Valuation-Informed Indexing #93
by Rob Bennett
The Buy-and-Hold Model posits that it is the economic and political events that take place each day that determine the stock price that applies at the end of that day. Investors are always digesting new information and resetting the stock price to reflect the new realities.
Buy-and-Holders are rooting for an economic recovery. They take comfort in rising stock prices, interpreting them as a sign that the smartest investors are already beginning to “price in” the bigger profits that will come with better economic times.
Valuation-Informed Indexers would like to see an economic recovery too, of course. But we have a very different understanding of the process by which stock prices are set. As a consequence of our belief about how stock prices are determined, we have little hope that the economic recovery will continue far into the future.
Valuation-Informed Indexers believe that stock prices are determined primarily by investor emotions. The economic and political developments justify a price gain of roughly 6.5 percent real per year. When prices rise by more, it is because investors have become emotional and we will see a price drop within 10 years or so to bring things back to fair-price levels.
So, for Valuation-Informed Indexers, it is not today’s events that set today’s prices. Price changes that we saw 10 years ago have a big influence on today’s prices. Prices went to three times fair value in 2000. It is going to take 20 years of poor returns for prices to work themselves down to where they need to be for the market to be able to produce sustained price gains once again.
We borrowed trillions of dollars to finance the bull market of the late 1990s. Now we are paying the bill.
Is it realistic to expect an economic recovery before the bill is paid in full?
It is not.
The problem with the economy is that consumers are not spending. They are afraid to spend. Portfolios that appeared to be worth $600,000 in 2000 possessed a true value of $200,000 and consumers who learned that they are $400,000 short of where they once thought they were are not inclined to spend freely on goods and services. We will not see a true economic recovery until millions of middle-class people feel good about their financial futures.
The various factors interact in troubling ways.
Some people start to feel better and begin spending a bit. Businesses see relief and consider rehiring. Stock prices rise. That causes investors who wished that they had gotten out of stocks before the 2008 crash to see an opportunity to spare themselves more pain. They jump on the higher prices, selling their stocks. The sales bring prices down. The lower prices make other consumers feel more fearful. The businesses let go of workers again.
We’re caught in a trap. The trap was caused by investor psychology and it can only be escaped through a change in investor psychology.
If we all came to accept that we caused the crisis with our bad behavior in the late 1990s, we could come to terms with what has happened and put it behind us. That’s the test. That’s what we should be looking for when we aim to assess whether a lasting economic recovery is on its way or not.
It’s not happening.
I am on the front lines. I write about how valuations affect long-term returns and so I receive lots of feedback from investors. Investors are more open to Shiller’s ideas today than they were before the crash. There has been an improvement. But most investors still do not want to hear that they caused the crash. This important and healing truth remains largely unspoken.
So the healing process has not yet proceeded very far.
Consider what Shiller is saying. If valuations affect long-term returns, investors must be able to hold two opposite thoughts in their heads at the same time. They must on one level believe that the nominal prices are real; otherwise, they could not follow Buy-and-Hold strategies. They must on another level understand that the phony prices are temporary. Otherwise, the upward price cycle could never be broken. Crashes come only after investors have worried for a long time that the phony gains are going to disappear and elect to sell before it is too late.
Investors need to believe on some level of consciousness for a long time before there can be a crash. We had a crash in 2008. So we know that investors have been worried about high prices on some level of consciousness for a long time now.
To overcome those concerns, we need to address the true worry here — Buy-and-Hold scares investors. Even those who love the strategy and follow it loyally do not really believe it can work for the long term. It’s not possible for any rational-thinking person to believe that prices could be a matter of indifference.
We need to start telling investors the truth. Valuations do matter. There is no mystical, magical world in which investors can sprinkle blue pixie dust into the air and expect a Buy-and-Hold strategy to work in the long run. When we start talking straight to investors, we will win back their confidence. The first economic recovery fueled by investor confidence will be the first economy recovery that will remain in place long enough to make a difference.