Author Topic: Philosophical Economics Post re: Stock Market Valuation  (Read 10975 times)

brooklynguy

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Philosophical Economics Post re: Stock Market Valuation
« on: April 03, 2017, 09:52:10 AM »
Philosophical Economics just published another thought-provoking post, arguing that structural changes in the nature of the stock market, including the stock market's own incorporation of information about itself into itself over time, have established a basis for higher sustained equity valuations (and lower sustained equity premiums).

http://www.philosophicaleconomics.com/2017/04/diversification-adaptation-and-stock-market-valuation/

dandarc

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #1 on: April 03, 2017, 11:19:20 AM »
Never seen that layed out so comprehensively.  The "high" valuations have been going on for so long.  Seems like the reason is largely "the internet and index funds".

So, we should expect both lower returns for stocks and lower variation going forward than we've seen in the past.  Now, what to do with that information?

CorpRaider

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #2 on: April 03, 2017, 11:22:01 AM »
He's really Irving Fisher, the zombie!

sol

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #3 on: April 03, 2017, 11:33:17 AM »
BG, you post articles from that blog often enough that I'm beginning to suspect you're secretly the blog's incognito author.  Ease up, man, you'll blow your cover.

Now I'll go read it, because you post good stuff.

brooklynguy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #4 on: April 03, 2017, 12:24:25 PM »
Well, first my "brooklynguy" cover would have to be blown, if that were the case.  But alas, I'm just a fan.

HeadedWest2029

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #5 on: April 03, 2017, 01:08:42 PM »
I came here to post the same link. Rational and well laid out.  I've punched in 5% real returns for my FI planning, but I may need to lower to a more conservative estimate after reading this.

anisotropy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #6 on: April 03, 2017, 01:48:49 PM »
I am a little confused. Is 4% real return from equities the result even with higher valuation multiples? Or will the higher valuation multiples juice the return further ?

691175002

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #7 on: April 03, 2017, 02:25:33 PM »
I am a little confused. Is 4% real return from equities the result even with higher valuation multiples? Or will the higher valuation multiples juice the return further ?

Higher valuations juice returns for a short period, but once prices have gone up, stocks are more "expensive" and therefore produce lower returns.  Saying current valuations are high is extremely pessimistic because it implies that both historical returns were inflated by a one time-boost and future returns will be lower.



His post provides a very intuitive understanding of what would happen in a world where his assumptions are true, but I think the analysis is too simplified to answer any of the hard questions.

I suspect that current market participants are pricing equities as if the Philosophical Economics model is true, but in practice drawdowns will be considerably more harmful than expected because correlations spike during a crash.

People also forget that a true crash forces investors to sell.  Many investors are basing their asset allocation around charts that show you will never lose money if you stay invested long enough.  The S&P500 might recover in 3 years, but if you lose your job and draw on savings to meet mortgage payments you will still get crushed.

Optimisim combined with rising correlations (equities are being traded as baskets so the constituatns all move together) could make a crash much more severe, should it occur.



I think improved policy response is the most convincing argument for higher equity valuations but that is hard to quantify.  Central banks have the tools and perhaps even the willingness to avoid recession to a degree that has never been seen before.

What happens if every facet of government is hell-bent on avoiding recession?  Do markets go up forever or are we just winding an ever tighter spring that will eventually snap?

TheAnonOne

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #8 on: April 03, 2017, 02:37:26 PM »
I am a little confused. Is 4% real return from equities the result even with higher valuation multiples? Or will the higher valuation multiples juice the return further ?
I think it's being stated that real returns will drop. This of course is on average, folks here will have bought at prices all over the map, so you never know.

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AdrianC

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #9 on: April 05, 2017, 07:34:24 PM »
I am a little confused. Is 4% real return from equities the result even with higher valuation multiples? Or will the higher valuation multiples juice the return further ?
I think it's being stated that real returns will drop. This of course is on average, folks here will have bought at prices all over the map, so you never know.

What's important to all of us is real return going forward. What will be the return on your stash going forward?

"The answer: 4% real...current investors have little historical basis for expecting to earn any more than that.  In fact, they should expect less."

Actionable? You betcha. Forget all that "stocks return 7%" BS. Assume 4%. Save more if you have to.

LAGuy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #10 on: April 05, 2017, 09:27:25 PM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

I mean, there's so much to this article that's written from a perspective of a person not living in the real world, "We saw the improved resilience of the system in the 2008 recession, an event that had all of the necessary ingredients to turn itself into a new Great Depression.  It didn’t–the final damage wasn’t even close to being comparable.  Here we are today, doing fine." Tell that to all the desperate people that turned out for the likes of Donald Trump.

This is just another confused sounding article from an economist who doesn't understand why people don't behave "efficiently" and ride the market down and then ride it right back up again.
« Last Edit: April 05, 2017, 09:34:52 PM by LAGuy »

farfromfire

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #11 on: April 05, 2017, 11:32:19 PM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

I mean, there's so much to this article that's written from a perspective of a person not living in the real world, "We saw the improved resilience of the system in the 2008 recession, an event that had all of the necessary ingredients to turn itself into a new Great Depression.  It didn’t–the final damage wasn’t even close to being comparable.  Here we are today, doing fine." Tell that to all the desperate people that turned out for the likes of Donald Trump.

This is just another confused sounding article from an economist who doesn't understand why people don't behave "efficiently" and ride the market down and then ride it right back up again.
+100

Out of 20 people I work with,  I'm the only one with stock market exposure since "stocks are like gambling".

People who do invest in the stock market are partially driven by emotion as well. There will always be a large number of investors that sell at the bottom out of fear that the market will go down to 0.

brooklynguy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #12 on: April 06, 2017, 07:49:36 AM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

The assertion isn't that panics are less likely to be seen as reasons to panic than they are not to be seen as reasons to panic, it's that panics are less likely to be seen as reasons to panic today than they were to be seen as reasons to panic in the past (for all the reasons outlined in the article, not least of which being the simple fact that today's investors have more history to look to than did investors in the past).  You can argue about the extent to which this is true, but it would be hard to argue that is entirely untrue (which, in turn, means you can argue about the magnitude of its impact on the market, but it would be hard to argue that it has no impact at all).

PathtoFIRE

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #13 on: April 06, 2017, 08:22:59 AM »
I don't think the article is arguing a complete paradigm shift or flip, but rather the flavor or stock investing today compared to prior years is subtly different, in large part due to enlarging history plus the ease and decreased costs of info plus fee and tax efficient methods of diversification that were hard to come by before. The author is not arguing that everyone or even most people aren't going to still panic sell on downturns, or many won't keep trying their hands at stock picking, just that increasing number won't engage in these actions (compared to prior years), and that will have the effect of blunting the stock premium. This argument has been made by many people from many different angles, and I appreciate this author's perspective.

aspiringnomad

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #14 on: April 06, 2017, 07:00:33 PM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

I mean, there's so much to this article that's written from a perspective of a person not living in the real world, "We saw the improved resilience of the system in the 2008 recession, an event that had all of the necessary ingredients to turn itself into a new Great Depression.  It didn’t–the final damage wasn’t even close to being comparable.  Here we are today, doing fine." Tell that to all the desperate people that turned out for the likes of Donald Trump.

This is just another confused sounding article from an economist who doesn't understand why people don't behave "efficiently" and ride the market down and then ride it right back up again.

Our financial system was truly at the edge of the abyss in the days, weeks, and months after Lehman failed. It was a bigger shock than what caused the Great Depression. While Trump's base probably didn't benefit much from the quick and relatively competent policy response (that probably has more to do with long-term globalization and technology trends), the global economy certainly did.

LAGuy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #15 on: April 06, 2017, 09:59:52 PM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

I mean, there's so much to this article that's written from a perspective of a person not living in the real world, "We saw the improved resilience of the system in the 2008 recession, an event that had all of the necessary ingredients to turn itself into a new Great Depression.  It didn’t–the final damage wasn’t even close to being comparable.  Here we are today, doing fine." Tell that to all the desperate people that turned out for the likes of Donald Trump.

This is just another confused sounding article from an economist who doesn't understand why people don't behave "efficiently" and ride the market down and then ride it right back up again.

Our financial system was truly at the edge of the abyss in the days, weeks, and months after Lehman failed. It was a bigger shock than what caused the Great Depression. While Trump's base probably didn't benefit much from the quick and relatively competent policy response (that probably has more to do with long-term globalization and technology trends), the global economy certainly did.

So, I guess what you're saying then is that you agree with the authors assertion of "Here we are today doing just fine."

aspiringnomad

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #16 on: April 06, 2017, 10:38:29 PM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

I mean, there's so much to this article that's written from a perspective of a person not living in the real world, "We saw the improved resilience of the system in the 2008 recession, an event that had all of the necessary ingredients to turn itself into a new Great Depression.  It didn’t–the final damage wasn’t even close to being comparable.  Here we are today, doing fine." Tell that to all the desperate people that turned out for the likes of Donald Trump.

This is just another confused sounding article from an economist who doesn't understand why people don't behave "efficiently" and ride the market down and then ride it right back up again.

Our financial system was truly at the edge of the abyss in the days, weeks, and months after Lehman failed. It was a bigger shock than what caused the Great Depression. While Trump's base probably didn't benefit much from the quick and relatively competent policy response (that probably has more to do with long-term globalization and technology trends), the global economy certainly did.

So, I guess what you're saying then is that you agree with the authors assertion of "Here we are today doing just fine."

No, I hear ya. Things are far from perfect. But it's relative and a long-term perspective keeps me optimistic. Nine years after the crash of 1929 more than 1 in 4 nonfarm workers were unemployed. Today, almost nine years after Lehman, it's fewer than 1 in 20.

aspiringnomad

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #17 on: April 06, 2017, 10:50:16 PM »
Beyond that I think he makes the most compelling case for lower future returns that I've seen.

TL;DR: Why shouldn't equities (as an asset class) be perceived as less risky when the cost to diversify plummets and data continues to support the long-term bull case? And if that's the case, why shouldn't returns lower somewhat to reflect lower perception of risk?

Radagast

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #18 on: April 07, 2017, 12:11:01 AM »
I would say there are even more reasons to expect higher valuations. It comes down to investors today being able to have a lot more confidence in the ability of their future selves to have use of their money. For example, in 1929 the Schiller PE ratio was supposedly similar to right now. But, 1929 was exactly halfway between world wars. Vaccines and antibiotics were hard to come by. Stock markets were largely unregulated, highly speculative, and in many cases literally gambling (apparently there were places that would allow you to bet on which stock would go up most without actually buying it, like a horse race). People in the 1930's were right to discount the future heavily. In 2017 people have learned to have a lot more confidence in the future.

Plus there are all the financial reasons why valuations should be higher, like greater liquidity, lower costs, less effort, better policy makers (at least for protecting the investor class), and the others mentioned in the article.

aperture

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #19 on: April 07, 2017, 06:50:54 AM »
I sort of wonder if this is the beginning of the, "This time it's different" line of thinking.
+1

I really enjoy this sort of analysis and considered thought, but at the end of the day, I just keep plodding forward with my same old asset allocation.  Execution of my FIRE plan is a marathon, and I am not changing my approach because of a new analysis.  At the end of the day I think 3.5% to 4% return is what I am hitching my wagon, but it is the flexibility to respond to unfortunate sequence of returns that will hold us aloft if things do not work out.  -ap

TheAnonOne

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #20 on: April 07, 2017, 08:41:39 AM »
I sort of wonder if this is the beginning of the, "This time it's different" line of thinking.
+1

I really enjoy this sort of analysis and considered thought, but at the end of the day, I just keep plodding forward with my same old asset allocation.  Execution of my FIRE plan is a marathon, and I am not changing my approach because of a new analysis.  At the end of the day I think 3.5% to 4% return is what I am hitching my wagon, but it is the flexibility to respond to unfortunate sequence of returns that will hold us aloft if things do not work out.  -ap
I've always had a goal of adding international and it has been my plan to aquire it via monthly purchases. This article at least pushes me to really get started on that.

At 290k stache getting even 20% int will take a long time.

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TheAnonOne

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #21 on: April 07, 2017, 09:09:58 AM »
I saw an internal McKinsey webinar a year or two ago with some similar discussions, though more from a future if corporate fundamentals perspective than from a market behavioral one.

Definitely food for thought for younger mustachians looking to use market returns as fuel for their FIRE.  I have posted my predictions for future market changes several times and also believe capital will be a less influential input to value creation in the future.

It nay be tough news to those of us who worked hard to accumulate capital.  But the good news is that durable goods and especially information goods will continue to get cheaper for consumers due to automation and technology/materials/biological scientific discovery. I expect a golden age, but perhaps a more private information equity driven capitalism paradigm  (eg based in control of information more than access to investor capital (money)) .
4% real is still pretty viable to FIRE on. Presumably, anything under a 4% SWR would work, so the accumulation phase might need to be extended a bit. Though this is true of any period over 20-25 PE

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Scortius

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #22 on: April 07, 2017, 09:27:22 AM »
One thing to think about is the fact that the main drivers of the stock market are often industries based on technologies that were not available 20 or 30 years prior.  The US has gone through many phases over the years, from agriculture and natural resource accumulation, to manufacturing, to industrial manufacturing, to computing and specialty manufacturing, to the internet, the information age, and the service economy.  Along the way, many of the "movers and shakers" of the economy of the time have gradually plateaued, but that doesn't mean the market has failed to progress.  The internet age is progressing at a much more reasonable pace.  Snap's IPO is a good example of how people are calming down over the hot new tech stock.  That doesn't necessarily mean that there won't be a next technology or paradigm that pushes us into a new age.  Quantum computing, biotech, renewable energy, drone delivery?  It could be something completely unknown at this time.  Just because internet stocks and the information economy are reverting to stable valuations doesn't mean the world economy will stay on the same trajectory for the next 30 years.

Eric

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #23 on: April 07, 2017, 02:12:34 PM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

I mean, there's so much to this article that's written from a perspective of a person not living in the real world, "We saw the improved resilience of the system in the 2008 recession, an event that had all of the necessary ingredients to turn itself into a new Great Depression.  It didn’t–the final damage wasn’t even close to being comparable.  Here we are today, doing fine." Tell that to all the desperate people that turned out for the likes of Donald Trump.

This is just another confused sounding article from an economist who doesn't understand why people don't behave "efficiently" and ride the market down and then ride it right back up again.

Our financial system was truly at the edge of the abyss in the days, weeks, and months after Lehman failed. It was a bigger shock than what caused the Great Depression. While Trump's base probably didn't benefit much from the quick and relatively competent policy response (that probably has more to do with long-term globalization and technology trends), the global economy certainly did.

So, I guess what you're saying then is that you agree with the authors assertion of "Here we are today doing just fine."

How could you not?  Even if you're not comparing it to this time after the 1929 crash that caused the Great Depression (which if you are, it's obvious how remarkable the recovery is), jobless rates are tiny, the stock market is booming, housing market has recovered in all areas and is also booming in many others, etc.  Just because a segment of the population somehow believes that "things are the worst they've ever been" doesn't make it true.
« Last Edit: April 07, 2017, 02:14:09 PM by Eric »

Indexer

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #24 on: April 07, 2017, 04:00:39 PM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

Actually the article isn't far off, index investors tend to be more disciplined than active investors. It is all behavioral.

Active investor: "If my fund is down that means the manager is an idiot. He should have zigged when the market zagged. I'm going to fire him." SELL!

Index investor: "If my fund is down that means the market is down. If the market is down that means everything is on sale." BUY!

Think about it. If you have given up on timing the market and you believe in the indexing approach, why would you start market timing in a crash? It's also easier to hold onto VTSAX in a panic than any individual stock. In 2008 a lot of companies went bankrupt, will yours be next? For VTSAX to hit zero the world has to end. If the world ends your money is worthless so it doesn't matter. VTSAX is therefore much safer than any individual stock, and it has the same expected long term returns. Sure, VTSAX will fluctuate, but that fear of ZERO is gone. The question morphs from "will this fall all the way to zero" to "how long it will take to recover?" Those are very different questions. That makes it a lot easier to hold onto. That logic applies to VTSAX. It doesn't apply to individual stocks or less diversified active funds.

We have seen this happen in the real world. Most investors underperform the funds they invest in because they buy and sell at the wrong times. The largest exception to this rule is the Vanguard Total Stock index fund(VTSAX). It was actually taking in money during the crash. Those active investors who fired their managers decided to switch to an index fund, and most of the index investors didn't sell. As a result, for awhile(maybe still true) the investor return for total stock exceeded the fund's return. It was because so many new investors jumped in at the bottom.

Classical_Liberal

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #25 on: April 07, 2017, 04:53:11 PM »
Active investor: "If my fund is down that means the manager is an idiot. He should have zigged when the market zagged. I'm going to fire him." SELL!

Index investor: "If my fund is down that means the market is down. If the market is down that means everything is on sale." BUY!

If indexing is one of the key drivers of a lower volatility/lower return on capital scenario, then wouldn't indexing itself cause an artificial valuation increase in companies which are included more indices?  Hence providing the potential for value in companies (mostly) outside of those indices. Meaning active investing would become worth the transaction costs.  I would think it is difficult to argue one, then say the other is not valid.

Grog

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #26 on: April 08, 2017, 12:52:33 AM »
Well after the bailout of automotive or banks I tend to agree. The concept of too big too fail is almost a concept of government-backed securities. Thus implies less risk and thus less returns and higher PE valuations.

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Indexer

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #27 on: April 08, 2017, 10:00:51 AM »
Active investor: "If my fund is down that means the manager is an idiot. He should have zigged when the market zagged. I'm going to fire him." SELL!

Index investor: "If my fund is down that means the market is down. If the market is down that means everything is on sale." BUY!

If indexing is one of the key drivers of a lower volatility/lower return on capital scenario, then wouldn't indexing itself cause an artificial valuation increase in companies which are included more indices?  Hence providing the potential for value in companies (mostly) outside of those indices. Meaning active investing would become worth the transaction costs.  I would think it is difficult to argue one, then say the other is not valid.

Well as PizzaSteve noted, valuations have been higher. That has been true most of the time since the internet and index funds made diversification cheap. PE and CAPE valuations have been above average the vast majority of the time since the late 90s.

Potential value in the companies outside of the index? Sure, but have fun investing in penny stocks...  Do you realize that VTSAX has over 3,500 stocks in it? Any company too small to be in that index will be so small that if an active fund did invest in it they would be buying all available shares that are for sale. It would be driving the price up, quickly removing any valuation benefit that existed. Even finding information on these tiny companies would also be very difficult.

Classical_Liberal

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #28 on: April 08, 2017, 11:00:07 AM »
Well as PizzaSteve noted, valuations have been higher. That has been true most of the time since the internet and index funds made diversification cheap. PE and CAPE valuations have been above average the vast majority of the time since the late 90s.

Potential value in the companies outside of the index? Sure, but have fun investing in penny stocks...  Do you realize that VTSAX has over 3,500 stocks in it? Any company too small to be in that index will be so small that if an active fund did invest in it they would be buying all available shares that are for sale. It would be driving the price up, quickly removing any valuation benefit that existed. Even finding information on these tiny companies would also be very difficult.

Yes I agree CAPE's seem to have reset at a higher valuation/lower return, for many reasons.  Including those outlined in the article, but not exclusively for those reasons.  I also tend to think recency bias may have a role to play in our expectations going forward, only time will tell.  Regarding index funds.  VTI and it's cousins are only a small part of the $'s invested in passive funds.  If you look at companies outside of the S&P 1500 & NASDAQ (hence outside many tech, large cap, mid cap, and small cap passive funds), could there be additional value because those companies are less captured in the entirety of the index picture?  It seems to follow the logic of passive investing driving up CAPE's.  Additionally, less investors in the US seem to play in international indexes, is this part of the reason we see lower CAPE's in other developed countries?  Is passive indexing just as common in Europe or Asia as they are here?  Food for thought, in my opinion.

frugalecon

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #29 on: April 08, 2017, 11:53:24 AM »
If this hypothesis is valid (and it seems reasonable), then the assumptions underlying many private and government pension funds are not valid, and there likely be a serious shortage of assets matched to liabilities in the future. At the very least, it seems to be important to question whether returns in the future are drawn from the same distribution as past returns.

Jeremy Grantham, in his writing about whether we are in "Hell" or "Purgatory', seems to be grappling with similar issues.

sol

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #30 on: April 08, 2017, 12:05:45 PM »
We have also previously discussed several alternative explanations for why indices might underperform in the future, including the explosive growth of private equity funds capturing a significant portion of the US economy in a publicly unavailable asset class.  Those folks seem to be taking on the additional risk, and with it capturing the additional reward that used to be part of the larger stock market.

Classical_Liberal

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #31 on: April 08, 2017, 12:13:44 PM »
We have also previously discussed several alternative explanations for why indices might underperform in the future, including the explosive growth of private equity funds capturing a significant portion of the US economy in a publicly unavailable asset class.  Those folks seem to be taking on the additional risk, and with it capturing the additional reward that used to be part of the larger stock market.

This is also a very interesting concept.  In those discussions was any data presented regarding the current percentage of private equity holdings vs public holdings on a historical basis?  I wonder if there has been a steady increase in private holdings over the last 150 years or if this is also cyclical.  I could see how this phenomenon would be driven by concentration of wealth in the upper few percentages of the populace, at least under our current structure.

DavidAnnArbor

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #32 on: April 08, 2017, 01:36:13 PM »
Well after the bailout of automotive or banks I tend to agree. The concept of too big too fail is almost a concept of government-backed securities. Thus implies less risk and thus less returns and higher PE valuations.

Sent from my YD201 using Tapatalk

The bailout of General Motors and Chrysler were essential to preventing a total liquidation of whole segment of industrial production (primary and secondary suppliers), which if that were to occur would hit tax revenues worse than temporarily supporting this industry with an infusion of federal government cash.
There's no reason why the auto industry couldn't be viable on its own if it weren't for a once in a hundred year bizarre economic crisis in which demand for cars dried up. The markets don't always work right, and this is a case in point, and it's fine the government steps in to assist.

ulrichw

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #33 on: April 08, 2017, 01:40:11 PM »
Good article; Thanks for the reference.

I think the author has come up with a great explanation of why the risk premium for equities has fallen and will likely continue to result in historically high PE ratios (translating to historically low yields).

It's important to point out, however, that the 4% target returns the author proposes have some stronger assumptions built in. Central to this thesis is this statement: "Now, I’ll be the first to acknowledge that the 6% number is likely to be lower going forward. In fact, that’s the whole point–equity returns need to be lower, to get in line with the rest of the asset universe."

In my opinion, this is an over-simplified conclusion from his thesis. What *can* be said is that "equity returns should converge with returns on the rest of the asset universe." The author is simplifying this by saying that other asset returns are immutable, therefore equity yields must go down - it's an "all else being equal" argument.

His thesis, however, can also be true if other asset prices drop (i.e., their returns increase) and equity returns stay constant.

This is what happens, for example, if technology advancements goose earnings growth in the equity sector. This will pull money from other asset classes into the equity market, causing prices of those asset classes to fall (and yields to commensurately rise, all else being equal).

The author's thesis could *then* be applied to say that the equilibrium point for equity prices that will be found will be at a higher PE than the historical average (i.e., when the implied yield is closer to the yields of other asset classes). So over time, as the impact of the technological advancement wears off, all yields might sink in unison toward a lower equilibrium point.

A separate factor which I've pondered is the impact on growing wealth: Assuming that the world economy continues to grow, the amount of wealth held by people will grow, too (members of this forum are symptomatic of this phenomenon, IMO). As wealth grows and the demand for invest assets rises, asset prices will be driven up (also leading implied yields to fall). This is an offsetting factor that can increase returns for current investors who bought at lower prices.

To me, the system appears sufficiently complex that any blanket statement that suggest a fixed constant target return is likely to be inaccurate. There are so many factors that interplay that it's very hard to predict an outcome.

brooklynguy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #34 on: April 08, 2017, 01:43:18 PM »
In those discussions was any data presented regarding the current percentage of private equity holdings vs public holdings on a historical basis?

The Wall Street Journal article cited in this post provided some statistics on private equity's growth trend.

Classical_Liberal

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #35 on: April 08, 2017, 02:59:56 PM »
In my opinion, this is an over-simplified conclusion from his thesis. What *can* be said is that "equity returns should converge with returns on the rest of the asset universe." The author is simplifying this by saying that other asset returns are immutable, therefore equity yields must go down - it's an "all else being equal" argument.

Very good point!  I agree with you, it seems in the current market ALL asset classes are at high end valuation.  From gold, to treasuries to real estate (thanks to low rates).  That's not to say there are exceptions, but trying to find exceptions is antithetical to passive investing. 

Any suggestions on how that is actionable from a passive asset allocation standpoint?  Because the case for cash

The Wall Street Journal article cited in this post provided some statistics on private equity's growth trend.
Thx! will read.

ulrichw

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #36 on: April 08, 2017, 07:23:14 PM »
In my opinion, this is an over-simplified conclusion from his thesis. What *can* be said is that "equity returns should converge with returns on the rest of the asset universe." The author is simplifying this by saying that other asset returns are immutable, therefore equity yields must go down - it's an "all else being equal" argument.

Very good point!  I agree with you, it seems in the current market ALL asset classes are at high end valuation.  From gold, to treasuries to real estate (thanks to low rates).  That's not to say there are exceptions, but trying to find exceptions is antithetical to passive investing. 

Any suggestions on how that is actionable from a passive asset allocation standpoint?  Because the case for cash [...]

Unfortunately it's not clear. If the article's thesis holds, stocks should have lower returns, but also less risk. Essentially they'll look more like bonds. If risk were reduced without affecting returns, that would argue for increasing your stock allocation. If returns are reduced without affecting risk, that would argue for decreasing your stock allocation. In actuality both will be changing, so it's not obvious what the correct adjustment should be.

Indexer

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #37 on: April 08, 2017, 08:52:45 PM »
VTI and it's cousins are only a small part of the $'s invested in passive funds.  If you look at companies outside of the S&P 1500 & NASDAQ (hence outside many tech, large cap, mid cap, and small cap passive funds), could there be additional value because those companies are less captured in the entirety of the index picture?  It seems to follow the logic of passive investing driving up CAPE's.  Additionally, less investors in the US seem to play in international indexes, is this part of the reason we see lower CAPE's in other developed countries?  Is passive indexing just as common in Europe or Asia as they are here?  Food for thought, in my opinion.

Look at the PE ratios for these different classes of investments. The PE ratios on small caps are very high. The PE ratios on international are only a little lower than US.

PE
Total stock: 24.9
500 index: 23.5
Extended index(total - 500): 34.2
Total international stock: 20.1

gerardc

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #38 on: April 08, 2017, 09:49:50 PM »
A problem with the popularity of index funds is that buyers don't know anything about the companies they are buying, they're just relying on other individual stock pickers due diligence. Obviously this isn't sustainable if everyone relies on the index. However, arguably there doesn't need to be that many stock pickers... a few good ones should be enough.

Classical_Liberal

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #39 on: April 08, 2017, 11:48:06 PM »
VTI and it's cousins are only a small part of the $'s invested in passive funds.  If you look at companies outside of the S&P 1500 & NASDAQ (hence outside many tech, large cap, mid cap, and small cap passive funds), could there be additional value because those companies are less captured in the entirety of the index picture?  It seems to follow the logic of passive investing driving up CAPE's.  Additionally, less investors in the US seem to play in international indexes, is this part of the reason we see lower CAPE's in other developed countries?  Is passive indexing just as common in Europe or Asia as they are here?  Food for thought, in my opinion.

Look at the PE ratios for these different classes of investments. The PE ratios on small caps are very high. The PE ratios on international are only a little lower than US.

PE
Total stock: 24.9
500 index: 23.5
Extended index(total - 500): 34.2
Total international stock: 20.1

Right, but the P/E's for growth companies are always high.  Most smaller cap companies tend to be less mature and offer more growth.  So I don't think that is apples to apples. 

A 20%+ lower P/E  in total international, on the other hand, is telling.  Particularly since the majority of that index is large cap Japanese and Western Europe.  Add in the recent strength of the dollar and I think there is a compelling reason to focus new money in VXUS, if its part of your larger AA plans.  Personally, I always tend to balance my AA in accumulation by purchasing the lagging asset class in any given month. 

DavidAnnArbor

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #40 on: April 09, 2017, 07:56:13 AM »
Maybe it has no bearing on what the philosophical economist is pointing out but apparently there is an economics model regarding the price of the stock market index and it is called the Gordon Equation
Who knew?

Price = Dividend / (Real Rate of Discount - The Expected Growth Rate of Earnings and Dividends)

Is the Philosopher making the same mistake as Kevin Hassett, Trump's CEA chair nominee ?

http://www.bradford-delong.com/2017/04/lets-talk-about-cea-chair-nominee-designate-kevin-hassett.html

JAYSLOL

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #41 on: April 09, 2017, 09:15:55 AM »
Just wanted to chime in and say thanks, this is the most interesting discussion in the Investing category in a damn long while.  Everyone above has posted well written, thought-provoking opinions and posted interesting links and data.  So rare to find a community like this, so thanks. 

TomTX

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #42 on: April 09, 2017, 11:00:58 AM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

I'm confused by the cognitive dissonance here.

"worst decades that the stock market has seen"

While also holding out that the stock market is overvalued.

Which is it?

TomTX

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #43 on: April 09, 2017, 11:12:18 AM »
Out of 20 people I work with,  I'm the only one with stock market exposure since "stocks are like gambling".

Buying individual stocks is like playing roulette.

Buying an index fund is like being the "house" at the casino.

Sure, you have ups and downs as the house - but in the long run, the house always wins.

LAGuy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #44 on: April 09, 2017, 07:22:03 PM »
"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of."

Yeah right. And this coming on the heels of one of the worst decades that the stock market has seen. You're damn right the stock market is worth its premium vs bonds; all you have to do is to this day look at all the people right here on this very forum that won't touch it with a 10 foot pole or keep talking about how a crash is imminent.

I'm confused by the cognitive dissonance here.

"worst decades that the stock market has seen"

While also holding out that the stock market is overvalued.

Which is it?

Did you read the article? That's where the quote is from, and it's total nonsense.

I make no claim on if the stock market is overvalued or not. However, for the author to claim that panics are a thing of the past because now everybody has apparently learned the value in just buying and holding is a ridiculous thing to say at any time. My point is that it's an ESPECIALLY ridiculous thing to claim after a terrible stock market decade that saw all sorts of panic selling. Does the author mean to say that investors in just the past few years have now learned their lesson for evermore? It doesn't seem that way to me given all the people that seemed to still be scarred from the previous decade, and for proof of that you only need to see all the people that are keeping all their money on the sideline and won't invest in stocks. And the ones who are buying, just because they're buying index funds does not suddenly make them brave and wise investors.

brooklynguy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #45 on: April 09, 2017, 09:22:56 PM »
However, for the author to claim that panics are a thing of the past because now everybody has apparently learned the value in just buying and holding is a ridiculous thing to say at any time.

Again, the author made no claim that panics are now a thing of the past (in fact, the sentence in the article that immediately follows the one you quoted begins by saying "Obviously, panics will still occur, as they must...").  The author's claim was simply that there is now a basis (i.e., the network of confidence that has evolved in the market) for panics to be less severe than they were in the past (hence the second half of that sentence reads "...but there's a basis for them to be less chaotic, less extreme, less destructive than they were in market antiquity").

LAGuy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #46 on: April 09, 2017, 10:15:16 PM »
However, for the author to claim that panics are a thing of the past because now everybody has apparently learned the value in just buying and holding is a ridiculous thing to say at any time.

Again, the author made no claim that panics are now a thing of the past (in fact, the sentence in the article that immediately follows the one you quoted begins by saying "Obviously, panics will still occur, as they must...").  The author's claim was simply that there is now a basis (i.e., the network of confidence that has evolved in the market) for panics to be less severe than they were in the past (hence the second half of that sentence reads "...but there's a basis for them to be less chaotic, less extreme, less destructive than they were in market antiquity").

Ok, I get that. But what basis does he have saying that coming off of one of the toughest decades the market has seen since the Great Depression?

Take a look at this chart.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

In the Great Depression, the market had 4 years in a row with negative returns. Since that time, there were only 2 sets of years where the market was down 3 years in a row. 1939, 1940, 1941. And the 2nd period? 2000, 2001, 2002. How about the year with the absolute worst return? -43.84% in 1931. The second? -36.55%...in 2008. That kind of punishment has deeply scarred the investing public, that's why fewer individuals are invested today in stocks than they were before the 2008 crash. And yet, this author would have us believe that everything is going just fine now...smooth sailing from here on out given that the investing public knows to just ride out the next crash and that we have had such an effective policy response, per the author! After one of the most unstable decades the stock market has seen, why should we now be in a new era of permanent stability that is leading to a convergence in returns of stocks and bonds? Maybe this authors point would be more credible if the 2000's hadn't JUST happened. About the only "network of confidence" I see in the current market is a lot of the people that don't have the stomach for the swings have been pushed out and haven't returned. But, they'll continue to return as the market continues to push higher, eventually leading to another crash. The way it's always been.

TomTX

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #47 on: April 10, 2017, 06:25:35 AM »
The 2000s ended more than 6 years ago. We are closer to the 2020s than the 2000s

brooklynguy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #48 on: April 10, 2017, 07:32:28 AM »
But what basis does he have saying that coming off of one of the toughest decades the market has seen since the Great Depression?

As the author said, "Here we are today [nine years later], doing fine."  I know you took umbrage at that statement, but, purely in the context of an argument about sustainable elevated stock market valuations (which is, after all, the argument the author was making), the statement seems irrefutable.  In the span of a few years, the market fully recovered from the single greatest shock to the system since the Great Depression and went on to push new boundaries.  Even at the absolute nadir of the financial crisis, the stock market barely dipped below its overall historical mean valuation (as measured using CAPE), which is not only consistent with, but actually bolsters, the author's argument that there are reasons to believe that mean-reversion to old-school valuations just ain't gonna happen.

LAGuy

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Re: Philosophical Economics Post re: Stock Market Valuation
« Reply #49 on: April 10, 2017, 03:08:42 PM »
But what basis does he have saying that coming off of one of the toughest decades the market has seen since the Great Depression?

As the author said, "Here we are today [nine years later], doing fine."  I know you took umbrage at that statement, but, purely in the context of an argument about sustainable elevated stock market valuations (which is, after all, the argument the author was making), the statement seems irrefutable.  In the span of a few years, the market fully recovered from the single greatest shock to the system since the Great Depression and went on to push new boundaries.  Even at the absolute nadir of the financial crisis, the stock market barely dipped below its overall historical mean valuation (as measured using CAPE), which is not only consistent with, but actually bolsters, the author's argument that there are reasons to believe that mean-reversion to old-school valuations just ain't gonna happen.

So, it's a "new normal" of converging stock and bond returns based upon a data set of 9 years? You find that to be a compelling and irrefutable argument?