How To Duck Market Crashes: The Buffett-Shiller Method

Pay less attention to stock prices and more to what your portfolio companies are earning.

Is the bear market about to resume? Maybe. But even if it doesn’t, there will be a big correction at some point and then another and then another. What’s your plan for coping with these crashes?

In the past half century there have been three nasty dips, cutting stock prices in half or close to it. It would be nice to have some way to insulate yourself from the turmoil. Here I offer a protective system, which I will call the Buffett-Shiller method. That is in honor of two market watchers whose thinking underlies it.

Buffett-Shiller is not a market-beating formula. It won’t allow you to time your way around corrections. It will, however, enable you to better cope with volatility. It will lower your risk of selling out at the bottom or becoming dangerously exuberant at the top.

Warren Buffett instructs us to think of shares not as objects to be traded but rather as pieces of businesses to own. Buy these pieces, he says, only if you would be content to sit on them while the stock market remains closed for ten years.

If you think like Buffett, you don’t care a lot whether the prices of your stocks go up or down this week or next. You do care about earnings. You want your pieces of different businesses to be earning good profits 10 years or 40 years from now, profits you could live off.

Robert Shiller, the Yale economist, is best known for his book Irrational Exuberance, published, with delightfully good timing, just before one of those three great crashes of the past half century. But his thinking about market irrationality goes back well before then.

In 1987 Shiller published an article about stock prices in, of all places, Science. (Who knew that playing the market was a science?) In it he argued that stock price volatility is all out of proportion to the volatility in corporations’ prospects. In principle, the price of a share should equal the discounted present value of all future dividends. Expectations about future dividends do move up and down, but nothing like the way stock prices move up and down.

Something else is making prices swerve. Maybe it’s people stampeding, the way cattle stampede; maybe it’s speculators trying to anticipate one another’s next move; maybe it’s social contagion, of the sort visible in meme stocks like GameStop and Bed Bath & Beyond.

Whatever their cause, the monthly lurches in the stock market should be irrelevant to most investors. Of course, you have to care about prices if you are planning to sell all your assets tomorrow and sail a boat around the globe. But if you are more normal, you spend 40 years gradually accumulating shares and then 25 years gradually liquidating them. In that case monthly volatility is beside the point.

The two contrasting views of the stock market are presented in the graph below.

The red line displays the growth in the prices of stocks. It shows what happened, in purchasing power, to a sum invested in the S&P 500 in the summer of 1972. It assumes that dividends are reinvested in the index.

The blue line looks at corporate equity the way Buffett or Shiller looks at it. It measures a portfolio by an investor’s share of the 500 companies’ earning power. Here, again, it is a real total return being plotted (the return, that is, that includes dividends and has inflation taken out).

Earnings fluctuate. To assess corporate value, we must smooth them out. The graph uses a trailing ten-year average of earnings to create what I am calling, with lingo borrowed from Arnold Bernhard, a value line. I set the value line at 21 times average earnings.

The notion that you should look at ten years of earnings instead of one is a staple of value thinking. It’s part of Shiller’s “cyclically adjusted price/earnings” ratio. It goes back at least to Ben Graham’s 1933 classic, Security Analysis.

Building reinvested dividends into an earnings history isn’t a Graham thing. It didn’t have to be, because in his day all companies distributed profits the same way, via quarterly checks.

Nowadays we have a confusing mix of companies like Artisan Partners Asset Management, which distribute earnings via cash dividends, and Berkshire Hathaway, which use stock buybacks to do the same thing. To finesse the shift in corporate habits across a 50-year span you really have to look at a reinvested S&P.

If my chosen P/E of 21 seems high, note that in a world of growth, ten-year average earnings are going to be less than last year’s earnings. Also, with the reinvestment of dividends, earnings growth in my statistics is a bit steeper than what you see in the published S&P earnings numbers.

Real earnings growth in the reinvested S&P over the past 50 years comes to 5.35% annually. That makes a P/E of 21 against the ten-year average equivalent to a multiple of 16.8 against the most recent earnings:

These multiples are in line with what stocks have averaged over the past half century, although, just at the moment, stocks are somewhat more richly priced.

So, there’s a price line and a value line. Which gets your attention?

If you care about value rather than price, you will have some modest disappointments (there was a 5% dip during the Great Recession, for example), but you will ignore most of the talk about bear markets.

Follow value rather than price and you can shrug when others are panicking and you can restrain your expectations when others are becoming exuberant. You can be a buy-and-hold investor. Buffett’s favorite holding period is forever, and that applies to most of Berkshire Hathaway’s assets.

An interesting illustration of Wall Street’s fixation on price rather than value comes in Berkshire’s second-quarter earnings. Applying the conventions of mark-to-market accounting, the company reported a loss of $44 billion. That came from declines in the prices of publicly traded stocks that Berkshire owns. But Berkshire’s true earning power—from businesses it owns outright, like a railroad, and from its share of businesses of which it owns a piece, like Apple—remains strong. The chairman saw no need to tender his resignation.

Buffett-Shiller can bring you peace of mind but, as I said, it does not deliver a way to beat the market.

It would be nice to imagine that you could have made a bundle over the past 50 years by loading up on stocks whenever the red line dipped below the blue one and selling stocks whenever the red line was far above. Unfortunately, in order to undertake that effort today you would need to know where the blue line for 2022-2072 will lie. I won’t be able to display that line until 2072.

Source: https://www.forbes.com/sites/baldwin/2022/08/22/how-to-duck-market-crashes-the-buffett-shiller-method/