February 2, 2010
| U.S Stock Market* 1884 – 2009 Rolling 3-Year Holding Periods 753 Observations | ||
|---|---|---|
| When the beginning Shiller P/E is… | ||
| 11.54 or less | 19.20 or more | |
| Median 3-Year Return (annualized) | 16.20% | 6.85% |
| Average 3-Year Return (annualized) | 17.03% | 7.07% |
| % of Periods with Negative Return | 0.00% | 28.10% |
| Best 3-Year Return (total) | 194.52% | 134.08% |
| Worst 3-Year Return (total) | 0.85% | (80.84%) |
*U.S. stock market returns for the period 1884 through 1926 are derived from the Shiller market index at www.econ.yale.edu/~shiller/data.htm. Returns from 1926 through 1969 represent the “Large Company Stocks” category from Ibbotson Associates. Returns from 1970 onward represent the S&P 500 Index.
Sources: Robert J. Shiller, Standard & Poor’s; Ibbotson Associates; Capital Advisors, Inc.
These data prompt numerous worthwhile questions for professional investors and financial planners. Here are three:
- Do professionals do their clients a disservice if they offer similar advice about stocks regardless of whether the starting P/E ratio is high or low, as so many financial software platforms prescribe?
- If presented with this data today, when the Shiller P/E Ratio is over 20, how many investors would knowingly accept a nearly one-in-three chance of losing money over three years in exchange for an expected annualized return of 6.85% with a majority of their savings (taken from the distribution of outcomes associated with a Shiller P/E of 19.20 or higher)?
- Would it be irresponsible for investment advisors to encourage a widow or a retiree to tilt her portfolio more aggressively toward stocks whenever the Shiller P/E sinks below 12?
To proponents of Efficient Markets and Modern Portfolio Theory, these questions have no meaning because the assumptions needed to “make the math work” in these theories require that market returns unfold randomly, like the flip of a fair coin. These theories, and the financial planning platforms that rely on them, tell investors to wager the same amount on every draw from the “jar of marbles.”
The evidence from the real-world history of asset markets suggests that market returns are not totally random. Sometimes “Mr. Market” removes a few red marbles from the jar, and sometimes he removes blacks. Simple indicators like the Shiller P/E Ratio can reveal which marbles have been removed at any given time. It is our job as investors to pay attention and adjust our wagers accordingly.
References
Tomlinson, Joseph, 2010, Shiller P/Es and Modeling Stock Market Returns, (Advisor Perspectives)
Tomlinson, Joseph, 2009, Shiller P/Es and Predicting Returns, (Advisor Perspectives)
Tomlinson, Joseph, 2009, Shiller P/Es and Predicting Returns – Some Additional Thoughts, (Advisor Perspectives)
Keith C. Goddard is with Capital Advisors, Inc., a Tulsa, OK-based advisory firm. He can be reached at .
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