Valuation-Informed Indexing #175
by Rob Bennett
People think of Yale Economics Professor Robert Shiller as “The Bubble Guy.”
I do not.
I think of Shiller as the fellow who showed that valuations affect long-term returns. That’s the most far-reaching finding in the history of investing analysis. It changes everything.
But lots of people view Shiller as nothing more than a researcher who has strong views on the dangers of bubbles. It’s not entirely unfair that they minimize the importance of his work in this way. Shiller DOES talk about bubbles an awful lot.
Motley Fool recently published an article titled Bubbles: No One Has Any Idea What’s Going On that illustrates the problem.
The article points out that the word “bubble” did not appear in economics textbooks 20 years ago and so Shiller felt a need to define the term. He argues that a bubble exists when prices are rapidly increasing and when people tell each other stories that purport to justify the prices and when those not participating in the bubble come to feel regret for not doing so and then join in.
Fine. We obviously saw this sort of thing going on in the late 1990s, when we lived through the most dangerous stock bubble in the history of the United States. What Shiller is saying about bubbles is both correct and important.
The trouble is that it is not terribly convincing to a lot of people.
The article quotes University of Chicago Economics Professor Eugene Fama as saying: “The word ‘bubble’ drives me nuts, frankly.” Fama explains: “If I can predict that housing prices will go down, if the market is working properly, then they should go down now. Because what you’re saying is ‘I have information that prices will go down’ and that information is not in the prices, But if the market is working properly, the information should be in prices.”
Fama makes a good point. Shiller describes bubbles. There’s value in that. But describing bubbles doesn’t get to the core question. The core question is — How can bubbles exist if investors act in their self interest? And how can investors ignore bubbles if they know that ignoring them hurts them?
I have been banned from participation at 15 investing boards and blogs.
That’s the answer to Fama’s question.
Investors fail to take bubbles into account because they don’t know about them. They don’t know about them because they remove people who talk about them from the communities in which they participate. You cannot take something you don’t know about into consideration when setting your stock allocation.
Why don’t investors want to hear from people who talk about bubbles? Because it hurts.
The single most important reality of stock investing is that it is investors that set prices. There are no objective realities that determine stock prices. Prices are whatever we want them to be and just about all of us naturally want prices to be as high as possible. So the natural tendency is ALWAYS for stocks to be overpriced.
It’s a mistake to focus on bubbles because there really is nothing special about bubbles. Shiller’s breakthrough was not discovering bubbles. It was discovering that it is investor emotions rather than economic and political developments that set stock prices. This reality applies during bubbles. But it also applies at times when stocks are reasonably priced and at times when stocks are insanely underpriced. It is ALWAYS investor emotion that is setting stock prices.
The benefit of looking at how prices are set rather than at bubbles is that it is something we can test far more effectively. Bubbles are a rare phenomenon. So it is hard to prove to skeptics that what you say about them is so. Even if your predictions prove out, it might be another 30 or 40 years before there is another bubble and you will be able to get a second bubble prediction right. Fama noted that he is not impressed by anything less than 10 correct predictions and Shiller noted that he will not live long enough to get 10 bubble predictions right.
Shiller WILL live long enough to get 10 valuation predictions right.
In fact, if Shiller turned the focus to what he taught us about the effect of valuations on long-term returns (regardless of whether bubble conditions apply or not), he could point Fama to 140 years of correct predictions. I have gone through the entire 140 years of historical return data available to us. There has never yet been a single time when the P/E10 level that applied on Year A did not tell us something important about the stock price that applied tens years following Year A. Bubble predictions impress once every three or four decades. Valuation predictions always work and always offer information of great significance.
Following the next crash, we will be at a P/E10 level of 7 or 8. We won’t be in bubble territory. But it will be very important for us all to be paying attention to valuations. The collective losses we will suffer going down to 7 or 8 will be in the trillions of dollars and we will be at risk of going into the Second Great Depression. If we tell investors that the losses were caused by economic factors and that there is no good side to the price drop, people will feel depressed and tempted to give up. But if we point out that the most likely annualized 10-year return on stocks purchased when the P/E10 level is 7 or 8 is 15 percent real, people will have reason to hope for a future better than the then-present.
Bubbles are an important topic because valuations are an important topic. But it is a mistake to focus too much on bubbles. It is valuations that matter. It is his finding that stock prices are set by shifts in investor emotions rather than by economic developments that is Shiller’s most important contribution.