Cheap valuations should not be a reason to panic
January 12, 2009
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As one rally after another fizzles out, many bloggers begin to sound almost desperate, and to pray for the market to go up. These people should be advised to be careful what they wish for. There is no way to get around this simple fact: in order to profit from stock purchases, one needs to buy at a low price, and this low price can only be found during a bear market. It is surprising that people would show such underappreciation of the basic thesis that makes purchase of stocks attractive to begin with.
Historically, stocks have shown a nominal return of 8-9% a year. However, these returns would not be possible if people had bought stocks at inflated valuations a few decades earlier. For example, those buy-and-holders who bought in 1982 are still comfortably ahead. But this success story would not have been possible if we had exhuberant optimism in 1982 and stocks fetched PEs of 30 to 40 like they did in 1999. Had things looked as rosy back then, most bloggers (if we stretch things a bit by assuming the Gardners had started Caps in the late 70s) would have sounded upbeat, cheerfully greenthumbing every Enron, Worldcom, and even an occasional GM. Little would they know what future held for them: 27 years of very mediocre returns. Looking back at 1982, they would have concluded that the whole game is pointless and that CDs and Treasuries offer better returns than equities.
Let us imagine that some Caps blogger starting his investing career in 1981 and sitting on a 30% paper loss prayed to the gods of the marketplace, begging them to end the bear market, and gods listened to his request, and sent the S&P index to an unbelievable 1000 points. Given that the actual value of the index back then was approximately 100, that would be a 1000% gain on the 1981 portfolio. But there would be a downside to it as well, because all his stock purchases in the 27 years that followed would bring him nothing but bitter disappointment. Looking back 27 years later, the blogger would likely have wished he didn't make that fatal prayer that destroyed his future returns. Indeed, had he allowed the bear market to last a few years longer, his ultimate returns would have been substantially greater.
The bloggers who pray for the current bear market to end soon are making the same mistake. If the S&P, which is currently trading at PE=15, were to double in value tomorrow, then whatever investments these bloggers are going to make in the future would likely prove an irrational waste of time and money. It is really ironic that the same people who claim they want a 1000% boost from the stock market would so happily deny themselves the low base from which to start. Just like the baby boomers owe their current wealth exclusively to the fact they were stepping on crushed skulls of the previous generation, picking houses at the construction cost and stocks at a PE of 3, we should now be welcoming the pain of the baby boomers and feeling greatful to whatever economic upheavals that might tear these coveted assets from their weakening hands. To think otherwise would be entirely unrealistic. You cannot keep your seller happy and still hope for a good capital gain in the future. Likewise, you can't expect the seller to part with his property on your terms without a major bear market that would drive him to a point of desperation. That desperation should be really great right now if even we, being exposed to the huge body of historical data that proves Buffett to be right, still feel like giving up on the market entirely and crying to Obama for help.
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