Overvaluation Is the One Market Inefficiency That Investors Will Always Be Able to Exploit

Valuation-Informed Indexing #127

by Rob Bennett

My good friend Mike Piper has written an article (“Investing Based on Market Valuation”) at his Oblivious Investor blog exploring my finding that the Old School safe withdrawal rate studies get the numbers wildly wrong (promoted recently by my other good friend Todd Tresidder) and the research done by my other good friend Wade Pfau showing that Valuation-Informed Indexing has for the entire 140 years for which we have market data available to us provided far higher returns at greatly reduced risk. Yet Mike concludes that Valuation-Informed Indexing (changing your stock allocation in response to big valuation swings with the aim of keeping your risk profile roughly constant) is not for him!

What’s up with that?

Mike says: “As a general rule, the market does not like to be predictable. For the most part, once market inefficiencies (i.e., patterns that can be used to reliably outperform the market) become well known and easy to exploit, they tend to disappear.”

It is so.

Mike does a good job here of articulating why it is that many Buy-and-Holders dismiss Valuation-Informed Indexing as too good to be true. There’s now 30 years of peer-reviewed academic researcher showing that we all can reduce the risk of stock investing by 70 percent just by giving up on Buy-and-Hold strategies and accepting the critical reality that we must adjust our allocations in response to big swings in valuation levels. The entire historical record shows this to be so. So it MUST be so! Yet it CANNOT be so! It cannot possibly be that easy!

The dispute between Buy-and-Holders and Valuation-Informed Indexers is an existential dispute. Debate cannot change it. Data cannot change it. Research cannot change it. The dispute goes to core beliefs. When Valuation-Informed Indexers tell Buy-and-Holders that there is an easy way for them to greatly increase their returns while also greatly diminishing their risk, we are essentially questioning their religion. They are not willing to go there because to go there would mean to revisit every belief about stock investing that they have come to hold over the course of their investing lifetimes up until today.

There’s an assumption hidden in Mike’s claim that market inefficiencies no longer remain exploitable after they are discovered by investors. The claim makes perfect sense. It is certainly so that what Mike says would hold true in a world in which investors were rational. But investors are not rational! It’s the persistent irrationality of investors that created the inefficiency in the first place! If you assume rationality, you assume away the 140 years of historical return data available to us. So much for the idea of rooting our investment strategies in research!

I believe that what Mike says is true regarding other market inefficiencies. If the market is mispriced given the current inflation rate, prices will change to reflect the realities. If the market is mispriced given current political realities, prices will change to reflect the prevailing realities. Inflation rates and political realities and lots of other factors that bear on market prices are generally incorporated in to the market price — these factors are priced in.

Overvaluation and undervaluation are NOT priced in. Never. These factors CANNOT be priced in.

Why?

It would be an absurdity to say that a mispricing is priced in. Once a mispricing was priced in, it would no longer exist. Overvaluation can always be exploited right up to the time when it disappears. That’s in the nature of the beast. Valuation-Informed Indexers need not worry that there will come a day when investors know enough about this inefficiency to cause it to stop working.

There’s another point that Mike makes later on in the article that I find more compelling. Mike points out that: “Prior to the existence of no-load index funds (i.e., prior to 1977), there was no cheap, easy way to invest in the market as a whole.”

That’s it! That’s the critical reality that most of those who examine these issues fail to take into consideration.

As I noted above, Valuation-Informed Indexing has always provided investors with a huge edge. So why have millions of investors remained ignorant of the power of this strategy for so many years? That’s a legitimate question.

The answer is that, for most of the history of stock investing, we have not had available to us peer-reviewed academic research examining the most important topics. People have been offering investing advice since the first market opened for business. But most of it was based on subjective impressions, not systematic study. The advice that was generated by that process was of limited value.

Stock investing became a subject of academic research in the 1960s. But index funds were not available until John Bogle founded Vanguard in 1976. So for the first decade or two in which academic research was being done, the researchers did not even think to examine indexes, they thought of stock investing as the purchase of individual shares. Valuation-Informed Indexing does not work with the purchase of individual shares. When the researchers tested whether timing works, they found that it does not work because they examined only the purchase of individual shares. They properly discovered that short-term timing does not work and improperly concluded that they had discovered that even long-term timing does not work.

Now that index funds are available, we can all advance on to the next round of powerful insights.

It works, Mike! Really. You gotta have faith, man!

Rob Bennett created The Investor’s Scenario Surfer, a calculator that lets investors test the Valuation-Informed Indexing strategy over realistic 30-year return sequences. His bio is here.