This isn’t actually anything new. Jeremy Siegel made it famous in his book “Stocks for the Long Run”, John Bogle advocated it (sort of) with the creation of his Vanguard funds and I thought I’d try to convince myself.

I got data from Professor Robert Shiller’s site, which very nicely gives data for the S&P 500 starting from January 1871 up to present day (That is A LOT of data). The data comprises of closing prices for each month, dividends, earnings, inflation rate, and a calculated CAPE.

CAPE needs some explanation. From The Big Picture (Btw, you can read the paper linked in that page to get an idea of some of the criticisms of the Shiller data, it seems fine to work with to me though):

Shiller uses an inflation adjusted S&P 500 Index (using simple monthly CPI data). The professor then divides that a 10 year average of trailing earnings (similarly CPI adjusted) earnings.

Essentially, P/E tells the Price per dollar of Earnings or how much is the price of the S&P 500 for a dollar of earnings. Cyclically Adjusting the earnings means taking a 10 year average of earnings to smooth out earnings so that one or two good (bad) years don’t skew the picture.

So what I did was rank the various Cyclical Adjusted P/E ratios into 10 bands (1 the lowest and 10 the highest) and then calculated the 5 and 10 year Compounded Average Growth Rate (CAGR) of buying the S&P 500 for each band. And since a picture paints a thousand words, I present my 4,000 word thesis below (click on pics for a better view):

Pop Quiz: S0 what can someone conclude from the pictures above?

1. A long time-horizon matters

Comparing the 10yr CAGR to the 5 yr CAGR charts, we can see that returns over a 10 year time-frame are less volatile. Even buying at low CAPEs may cause losses of up to -20% p.a. over a 5 year period. If you extend it to a 10 year period, losses rarely go over -10% p.a.

2. Low Valuations matter

Chances of positive return increase when buying at low CAPE. While buying at low CAPEs does not guarantee that one avoids capital loss, buying at high CAPEs almost guarantee that one’s capital will be impaired.

3. Dividends matter

With dividends, the odds of one getting a positive return increases much, much more. Over a 10 year timeframe, there hasn’t been a period of negative CAGR. Yet.

Reminder, this doesn’t mean you can do the same for individual stocks- understanding the nature of the operating business and accounting is greatly needed there. While history doesn’t repeat itself, I’d say that one’s odds are greatly increased. Also, the above lessons doesn’t work for Traders since most traders operate on a much shorter timeframe.

So the lesson I’m recording for my benefit is: Low CAPE, Dividends matter and Long Timeframe.

Note: The CAGRs only go up to returns if you bought in Sep 2006 (for 5 year CAGR) and if you bought in Sep 2001 (for 10 year CAGR).