Stocks Are Far More Risky When Valuations Are High

The following is a guest post by Rob Bennett.

I advocate Valuation-Informed Indexing. This strategy calls for the investor to increase his stock allocation when prices are low and to decrease his allocation when prices are high. You can read about the basics of the strategy in a guest blog entry that I recently wrote for the Free From Broke blog titled “A Better and Less Risky Way to Invest in Stocks.” Recent research shows that Valuation-Informed Indexing beats Buy-and-Hold in 102 of 110 of the rolling 30-year time periods in the historical record.

I have a calculator at my web site (“The Stock-Return Predictor”) that performs a regression analysis of the historical data to reveal the most likely annualized return for the purchase of a broad index fund made at any valuation level. For example, the Return Predictor would have told you in 1982 that stocks were a great buy — the most likely annualized 10-year return at the P/E10 level (P/E10 is the current price of the S&P 500 over the average of the last 10 years of earnings) that applied at the time was 15 percent real. The same number when prices are where they were in 2000 was a negative 1 percent real.

By revealing the range of possible returns and assigning rough probabilities to each of them, the calculator is also revealing the extent of the risk associated with buying stocks at various valuation levels. To know how risky stocks are at a given valuation level, you need to look at the worst-case scenario — the annualized return that will apply in 10 years in the event that we see the worst 10-year returns sequence that exists in the historical record.

To see how this works, please go to the calculator, enter a P/E10 level of “14” (that’s the fair-value P/10 level) and click “Calculate.” The calculator reports that the worst possible 10-year return is 0.34 percent. That’s not great. But it’s a positive number.

There’s a 50 percent chance that the 10-year return will be 6.3 percent or better. And those who hold for 20 years obtain an annualized return of 2.3 percent even in a worst-case scenario.

My interpretation of these numbers is that stocks are a less risky asset class than most believe. So long as you limit yourself to buying stocks only at moderate or better prices and commit to a 10-year holding period, you are virtually guaranteed to at least break even. That’s a very good deal, given the upside potential that applies when stocks are purchased at those prices (the annualized return that applies if the best-case returns sequence in the historical record happens to turn up for stocks purchased at fair value is 12.3 percent).

It’s a very different story when stocks are purchased at high prices. The P/E10 level in January 2000 was “44.” The worst-case 10-year return for stocks purchased at those prices is a negative 7.09 percent. That means losing an average of 7 percent of your money every year for 10 years running!

Even the most likely return here is a negative number. And even at 20 years there is a 20 percent chance that your annualized return would be a negative number. And even at 40 years there’s a chance that your annualized return would be under 3 percent. Now that’s risk!

Stocks are less risky than generally thought at times of moderate prices and more risky than generally thought at times of high prices. That’s a very cool thing to know! There is no law that says we must purchase stocks at times of high prices. Refrain from doing so and you change the nature of the asset class from a highly risky one to a not-too-risky one.

Most of the riskiness of stocks is elective. Stocks are truly risky only for those who refuse to take price into consideration when setting their stock allocations.

How about today?

Today’s P/E10 level is “24.” In a worst-case scenario, the annualized 10-year return would be a negative 4.20. The likelihood is that the returns will be worse in the early years of that 10-year period because we always go to a super low P/10 value ( 7 or 8 ) in the wake of huge bull markets.

If you have already taken an emotional hit as a result of the poor returns experienced during the Lost Decade, you need to be aware that we may be in for another 10-year period in which the overall return is slightly negative or slightly positive but in which the early years are marked by bone-crushing losses that are then mitigated by the far more appealing returns that become likely once prices fall hard (the most likely annualized 10-year return starting from a P/E10 value of 8 is 15 percent real!).

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Rob Bennett created the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. His bio is here.

[Kevin] Rob offers a compelling case for Valuation-Informed Indexing, and the impact that the current price of the S&P 500 over the average of the last 10 years of earnings can have on your returns. If earnings are unable to rise quickly enough to justify the current valuation levels, then it might be time to hold on to our seats!

I was first introduced to Rob’s writings through his comments over at Balance Junkie, and when I asked him if he would be willing to write a guest post he kindly obliged. Thanks for the great guest post, Rob!