Monday, May 17, 2010

Investing: The Power of the Stock Return Predictor

Originally posted at DBKP: Investing--The New Rules: Harness the Power of The Stock Return Predictor

The Stock Return Predictor is one of the most powerful online tools for investing today. Find out why.

The Stock-Return Predictor tells you the price of stocks at a given time.

You wouldn’t give a thought to buying a car or a movie ticket or a chocolate bar without first knowing the price you were being asked to pay. The same should go with your purchases of stocks. My view (I am biased, to be sure) is that this calculator is the most powerful investor’s tool available on the internet today.

All buying decisions are made through a two-step process. Say that you were planning to buy a car. Your first step would be to determine which model was the right one for you. You might spend a good bit of time researching different possibilities before deciding that Car X is the one for you. But at that point the job is still only half done.

Say that you look up Car X in Consumer Reports and learn that the fair price for the car is $20,000. Then you go to a dealer who offers to sell you one for $18,000. You are probably going to sign the papers quick before he changes his mind. You can confidently make that deal because you know this is the car for you and you know that you are getting a more-than-fair deal.

Now say that the dealer demands $25,000 for the car. You are probably going to walk away. It’s not that the car is not right for you. It’s that the price is too high. When you determined that this car offered a strong value proposition for you, that determination assumed that you would be buying it at a reasonable price. There is no car that does not become a poor choice when priced too high.

So it is with stocks. We explored last week why index funds represent the best choice for the typical middle-class investor. When you buy an index fund, you are buying a share of the productivity of an economy that for 140 years now has generated enough profits to finance a long-term average return of 6.5 percent real. That’s plenty good enough for those of us looking for a no-muss/no-fuss investing approach.

But you cannot realistically expect to see that 6.5 percent return if you pay a price well in excess of fair value.

Say that you pay two times fair value for your index funds (that you buy them at a time when valuation levels are double what they should be). In that event, half of your money is going to buy an asset that will indeed generate a long-term return of something in the neighborhood of 6.5 percent real. But the other half of your money is going to purchase cotton-candy nothingness, stuff that is going to be blown away in the wind as prices work their way back to fair value. Spending half of your money on cotton-candy nothingness is not the way to finance an early retirement or even a reasonably comfortable age-65 retirement. Investors who care about getting value for their money need to do better.

Please plug the number “8” into The Stock-Return Predictor and push the “Calculate” button. That is the P/E10 value (“PE10” is our valuation metric; I’ll explain why it is the best valuation metric in a later column) that applied in 1982, when stocks were priced insanely low. The calculator tells you that the most likely 10-year annualized return starting from that valuation level is nearly 15 percent real. That’s an amazing return. Check with any friends who bought stocks in 1982 and they will confirm for you that the calculator got it right; investors who bought stocks in 1982 really did obtain big rewards for doing so over the next 10 years.

Now enter the number “44” into the Predictor. That’s the P/E10 value that applied in January 2000, when stocks were priced higher than they have ever before in history been priced. The calculator reveals the most likely 10-year annualized return as a negative 1 percent real. Again, checking with friends who bought stocks at those prices will show that the calculator is doing something important. The 2000s have come to be known among U.S. stock investors as “the lost decade.” Stocks were not the best choice for the long run for that 10-year stretch. They were the worst choice (money market accounts did better).

Why? Because stocks were so overpriced that two-thirds of the money that people put into stocks in January 2000 was going not to buy an asset class paying a 6.5 percent real return but to buy cotton-candy nothingness. Putting that much of your money into cotton-candy futures is going to go a long way toward setting back your financial freedom dreams every time.

It’s simple, isn’t it? You pay attention to price when buying everything else you buy. You need to begin paying attention to price when buying stocks too. Regardless of what The Stock-Selling Industry tells you is best. The “experts” in The Stock-Selling Industry are telling you what is best for them. You need to start tuning out their marketing slogans with the aim of doing what is best for you.

Next week’s column will explain where the numbers that pop up in The Stock-Return Predictor come from and how you can be sure that the calculator really works.

Every Monday at DBKP:
* Investing–The New Rules: Get the Odds on Your Side
* Stock Investing: Much of Today’s Understanding is Primitive

by Rob Bennett

images: Passionate Savings

Rob Bennett recently authored a Google Knol arguing that “The Bull Market Caused the Economic Crisis.” His bio is here.

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