Wall Street is having a sale.


If the alternative is indexing, then the question of timing stock purchases and sales is mostly a question of whether being out of the market is better than being in the market. Add in the presumption that stocks, on average, do better than Treasury bonds, and we should be pretty confident that stocks are overpriced before exiting the stock market.

Jumping in and out of the market weekly, daily, or even more frequently is undoubtedly a mistake. Short-term movements in stock prices are just too hard to predict. However, there are bubbly times when stocks are clearly overpriced and the prudent course is to wait out the bubble, and there are panicky times when the prudent course is to buy stocks at bargain prices.

Some signs of a bubble are anecdotal. When barbershop patrons think stocks can’t fail. When people take out second mortgages to buy stocks. When investors measure a company’s success by how much money it spends.

In 2000, I went to Bill’s Barbershop in Dennis, Massachusetts, and heard people talking about stocks that were sure to double or triple in weeks, if not days.

In 2000, a relative told me that he was taking out a second mortgage to buy Qualcomm because it had great patents; when I asked him about Qualcomm’s dividends and earnings, he didn’t know and didn’t care. I didn’t really know or care, either. What was interesting to me was that he was going all in on a company with a great story, and he didn’t know or care about anything beyond the great story. He evidently believed that no price is too high to pay for a stock with a great story.

In 2000, a friend told me that he had started a dot-com company, sold it for millions, and promptly started another—which he planned to sell as soon as possible. He had no interest in running companies—it was boring paying people to make things that customers wanted. His plan was to get rich fast by creating companies that investors wanted. Start it. Sell it. Move on. I asked him about his new company’s profits and he said profits didn’t matter. What mattered was his burn rate—how fast he could spend the money given him by venture capitalists. I thought he was joking. He wasn’t.

In 2000, a friend who was a VP at a dot-com company told me about hits, the number of files downloaded from servers, including web pages, images, and JavaScript. Investors evidently thought it was good if a company had lots of hits. Perhaps they were confusing file requests with web page visits, or maybe they were looking for something to justify their stock purchases. Either way, her company obliged by cluttering their web pages with images in order to pump up their hit numbers. Investors paid real money for garbage.

In 2000, the anecdotal signs of a bubble were unmistakable, though I also remembered Keynes’s admonition that “the market can remain irrational longer than you can remain solvent.” It is risky to short the market—with short sales, options, or futures—but it is prudent to wait for sanity to return.

Part I of this book identified several value-investing tools. Let’s apply the JBW equation, Shiller model, and Bogle model to three scenarios: March 2000 (when I warned of a bubble), December 2008 (when I urged investors to buy stocks), and August 2016 (the most recently available data). All the data were taken from Robert Shiller’s Online Data website, a wonderful source of useful facts and figures for value investors who want to assess the S&P 500.


One investing benchmark is implied by the John Burr Williams (JBW) equation:


where R is the total annual return, D is the annual dividend, P is the current stock price, and g is the annual rate of growth of dividends.

We can apply this equation to the overall stock market by calculating the dividend yield for the S&P 500 and making an assumption about the long-run growth of dividends and perhaps the long-run growth of the economy. This total return estimate—the dividend yield plus the dividend growth rate—can be compared to the interest rate on long-term Treasury bonds plus whatever risk premium seems appropriate.

Table 12-1 compares the JBW valuations for the S&P 500 in March 2000, December 2008, and August 2016. In March 2000, the S&P 500 dividend yield was 1.16 percent. Adding in a 5 percent long-run growth rate for dividends, the predicted total return is 6.16 percent:

R = 1.16% + 5% = 6.16%

This was lower than the 6.26 percent return on ten-year Treasury bonds, indicating that stocks were not an attractive long-term investment. Earning less than Treasury bonds with a lot more risk is not appealing.

In December 2008, in contrast, the S&P 500 dividend yield was 3.23 percent, and a 5 percent long-run growth rate gives an 8.23 predicted total return.

R = 3.23% + 5% = 8.23%

This was 5.81 percentage points above the 2.42 percent return on ten-year Treasury bonds, indicating that stocks were an attractive long-term investment for all but the extremely risk-averse. Making 5.81 percent more per year, multiplied by the miracle of compound interest, is irresistible. If these return projections turned out to be correct, $100,000 in Treasury bonds would grow to $127,000 in ten years, while $100,000 in stocks would grow to $221,000.

As for the most recent data available at the time of this writing, August 2016, the S&P 500 dividend yield was 2.13 percent, and a 5 percent long-run growth rate gives a 7.13 predicted total return.

R = 2.13% + 5% = 7.13%

That’s 5.32 percentage points above the 1.81 percent return on ten-year Treasury bonds, again indicating that stocks are an attractive long-term investment.

TABLE 12-1. Three different valuations using the JBW equation



Robert Shiller calculates a cyclically adjusted P/E ratio (CAPE) by dividing the inflation-adjusted value of the S&P 500 by cyclically adjusted earnings (the average value of the inflation-adjusted earnings over the preceding ten years). For a value-investing benchmark, I noted previously (in Chapter 7) that we can calculate the cyclically adjusted earnings yield (CAEP) by taking the inverse of CAPE. The earnings yield is a rough estimate of the real rate of return on stocks, so we can compare this number to the real interest rate on ten-year Treasury bonds and see whether stocks or bonds look more attractive.

Table 12-2 shows the calculations, using an assumed 2.5 percent rate of inflation, the average over this period. In March 2000, the earnings yield (CAEP) was 2.31 percent, which was 1.45 percentage points lower than the real Treasury rate, indicating that stocks were an unappealing investment. In December 2008 and (to a lesser extent) in August 2016, the earnings yield was well above the Treasury rate, indicating that stocks were an attractive investment.

TABLE 12-2. Three different valuations using CAEP, the inverse of Shiller’s CAPE



John Bogle’s model for estimating stock returns over a ten-year horizon is

stock return = dividend yield + annual growth of earnings + annual change in P/E

I can use the Bogle equation to assess the attractiveness of stocks in March 2000 and in August 2016, but there is a complication for December 2008. Earnings had fallen by more than 80 percent from a year earlier because of the severe economic recession. Stock prices only fell 40 percent because investors anticipated that the recession would be temporary. The price-earnings ratio consequently tripled, from 18 to 59—not because stock prices had risen, but because stock prices had not fallen as much as earnings. To use the Bogle equation, I would need to forecast a surge in earnings as the recession ended and a drop in the P/E ratio as earnings surged. It is doable, but more complex than the other calculations in this book, so I will not use the Bogle equation for December 2008.

Table 12-3 shows the Bogle calculations for March 2000, using the 1.3 percent dividend yield for the S&P 500 and assuming a 5 percent annual growth in earnings. The price-earnings ratio was 28.3 in March 2000, and I considered four different scenarios for the price-earnings ratio ten years ahead, in 2010. Unless investors expected a substantial increase in the price-earnings ratio for the S&P 500, stocks were not an attractive investment.

TABLE 12-3. Four scenarios, March 2000


Table 12-4 shows similar calculations for August 2016 using Bogle’s model, now with a 2.13 percent dividend yield and again assuming a 5 percent annual growth in earnings. The S&P 500 price-earnings ratio was 24, and I considered four different scenarios for the price-earnings ratio in 2026. Unless the price-earnings ratio were to drop substantially, stocks look like a good investment.

TABLE 12-4. Four scenarios, August 2016


These three models come to the same conclusion. Stocks were too expensive for value investors in March 2000, so it was a good time to be out of the market (and I said so at the time). Stocks were cheap in December 2008, so it was a great time to be in the market (and I said so at the time). Stocks were inexpensive in August 2016, so it was a good time to be in the market (and I am saying so at this time). I don’t know what will happen to stock prices over the next few months or years, but ten years from now, in 2026, I expect value investors who were fully invested in August 2016 to be pleased with the results.

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