Valuation-Informed Indexing #113

by Rob Bennett

We tell millions of middle-class people to invest in stocks to finance their retirements. Stocks are real. Stocks are a respectable investment class.

Or are they?

The full truth here is that at least one leading figure in the field, Yale Economics Professor Robert Shiller, has argued that during bull markets stocks become a Ponzi scheme. Shiller’s book was widely read and widely praised. But there has been little discussion of Shiller’s charge that stocks can become for long periods of time (we have been at bull market prices from 1996 through today — that’s 17 years!) a disreputable asset class, a fraud. Just about all of us have money in stocks. We think of Ponzi schemes as dirty stuff and we don’t like thinking of ourselves as participating in Ponzi schemes.

I think that we need to look at the question. There are good reasons why we think of Ponzi schemes as dirty. If the stock market really can for a long period of time become a Ponzi scheme, we need to examine whether we should be investing in it at those times and encouraging our friends and neighbors and co-workers to do the same.

To understand where Shiller is coming from and why his charge comes across as so shocking, you need to understand the history of our efforts to learn how stock investing works.

Research done in the 1960s and 1970s indicated that the stock market is efficient in how it sets prices. If this were so, the market would never be a Ponzi scheme. The conventional view, based on this research from three and four decades back, is that those who buy shares in the market are buying shares in U.S. productivity. We call Ponzi schemes “fraud” because the promotors of Ponzi schemes sell air to their marks. Ponzi schemes are not real. Ponzi schemes cannot work. That’s why they are not respectable. That’s why we warn people about them rather than encouraging them to invest in them.

The stock market is real. There are real firms selling real goods and generating real profits. A market for the selling of real goods is not a Ponzi scheme. There’s nothing shameful about buying or selling stocks, according to the conventional thinking.

But what if the idea that the market is efficient is a fantasy, as Shiller’s research shows? If that’s so, the term “Ponzi scheme” really does fit. That’s why Shiller’s book makes the case that the stock market is a Ponzi scheme at times of excessive prices.

The market was priced at three times fair value in January 2000. This was of no concern to those who believe in the Efficient Market Theory. To those who believe in market efficiency, the overvaluation was an illusion. An efficient market is one that takes all relevant factors into consideration in setting prices. Another way of saying it is that an efficient market is one which is always priced properly. Setting the price where it would be if all relevant factors were taken into consideration is the proper thing to do, no?

Shiller disputes the idea that investors set prices properly (and puts forward  research that supports his case). If the finding that stocks were priced at three times fair value in 2000 were an illusion, the P/E10 level (Shiller’s valuation metric) would tell us nothing about where stock prices would be in 10 years or in 20 years. But Shiller’s research shows us that today’s P/E10 level does predict the price that will apply 10 years and 20 years out. The P/E10 value is telling us something real. Overvaluation is a real phenomenon.

Overvaluation is fraud.

We don’t often say it that way. But that’s a fair way of putting it.

Someone who bought $30,000 worth of stock in the year 2000 in reality purchased $10,000 worth of stock and $20,000 worth of air. That’s why his returns have been so poor. The profit-generating stock (the real part of the transaction) has been providing a return close to the 6.5 percent real return that has been the long-term average for U.S. stocks for many years. But the zero return provided by the air portion of the transaction has been pulling the overall return down to a level not much greater than zero on an inflation-adjusted basis. Stocks truly are a super investment class. Air is a truly horrible one!

Selling people air is fraud. No?

We don’t think of it that way because for many years we didn’t know that we were selling people air. Shiller’s breakthrough research was published in 1981 and his book was not published until 2000. So people are only now beginning to appreciate the far-reaching implications of his work. But I do think that it is fair to say that, if Shiller’s ideas hold up (and all signs are that they will), we are as a society going to in time come to the conclusion that selling people stocks at times of insane overvaluation is an act of fraud, a dirty, disreputable thing to do.

Will we be shutting down the stock market at times of overvaluation.

Actually, that won’t be necessary. Shiller is a teacher. He has taught us things we did not know before. Once we process the insights, we will not only understand that selling stocks at a time of insane overvaluation is an act of fraud but also that stocks become less appealing as they become increasingly overpriced. Once that reality becomes common knowledge, we will never again see insane overpricing. Unwarranted price increases will cause sales and the sales will pull prices back to reasonable levels.

Stock investing is a dirty business today. We don’t like to accept that that is so. The good news is that, once we do work up the courage to accept it, we will come to possess the enhanced understanding of how stock investing works that we need to possess so that the unfortunate reality will no longer apply. Shiller’s showing that the stock market is a Ponzi scheme at times of high prices will allow us for the first time to discover what it is we need to do as investors to insure that the stock market never again becomes a Ponzi scheme.

Rob Bennett has written an article titled The First Retirement Calculator That Gets the Numbers Right. His bio is here.