Robert Shiller in his book Irrational Exuberance tells the story of how he was told while waiting to do a television interview that he should be careful what he said lest he did something to cause stock prices to fall. That could happen, right? Shiller says that valuations matter. He says that stocks provide lower returns when purchased at times of high prices than they do when purchased at times of low prices. If he were to make his points effectively in his television interview, there is a good chance that some of the investors who heard it would become discouraged over their stock holdings and would elect to sell some shares, pulling prices down.
Would that be a bad thing?
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I don’t think it would be a bad thing. Shiller’s interviewer obviously thought it would be a bad thing if stock prices fell. And the vast majority of investors share her feelings. Most investors cheer news that stock prices has risen and bemoan news that stock prices have fallen. But why? We don’t think of high prices as a good thing in most other markets. Most people would prefer to hear that gas prices or car prices or movie ticket prices are low to hearing that they are high. Why do we feel differently about stock prices?
It’s because we own stocks. We think of ourselves of buyers of gasoline and cars and movie tickets. We think of ourselves as owners of stocks -- we hold a portfolio of them that we hope to be able to sell at high prices to finance our retirement. We like high stock prices because we think of ourselves as owners and eventual sellers of stocks, not as buyers of them.
But that’s not quite right, is it? Most of us own a certain number of stocks today. We intend to hold those stocks but not to sell them for a good number of years. So it really doesn’t matter whether they are currently assigned a high price or a moderate price or a low price. Seeing a high price assigned to them assures us that they will go for a high price when the time comes when we need to sell them. So there is some cause for us to like high prices. But the full reality is that we will not benefit from high prices for a good number of years.
And high stock prices are not entirely a good thing for most of us. In fact, high prices are more of a bad thing than a good thing for most of us.
Most of us are buying additional stocks with each paycheck. When the price goes up on the shares in our portfolio, the price also is going up on the shares that we purchase with a portion of each paycheck. A price increase yields a long-deferred benefit on the shares we already own (because we will not be selling them for many years) and an immediate detriment on the shares that we will be purchasing with our next paycheck.
And then of course the penalty associated with the price increase grows bigger when we purchase more shares next month and then bigger again the following month and in all the following months until we reach retirement age and being selling off shares.
For most investors at most times, an increase in stock prices is more of a negative than a positive. The other way of looking at it is that, for most investors at most times, a decrease in stock prices is more of a positive than a negative. Do you think that when Jeremy Siegel is about to be interviewed on television, the interviewer warns him to be careful when making his case that stocks are always best for the long run not to talk stocks up too much because he might cause a price jump? Something causes me to doubt that that has ever happened.
We use the word “market” to describe the place where stocks are bought and sold. But it’s a funny kind of market. In every other market that I can think of, there is a tension between the forces pulling prices up and the forces pulling prices down. Sellers want high prices and buyers want low prices and they argue with each other until there is a meeting of minds on what the price should be and that is the price that results from the tug of war between the factors arguing for high prices and the factors arguing for low prices. Does that happen in the stock market? Is there anyone who argues for low stock prices?
The buyer of individual shares argues for low prices. The tension that is present in transactions taking place in other markets is present when individual stock shares are sold to a new owner. But that tension is not present in the setting of the overall market price. All of the sellers of all of the individual shares want the overall market price to be high and all of the buyers of all of the individual shares want the overall market price to be high too. People want to get the best price they can on the shares that they personally purchase. But people want the overall market price to be as high as possible.
So interviewers warn Shiller to take care not to say something that might cause prices to fall too sharply but they do not warn Siegel to take care not to say something that might cause prices to rise too sharply. When it comes to the overall market price, there is a heavy bias in favor of high prices. When it comes to the overall market price, the stock market does not operate like any other market that exists.
Shiller once described the jump from a finding that stock prices are unpredictable in the short term to the conclusion that stocks are priced properly as “the most remarkable error in the history of economics.” It is that error that he revealed with his Nobel-prize-winning research showing that valuations affect long-term returns. That shouldn’t be. If the stock market worked like other markets, prices should fall in the pattern of a random walk both in the short term and in the long term. Shiller showed that they do not. In the long term, stock prices fall in a hill-and-valley pattern. For about 25 years, valuations move generally upward and then for about 15 years they move generally downward, and then the pattern repeats.
I think that’s because of the unfortunate bias we have in favor of price increases. Because of our bias, the natural direction of stock valuations is upward. As the hill part of the hill-and-valley pattern is established, our irrational exuberance grows stronger and stronger. At some point, our common sense does not permit us to maintain confidence in further price increases and our irrational exuberance is transformed into irrational depression until the boom/bust cycle is complete and can begin over again.
We could greatly stabilize stock prices by diminishing the bias in favor of price increases. Most of us are more buyers of stocks than sellers of stocks. We need to keep that in mind when we hear reports that stock prices have gone up or down. Shiller is not causing us any harm when he says something in a television interview that causes stock prices to fall.
Rob’s bio is here.
