Valuation-Informed Indexing:
Overvaluation Cannot Be “Exploited” Away

The big problem with Buy-and-Hold Investing is overvaluation. If stock valuations were steady, sticking at the same stock allocation at all times would make perfect sense. In a world in which stocks can become insanely overvalued, it’s too dangerous. Overvalued markets always crash. Who wants to be heavily invested in a crashing stock market?

University of Chicago Professor Eugene Fama’s Efficient Market Theory says it is not supposed to work like this! Inefficiencies in pricing should be rooted out by investors happy to take advantage of any opportunities that can be discovered by the human mind by “exploiting” them for profit. Under the theory, significant overpricing should be met with selling by the smartest investors and significant underpricing should be met by buying by the smartest investors.

The trouble is that there is no practical means for the smartest investor in the world to exploit inefficiencies in the pricing of the overall market.

Say that you noticed in January 1996 that the P/E10 level for the S&P had risen to 25, the level that always brings on a price crash and an economic crisis sooner or later. How would you go about using this insight to make a financial killing and thereby do your part to exploit away pricing inefficiencies?

You could short the market. But the price crash did not take place until September 2008. Those who shorted the market when prices first went insane all went bust long before they obtained any reward for their efforts to exploit the pricing inefficiency.

Fama was on the right track in his thinking. He is right that the best way for the market to get prices right is for it to provide financial incentives to those who possess insights not shared by many others. A market in which those who are aware of overpricing benefit financially by exploiting it is a market in which overpricing has become a logical impossibility. People really do respond well to financial incentives. If such incentives existed, the market would always price stocks properly and price crashes would be a thing of the past. Wouldn’t that be nice?

No investor should today be putting his confidence in Fama’s discredited theory. But all investors should be anxious to learn what it would take to make the Efficient Market Theory a future-day reality. If there were financial incentives for identifying overvaluation and undervaluation, market efficiency would become a reality, price crashes would become a thing of the past, and our entire economy would function more smoothly.

What would it take?

All that it would take is an educational effort.

No individual investor can make a killing by “exploiting” the inefficiency of overvaluation via shorting. But all investors possess an incentive to adjust their allocations in response to valuation changes. The most important choice that an investor makes is his choice of a stock allocation. In a world in which valuations affect long-term returns, increased valuations make stocks less appealing. So all investors should naturally adjust their allocations in response to valuation changes to keep their risk profiles roughly constant.

Fama was onto something. All investors possess an incentive to change their stock allocations in response to valuation shifts and stocks can never become overvalued so long as investors act pursuant to the incentive. Stocks can never become overpriced so long as investors rationally pursue their self-interests. So what has gone wrong? Why don’t we have efficiency in the real world?

It’s an odd aspect of how the market operates that causes all the trouble. Market efficiency can be attained only if investors act rationally. But there is an aspect of how the stock market works that makes it very difficult indeed for investors to keep their heads.

Temporary prices can be whatever we want them to be.

Say that we all became concerned that we have not saved enough for retirement. Say that the idea occurred to us that a doubling of stock prices would go a long way to solving the problem. We could act collectively to double stock prices! What would stand in our way? We have the power!

This really is so. There are no limits on how high we can set stock prices in the short term. They can be absolutely anything we want them to be. And of course our foolish (because the fantasy cannot last) desire is to set them as high as possible. If someone gives you the choice of doubling your wealth without work or cost, you say “yes!” Investors usually say yes to this option (without consciously thinking through what they are doing, of course). There is always an incentive for investors to price stocks as high as possible, far higher than fair value.

To obtain an efficient market. we would need to resist that temptation.

Do we do so today?

Do investment experts help us to do so?

Do they remind us daily of the problems we cause when we permit stocks to become overvalued and the market inefficient?

Do they point out the financial losses we incur by staying at the same stock allocation at all times rather than adjusting our allocations to maintain the same risk level at times of changing valuations?

They do not. Not in the Buy-and-Hold Era.

That’s what needs to change. It’s the promotion of Buy-and-Hold that has made the market so inefficient.