Valuation-Informed Indexing #106
by Rob Bennett
People are having a hard time accepting that Buy-and-Hold Investing caused our economic crisis, an economic crisis that is likely to turn into the Second Great Depression unless steps are taken to head off that possibility. I view it as important that we launch a national discussion of the question, for obvious reasons.
I’m thinking that perhaps I should try a different angle. Maybe we will feel more comfortable talking about things if we go back in time to the First Great Depression, the one that started in 1929.
I entered the phrase “Cause of the Great Depression’ in the Google search engine and turned up an article titled “Top Five Causes of the Great Depression.” Here are the top five causes listed: (1) Stock Market Crash of 1929; (2) Bank Failures: (3) Reduction in Purchasing Across the Board; (4) American Economic Policy with Europe; and (5) Drought Conditions.
I was happy to see that the 1929 crash was listed as the primary cause. I believe strongly that the 2008 crash was the primary cause of today’s economic crisis, but you rarely even hear that possibility mentioned. My sense is that the stock market plays a bigger role in middle-class life today (only the rich had enough money to invest in stocks in the 1920s) and so the issue is just too delicate for too many of us. Anyway, we seem okay with assigning blame for the earlier depression at least in part to that day’s stock crash.
Now let’s consider the other factors listed. Aren’t they all things that could well have followed from the crash? Yes, we had bank failures. People had just lost most of their money in a stock crash! So what would you expect? I think it would be fair to say that these purported causes might be only secondary factors, things that themselves were caused by the crash and that then went on to cause the economic crisis. If that were so, it would really be that nasty stock crash that caused all the trouble.
The same general pattern applies today. People say that it was mortgage failures that caused the economic crisis. But wouldn’t a crash in stock prices cause mortgage failures? People say it was the unexpected performance of derivatives. Okay. But wouldn’t derivatives perform in funny ways following a price crash? Could it not well be that all of the factors that we put forward to explain the economic crisis were only secondary factors and that the primary factor was the price crash?
If the stock crash was the primary problem, then we don’t need to worry much about addressing the other factors. If they were secondary causes, we just need to address the problem of stock crashes. It’s obviously easier to solve one problem than five or six.
I know the objection that many people will raise to what I am saying here. They will argue that the fact that stock crashes always occur at the same time as economic crises does not prove that stock crashes cause economic crises. It might be that the causation is the other way around. Perhaps stocks always crash when any of a big number of possible factors cause the economy to go bad. That would make sense.
It would make sense in other circumstances. But the full reality here is that it is a way of explaining things that is not in accord with the facts available to us.
If it were bad economies causing price crashes rather than price crashes causing bad economies, price crashes would take place randomly. We never know when the economy is going to go bad. If it is the economy going bad, price crashes should turn up unexpectedly. They should be unpredictable.
That’s not even a tiny bit true. Price crashes are highly predictable.
Once the P/E10 level reaches 25, we always have a price crash. We have hit 25 four times in U.S. history. We have had four price crashes in U.S. history. Not at random moments. The first time we hit 25, we had a price crash and an economic crisis. The second time we hit 25, we had a price crash and an economic crisis. The third time we hit 25, we had a price crash and an economic crisis. The fourth time we hit 25, we had a price crash and an economic crisis. We have never had a price crash or an economic crisis without first hitting 25.
This is an exciting finding. If we learn that price crashes cause economic crisis, we know how to avoid economic crises. Stop price crashes!
Can we do it? My guess is that the reason why more people don’t explore this line of thinking is that most people don’t think we can do much to stop price crashes. So, even if it turns out that price crashes really do cause economic crises, there’s not going to be much that we will be able to do about it.
But there is!
If we tell investors that stocks are far more likely to crash when prices are high, investors will naturally want to go with lower stock allocations when prices are high. If large numbers of investors adopt a policy of lowering their stock allocations when prices rise to high levels, guess what? We can never again have high prices. Prices cannot get too high if investors respond to high prices with sales.
And if prices cannot get too high, we cannot have crashes! Or economic crisis! We have just solved the problem of economic crisis!
Some will say that The Stock-Selling industry is never going to go along with the idea of warning investors to sell stocks once prices get too high. Perhaps not. But that’s not so unusual. The car industry doesn’t tell people not to pay high prices for cars. The Stock-Selling Industry is like all other industries in wanting to convince people that its product is worth buying at any price.
There’s one respect in which stocks are different, however. With all other goods and services, the industry selling them wants people to buy regardless of price but the consumers doing the buying are too canny to fall for the tricks. Most of us know to tune out marketing mumbo jumbo aimed at persuading us to pay high prices for products and services.
What if we followed the same principle when buying stocks? What if stock investors learned about the 30 years of academic research showing that stocks are not worth buying at high prices, that super-safe asset classes like money market accounts do better in the long run than stocks when stocks are selling at high prices?
That would change everything. That would in all likelihood bring an end to economic crisis.
Should it become a major public policy initiative to get the word out about that 30 years of academic research? I sure think so.