by Rob Bennett

The Efficient Market Theory says that all available information is incorporated into the stock price. If anything were left out, some enterprising investor would jump in to “exploit” the edge he gained by knowing more than the market about how stocks should be priced.

Economic developments bad enough to cause a stock crash do not happen in the space of a day or a week or even a month. So it is impossible under this model for stock prices to fall as dramatically as they need to fall to cause observers to properly describe the price drop as a “crash.”

Stock crashes cannot take place under the Buy-and-Hold Model.

So why do they?

The trouble is — the stock market doesn’t understand the expert theories. It keeps behaving in the manner it has always behaved no matter how many books are written saying that it cannot do so. The stock market can be a stubborn cuss when it sets its mind to it!

What’s really going on is that the Efficient Market Theory (and the Buy-and-Hold Model for understanding stocks rooted in it) is missing an important part of the story. All overvaluation and undervaluation is irrational (the rational thing for investors to do would be to set prices art fair-value levels). The P/E10 value (and all other effective valuation metrics) reveals to us the extent to which investor emotion is influencing stock prices at a given time.

Unlike major economic developments, major emotional shifts can and do evidence themselves quickly. Those making use of an Emotional Market Theory to understand price changes have no difficulty seeing how stock crashes come into the picture. Stock crashes take place when investor moods change and investor moods can swing wildly from one day to the next. No logic can be ascribed to mood swings. Emotions are by their nature outside the control of logic (which is not to say that logic cannot influence them).

Famed Asset Allocation Strategist Paul McCartney explored how emotion swings can evidence themselves in stock price changes in his song “Yesterday.” He explained that: “Why she had to go, I don’t know, she wouldn’t say. I said something wrong…”

McCartney gets it. The young lady in question probably could not herself give a fully logical reason why she one day “had to go.” It’s not something that hit her all at once. She no doubt had been mulling the matter over for some time. But she knew that leaving was a big step. So she pushed those thoughts out of her mind as long as she could. Eventually, though, things reached a point where she could push them out of her mind no longer. At that point she “suddenly” changed her mind

The Buy-and-Hold Model is a model that envisions millions of Spock-like investors combing annual reports for new data inputs and adjusting stock prices as needed to bring them into conformity with the latest market take on what they should be. The analysis of data points really does take place, of course. What is being described is real. The flaw in the Buy-and-Hold Model is that it misses the other part of the story, the non-rational, non-Spockian side of it.

The market is comprised of millions of humans. This is a point that should be obvious but that needs to be noted because it is so often overlooked by the “experts” in this field. The humans are like the girl who caused McCartney to favor yesterday over tomorrow. At some point they form doubts over the stock price. They dismiss these doubts, they refuse to acknowledge these doubts. But a time comes when they can refuse them no more. And then stock prices are not half what they used to be — suddenly.

The market knew in 2000 that stock prices had gone nuts. How could anyone paying attention not know? The extraordinary gains of the bull market were written up in all the papers. Where did all the money come from? We all knew it wasn’t real. But we liked how the funny money made all our retirement planning troubles seem so far away. So we kept our doubts to ourselves. Until we could do so no more and we let stocks crash in September 2008.

The question of whether price changes are caused primarily by economic developments or emotional ones is an important one. The full reality is that both play a role and so both matter. But the there’s a sense in which the emotional factors are more important today because they are so rarely examined. When we force the emotional factors out of mind (Yale Professor Robert Shiller has said that he has never spoken about many things be believes about stock investing because he would be viewed as “unprofessional” if he did so), we put ourselves in circumstances in which the natural playing out of these factors is sure to shock us.

There have been four times in U.S. history when we permitted stocks to become insanely overpriced. On the first three occasions, prices ultimately fell not to fair value but to one-half of fair value. The fellow who loses the girl of his dreams does not go back to feeling about life the way he felt on the day before she came into his life; he experiences a shadow hanging over him until enough time has passed for him to come to terms with the new realities. We are now in the process of coming to terms with the new realities.

We have so far let enough of the realities in to cause the P/E10 level to drop from 44 to 20. In the event that things play out this time as they did on the three earlier occasions, we will be in stages letting the P/E10 value continue to fall until it reaches 7 or 8. That’s not rational. The fair value P/E10 level is 14 or 15. But this is a game played by humans, not Mr. Spocks. We are slow at coming to terms with emotional realities. And when we do begrudgingly come to terms with them, we do so suddenly. Getting to a P/E10 level of 7 or 8 is going to take one more of those impossible crashes.

After that, we will be ready to try to love again.

Rob Bennett often writes on behavioral finance. His bio is here.