The Silliness
“Yes! The stock market is down another 2.5% points! 11.8
points for the year,” I said joyfully. My colleague, Bill, is accustomed to
hearing such strange things from me early in the day, but he had a puzzled look
on his face that begged for an explanation of my mirth.
“Oh, right. That’s a good thing, because I invest in
Canadian stocks.” As he continued to stare at me, I first asked myself whether
I had slipped into speaking Esperanto, but quickly remembered that most people
think that stock crashes are bad events that ought to cause investors grief.
Also, I don’t speak Esperanto.
“Stocks are on sale!” This seemed to be mildly more sensible
and it was definitely English this time. So I continued on.
If you are an investor who plans to be buying stocks into
the future, you should prefer the price of those stocks to be low right now. The
only time that it is important for stock prices to be high is before you sell.
This year is an unlucky time to be selling stocks and retiring. But if that is
so, it should be a good time for buying. To see how that works, suppose that
you managed to save $10,000 this year. Good for you. Historical returns of the
Toronto Stock exchange are 6.1%, before inflation, so if the future matches the
past, then your $10,000 could grow to $18078 by 2026.
“But isn’t it risky to buy when the market is falling?” one
may ask. This question needs to be unpacked. We don’t know that the market is
falling. We know that the market has fallen. Is it going to continue to fall
this year? Possibly. But it is far riskier to buy after the market has been
rising. Market rises are what ultimately result in crashes when the bubbles
burst. This current downturn has followed a period of market growth going back
to 2008. That crash followed a period of people over-investing in US houses and
related products. Before that, the crash of 2003 was the result of people
getting too excited about the internet boom, which became a bubble that
ultimately burst. People feel secure after they see a period of increasing
stock prices, when that’s precisely the wrong time.
In fact, one of the best predictors we have of future stock
market price is Robert Shiller’s cyclically adjusted price to earnings ratio
(CAPE). The intuition behind it is that we should examine the average earnings
of stocks over the previous 10 years. Divide that by the current average price
in the stock market. Historically speaking, people buying American stocks will
pay 16.65 times the yearly earnings for a stock on the main index (S&P500).
So if the CAPE is much above 16.65, stocks are said to be expensive and we
should expect a slower or negative growth of stock prices. If they are less
than 16.65, cheap. Stocks should grow faster than average. But if the CAPE is
exactly 16.65, we expect stocks values to grow at their average
rate, around 9.5% per year.
Source:
http://www.multpl.com/shiller-pe/
In the US, Schiller’s CAPE was found to account for about
40% of the 10-year future stock market returns. So we can predict to some
extent how valuable our investment will be,
in ten years. On the other hand, it explains very little of the return this year. The message is clear. In the
short-term, the markets can do just about anything. But in the long-run, buying
the stocks of companies with high earnings—or buying the stock market when it
is cheap—has been a winning move. Also, crucially important: there are no
guarantees. The casino bets that each night it will make money on slot
machines, but sometimes the customer gets lucky and the casino has a bad day.
So just how cheap are stocks right now?
That depends where you are buying. American stocks are
relatively expensive right now. At the time of writing, the American stock
market** had a CAPE value of 24.42, perhaps overvalued by 50%. So a prediction
based on the CAPE would suggest American stock prices probably won’t increase
much over the next 10 years.
What about the Canadian market?
The Canadian market hasn’t been studied nearly as much as
the American. Still, we do have some basic statistics. According to the Wall
Street Journal, Canada’s
historical CAPE average is 19.4 as of last year. As of late January, the Canadian CAPE
was 16.9. This would suggest that the Canadian market is a bargain—undervalued
by perhaps 15%, which is about the value of the fall of the Canadian market
from its high in 2015. Average returns of the Canadian Toronto Stock Exchange
between 1979 and 2016 were 6.1%, before inflation (original calculations based
on this). So if
the past is a useful guide, we should have higher than historical returns.
Yeah, but isn’t it risky to invest in the stock market now? Well, it might be. You already asked that question. There
tends to be an advantage to using historical data and economic theory to make
decisions. It might be true that this time is different. Maybe the economy is
going to grow at a much slower rate than the past 200 years. Maybe we are
seeing the beginning of a new era. But consider that the optimists said the
same thing during the tech bubble of the late 1990’s with undue optimism. Allen Greenspan and Ben
Bernanke said the same thing during the American housing bubble: “This time is
different.” We were supposed to be entering an era of stability and
continuously improving economic indicators. But it wasn’t really so. During
upswings it can be easy to get on the bandwagon and proclaim that all is well
and there is nothing to worry about. But the same tendency obtains during
depressed economic times. And with the benefit of hindsight we can see that
those periods of difficulty give way, eventually, to better times.
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