by Rob Bennett
The conventional view is that it is economic developments that determine stock prices. When investors believe that the future is looking good, they bid stock prices up. When investors believe that the future is looking poor, they bid stock prices down.
I don’t see it.
There’s certainly a connection between economic developments and stock prices. But my take is that the causation goes the other way. When people believe that stock prices are going up, they bid them up. The higher prices put imaginary money in their pockets and the imaginary money sets the economy humming. When people lose confidence in the imaginary money, prices crash and the loss of spending power experienced by investors craters the economy.
One reason why I believe that it is stock prices affecting the economy rather than the other way around is that stock mispricings are sticky. If it were the economy affecting stock prices, stock prices would quickly move in response to economic developments. This is not what we see in the record. What we see is that mispricings on both the high and low side remain in effect longer than a logical appreciation of the economic realities dictates they should.
It’s hard to imagine a more down economic time than today. If stock prices reflected economic developments, we would today be at one of the lowest P/E10 levels on record, something in the neighborhood of 7. We are at 22! We are at three times where we would be if stock prices reflected economic developments.
The reason why valuations remain so high is that stock prices (and the emotions that determine them) are sticky. The P/E10 level in January 2000 was 44. We have been gradually working our way downward ever since. What’s holding prices up is our unwillingness to let in the horrible reality of how much human misery we caused by letting valuations get that high. We cannot face it all at once. So we let it in a bit at a time, moving over the course of a number of years from 44 to 30 and then over the course of more years from 30 to 22.
In time we likely will work our way down to 7. That’s one of the big implications of this way of thinking about things. If it is economic developments that determine stock prices, we cannot know whether stocks are headed higher or lower over time; no one knows where the economy is headed. But if it is the stock market that is the driver, and if the only thing holding prices up today is our emotional inability to take in how much destruction we caused during the bull market, then the odds are strong that prices will be coming down hard over the next few years.
If stock prices are sticky, stock prices are predictable. We know where prices “should” be (logic says that stock prices always should be at fair value). If it is only stickiness keeping them from going lower today, we know that as the stickiness is overcome, prices will go where they “should” have gone sooner — to lower levels.
But wait. You object that this cannot be. If stock prices were predictable, investors would take advantage of that reality and send them down immediately.
The logic is sound except for the error of presuming that humans can become aware of their own emotional incapacities. If we are not able to accept lower stock prices today, we are not able to accept lower stock prices today. Emotional realities are every bit as real a economic realities.
Whether there is a profit to be had in doing so or not does not matter. We cannot do what we cannot do. If some investors found insight in this article and sought to take advantage of what they learned by selling their stocks in anticipation of lower prices coming down the road, that act would cause prices to drop. But the lowering of prices would cause investors living in denial of this reality to buy even more stocks than they otherwise would be buying, sending prices back to the P/E10 level that gives the overall community of investors emotional comfort at this point in time. There’s one sense in which it really is true that you cannot beat the market!
The Stock-Return Predictor employs a regression analysis of the historical return data to identify the most likely annualized 10-year return starting from any of the possible starting-point valuation levels. At today’s P/E10 level of 22, the most likely annualized return is 2.4 percent real. I often have people ask me what stock allocation makes sense in those circumstances. I don’t believe that there is one answer to that question that applies in all circumstances.
We experienced a P/E10 of 22 in the mid-1990s on the way up to 44. We today are experiencing a P/E10 of 22 on the way down in a bear market that will likely ultimately take us to a P/E10 level of 7 or 8. In both cases, the most likely annualized 10-year return is 2.4. That doesn’t mean that both situations justify identical strategic choices. The road to achieving the 2.4 percent return is likely to be far more bumpy for those investing in stocks today than it was for those investing in stocks in the 1990s.
It may be that this time the 10-year return will be comprised of a time-period in which we see a price drop of 50 percent followed by a time-period in which we see high positive returns. It takes a special kind of investor to be able to hold through a crash taking place only a few years after an earlier crash. So today’s 2.4 percent likely return can fairly be characterized as a more dangerous 2.4 percent likely return than the 2.4 percent likely return that applied for stocks purchased in the mid-1990s.