Letters to the Editor

Do All Really Bad Price Drops Happen at Times of High Valuation?

Rob Bennett sent me this letter to the editor:

This is a question that I long have wondered about. It may be that you have addressed it previously, but that the answer has just not yet "clicked" for me.

Is it a fair statement to say that all really bad price drops happen at times of high valuation? If yes, that would be a big deal, in my view.

I presume that there are large percentage drops at times of low and moderate valuation, but my impression is that those don't remain in effect for long. And I presume that there are prices drops that remain in effect for a long time that start from times of low and moderate valuation levels, but my impression is that those are generally not really big drops.

I imagine that the way to address this question would be to define precisely what is meant by the term "really bad price drops." Would it be reasonable to say that a price drop of 20 percent that is still in effect five years later (even if there were temporary increases in price over the course of that time-period) is a really bad price drop? There obviously are other reasonable ways to define the phrase.

Would it be necessary to factor in the effect of inflation in studying this question? My thought is that, if the assessment only required going out five years, inflation might not be that big a deal. If it went out 10 years, it would probably be necessary to include the effects of inflation in the analysis.

Anyway, I would be interested in seeing any thoughts or data that you presented on this question.

My Request for Clarification

I wrote the following as part of an email to Rob.

In regards to your latest inquiry, the answer is not going to be simple. I have to figure out exactly what the important relationships are. Tentatively, we might talk in terms of double-digit losses that extend into the second year. Even then, neither P/E (single-year) not P/E10 has to be horribly bad. Nor does a high single-year P/E necessarily imply danger.

Another issue: a short, sharp drop as in 1987 does NOT show up in annual returns. Do you want to look at such short, sharp drops? This is an important issue from the human standpoint. People who panicked got wiped out. Those who waited only for a single year did OK.

Rob's Clarification

Re the question. I am not concerned with drops of only 10 percent that remain in effect of only a few years, nor am I concerned with the larger drop experienced in 1987 that remained in effect only for a short time-period. I am interested in knowing whether serious price drops (those of at least 20 percent in depth and at least 4 or 5 years in length) are always associated with high valuation levels. I'd like to be able to say that stocks are safer at times of low and moderate valuation levels than they are at high valuation levels.

It's clear from playing with FIRECalc that this is largely true in the distribution phase (the worst results for retirements are retirements that begin in high-valuation years). But I'd like to make a more general statement. Is this also so for those in the accumulation stage? And to what extent is it so? Are there exceptions? I wouldn't view the 1987-type experience to be an exception because the loss was not a serious one for the buy-and-hold investor. And I wouldn't view a loss of less than 20 percent to be an exception even if it lasted for some time (because the loss is not substantial). My rough assessment of what constitutes a serious loss is one of 20 percent that remains in effect for five years (regardless of whether there are moments of time within the five-year time-period at which the loss dropped to less than 20 percent).

If an investor could be assured of not being likely to experience a loss of greater than 20 percent for more than five years, I think that would make stock investing more attractive. Does the data offer realistic support for a hope of not suffering losses greater than that, if one purchases the stocks at times of low valuation? How about moderate valuation? If such a belief is NOT reasonable, is it reasonable to count on not suffering losses too much greater than that (say, 30 percent losses that extend more than five years)?

I understand that there are some who panicked in 1987. I am trying to suggest strategies that assure investors that they do not need to panic. The conventional advice says not to panic, but it is rooted in the myth that valuations do not matter. So I view that as a false comfort strategy. I am trying to determine if there is realistic "don't panic" advice that can be put forward. Is it fair to say that stocks become a good bit safer if one avoids making purchases at times of high valuation? It's a question you have looked at before, but this question aims to come at it from a different direction.

My Response

New Post

I wrote my response in Do All Really Bad Price Drops Happen at Times of High Valuations? and posted it immediately as a New Post.
Do All Really Bad Price Drops Happen at Times of High Valuations?

The best threshold is for $100000 in stocks to fall to $70000 in NOMINAL dollars. A fall to $80000 in NOMINAL dollars is a useful threshold as well.

I have posted background material in my Yahoo Briefcase. See my Folder about First Decade Price Drops. Its contents are available for viewing by the general public as Microsoft Word documents.
Yahoo Briefcase

Readers can use FIRECALC to display stock market balances in NOMINAL dollars when all dividends are reinvested. Start with an initial balance of $100000, a withdrawal amount of $0, a stock percentage of 100%, expenses of 0.00% and the CPI for the inflation adjustment. Set the portfolio lifespan to 10 years or whatever you prefer.
FIRECALC

Here are a couple of hints for those using FIRECALC:

Readers can see what happens with dollar cost averaging by withdrawing NEGATIVE amounts. NEGATIVE withdrawals are POSITIVE deposits. You can set your initial balance to whatever you choose. Typically but not necessarily, this would be zero dollars.

You can see what happens when you withdraw a constant percentage of your portfolio’s CURRENT balance (instead of its INITIAL balance) by placing the withdrawal percentage into the entry for EXPENSES (and setting the withdrawals to zero dollars).

Earlier Letters

I Bonds versus TIPS

I Bonds versus TIPS, Should You Buy an Annuity? New Letter Inspires a New Area of Research.
I Bonds versus TIPS

How Long Do You Have to Wait for 7%?

I finally answer Rob Bennett's October 6, 2005 question. Well, I come close enough.
How Long Do You Have to Wait for 7%?

Rob Bennett's October 6, 2005 Request

This is what Rob asked for in the first place. I provided information, but I did not answer his question. He wanted A New Take on the 7% Rule.
Rob Bennett's October 6, 2005 Request

Glossary for Beginners

I am amenable to writing a Glossary for Beginners.
Glossary for Beginners

From a Novice in Investing

Read this letter and take advantage of its links to earlier letters.
From a Novice in Investing

Have fun.

John Walter Russell
October 23, 2005
Updated: March 16, 2007