Valuation-Informed Indexing #328

by Rob Bennett

Stock prices soared following the election of Donald Trump as our 45th President. The conventional belief is that this signals economic good times. Investors see something in the political change that causes them to expect increasing corporate profits in days to come.

I don’t buy it, of course. I believe that stock prices are determined primarily by shifts in investor emotion and only in a secondary way by economic developments (and even then only because economic developments influence investor psychology, the real driver of stock price changes).

My first challenge to those advancing the conventional view is — Why did stock prices (on the futures market) fall hard on election night when it first became public knowledge that Trump would prevail? If it is true that the market is efficient, why did the millions of rational investors miss the bet for a few hours before figuring out that the unexpected election result was in fact very good news rather than the very bad news that it was perceived to be on the first hearing of it?

I view the quick change in market reactions as support for the view that the market is emotional. It is a common human emotion to fear change. Investors heard something that they were not expecting to hear and their first reaction was to fear what it might mean. Then they calmed down, thought things through a bit, and concluded that perhaps there were things that Trump would do that would increase corporate profits rather than diminish them.

Please note that they were not necessarily any more right in their second take than in their first take. If emotion drove the first take, it also drove the second. If it is investor emotion that drives stock price changes, we cannot point to stock price changes as evidence of the accuracy of any claim that stock price changes tell us where the economy is headed. Trump might be a disaster for the economy, as investors thought in the first hours of learning of his victory, or he might be a boon, we will just have to wait for other sources of edification to reveal to us which it is.

I view it as a bad sign that stock valuations are insanely high today. The higher prices go, the greater the risk of a price crash and price crashes take trillions of dollars of spending power out of the economy. So we are at high risk of seeing trillions of dollars of spending power removed from our economic system.

On top of that, these high valuation levels have applied for a long time. We saw a drop to fair-value prices in early 2009 but sky-high valuation levels have applied for close to eight years now. It is rare for high valuation levels to remain in place for more than ten years. And of course valuations were sky high for 12 years before the 2008 crash hit; we have not yet seen the drop to low valuation levels that in the past has always appeared in the wake of a major bull market. So the pressure for a big price drop (and the loss in consumer buying power that accompanies it) is strong.

Investors don’t see it that way, to be sure. If investors saw it that way, we wouldn’t have the high prices in the first place; if investors saw a crash on the horizon, they would move out of stocks and pull prices down to more reasonable levels. So I certainly am not surprised that prices have been rising.

My concern is over the question of why investors are reacting to Trump’s election in the way they are. A Buy-and-Holder would say that it is because they expect to see tax cuts or a huge bill that will produce jobs and spending and profits. But someone who believes that price changes are caused by shifts in investor emotion sees something different in this investor reaction. I see investors who are fearful that a crash is coming and who are trying to quiet those fears and who are generating optimism about the economic effects of Trump’s election as a means to do so.

Stock prices were insanely high in 1996. It would have been correct (in my view) to conclude from that that stocks were dangerous. However, it would not have been correct to conclude that stock prices would fall hard in 1997. As we saw, stock prices soared in 1997 and in 1998 too and in 1999 as well. A natural human reaction in times of desperation is to embrace the thing that is causing the fear that cannot be acknowledged. An alcoholic drinks harder to prove to himself that he has things under control. A man close to losing his job becomes more outspoken in criticism of his boss to persuade himself and those within hearing distance that he is sure that all is well.

Are we bidding up stock prices because we think that Trump is going to take the economy to a good place? Or are we fearful that the time to pay the piper for the phony profits of the past 20 years has finally arrived and feeling a need to convince ourselves otherwise with one final high-valuations fling?

Short-term timing doesn’t work. I don’t make predictions as to when price crashes will arrive (at least I should’t do so — every time I have tried, I have made a fool of myself, just as the good Professor Shiller’s research warned me would be the case if I became so daring). But I remember what I said when Barrack Obama was being sworn in as the new President. I argued in a podcast recorded at the time that his presidency might be doomed because, while stock prices fell hard just before his election, they had been high for so low prior to it that it might take four years for us to recover from the losses and get the economy moving again. The price crash that I then foresaw being an anchor for Obama’s economic plans is more overdue today than it was eight years ago.

Rob’s bio is here.