Last week, we wrote a piece on the Shiller PE Ratio. In that article, we acknowledged that stocks are expensive by historical measures. We suggested it be used as a precautionary indicator rather than as a timing device. This week, we will delve a little deeper into market timing.
There are multiple ways to approach the market, but one of the most commonly heard bits of advice is not to try to time the market. Buy-and-hold is the mantra. We understand the theory. Timing the short-term twists and turns of the market is a difficult task at best, and seemingly impossible at worst. But for the sake of this article, we aren’t talking about short-term market timing. We are looking at what the long-term expected returns should be for a buy-and-hold investor.
We get asked often what kind of returns one should expect from the stock market. The short answer is that nobody knows for sure what the future will bring, but if we look at the past, returns depend on when you started. First, let’s take a look at the Shiller PE Ratio again below.
You will notice that stocks go from cheap to expensive over periods of many years. If we want to look at buy-and-hold, we still need to come up with a time period in which to hold. We get the whole investing for the long term, but in the long term, we are all dead, so we need to put some kind of time frame on our investment horizon. For the sake of this article, we will look at what would have happened in the past, if we invested for the long-term by matching the stock market.
Even this exercise is stretching reality, because the stocks that make up the indexes we are measuring have changed over time. While the major market indexes have a lifecycle of their own, so do the individual stocks that make up the index. Since market ETFs didn’t exist until recently, one would have to be a stock picker anyway, but we will assume it were possible to somehow match the index (also keep in mind that as recently as the 1980s the average brokerage commission was around $50 PER TRADE, PER STOCK!). Now, let's take a look at the previous times stocks were expensive and assume that is your starting point as an investor. How would you do if you followed the advice of the professionals, bought the market, and held on tight for a while? How long? Let's find out how long it would take to be made whole if you followed the wise advice to buy and forget you own it. We'll assume it was possible to buy the market with an ETF that tracks the index, so you can buy it and walk away. First, let's look at what happened if you jumped into the market peak in 1929.
Yikes! Can you imagine nearing retirement and putting your life's savings into the market in 1929? You could be an obedient investor and not even look at the market for a year, two years, three? When will you start to make money? In this case, it took twenty five years! Now that is long-term investing.......
Next, let's look at the next time the market got very expensive by historical measures. That would bring us to 1966. Some of you would have been investing during that one, or at least your parents might have been.
Again, there was no practical way to buy the Dow in 1966. The ETF DIA didn't exist. You could have bought all of the stocks that are in the Dow, but they change, so you'd become an active investor. But, if it were possible to buy the Dow and forget you own it, how long would you have to wait before buy-and-hold began to pay off? In this case, 16 years. Better than 1929, but then again, stocks didn't sport quite as high of a PE ratio as they did in 1929.
Next, let's take a look at the bubble in 2000. By the year 2000, it was becoming easier to invest in the market and walk away. Let's see how you would have done.
This time, it shows a brief period of positive returns during the real estate bubble in '06, but shortly after that your investment was cut in half, and it didn't recover for any sort of sustained profit for nearly twelve years.
As you can see, how well you do in the market depends on WHEN you begin to invest. Buy-and-hold is a great idea when you buy near a market bottom. But near market tops, it is a recipe for losing money for years.
That brings us to today. Take a look at the Shiller PE Ratio again in the chart on top. There is only one other time when stocks were more expensive by this measure, and that was in 2000. So, is now a good time to be a buy-and-hold investor? Perhaps, but history would tell us otherwise.
We realize we are cherry picking our start dates to get the worst possible outcome. In the real world, we don't all invest our life's savings in one fell swoop. But occasionally we do come into an amount of money that took years to accumulate, but the gain comes suddenly from the sale of a business or a home. If years of hard work pay of rather suddenly for you, it pays to be careful about taking long term averages at face value and assuming your results will be similar. It might, but if history is any guide, it does depend on when you start.
Scaling into the market over a period of time can help to smooth out results and of course the most important factor many years from now will be that you continued to invest on a regular basis regardless of your strategy. But paying attention to the market valuation can help to guide you on whether it is a time to be more aggressive or defensive in the market. Few people regret being defensive in the past when the market became as expensive as it is right now.
Living and traveling on a boat means for a few months each year we have to wait out hurricane season. This year we did that in Guatemala, and have had a great time. But it still feels great to untie the docklines. We were due to set off a couple of days ago, but in typical fashion, after months without any boat problems, our water lines began to burst the morning of departure. Turned out to be a problem with the accumulator tank—not a huge issue—that took two days to work out. Finally, Saturday afternoon we were on our way. We said our goodbyes and pulled out of the marina with an exciting season of cruising ahead of us. This year will take us—assuming our plans actually work out—from Guatemala to Honduras, the Grand Caymans, Jamaica, the Dominican Republic, and finally Puerto Rico. As I write this I'm anchored in front of a 1600s Spanish colonial fort built to defend against pirates. It's still astounding to me that I can sit on my boat at anchor in foreign lands, trading the stocks of companies located around the world, and communicate with all of you at the same time. The uniqueness of this life is not lost on me.
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