How To Duck Market Crashes: The Buffett-Shiller Method

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

Is the bear market about to resume? Maybe. But even if it doesn’t, eventually there will be a major correction, and then another, and then another. What is your plan to deal with these crashes?

In the last half century there have been three nasty crashes that cut stock prices in half or nearly half. It would be nice to have a way to isolate yourself from the turbulence. Here I offer a protection system that I will call the Buffett-Shiller method. That’s in honor of two market watchers whose thinking underlies this.

Buffett-Shiller is not a market-beating formula. It does not allow you to bypass corrections in time. However, it will allow you to better manage volatility. It reduces your risk of getting sold out at the bottom or dangerously exuberant at the top.

Warren Buffett instructs us not to think of stocks as objects to be traded, but as part of a company to be owned. Buy these pieces, he says, only if you’d be content to sit on them while the stock market stays closed for a decade.

If you think like Buffett, you don’t care if your stock prices go up or down this week or next. You care about the earnings. You want your shares in various companies to have good returns in 10 or 40 years, profits you could live on.

Yale economist Robert Shiller is best known for his book Irrational exuberance, released, with wonderfully good timing, just before one of those three big crashes of the last half century. But his thinking about market irrationality goes way back before that.

In 1987, Shiller published an article about stock prices in, of all places Science. (Who knew there was a science to gambling in the market?) In it, he argued that volatility in stock prices was disproportionate to volatility in companies’ prospects. Basically, the price of a stock should equal the discounted present value of all future dividends. Expectations about future dividends move up and down, but not the way stock prices move up and down.

Something else makes prices fluctuate. Perhaps men charge as cattle charge; perhaps they are speculators trying to anticipate each other’s next move; maybe it’s a social contagion, as seen in meme stocks like GameStop and Bed Bath & Beyond.

Whatever their cause, monthly swings in stock markets should be irrelevant to most investors. Of course, if you plan to sell your entire fortune tomorrow and sail around the world in a boat, you have to worry about prices. But if you’re more normal, spend 40 years gradually accumulating stocks, and then 25 years gradually liquidating them. In this case, the monthly volatility does not matter.

The two opposing views of the stock market are illustrated in the chart below.

The red line shows the growth in stock prices. 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 as Buffett or Shiller sees it. It measures a portfolio based on an investor’s share of the profitability of the 500 companies. Again, a real total return is presented (ie the return that includes dividends and excludes inflation).

The income fluctuates. In order to assess enterprise value, we need to smooth them out. The chart uses a 10-year trailing average of earnings to create what I call borrowed jargon Arnold Bernhard, a value line. I set the value line at 21 times average income.

The notion that you should look at 10 years of earnings instead of 1 year is a cornerstone of value thinking. It’s part of Shiller’s “cyclically adjusted price-to-earnings ratio.” It dates back at least to Ben Graham’s 1933 classic, security analysis.

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

Today we have a confusing mix of companies like Artisan Partners Asset Management, which distributes profits via cash dividends, and Berkshire Hathaway, which uses share buybacks to do the same. To refine the change in corporate habits over a 50-year period, you really have to look at a reinvested S&P.

If my chosen P/E ratio of 21 seems high, note that in a growing world, average ten-year earnings will be below last year’s earnings. Also, the earnings growth in my stats with dividend reinvestment is a bit steeper than what you see in the published S&P earnings numbers.

The real earnings growth of the reinvested S&P over the last 50 years is 5.35% annually. That gives a P/E of 21 versus the 10-year average, which is a multiple of 16.8 versus recent gains:

These multiples correspond to the average value of stocks over the last half century, although stocks are valued slightly higher right now.

So there is a price line and a value line. What catches your attention?

If you’re more interested in value than price, you’ll encounter some modest disappointments (e.g., there was a 5% drop during the Great Recession), but you’ll ignore most of the bear market talk.

Follow value rather than price, and you can shrug when others are panicking and you can hold back your expectations when others are getting exuberant. You can be a buy-and-hold investor. Buffett’s preferred holding period is perpetual, and that’s true of most of Berkshire Hathaway’s assets.

An interesting example of Wall Street’s fixation on price rather than value is Berkshire’s second-quarter earnings. Using mark-to-market accounting conventions, the company reported a loss of $44 billion. That came from declines in publicly traded stocks that Berkshire owns. But Berkshire’s true earnings power — from companies it wholly owns, like a railroad, and from its stake in companies it owns a stake like Apple — remains strong. The chairman saw no need to submit his resignation.

Buffett-Shiller can give you peace of mind, but again, it doesn’t offer a way to beat the market.

It would be nice to imagine that over the past 50 years you could have made a bundle by loading up stocks when the red line went below the blue and selling stocks when the red line was well above it. Unfortunately, to make that effort today, you would need to know where the blue line will be for 2022-2072. I can’t see this line until 2072.