Valuation-Informed Indexing #317

by Rob Bennett

We need more recessions!

It sounds like a joke. But I am making what I believe to be an important point.

Prior to the 1930s, the government played a greatly limited role in the running of the economy compared to the role it plays today. Things changed following the Great Depression. We collectively decided that laissez faire economics had failed and so we shifted to a system in which there is more government control.

Eventually, this new way of thinking led to the expansion in the responsibilities of the Federal Reserve until it came to play the role it plays today. When the economy appears likely to fall into a recession, the Federal Reserve steps in to encourage the lending needed to stimulate economic growth. And occasionally it works the other way too. If the members of the Federal Reserve conclude that the economy is overheated, lending is discouraged with the aim of bringing economic growth back to more moderate and therefore more sustainable levels.

The problem is that, while the Federal Reserve is organized to be more independent of partisan political considerations than most other government entities, it is nonetheless inherently a political institution. Voters prefer economic good times to economic bad times. It is impossible for the members of the Federal Reserve to entirely ignore the strongly felt preferences of the majority of the population. The Reserve is more aggressive in its efforts to avoid recessions than it is in its efforts to avoid booms.

The best feature of capitalism is that it exacts a price for inefficiencies. Companies that do a poor job of satisfying consumer wants fail in a capitalist economy. The elimination of poor performers opens up space in which new companies can thrive. We all live better lives because the heartless capitalist system does the dirty work that few human beings would be willing to take on.

Recessions aren’t bad. They serve an important purpose. Our economy doesn’t grow only when things are zipping along. Important progress is being made when companies are failing and thereby preparing the way for future success stories.

We cannot persuade the members of the Federal Reserve to cause more recessions. They are humans. They aren’t going to do it. We need another way to bring on more recessions.

Or perhaps we don’t actually need more out-and-out recessions. If economic boom times — times in which companies that could not succeed on their own efforts succeed because it is easy to find customers when paychecks are increasing at artificially accelerated rates — could be better kept in check, there wouldn’t be as much need for recessions to kill off poor performing companies. Steady, slow growth works best from all sorts of perspectives.

Valuation-Informed Indexing can do the job that the Federal Reserve cannot.

People think of Robert Shiller as an investing expert. The focus of his most important work is how the stock market works. But he is an economist and his work possesses a boarder reach than the word of most investing experts. When Shiller changed our understanding of how the stock market works, he advanced our knowledge of how the economy can function more effectively as well.

We used to think that stock price changes were caused by unforeseen economic developments. We now know that that is not so; the primary determinant of stock price changes is shifts in investor emotion. There’s magic in knowing that. If stock price changes were caused by economic developments, there would be nothing that we could do to stabilize stock prices — we would be stuck with experiencing whatever stock price changes occurred as the economic developments causing them played out. We can influence investor emotions by providing investors with the tools they need to manage their emotions more effectively. Stock price changes are now at least partially under our control.

Rising stock prices make people feel more wealthy, causing them to spend more and thereby causing companies to hire more workers to produce more. Rising stock prices bring on economic good times.

Falling stock prices make people fear for their futures, causing them to spend less and thereby causing companies to let go of workers. Falling stock prices bring on economic bad times.

We can stabilize stock prices by dropping the Buy-and-Hold stuff and just telling people the clear message of the last 35 years of peer-reviewed research in this field — stocks offer a better deal when prices are low than when they are high and thus investors seeking to keep their risk profiles roughly constant must be certain always to adjust their stock allocations to be responsive to big valuation shifts. By stabilizing stock prices, we would also stabilize economic growth. By telling people about the implications of Shiller’s research findings, we could insure that we would have fewer and less painful recessions (while also having fewer boom times as well, to be sure).

Teaching people research-based investing strategies would make capitalism more palatable for the millions who fear the boom/bust cycle that has long been associated with it. The appeal of capitalism is the real growth it fosters. Fake growth hurts us all. Bull markets are an exercise in fake growth. It is time to put an end to them.

Rob’s bio is here.