Monday, March 22, 2010

Why Now Is Not the Time for Buy and Hold

The most common question I get from clients is, 'Is now a good time to invest in stocks?' What clients are really asking is, 'If I invest now, will stocks take me where I want to go, on my timeline?' Most advisors answer this question by referring to long-term average returns. Some reference the last 20 years, others the last 30 years, and a small few know average returns over the last 100 years or more. Advisors quote these average returns as though investors are actually likely to achieve this growth regardless of when they invest.

It Matters When You Invest

In reality, the timing of your decision to put your money to work in the stock market has an enormous impact on your likely future returns. For example, if you chose to invest your money in stocks in September of 1929, your portfolio would have achieved growth of -2.34% per year over the next decade. In contrast, if you invested in July of 1932, your portfolio would have grown at over 8% per year over the next 10 years. Investing in August 1972 would have shown investors -3% a year over the next decade, but putting your money to work exactly 10 years later would have netted an investor 10.6% per year after inflation!

Given that timing matters, one is left to wonder if there is something about those dates that would have given investors a clue about what to expect from stocks over the following 10 year period. It turns out that by analyzing Yale Professor Robert Shiller's publicly available database of stock market information going back to 1870, clear patterns emerge that can help investors set expectations about future returns. That's the good news. The bad news is that future returns from here are likely to leave buy and hold investors in the dust.

Are Markets Cheap or Expensive

Most investors are familiar with the commonly cited Price to Earnings Ratio, or PE ratio. This is simply the current price of a stock divided by its last year's earnings, and it is used frequently to describe , very loosely, whether a stock is cheap or expensive. Interestingly, though the PE ratio is the most commonly cited statistic in finance, it provides very little useful information when picking stocks. A stock with a high PE may be growing very quickly in a market with little competition, high margins and high barriers to entry, so that the price is justified. Alternatively, a low PE stock may be lagging its competitors in terms of growth or profitability, and so the low price is justified.

The same ratio can be used to describe the stock market in aggregate. The market's PE ratio is just the current level of the index divided by the combined earnings of all its constituent companies. However, when analyzing the stock market in aggregate it makes sense to adjust the ratio by using average stock market earnings over the past 10 years, adjusted for inflation, rather than just the previous year's earnings. This method was first proposed by Warren Buffet's mentor and value investment guru Benjamin Graham. He wanted a ratio that reflected the long-term trend of corporate earning potential in the economy, adjusted over one full business cycle. The Cyclically Adjusted PE, or CAPE, helps investors avoid the the misconception that markets are cheap just because the economy is at the peak in the current business cycle.

It turns out that, at the aggregate market level, the PE ratio does provide information that is useful to investors. Over time, investors are likely to receive above average returns by investing when markets are cheap (low PE), and below average returns by investing when markets are expensive (high PE). One can see from Chart 1. below that over the last 140 years, markets have traded in a PE range of about 5%(1921, 1932, 1982) through 45% (2000).

Chart 1.

Source: Robert Shiller

Do Cheap Markets Deliver Better Future Returns?

In Chart 2. below, one can clearly see the relationship between the PE of the market and future returns. Starting PE and future returns are inversely related, so low PE = high future returns and high PE = low future returns. In order to illustrate this relationship, I have inverted the PE ratio to show the market's earnings yield (10-year average earnings divided by current price), so the blue line on the following chart is the inverse of the blue line in Chart 1. When the market is expensive, the blue line in Chart 2. is closer to the bottom, not the top. The red line shows the returns to an investor who invested on each date over the subsequent 10-year period, after inflation and including dividends.

Chart 2.

Source: Robert Shiller, Butler|Philbrick & Associates

It is plain to the eye that the 10-year forward returns (red line) very closely track the market's long-term earnings yield ratio (red line). A cheap market (low PE, high earnings yield) usually results in high long-term returns, while an expensive market (high PE, low earnings yield), usually results in low long-term returns.

It is worth noting at this point that the predictive value of the CAPE ratio is less robust when markets are neither very cheap nor very expensive. For the purpose of the analysis below, we assume the market is cheap when it trades in the 1st quartile of all CAPE ratios over the 140 year time period; it is expensive when it trades in the 4th quartile. When the market is priced in the 2nd or 3rd quartiles, it is neither cheap nor expensive.

Chart 3. is a scatter plot of all monthly CAPE ratios and the corresponding future 10-year returns, for all months where the market is either cheap (1st quartile), or expensive (4th quartile). The chart also shows the best fit line for the plot, as well as the least-squares linear approximation formula and R-square value. I then calculated the model's expected future returns from the formula using the current market CAPE ratio (20.63). An R-square value above 0.5 suggests a very strong relationship, so the market's current CAPE ratio does an excellent job of explaining future returns.

Chart 3.

Source: Robert Shiller, Butler|Philbrick & Associates

Chart 4. attempts to illustrate the relationship between the market's CAPE ratio and future returns by showing the distributions of future returns for both cheap (1st quartile CAPE) and expensive (4th quartile CAPE) markets. You can see that the median 10-year real return to stocks when markets are cheap is 10.62% per year, while the return to stocks when markets are expensive is 3.77% per year. Chart 3. shows that the modeled return to stocks when markets are priced at a CAPE of 20.63 is approximately 4.64% per year.

Chart 4.

Source: Robert Shiller, Butler|Philbrick & Associates

Lower Expectations or Pursue Alternatives to Buy and Hold

Many advisors will argue that a 4.6% expected return may be poor, but it is much better than what an investor can expect from bonds or cash. On this basis, an investor should allocate a larger portion of his or her portfolio to stocks. While this logic may be sound if several other conditions are met, it is peripheral to the main conclusion of this analysis. It is helpful to think of the market in the same way that an insurance company thinks of a life insurance policy. Based on a large body of evidence, an insurance company computes the most probable lifespan of a smoker to be less than a non-smoker. All other things equal, a non-smoker has a very high likelihood of out-living a smoker, though any one smoker may live a long, healthy life. In the same way, an expensive market may deliver strong future returns, but the odds are stacked against it.

The primary take-away is that investors should set lower expectations for future returns from here, and build these lower returns into financial and retirement planning models. While most planning software uses future nominal returns of 8% per year (every year!), investors are unlikely to see these returns in practice, especially after fees.

Alternatively, accredited investors may wish to pursue alternative strategies that have demonstrated an ability to deliver robust real returns in good markets and bad. I will spend more time on these strategies going forward, but for an excellent example, look no further than last week's post.

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