Most people remember Ben Stein as the teacher in “Ferris Bueller’s Day Off” or from his show “Win Ben Stein’s Money.” However, he is also an accomplished economist, with a degree from Columbia and the valedictorian of Yale Law School. He worked in the White House in the 70s, and has written articles on finance for Barron’s and the Wall Street Journal.
Phil DeMuth was valedictorian of his class at the University of California, and has a masters & doctorate degrees. He is a registered investment advisor and president of Conservative Wealth Management in Los Angeles. He has also written extensively for the Wall Street Journal and Barron’s.
The book was written in 2003, after the dot-com crash. It came out of a series of lunches and bike rides in Santa Monica from 1997 to 2000, where the two argued/discussed how the market appeared to be overpriced. However, since conventional wisdom was that you couldn’t “time the market” what were you to do? Market timing “had been the province of short-term fortune-telling cranks” and has had a justified bad reputation in investing circles. What the two authors wondered (and set out to research) was that, in the long-term (10+ years) were their valuation metrics that could be used to determine when to buy, and when not to buy, stock funds. Note that they were using stock mutual funds (S&P 500 Index) for your purchasing decision here, because individual stock analysis is something completely different.
The authors then set out to look at various metrics for determining the time to purchase, compared them, provided their strengths and weaknesses, and then judged them over various time periods (5, 10 and 15 years). They also provided methods for the reader to do similar analysis in the ongoing years, so you could continue to use the methods. The list of metrics they came up with were:
- Price vs 15-year moving average of price
- Price-to-earnings ratio (PE) vs 15-year moving average
- Dividend yield vs 15-year moving average
- Fundamental value (can’t use this now, their source no longer provides the data)
- AAA bond yield vs stock “yield”
- Price-to-Cash Flow and Price-to-Sales (can’t use this now, their source no longer provides the data)
Each of these metrics provide a point where the investor should start purchasing stocks, or should stop purchasing (but continue to let the stocks sit and reinvest the dividends). Again, this is long-term timing, so there is nothing in here to show when to exit the market completely and put it in bonds or your bank.
They end by showing that, by combining each of these metrics, rather than using just one, and using that to determine your time to purchase, you can enjoy even greater stock.
Price: This metric is just a comparison of the current S&P 500 (adjusted for inflation) versus the 15-year moving average. When the current price is above the 15-year average, you should stop purchasing and let your stocks ride. When it dips below, you can begin purchasing again. As you would expect, since it has been climbing steadily for many years, this one doesn’t provide a signal to purchase as much. In fact, using this metric, it suggests you shouldn’t have been purchasing from 1985 to 2008 (one of the great run ups of stocks). The only time it wanted you to buy recently was from 2009 – 2012.
Price-to-Earnings: This one seems to be a little more accurate, in my opinion. Many folks have used the P/E ratio for their investing decisions. Here you are measuring the current S&P500 P/E ratio versus the 15-year moving average. Again, when its above the average, you shouldn’t buy, when it is below the average, you should buy.
Again, if you look at the chart, it recommends not continuing to buy in 1985, and only starting back up again in 2004. The book provides documentation to show that, as of 2003, this method rewarded the investor better than continuing to purchase during the great stock run up. Perhaps if t went past 2003 (when the book was written) it wouldn’t be valid. Something for me to check out in the future.
Dividend Yield: Companies can elect to distribute some of their excess earnings to their shareholders, and these take the form of dividends. Nowadays, companies don’t like to give out dividends – their CEOs think they have a better use of the earnings to grow the business. In the book, they track the S&P500’s dividend yield versus the 15-year moving average. When the current yield is below the 15-year average, the assumption is the stocks are overpriced, and you should not be purchasing new stocks (but you should continue to reinvest the dividends). Again, based on this, the book shows how, over a long period (15-20 years) the investor beat out the others (in the case of 20 years, it was almost a 50% increase in overall returns). This is also the third metric in a row which says to stop buying new stocks n 1985 (?)
Dividend yield chart
Earnings Yield vs AAA Corporate Bond: In this fourth and final metric, the book compares the yield of a AAA corporate bond to the S&P500 Earnings Yield (you get this by dividing 1 by the P/E ratio). The earning’s yield has always been a short-hand way to compare bonds to stocks. The idea here is that if someone can earn more “yield” from a bond than a stock, they should invest in bonds. Except for a dip between 2008-2010, this metric was also suggesting investing in stocks for the past several years.
Earnings vs bonds
The book concludes with an analysis of how to use all the metrics together to significantly increase your returns. It compares using 1, 2, 3 or 4 of the metrics together, and their returns over 5, 10, 15 and 20 years, as well as comparing them with other strategies (asset allocation, other investments like real estate, etc.) In the end, this long-range market timing was shown to be more successful.
However, the authors note that this strategy is not for the faint of heart. It is a true contrarian strategy, where people will be purchasing stocks when there is “blood in the streets” and refusing to buy, when the market is going up like a rocket. It is also, very much, a long-term strategy, where you are not looking to capitalize on the investments for 15-20 years.
By the way, as of August 1, 2017, three of the four metrics have turned to “don’t buy” additional stocks. Only the S&P500 earnings yield vs bond yield still is pointing towards buying more, and even that is pretty close (S&P500 yield was 4.05%, AAA bonds were 3.75%). Also remember that this metric does not say to sell your stocks, just don’t buy any new ones (and continue to reinvest your dividends).
Overall, I liked the book, and may keep the metrics in mind for my “fun money” accounts. For my 401K/IRAs I plan on sticking with my asset allocation strategy.
I give it 3.5 stars out of 5
Mr. 39 Months