If you're something of a geek, you may spend just as much time as me reading academic papers and research about markets and valuations.
And you may find one paper about the market and valuations quite valuable.
Wim Antoons, the head of asset management at Bank Nagelmackers in Brussels and a member of the Brandes Institute Advisory Board, wrote the paper. The Brandes Institute is a research firm associated with legendary value investor Charles Brandes, and they publish some cutting-edge research on a pretty regular basis.
The paper was titled "The CAPE Ratio, and Future Returns: A Note on Market Timing," and it covered the use of the 10-year average P/E ratio as defined by Nobel Prize-winning Yale Professor Robert Shiller. Professor Shiller uses a definition of earnings that are adjusted for inflation, and this gives us a much clearer view of the market's current valuation.
Not surprisingly, the study found that when the Cape Ratio is low, future stock market returns tend to be higher than average. When the ratio is very high, future stock returns tend to be awful. This has been studied by numerous academics and investment managers who determined it a fairly accurate measure of what we can expect from stock prices over the long term.
The ratio is currently at 29, which is well above the historical average of 16.7. So we can expect that future stock market returns will be lower than the historical average, and Antoons' study tells us that future returns will be somewhere between bad and abysmal.
But you can't just assume that a high Cape Ratio means that stock prices will immediately fall. The problem we face as investors is that the path to lower returns is not necessarily straight down; there are actually many paths to lower returns.
So let's take a look at the three scenarios that could lead us down...
Here Are 3 Paths to Lower Returns – the Good, the Bad, and the Ugly
Let's start with the ugly...
The Worst-Case Scenario
We could see years of long, slow, and weak markets with little to no annual return, which would be incredibly painful for most investors.
But in order to offset the problems of this scenario, we can adjust our approach so that we still profit while other investors struggle.
We can buy dividend-paying REITs and special situations that the numbers tell us will do very well. REITs, in particular, do very well in bear markets not caused by a credit collapse. They fell with everything else in 2008–2009 – but during the Internet collapse, REITs did very well, with positive returns each year from 2000 to 2004 that easily outperformed the collapsing overall market.
We should also be able to use a period of underperformance to pick up good companies at great prices, as historically these periods of poor returns lead to investor disinterest in the stock market. Even companies with solid cash flows and good assets will see their stock price suffer from disinterest, and we will be able to scoop them up at bargain prices.
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As a bonus, weak markets tend to lead to merger waves as companies expand on the cheap, and private equity and distressed investors gobble up assets at fire sale prices.
The Medium-Case Scenario
We could see the market rally into a blow-off top that then recedes over several years, bringing prices back to the starting point.
If we get a blow-off top, the stocks that we do own right now will appreciate and reach levels where it makes sense for us to be sellers.
We may not hit the exact top of the market, but when we see a blow-off to the upside, things get overvalued pretty quickly, and we will be booking profits on the stuff we bought at bargain prices.
The Best-Case Scenario
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In my preferred scenario, we have a huge sell-off relatively soon and then rebound back to current levels over a multi-year period.
The stocks we have purchased in 2018 were at bargain prices and should hold up better than the broader market averages. We also have all those dividends from the REITs and unique situations to provide a cushion.
But a collapse is my favorite scenario because fortunes are born in horrendous markets. That type of event would create a large inventory of good companies and great prices and would be a fantastic wealth creation event.
When prices are tumbling, traders are puking, and fear has Wall Street in its grip, those of us willing to act as buyers of last resort can buy world-class assets at dumpster diving prices. If you go back and look at what blue-chip stocks were selling for in early 2009, you get an idea of just how much money numbers-driven investing can help you make when the market collapses. When you take emotion out of investing, panic and fear become your very best friends.
Use Math as Your Guide
While the numbers are telling us that the probability of lower returns over the next several years is very high, we do not know what path to that destination the markets will take.
Trying to predict the path is futile at best and disastrous at worst if we guess wrong. Imagine the pain of deciding we will have a collapse and shorting stock into a rip-your-face blow-off top that leaves your account decimated. Or imagine the financial suffering that will ensue if you bet heavily on the blow-off and we instead get the collapse.
I have no idea what the market will do next. I do know that relying on the math will allow me to react in whatever way leads to outsized returns. Big money is made by responding to what the market actually does and not trying to predict what it might do. And that is why using non-emotional math as our investment guide works so well.
Much like using sabermetrics in baseball can keep teams from falling in love with a player who used to be good, we want our portfolio to have a lot of J.T. Realmuto and Christian Yelich stocks that do not cost us much and do great things. We do not want a bunch of Chris Davis and Dexter Fowler stocks that cost us a ton and underperform.
The numbers help us make the right choice.
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About the Author
Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.