Valuation-Informed Indexing #117

by Rob Bennett

This November’s election results will likely cause a stock crash within a year or so. I believe that that’s so REGARDLESS of whether Barack Obama or Mitt Romney is the winner.

My starting point is that I do not believe that it is economic developments that cause stock price changes. If it were, it would not be possible to predict stock returns. But Yale Economics Professor Robert Shiller’s research shows that it IS possible to predict long-term returns using today’s P/E10 value. It has ALWAYS been possible to do this. This has been so for the entire 140 years for which we have return data available to us.

If it is not economic developments that cause price changes, what causes them? Shifts in investor emotion. Investors like to see big numbers on their portfolio statements because it makes them feel better about their retirement prospects. So they bid prices up to crazy levels. But investors possess common sense and worry that the crazy prices are not sustainable. So eventually a point is reached at which investors bid prices down rather than up.

It is emotion that drives the market. That is the important point here.

It is because emotion drives the market that both bull markets and bear markets are stretched out so long. If we were rational, we could have bid stock prices down to fair-value price levels back in early 2009 and then kept them there. Instead, we got scared by the loss of wealth we would suffer if we let prices remain at far-value prices and bid prices up to high levels again. Now we are trying to work up the courage to face the music once again.

It’s hope that keeps us hanging on. So long as we can maintain hope that another price crash is not required, there will not be one. Once we give up hope in the fantasy, the fantasy goes “Poof!”

Our hope comes in two different flavors. Democrats have hope in President Barack Obama. Sure, he hasn’t brought on an economic recovery yet, they acknowledge. But he’s trying! He’s doing the best he can! If only he is reelected, his policies will have time to work. Re-electing Barack Obama is the key to keeping our hopes for an economic recovery alive, according to about half of the American public.

The other half sees hope in replacing Obama with Romney.  This group blames Obama for the continuation of economic bad times. Fire that Barack Obama fellow and the good times will begin rolling once again, this group believes.

Now —

Say that Romney wins. What is going to happen to the hopes of the Barack Obama followers? These people are going to lose hope in an economic recovery. Their hope has been under assault for a long time now. Things have not gone the way they wanted to see them go. But they held off the temptation to fall into despair with the thought that Barack Obama’s reelection would give his policies another four-year test. Romney’s election would undercut those illusions. These people are not going to change overnight from believing that Barack Obama’s policies are the answer to believing that Romney’s policies are the answer. Half of the population is going to give up hope for an economic recovery if Romney wins the election.

What if it is Obama that wins? Then the other half of the population gives up its illusions! The Romney people have been feeling mighty discouraged during the past four years. They get through each day by telling themselves that Obama won’t be reelected, that Romney will be coming in soon. An Barack Obama win would make this half of the population feel as bad about the future as the Obama supporters will feel in response to a Romney win.

It gets worse.

You might think that the saving grace from a hope perspective if Barack Obama wins is that the Barack Obama voters will feel renewed hope. They will. For a time. But if the theory behind the Valuation-Informed Indexing model is on the mark, it is not economic conditions that are causing our troubles — it is the largely ignored reality that we borrowed $12 trillion from future investors to pay for the bull markets of the late 1990s and that we now need to pay that money back. Obama’s policies cannot make up for the $12 trillion in lost wealth we caused by letting the bull market get so out of hand. So the hopes of the Obama supporters that Barack Obama will turn things around in a second turn will not be vindicated.

It may take a year for the Obama voters to recognize that the second term is going much the same as the first term. But, when they do, it is going to be a big letdown. It will not work for them to tell themselves that they just need to hold out for the next election one more time. Barack Obama’s reelection is likely to cause Romney voters to lose hope in an economic recovery immediately. It is likely to cause Barack Obama voters to lose hope sometime within the following 12 months.

Not that a Mitt Romney election will produce a better result. A Mitt Romney election will cause Romney voters to lose confidence in an economic recovery. They too have been waiting for the election to usher in better times. But, again, if it is not economic policies that are our problem, neither a continuation of today’s economic policies nor a change in today’s economic policies can help us. If Mitt Romney is elected,Barack  Obama voters will lose hope quickly and Mitt Romney voters will lose hope within the following 12 months.

I am NOT preaching Doom and Gloom. I do not believe that we are doomed. I do not believe that gloom is appropriate.

What I believe is that we need to lose confidence in false hopes before we will be willing to take on the job of developing a new investing model that will permit us to put the nasty bull/bear cycle that has capsized our economic system four times now behind us once and for all. The election may serve as the catalyst we need to get this constructive process going.

Rob Bennett has written extensively about the risks of holding overvalued stocks in retirement. His bio is here.