There’s a lot of great investment advice out there. My favorite for years has always been to NOT try to time the market. No one accurately predicts crashes. Just because the market is at its peak, it doesn’t mean it can’t go higher.
Have you heard any of these?
A lot of it makes sense. However, I’m going to tell you why a lot of seemingly sound advice might be… let’s just say, “Less than ideal.”
Today’s article is inspired by a couple of personal finance articles I read yesterday The Tiny Truths That Completely Changed How We Money and Why You Should Invest, Even in Peak Markets. I don’t read as many personal finance articles as I used to nowadays, so it is significant for me to see two articles in one day that have a focus on this advice.
I’ll start with the Tiny Truths article as it was the easiest. The point made was:
“Condensed version of all this: don’t try to time the markets, and especially don’t hold off on investing just because the markets seem ‘high,’ a term that is so relative as to be essentially meaningless.”
If you think the markets “seem ‘high'”, yes it’s a probably a good idea to just continue investing anyway. However, what if there was a way to statistically quantify how “high” the markets are and look at how similar markets have performed over the past… say nearly 140 years? Would you be interested in that?
Let me introduce you to the Shiller P/E (also known as CAPE)
(For more on Shiller P/E see How Expensive Are Stocks Now? and How We KNOW Where the Stock Market Will Go.)
A number such as Dow 22,000 doesn’t really tell us anything. It’s like saying that IBM at $141 a share is expensive while Citigroup at $68 is much cheaper. Citigroup is the larger company (by market capitalization) because their are fewer shares.
Instead of using share price to evaluate stocks, we can use value metrics. The most famous of which is price/earnings (or P/E). People have been using price/earnings ratios for determining the value of a stock for decades. Benjamin Graham has used it in his winning strategy for 60 years. Value investors look for a small price for a high earnings. Thus the smaller the P/E the better. (There are other factors and this is an over-simplification, but hopefully you get the general idea).
The Shiller P/E is essentially the price/earnings of the market. Take a look at the above graph and write down on a piece of paper or in a note taking app what you see. (Or just cheat by continue reading, I can’t see what you are doing anyway.)
Here’s what I see. From 1880 until 1995… a span of 115 years, nearly any time the Shiller P/E got above 20 the market would crash:
- It hovered in the 20’s around 1990… and worked its way down to 5 in 1920.
- Then over the next 10 years people got really excited and it worked its way to 30 at the top of 1929 stock market crash… and then it crashed back down to 5 by ~1932
- Then ~1936 it got up around 22… and then it crashed down 9 by ~1942.
- From ~1955 to ~1965 it hovered around the 20 range peaking at around 24… and then it crashed to around 7 in ~1982
- From that 1982 to 1987 it moved up from 7 to 17 and then had a mini-drop to 14 on Black Monday.
From the above, it feels to me like 20 is DEFCON 3, 25 is DEFCON 2, and 30 is DEFCON 1.
From 1995 to now, things get very interesting.
- From 1995 to 2000, Shiller P/E jumped from 20 to 44. That DotCom Boom was really something, wasn’t it?
- From 2000 to 2002, it went from 44 to ~23. That DotCom Bust was really something, wasn’t it?
- From 2002 to 2008, we a recovery up to around 27
- From 2008 to 2009, the P/E dropped from that 27 to 15. This period is commonly known as the Great Depression
- From 2009 to today, the P/E has mostly gone straight up from 15 to 30. For the majority of personal finance bloggers, they’ve only known this era of prosperity.
We’ve seen the Shiller P/E reach 30 three times. The first was the 1929 crash. The second was May of 1997 a couple of years before the peak and DotCom crash in Dec. 1999. From the graph these two crashes look to be the largest in American history… and it’s not even close.
The third Shiller P/E is now.
Remember that before 1995, investing when the Shiller P/E got in the 20-25 was a sign of a significant downturn. Maybe the new normal in the Internet economy is that the Shiller P/E should be 25. In that case maybe 30 isn’t too bad.
Is it reasonable to suggest that we should be cautious with investing in high P/E environment? Of course! Usually, investors only pay 30 P/Es for companies due to their growth potential. CitiGroup is reasonable 13.65 P/E with a decent dividend. IBM is at 11.77 P/E with a better dividend (Full disclosure: I own IBM stock.) Investors may be attracted to these companies because the price for the earnings is low.
So would you buy the S&P 500 at 30 P/E if you knew it that it generally trades at 16 P/E? (Again, that’s an over simplification, but it illustrates the point). Wouldn’t you like to own nearly twice as many shares for the same price? I know I would!
So let’s turn our attention to MamaFishSaves:
“On August 26, 2014, the S&P 500 closed above 2,000 for the first time. At the time, plenty of people were there to say that valuations were too high, the underlying economy wasn’t strong enough, and we would see a downturn in the near term. Some claimed that even if the economy improved, stocks would have to drop by about half to see normal rates of return in the next cycle (source). But if you had listened to the naysayers and pulled your money out of the market in August of 2014, you would have missed out on 7.8% annual returns (9.8% if you reinvested dividends) between then and now.”
She’s not wrong. However, what if this is like investing in 1997 when valuations are high (Shiller P/E of 25+), but still went higher? In early 1999, someone could make a great case that by not investing you missed out on a ton of gains. In 2002, you could have said, “I told you so!” Maybe in 2019, one could say the same thing.
I think the strongest argument that Mama Fish makes is:
“In March of 2009, your $10,000 would have fallen to $4,322 in value. A greater than 50% drop would be a pretty big gut punch. But by holding steady and recognizing that the market naturally rises over time, you would have recouped your whole investment by August 2013. By now, you would be up over $5,000. Your average annual return would be 4.7% with a total return of 54.7%. Not the 7% long-term average, but well above the 0% of your checking account and the 1%-2% annual inflation rate. And this is forgetting one very important thing. Dividends.”
This is part of an illustration of investing at the market peak of the Great Recession on October 9, 2007. For reference that was Shiller P/E at 27… below today’s 30 Shiller P/E. Let’s pause for a second on this point: The valuation of the market before “the Great Recession” is quite a bit less than it is today. So this is making a point about investing at the peak of a historically bad period, but when there was MORE value in investing than today.
The point that you would have made all your money back and more over the long haul is a strong one. Again, if you are new to investing you shouldn’t be scared to invest because it works out eventually… and eventually is usually a pretty short time.
However, isn’t it fair for me to suggest that going from one bubble to the next isn’t a great measuring stick?
What if we ask the question, “Maybe I can do better?”
So let’s say that you decided that Shiller P/E 25 is too risky for you. You don’t buy at the Great Recession peak in 2007. Instead, you start buying in from Jan 2008 and continue to invest until May 1, 2014 according to this Shiller P/E table. Wouldn’t you have done better? Let’s find out.
Rather than being a “Negative Nate”* and thinking about investing at the worst time (and a bad value), wouldn’t it be great to measure what your investment could do if you invested at a good valuation? This calculator seems to allow us to do that. Investing $10,000 on Jan. 2008 grows to $21,495.21 (in July of 2017 – close enough). The graph from Mama Fish of investing at the peak shows that you’d “only” have $15,233. (“Only” is in quotes, because that’s still a solid return.)
This isn’t a calculation about predicting the bottom of the market. That’s impossible… like bending spoons. This is simply investing at the time that the Shiller P/E is below 25, an arbitrary number that I feel is a warning sign.
What if we are “Positive Patty”** What if you were able to bend spoons and predict the bottom.
If you use the same calculator, you’d find that investing $10,000 from March 2009 would be $37,953.93 (July 2017)! Where did that March 2009 come from? I picked it from the Shiller P/E chart when it was at its low, 13.32.
It’s amazing to think that you could have somewhere between $15,000, $21,000, and $38,000 by just changing the time when you invest.
Can we objectively look at a valuation and say that 25+ is “fire bad” and that ~13 is “tree pretty” when it comes to investing? Even cavewoman Buffy would agree that your brain doesn’t need to be functioning on the higher levels to understand this, right?
Unfortunately, I lack the tools to backtest the performance of investing at various Shiller P/E numbers.
The counter argument is that by not investing the $10,000 you are getting a return of nothing. Also inflation is making that $10,000 worth 2.5% less every year. Some quick math tells me that you’d have the buying power of ~$8800 if you didn’t invest for 5 years. So there’s a downside of losing around 12% of your investment by doing nothing for 5 years. Is it better to lose $1200 through inaction or make an extra $6000 ($21,000 vs. $15,000) or $23,000 ($38,000 vs. $15,000) by waiting for a good valuation?
Conclusion: Pick a Path That’s Right For You
I’m divided on this topic. I see two paths:
1. There’s the behavior finance view that for people who don’t invest you should be like Nike, “Just do it!” I agree, because I know people like this. It is probably most of America (if most of America actually invested). Take your blue pill and “the story ends… and believe whatever you want to believe.” As Mama Fish shows you’ll do very well over the long haul.
2. There’s the informed investor view for people who want to take charge of their investing. I tend to think this is the majority of my readers. It’s not like you are here for my late 90’s pop-culture references, right?
I think we should tell people that it is okay to be in the second group. It’s not wrong for people to pause when valuations are so high that they historically lead to crashes. It’s something that investors should at least consider, right?
To be clear, I’m not suggesting that one should exit the market completely. I’m still heavily invested in this market. Instead, I think it makes more sense to adjust your risk allocation which may mean investing in countries with lower Shiller P/Es.
It’s your turn. What are your thoughts on using Shiller P/E for market timing? Have you read any good articles using Shiller P/E with relation to market timing? If so, could you pass them along in the comments?
* I feel like the terms “Negative Nancy” and “Debbie Downer” are sexist. So “Negative Nate” it is.
** Will you allow me to sexist in positive way with this one?