Valuation-Informed Indexing #109

by Rob Bennett

The stock market is not like any other market.

Markets set prices properly. That’s what they do.

Say that you were going to buy a used car. And say that you were not willing to spend any time negotiating. You were going to walk onto the lot and pay the price asked for the model you sought. Would you be raped?

You would not be raped. You would overpay. The dealer sets the asking price by assuming that negotiations will follow. So those who can’t be bothered pay more. That’s fair, isn’t it? Negotiating with car dealers is a pain. Those of us who negotiate deserve a price break over those who don’t.

But the overpayment would only be a few thousand dollars. Dealers don’t dare to set asking prices more than a few thousand over what they expect to be the selling price because to do so would drive away potential customers. An asking price that is $10,000 above the expected selling price sends a signal to possible buyers that this dealer is not to be trusted.

It doesn’t work that way with stocks.

Stocks were priced at three times fair value in 2000. Those who contributed $1,000 per month to their Section 401(k) accounts paid $12,000 for stocks and obtained only $4,000 worth of return-producing goodness in exchange for their dollars. No car dealer would dare to ask $12,000 for a car with a true value of $4,000. How is it that those selling stocks can get away with it?

The problem is that we are not clear in our minds as to who is the buyer and who is the seller.

The car dealer wants a high price. The car buyers wants a low price. Each of the parties to the transaction is clear as to his or her role. That’s why the car market does so much better a job of setting prices.

The stock market is dysfunctional. Prices go up and what happens? People who are in the process of accumulating stock portfolios to finance their old-age retirements cheer! We do! Most of us are stock buyers until we reach retirement age, when we start to sell off our portfolios rather than add to them and thus become net sellers. But in all those years in which we are buyers we root for higher prices. That’s crazy. That’s why the stock market is the one market that does a poor job of setting prices.

I have a calculator at my site that permits you to quantify the effect of this crazy behavior. You can enter into the calculator whatever assumptions you want as to how stocks will perform for various time-periods so long as you honor the “Iron Law” (Bogle’s term) of stock investing that prices always revert to the mean (for the U.S. market this means that the long-term average return is always something in the neighborhood of 6.5 percent real). The calculator shows that the best thing for investors buying stocks each year is for prices to fall for many years. But how many of us rejoice at news of price drops?

We get fooled by the fact that we own stocks.

If gas prices go up and that causes the price of a car we are looking to buy to fall, we laugh at the misfortune of the car dealer forced to cut a better deal. It’s not our problem! At least not until we buy the car. Then we want the car to retain its value. During the buy phase, though, price drops are perceived as a good thing.

When we hear about stock prices dropping, our first thought is not of the stocks we will be buying next week re which we will be paying a lower price. We think of those shares we already own and we feel that something is being taken from us when we recalculate the value of our portfolios and arrive at a smaller dollar figure. We are better off overall when prices fall. But the many shares we will be acquiring in coming years are abstractions. The shares we already own seem more real. Those price drops hurt emotionally.

So the market does a horrible job of setting prices. The people who sell stocks naturally want higher prices. Why not? The people who buy stocks want higher prices too, for the reasons described above. And the people who earn commissions on the transactions want higher prices too because higher prices translate into bigger commissions. When every party to a transaction wants the same thing, that thing is the thing you see take place.

Why do prices ever fall?

It’s this common-sense thing we cannot shake. We like price increases. But they scare us. We ignore the fears and we ignore the fears and we ignore the fears and then one day we cannot ignore the fears anymore and we causes prices to crash.

Car prices don’t crash. There is no need for crashes in car prices because the market sets prices effectively enough so as not to require them. It’s only in the stock market that you see price crashes. The market couldn’t survive unless it figured out some way to get prices down again at least once every few decades. Price crashes are a survival mechanism.

Can we change? Can we improve?

We better. There’s a lot of money tied up in the stock market today. Unless we do something about the dysfunction of this crazy market, the price crashes will grow so big that our economic  system will no longer be able to take the hits. We all need a sane stock market. We all need to start caring about paying a good price when we buy the stocks we buy.

Rob Bennett believes that we all need to adopt a new vision of retirement purpose. His bio is here.