Valuation-Informed Indexing #224

by Rob Bennett

Please take a look at the following series of numbers:

25, 6, 33, 6, 22, 9, 24, 7, 44

If the pattern evidenced in this series of numbers continues, which of the following numbers will come next?

(1) 25 or something in that neighborhood

(2) 15 or something in that neighborhood

(3) 8 or something in that neighborhood

(4) It’s impossible to say, there is no pattern evidenced in the above series of numbers

I took the nine numbers in the series above from Yale Economics Professor Robert Shiller’s site. Shiller reports at his site the P/E10 value for every month from 1870 forward. The numbers above are the P/E10 values that occurred at the high and low ends of each of four secular bull and bear markets we have experienced during that time (the next number will be the low end of the secular bear market that began in 2000). From 1870, the P/E10 value continued climbing (with temporary drops mixed in, to be sure) until it hit 25 or so. Then it fell until it hit 8 or so. Then it rose until it hit 25 or so. And so on.

We have been working our way down from 44 since January 2000. If the pattern that has applied without fail for 140 years now continues, we will not see this secular bear market end until we hit 8 or something in that neighborhood. That’s a price drop of 65 percent from where things stand today.

That’s the bad news.

Fortunately, the good news here is ten times more good than the bad news here is bad.

The good news follows from making an effort to understand why this pattern plays out over and over again.

The P/E10 value goes up and up and up and then the P/E10 value goes down and down and down. Why?

Investors like high P/E10 values. The P/E10 value remains the same in every year in which stock prices rise by 6.5 percent real. When stock prices rise by less than that, the P/E10 value falls. When stock prices rise by more than that, the P/E10 value rises. What the pattern shows is that the natural inclination of investors is to push the P/E10 value up, up, up.

Until something happens.

When the P/E10 value hits 25, or in one case 33 and in another case 44, something happens. Common sense intrudes on the happy belief that investors can push stock prices as high as they like without consequence. Once that happens, irrational exuberance is transformed into irrational depression. From that point forward, prices go down, down, down. Not just until prices are back at fair-value levels. Prices continue going down until they reach a level of one-half fair value. Only then do they begin working their way back up again.

The good news is that there is no reason to believe that this pattern is locked in stone. It is rooted in human psychology. We all posses a Get Rich Quick impulse. And we all possess common sense. The Get Rich Quick impulse is strong enough to push the P/E10 value to 25, or perhaps to 33, or perhaps even to 44. But common sense always overcomes it eventually and sends the P/E10 down to 8 again.

So the conventional understanding that it is economic developments that cause stock price changes is wrong. Economic developments should play out in a random walk. The series of numbers put forward at the top of this column is not a random series of numbers. It is not possible that this same pattern could repeat over and over again for 140 years as the result of coincidence. This series of numbers is telling us that stock prices are determined by shifts in investor emotion, not by economic developments.

Which means that we can change the pattern.

Investor emotion can be changed through education. We didn’t know what caused stock price changes until Shiller published the research showing why this series of numbers is significant. Now we do. We haven’t made much use of Shiller’s revolutionary (his word) findings in the 33 years since he came forward with them. But we could start doing so. By educating investors as to how they cause prices to swing wildly upward and then wildly downward, we could change the world in a very positive way.

The conventional view is to think of the boom/bust cycle as an economic problem. Businesses sell lots of products and services. So they hire more workers. That puts more money in people’s pockets. So people are able to buy more goods and services. The cycle feeds on itself until it stops, then its reversal feeds on itself.

But the biggest influence on the cycle is the increase in stock prices evidenced in the series of numbers put forward at the top of this column. The stock market was overpriced by $12 trillion in January 2000. The economy naturally crashed hard when trillions of dollars in spending power was taken out of the portfolio accounts of millions of investors in late 2008. And it will crash again when the P/E10 resumes its march downward.

The wonderful thing about the part of the boom/bust cycle caused by stock overvaluation is that the problem of stock overvaluation can easily be solved. Most investors are not aware when stock prices rise so high that stocks no longer offer a strong long-term value proposition. But people like to act in their self-interests. The millions of investors who follow Buy-and-Hold strategies when buying stocks are price conscious when they purchase cars and sweaters and bananas. They would be price conscience when buying stocks too if the experts in this field provided them with tools helping them to understand how much they delay their retirements by failing to exercise price discipline when buying stocks.

Bringing the boom/bust cycle to an end would be a huge advance. Not only for stock investors. It would be a huge advance for capitalism. It would mean a more stable unemployment rate and it would permit workers to plan their financial futures more effectively.

When we push investing strategies that cause price crashes, we don’t only hurt the investors who listen to our advice. We cause millions to lose confidence in our economic system and ultimately in the political system in which it operates.

Rob Bennett has recorded a RobCast titled Stock Cycles. His bio is here.