or so.
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Re: Do Indexers even need to pay attention to market valuation?

Post by BJJ_GUY »

Nathan Drake wrote: Thu Jul 22, 2021 8:57 am I agree that using CAPE to forecast exact returns doesn’t have much predictive power. I can’t look at US CAPE and say it will definitively be poor. Valuations could continue to increase.

The idea that Meb points out is that over the long term, the wider the spreads in CAPE are amongst asset classes with similar expected long term returns would allow us to possibly tactically tilt away from those that are much more highly valued than others.

Which is to say, CAPE won’t tell me if US returns 10% next decade, but it does suggest that if US is greatly overpriced relative to EM, that EM is more likely to have stronger returns than US going forward.

I would argue that we are approaching such a time right now. That still may mean that for you personally no changes to your AA are desired, but I think one can look at the data and take reasonable action knowing the risks.
Keep fighting the good fight, Nathan. I've previously attempted to make many of the same points that you have in this thread, and most folks on this group aren't wired to think about valuations and the fundamental relationship to future returns. If something can't be easily back-tested with perfect results, and/or if they can make a counter-point using the last ten years, then it just isn't going to resonate.

If I had my way, I'd change the way the debate is set-up, and the framed with the following:
1.) Stop using P/E based valuations (like Shiller). A better valuation for the broad market is: Non-financial Market cap / Gross Value Added (or a crude approximation of market cap / GDP) are materially better than P/E versions. A better method would result in fewer arguments about the lack of statistical significance between valuations and subsequent returns.

2.) Valuations can simply be used to understand relative over-priced vs under-priced markets. To utilize this, no one needs to make an assumption on the long term return expectations across various markets. Instead, you can simply figure out how many standard deviations from historical median valuation each broad asset class is.

3.) Think about using valuations as a tool to avoid losses rather than just a way of seeking the best means of increasing returns when everything is based on baseline estimations. Valuations helped smart investors avoid, or at least shade away, from tech in the late 1990s and away from real estate, banks, and other trouble spots in 2007/8. The avoidance, or underweight, to hot markets hurt for many years, and these investors were ridiculed for underperformance. In the end, avoiding the losses of a brief, but painful market drawdown, more than made up for the years of foregone paper gains during over-extended markets.
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HomerJ
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Re: Do Indexers even need to pay attention to market valuation?

Post by HomerJ »

ScubaHogg wrote: Thu Jul 22, 2021 2:52 pmTo use a little reductio ad absurdum, if bonds and what-not stayed roughly at their current yields, but the TSM shot up to a PE10 of 200, would you just say “nobody knows enough” and do nothing? Maybe you would. Heck maybe I would. But I don’t know that just the fact I might not do anything would make it a wise decision.
Since I rebalance a 50/50 portfolio, I would have locked in enough gains to retire comfortably even if TSM thereafter crashed 90% after rising to a PE of 200 :)
(And a PE of 25 shouldn’t seem extreme in the mid 90s when you could look across the pacific from a few years earlier and see a developed market with a PE almost 4x higher. Maybe 25 felt high, but “extreme” would have been hyperbolic)
No, it was considered extreme. Every time CAPE crossed 20 in the past, a crash occurred soon after.

It had only gone higher than 25 once, and that was in 1929, right before the Great Depression (where stocks ultimately dropped 88% at one point from their 1929 highs).

Crossing 25 was HUGE. It hadn't been that high in nearly 70 years. Irrational Exuberance speech by the Fed Chairman himself.

(Imagine what would happen today if the Fed Chairman, at the next televised meeting, said "Stocks prices are crazy high, ya'll! I mean stupid high!")

But actually 1996 ended up a good time to buy. Which is the crazy part... It wasn't that 1996 turned to be not as bad as predicted. It was actually a GOOD time to buy. Highest valuations in 70 years, and it was a good time to buy. Even during the crash of 2000-2003, the market never dropped as low as 1996.

The model was invented in 1988 using 1876-1988 data, and less than 10 years later it utterly failed as a prediction tool. And again and again and again in the following years.

In 2011, CAPE predicted 4.5% real 10-year returns... Instead we've gotten 13% real. That's not just a little bit off. That's wildly wrong. 99% percentile wrong.

Maybe we keep getting lucky. Or maybe, just maybe... the model is missing some important variables. Maybe it's not easy to predict the future.
Last edited by HomerJ on Thu Jul 22, 2021 5:05 pm, edited 1 time in total.
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Scooter57
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Re: Do Indexers even need to pay attention to market valuation?

Post by Scooter57 »

Thing is, 1996 marked the beginning of the masses being introduced to the internet, a development as transformative as the railroad, the automobile, and air conditioning. Now we are working out the details, but it is far from certain that you will see the kinds of new industries and mega companies emerging with enormous growth in the next 20-30 years like we did since 1996.

Current valuations are based on the assumption of tremendous real annual earnings growth for decades to come. (As opposed to financially engineered earnings growth based on borrowing and buybacks IBM-style without sales growth.) If that doesn't happen things get interesting.
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