How to Avoid Market Crashes Using the CAPE Ratio | Meb Faber | Stocks | Investment

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[00:00:00]I was going to name this chart or this topic, you suck at investing.

[00:00:04]Um and when I say this, I don't mean any of you specifically. I'm not pointing out any one of you, although most of you do.

[00:00:10]But you're terrible at investing. This is the broad investing public. This is an example of a study that comes out by Dalbar that shows investor returns, dollar weighted returns. As you can see, typically everything did good except for the average investor. Morningstar replicates this study for funds, right?

[00:00:27]So the average investment fund when the money comes in, when the money comes out. And typically what happens, people are emotional, they have a behavioral bias where they rush into stocks or performance of a fund at the top and then sell at the bottom, and they do it over and over and over again. That costs you roughly about 2% a year, typically, right?

[00:00:47]So all you that are getting really excited about stocks again after the fifth year of this bull market, but weren't investing in 2008 or 2009, you maybe want to take a little bit of pause, think about it. Um but it's important to come up with a systematic investment approach um it's to avoid some of these genetic behavioral biases we have. But we do see, when were people most bullish? The absolute worst time in history to be bullish, January of 2000.

[00:01:12]For those of you that were investing then.

[00:01:14]When were people most bearish? The absolute best time to be investing in my career, March 2009.

[00:01:20]This goes to show, the whole point is that your emotions can work against you, right? And and and it's what has come down in our genetics for many millions of years, right? What was important when you're on, you know, the savanna and a tiger's chasing you is very different than what um the skill set and genetics needed to trade shares of IBM or Google or short gold or whatever it may be, right? So um but this isn't anything new. This is something that's been going on for hundreds of years. This is an example that goes back to the early 18th century. This is in a paper we wrote called learning to love investment bubbles, but this is an example of one of the most famous bubbles, and there's some great books on this topic.

[00:01:57]Extraordinary Popular Delusions and the Madness of Crowds is a really wonderful one. It talks about many historical bubbles. What this shows is an example of a stock that went parabolic in the early 18th century. It was a South Sea stock.

[00:02:10]We talk about it in this paper. It's a really interesting story. It involves a lot of the things that typically happen in bubbles, easy access to money, credit, people borrowing. But the most important one is people making a lot of money. And and and a very great example is one of the most rational, brilliant scientists of all time, Sir Isaac Newton, was an investor in this company.

[00:02:29]It goes to show his experience that will probably mimic a lot of investors' experiences in stocks that went parabolic and went in bubbles. So, an example he and I I joke a lot on my blog and Twitter that this probably looks like a chart of Bitcoin, to which I get a lot of hate mail about, strangely. I've been writing for 7 years, and all of a sudden I start getting hate mail. Um Anyway, so this example is Newton buys in.

[00:02:53]Doubles his money. What is that? Yeah, doubles his money. Cannot be happier.

[00:02:57]What's the worst possible thing when you've made money and gotten out?

[00:03:01]Well, it's that your friends are making more money, right? Someone just sold an app company. Uber's valued at 18 billion. Someone else did this Yo app that's getting millions of downloads, right? What's the worst possible thing that could happen? Is your friend in the next cubicle is making more money than you, or your friends are all getting rich, but you're not. So, what happens of course? Well, then he decides to buy back in. Okay?

[00:03:22]Well, of course he's buying near the top, at the peak. What happens? It crashes 90%. Well, then he sells at the bottom. Okay? Well, this is this is something that happens over and over again in investing. And so, I just want to show it's nothing new.

[00:03:35]And think about this as we go forward.

[00:03:38]So, what can you do? Is there anything you can do to remove this emotional decision-making, right? To to to combat our behavioral biases? Well, so there's these two good-looking guys.

[00:03:49]You may You may recognize, may not. On the left is Ben Graham, often known as the father of security analysis. He wrote a couple great books. He was a professor early 20th century called Security Analysis and Intelligent Investor, right? And what he proposed is when looking at an investment to value the company and often to smooth out the the valuation by using earnings over a number of years. Not just looking at one year of earnings, but his preferred metric was smoothing it out over 5 to 7 years. It's a way to smooth out the business cycle, right? As as a way to have a fundamental anchor to be able to compare companies to each other on a long-term basis. Um fast forward 80 years later. So this is nothing new.

[00:04:27]This has been around almost a century.

[00:04:29]Robert Shiller, recent Nobel laureate, just won with with Eugene Fama, professor at Yale. He put out a white paper in the late '90s called Irrational Exuberance. Sorry, excuse me, a white paper and a book called Irrational Exuberance. Alan Greenspan later used the term in Congress, promptly sent the stock market down quite a bit. But he says, let's take a look at this, but let's use it on the market-wide basis as a whole.

[00:04:50]Let's let's look at 10-year average earnings across the entire US stock market.

[00:04:54]Call it the 10-year cyclically adjusted price earnings ratio, okay? Right? So this is an example of what that looks like back to 1881. That's a long time.

[00:05:02]And the problem you have with efficient market people, people say the market's efficient, you can't predict bubbles. Or sorry, bubbles don't exist. First of all, they say bubbles don't exist. They do exist, you can't predict them. And that doesn't make much sense to me.

[00:05:14]If you look at this chart, there's an average value around 16, 17 times earnings, right? That the US stock market has been in.

[00:05:20]There's times when it's been incredibly low on the low single digits. Think 1910s as well as post-depression, but there's also times when things get incredibly bubbly. If you look at the late '20s, you got to a value of over 30. If you look at the biggest bubble in the US stock market's ever seen, the late '90s, you had a value of 45. Does it seem even remotely reasonable that it is a good a time to buy stocks when they're trading at 45 times earnings in 1999 as it was in the early '80s 1980s at a value of five. That does not pass a common sense sniff test for me. So, if you look at this, you say, "Okay, does it work?" Historically, you know, being a scientist and engineer, does this work? Historically, it's worked great.

[00:05:59]If you buy a stock market when it's cheap, it'll say less than a CAPE ratio of 10, you get great future returns.

[00:06:04]These are 10-year returns going forward, real returns. So, we're not netting out inflation. Um and it's a nice stair-step down. The more you pay for a stock, the lower your future returns are. It is Again, it's not rocket science. It's simple.

[00:06:19]Um but this works out over a long-term time horizon. If you look at where we are now, we're at a value of around 26. So, unfortunately, in the worst bucket, uh the where the red line is right now, where future returns should be pretty muted, pretty low.

[00:06:33]Um we don't think it's a bubble, you know, we're It's not crazy, but it I was talking about this at lunch today.

[00:06:39]There's a spectrum of future returns, right? And simply, the more the market goes up in the meantime, means the lower your future returns are going to be.

[00:06:47]The more the market goes down in the meantime, the higher your future returns are going to be, in general. Um the best possible thing that could happen if you're a young person in this room is the market to crash by 50%.

[00:06:57]May Maybe not the best possible thing, but the best possible thing for your investing career. Because you can then invest in the US for the next 10, 20, 30, 40 years at a much cheaper valuation. That is not the opportunity set right now, unfortunately. In investing, emotions can become your biggest enemy. Meb Faber shares a powerful story from the 18th century, showing how even one of the history's greatest minds, Isaac Newton, failed to control his emotions during the stock market bubble. Newton initially made profits in the infamous South Sea bubble, but envy and fear of missing out pulled him back into the market at the worst possible time. The crash eventually wiped out almost 95% of his investments, costing him 20,000 pounds, that is equivalent to millions in today's money. [music] After the devastating loss, Newton famously said, "I can calculate the moment of the stars, but not the madness of men."

[00:07:45]>> [music] >> His story is a timeless reminder that even brilliant people can make irrational investment decisions when emotions take control. Meb Faber explained us the psychology behind the stock market bubbles, investor behavior, and the costly mistakes that still repeat in today's market.