Valuation-Informed Indexing #162

by Rob Bennett

The first 12 years of my journalism career were devoted to writing about budget and tax legislation working its way through Congress. I felt that the issues I was writing about were important and I worked it hard. After a time, though, I began to lose confidence that we were ever going to see our lawmakers take serious action to solve the deficit problem. I’m slow to catch on!

I left that kind of work behind to focus on personal finance journalism. My thought was that, in the personal finance realm, it is possible to share information directly with readers that they can use to improve their lives. No politicians messing things up! I figured that I would see more positive and constructive and life-affirming results that way.

The joke was on me!

The sad reality is that the same human weaknesses that causes the budget deficit draw us to Get Rich Quick investing strategies. The politicians aren’t doing the job they need to do, that much is so. But it’s not because politicians are by nature bad people. It’s because politicians need to get elected to remain politicians. And the politicians who take serious steps to address the deficit problem don’t win elections. The people doing the voting don’t want to hear the realities spoken out loud.

It’s the same story in the investing realm. The big shots in this field recommend Buy-and-Hold strategies. Not because they are bad people. Because that’s what sells. Everybody knows that spending more than you earn cannot lead to anything good and everybody knows that not taking price into consideration when buying stocks cannot lead to anything good. But we all like to pretend that we do NOT understand. So those who want to make it in the political realm play along with us. And those who want to make it in the investing realm do the same.

The problem is actually worse in the investing realm. The level of stock overvaluation that we have seen in recent years does far more harm to our goal of achieving economic growth than do today’s budget deficits.

This can be shown with numbers.

The Federal Debt is something in the neighborhood of $15 trillion. That’s the aggregation of every annual budget deficit going back to the days of George Washington. It’s a big number. We all should be ashamed that we have collectively permitted the number to rise so high.

We should be even more ashamed of the stock overvaluation problem of recent years.

Those numbers are worse.

Stocks were overpriced at the top of the bull market by only (!) $12 trillion. But the total problem is bigger than what that plenty-big-enough-all-on-its-own number suggests.

Once a bubble bursts, stock prices never return just to fair-value levels and then stop falling. The bursting of a bubble always brings on an economic crisis and the economic crisis always causes stock prices to continue falling until they reach levels of one-half the fair-value level. That’s another $4 trillion of losses we will be seeing in coming years. Bringing the total amount of economic dislocation up to $16 trillion.

And the stock bubble is not the only bubble that we are trying to recover from today. When we told investors that they possessed $12 trillion more in wealth than they really possessed, they naturally went looking for things to do with that money. One of the things they did was to buy enough real estate to send real estate prices into bubble territory too. We are in the process of experiencing the bursting of $4 trillion in inflated real estate prices that were to a large extent caused by the $12 trillion in inflated stock prices.

That brings the total amount of economic dislocation to $20 trillion. On top of that we have the government spending that was directed at stimulating the economy so that we would survive the financial crisis, money that we could have directed to other purposes if only we had not permitted stock prices to get so out of hand. We are more than $20 trillion in the hole as a result of our foolish desire in the late 1990s to pretend that our stock portfolios were worth a whole big bunch more than they really were worth.

There’s a good-news side to this story.

Solving the deficit problem is a toughie. The only two ways to make progress are to increase taxes or to cut spending and there are of course interest groups hotly opposed to both alternatives. So that one goes around and around and around. You get the sense at times that, like the poor, big budget deficits will be with us always.

It’s not that way in the investing realm.

We didn’t know that valuations affected long-term returns until Yale Economics Professor Robert Shiller published research showing that to be the case in 1981. So we now have a weapon that can be used to stop bull markets from forming that we never possessed before. Teach investors how stocks offer a poor long-term value proposition when prices get too high and no bull market will ever again be able to sustain itself. Stock prices are self-regulating in a world in which knowledge of the implications of Shiller’s “revolutionary” (his word) findings is widespread.

There is no downside to taking action against the stock overvaluation problem as there is to taking action against the budget deficit problem. In the stock realm, addressing the problem is good stuff piled upon good stuff piled upon good stuff. Dealing with the overvaluation problem permits us to change stock investing so that returns will be on a going forward basis much higher than they have ever been before while risk will be greatly diminished from what it has ever been before.

Hey! Maybe the joke will not turn out to have been on me after all!

Rob Bennett has recorded a podcast titled What Your Money or Your Life Taught Me About Investing. His bio is here.