Valuation-Informed Indexing #310

by Rob Bennett

Most articles that discuss the problem of stock overvaluation refer to “bubbles.” Investors are warned that bubbles pop. They are informed of the risks of price bubbles but also told that it is hard to identify price bubbles.

Bubbles are clearly perceived as a negative. The term is a pejorative; nobody says “I just love to invest in bubbles!” But the sense that is usually conveyed is that bubbles are something that investors just need to accept.

Bubbles show up from time to time. But no one can say for sure whether a particular price jump has sent the market into bubble territory or not. It doesn’t make sense to avoid stocks altogether. So the smart stock investor needs to learn how to live with bubbles. They are an annoyance, not a deal-breaker.

This is the wrong way to think about bubbles, in my view.

A bubble is an extreme event that comes about as the result of many years of wrongheaded thinking about how the market works by many people. The true problem is not the price bubble. The true problem is the wrong-headed thinking that produces it.

A better way to think about the problem of overvaluation is to compare a market in which investors are not exercising price discipline to a car lacking brakes. Someone who is planning to buy a car does not spend much time researching the brakes it contains. He more likely focuses on the power of the engine. He wants to know what powers the vehicle; it is the fact that they move quickly that gives cars their appeal.

But we all assume that the cars that we buy do indeed have brakes installed. If the buyer of a new car learned that it did not contain brakes, he would call a tow truck to have it returned to the dealer. He wouldn’t even dare to make the return trip in the brakeless vehicle. Brakes are a boring part of a car but a very important part too in the eyes of all car buyers.

Stock crashes are as painful financially as car crashes are physically. The difference is that cars without brakes crash quickly and so the problem is discovered quickly. There is no phenomenon that causes markets full of investors not exercising price discipline to crash quickly. Price increases can pile on top of one another for years before producing negative results. And by then the runaway market has picked up so much speed that the damage done is devastating to millions. Stock market investors suffer The Curse of the Slow Feedback Mechanism.

Talk about bubbles gets us thinking about the wrong things. We use the word “bubble” because the dramatic thing about a stock crash is the “pop” that causes trillions of dollars of spending power to disappear. But the sad reality is that there is little that can be done about bubbles. Since they are defined as “things that pop,” it really is so that we can not identify bubbles in advance. We know that “that was a bubble!” only after we have heard the pop and experienced the life-changing (in a negative way) losses.

The best that we can do is to speculate that prices have been going up so quickly for so long that it kinda, sorta feels like there’s a bubble out there waiting to pop. That’s vague. And the very thing that makes a bubble dangerous (the insanely high prices) creates widespread resistance to the idea that the market has entered bubble territory. Bubbles sell stocks, so the experts in the field will go to any lengths to rationalize high prices as representing something other than a bubble. Bubbles sell newspapers, so the stories written about what the experts are saying place their comments in a favorable light. Bubbles make retirements seem more in reach, so the millions of investors who stand to be done great harm by the bubbles possess a huge desire to believe any story that undercuts any case being made that one exists.

Once there is a bubble, it’s too late to do anything about it. That’s the bottom line.

We need to adopt a new way of thinking about stock overvaluation, a way of thinking that promises benefits to investors who adopt it. The key to success in any market is the exercise of price discipline. Price crashes are not a mysterious phenomenon visited on investors for unknown reasons but the inevitable result of a lack of exercise of price discipline by the investors participating in the market. Price crashes follow when we drive a car without brakes, when we invest in a market filled with investors who believe in the merit of Buy-and-Hold strategies.

Investors naturally want to act in their self-interest. Investors who are informed of the findings of the last 35 years of peer-reviewed research in this field will lower their stock allocations as prices increase and the long-term value proposition of stocks diminishes. Those sales will supply brakes to the car. A market filled with price-sensitive investors can never develop bubbles.

The bubble problem can never be fixed. One there is a bubble, it’s too late for any fixing efforts to succeed. The investors who created a bubble are emotionally invested in keeping it growing.

But the problem of a lack of price discipline can be addressed through education. The reality is that all overvaluation is a bad thing; small amounts of overvaluation lessen the value proposition in the same way as the large amounts of overvaluation that are referred to as “bubbles,” just to a lesser degree. Investors taught to object to all overpricing (as the participants in all markets other than the stock market have been taught to object to all overpricing) will tap the brakes each time a little bubble-generating irrational exuberance is applied to the engine.

Bubble cannot be prevented in markets lacking price discipline and cannot develop in markets possessing price discipline. Talk about bubbles wastes our time. Our focus should be on educating investors on the need to always exercise price discipline so that bubbles become a thing of the past.

Rob Bennett’s bio is here.