Valuation-Informed Indexing #242

by Rob Bennett

Yale Economics Professor Robert Shiller argued in his recent presentation to the Credit Suisse Group Asian Investment Conference that stocks are overpriced today not because of the irrational exuberance that he used to explain the runaway valuations of the late 1990s but because workers are anxious about their futures. He told the group that: “People today are worried about their future, and that is part of the reason why asset prices are so high….It seems obvious to me that we are living in a time when people are thinking ‘the job I have today might be obsolete in ten or twenty years.’ I think it reflects a deep anxiety and I think it must have ramifications in financial markets.” Shiller’s thought is that people are saving more than would be expected during an economic recovery and that the added saving is pushing stock prices up.

I think it is wonderful that Shiller is talking about this subject. I would like to see many more people in this field address the psychological drivers of market performance rather than the economic factors. The economic factors have been examined in great depth. Rarely do we see good analyses of the psychological factors. And Shiller is of course the master in this niche. Perhaps he is picking up on things that I am not able to see only because my knowledge base is not as strong. But I do not find the Shiller explanation entirely convincing.

People are certainly worried about their jobs. The factor that Shiller is pointing to is a real one.

And it certainly makes sense to think that this factor would indeed have ramifications in financial markets, as he suggests.

The problem that I have with the Shiller analysis is that he seems to be saying that opposite sorts of emotional takes could produce the same result. Investors were irrationally exuberant in the late 1990s. That caused prices to rise to insanely dangerous levels. Now investors are not exuberant but anxious. And the anxiety too leads to high prices. When investors are happy, they push stock prices up. When investors are unhappy, they push stock prices up. In Shiller’s world, investor emotion always pushes prices up.

I know that he doesn’t really think this. But I can’t say that I have ever heard Shiller address himself to the question of what causes investor emotion to pull prices down to insanely low levels. It may just be that he is usually asked to explain current realities and we haven’t seen insanely low stock prices since the early 1980s. But I think it would aid our understanding of how the market works if we all put a bit less focus on explaining bubbles and a bit more on explaining their opposite.

I certainly agree with Shiller that investors were irrational in the late 1990s. Stock prices rose to three times fair value. The dollar value of the overvaluation was $12 trillion. That was dangerous stuff.

I am tempted to say that what we did in the late 1990s made no sense. But in one respect that’s not so. That $12 trillion was reflected in the numbers on our portfolio statements. We were fooling ourselves. The money was Pretend Money. We are now in the process of paying back the huge debt that we incurred to our future selves when we permitted that runaway bull market to continue so long. But, while the word “irrational” certainly applies, there is at least one sense in which what we did in the bull market was understandable.

We created Pretend Money. Pretend Money is fun. We were like bank robbers. Bank robbery is irrational because it is ultimately a self-destructive event. Still, we all know why bank robbers do what they do. They want the money! Bull markets, as irrational as they are, can be explained as simply. We want the money! Bull markets are irrational but they are irrational in an understandable sort of way.

Bear markets are harder to figure out. Bear markets are every bit as irrational as bull markets. But there is no fun in them. When we push valuations down to one-half of fair value rather than up to double fair value, we are not creating Pretend Money but Pretend Poverty. Why? What could motivate us to do that?

We create Pretend Poverty because our spirits are crushed when we come to accept the long-term damage we did to ourselves when we created Pretend Money. Bull market prices are a lie. We know that on one level of consciousness even when we are telling the lie to ourselves. When the lie is found out, we feel bad about what we have done and lose confidence in our ability to manage our affairs effectively. So for a time we undervalue our work product rather than overvalue it. It takes time for us to come to terms with the mistakes we made in the past, forgive ourselves, and develop the courage we need to face a new day on its own terms.

Investors are worried about their jobs. I don’t think that Shiller is wrong about that psychological reality. But investor anxiety should pull prices down, not up. If anxiety re future employment were today’s dominant emotional reality, we would be seeing a P/E10 level far below fair-value levels rather than far above them.

The primary determinant of stock prices is not the stories that investors tell themselves about why the economy is booming (Shiller points to these stories as his explanation for the P/E10 levels we saw in the late 1990s and early and mid-2000s) or the worries they feel over their future but just their simple desire for high stock prices. That psychological reality always applies. Investors always want prices to be higher and always possess the ability to push them higher. So the general rule is that that is what they always aim to do.

The check on that primary reality is that investors possess common sense and can thus push prices only so high before they lose confidence in their ability to push them any higher. Then prices unwind and the unwinding causes investors to experience feelings of self-loathing for having engaged in the multitude of self-deceptions that make a bull market. Bull markets are a natural phenomenon that inevitably cause bear markets and economic crises.

Prices are high today not because investors are worried about their jobs (although of course they are) but because they have not yet allowed enough common sense in to send prices spiraling downward. We let a little common sense in a few years back and the crash that resulted frightened us enough to cause us to pull back and try to believe in at least some of the self-deceptions a little while longer. We have accepted that the bull market was largely phony. But we cannot yet accept just how phony it was. So we live today in a twilight zone in which valuations cannot return to the levels we saw in the late 1990s until they have fallen to the levels we saw in the early 1980s but in which we cannot bear just yet to permit the 65 percent price drop that that entails.

The relevant fear is not that we will

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