Valuation-Informed Indexing #313

by Rob Bennett

I argued last week that the 37 percent loss experienced for U.S. stocks in 2008 was largely a mirage. Contrary to the core premise of the Buy-and-Hold Model, stock price changes do not reflect rational reassessments of the value of stocks made by investors in response to unforeseen economic developments but primarily emotional responses by emotional human investors. Investors over-reacted to the bad news of 2008 and then compensated for the overreaction over the course of the following eight years, causing gains that have exceeded by a good bit the average long-term gain for U.S. stocks.

It’s a different way of thinking about what is happening when stock prices change over time, one that I find more in tune with both common sense (price discipline is critical in all markets other than the stock market and so it is hard for me to accept that investors don’t need to adjust their stock allocations in response to big changes in the price of stocks) and with the 145 years of return data available to us for review (the last 35 years of peer-reviewed research shows that valuations affect long-term returns and that would not be possible in a world in which the market was efficient and returns played out in the pattern of a random walk).

I noted that this new way of thinking about how stock investing works does not permit us to know with precision how stocks will perform over short periods of time. I recorded numerous podcasts in the months following the crash of 2008. Once the P/E10 value dropped to reasonable levels (it ultimately fell to 13, which is a bit below the fair-value P/E10 number of 15), I advised listeners that stocks offered a strong long-term value proposition. So I think it would be fair to say that I was not taken in by what most would agree today was the excessive pessimism of those days. However, I did not increase my own stock allocation (I have been at zero stocks since the Summer of 1996) because the P/E10 value always drops to 8 or lower before a secular bear market comes to an end and I was not in financial circumstances where it was a good idea for me to take on even short-term losses.

This new way of thinking about what causes stock price changes has many far-reaching implications.

I am arguing that stock price changes are caused primarily by investor emotion. This means that stock price changes are to a large extent irrational. It does not mean that they are entirely irrational. Emotional reactions often are rooted in something real. A jealous lover who kills his rival for the affections of his beloved is not acting in a rational manner but there is clearly some sort of logic driving his behavior — losing a loved one hurts. Since all investors are human, I do not consider it too terribly far-fetched to believe that something similar is going on when investors reprice stocks. We take into consideration events that really should affect stock prices but we do often react too far in either one direction (excessive price jumps) or the other (excessive price drops).

Since Buy-and-Holders believe that price changes are rational, they use stock price changes as a guide to understanding economic realities. Stock prices dropped by 37 percent in 2008. If that price change was the result of a rational reassessment of the value of U.S. companies, the mortgage crisis and the banking crisis must have been truly terrible things.

If one comes to believe that the stock price changes were not rational, different sorts of considerations come into play. Stocks were insanely overpriced in the years prior to the 2008 meltdown. Overpriced markets always crash. Could it be that the 37 percent price drop was the product of investor fears over where an overvalued market was headed and that the loss of buying power that followed from the evaporation of trillions of dollars of spending power is what brought on the mortgage crisis and the banking crisis? Starting from a different premise leads one down a different sort of logic chain.

We cannot say that years in which there were big price drops were years in which there were a lot of unforeseen negative economic developments. It might be that the price drops were the result of high valuations that scared investors into thinking that prices would be headed downward regardless of what sort of economic news appeared before them. Or it might be that investors who ignored negative economic developments that took place in Year One would give recognition to those developments in Year Four, causing prices to fail to drop in a year in which they should have dropped and to drop in a year in which they shouldn’t.

I believe that there is hardly ever a year in which the true stock return is negative. The businesses that underly the U.S. stock market possess assets that grow in value over time. Rational investors would not permit short-term developments to influence their assessments of market value too much. They would respond with a shrug of the shoulders to negative economic developments, assuring themselves that the U.S. economy has for over one-hundred years been generating sufficient growth to support an annual price increase of 6.5 percent real and that the best bet is that that will continue to be the case. The true stock return (that is, the amount that the market as a whole would increase in value if only investors were as rational as the Buy-and-Holders assume them to be) is always 6.5 percent real or something close to it.

Rob Bennett’s bio is here.