Valuation-Informed Indexing:
Emotional Market Theory

<i>Valuation-Informed Indexing:</i><br /> Emotional Market Theory

by Rob Bennett

If the market were efficient, it would always be priced properly and both overvaluation and undervaluation would be meaningless concepts. We know that is not so. Yale Professor Robert Shiller long ago published research showing that valuations affect long-term returns. So valuations are meaningful and the market is not efficient.

This reality raises troubling questions.

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The Efficient Market Theory explains why stock prices change. Investors are reacting rationally to economic developments. As new things happen, investors change their take on how valuable stocks are and prices change accordingly. If we give up on the Efficient Market Theory, we need an alternative explanation of why stock prices change. What is the alternative?

The alternative is to believe that stock prices are set not by investor rationality but by investor emotion. If we don’t have an efficient market, we have an emotional market, one in which investors fail to take economic developments properly into account when setting stock prices. We need an Emotional Market Theory.

Back in early 2009, Vanguard Founder John Bogle argued that it was absurd to believe that the market had lost $8 trillion in value over the course of less than a year. He offered this observation as reassurance to stock investors. The suggestion was that the price crash of late 2008 and early 2009 was excessive; stocks had become a good buy because prices had fallen too far.

I am in complete agreement with Bogle that the loss of market capitalization that we saw during the price crash was irrational; nothing happened in the world over the course of that year to justify the loss of $8 trillion in market capitalization. However, I believe that Bogle came to an entirely unwarranted conclusion about this irrationality.

The irrationality that evidenced itself should not have been reassuring to Buy-and-Hold investors (the investors most interested in hearing Bogle’s take). It should have scared them to death. Bogle, the lead advocate of an investing strategy rooted in a belief that prices are set rationally, was saying that prices are in fact irrational. The logical conclusion to be drawn from Bogle’s statement is that the lead advocate of Buy-and-Hold has lost confidence in its core premises. That’s disturbing in the extreme, not even a tiny bit reassuring.

The price crash was irrational. But so was the bull market that caused it. The price crash was an irrational means of correcting an irrationality. The net effect was to render stock prices more rational, not less so. Stocks were priced closer to fair value after the crash than they were at the top of the bull.

Those of us who believe that prices are set through irrationality see different things in every price move from those who believe that prices are set through rationality.

Say that prices were to take off next week. Buy-and-Holders would interpret that as a good sign, evidence that rational investors had come to the conclusion that the economic crisis was nearing an end. I would interpret it as a bad sign, evidence that emotional investors were going deeper into denial and thereby insuring that the economic crisis will be even more prolonged (I do not believe that the crisis can end until investors come to terms with the mistake they made in permitting the bull market to get so out of control).

Say that the Fed eases interest rates and that stock prices fall. Buy-and-Holders would interpret that as a vote of no confidence in the Fed’s ability to manage us out of the crisis. I would interpret it as an expression of investors’ fears re the future. According to the Emotional Market Theory, stock price changes are the consequence of investors working through their emotions and do not necessarily have much logical connection to events. It could be that a Fed tightening would have also caused a price drop. It could be that investors were looking for any excuse to take prices down and that the Fed action merely served as a catalyst for something that was going to happen no matter what the Fed did.

Say that a new President is elected and stock prices soar. Buy-and-Holders would interpret that as showing that informed people believe that the new Administration’s policies will be good for the economy. I would interpret it as showing nothing more than that many investors wanted to see stock prices go up at that moment of time. It could be that they had confidence in the new Administration’s policies; there are of course times when our emotions are entirely rational. It could also be that they lacked true confidence in the new Administration’s policies and were bidding up prices because they wanted to enjoy a last fling before the dark days they secretly anticipated.

The difference between believing that stock prices are the result of reason and believing that stock prices are the result of emotion is stark. Making the switch from one to the other changes the nature of the analysis performed in a fundamental way. It’s like the difference between believing that the words of every character in a play are an accurate reflection of his or her plans and motives and understanding that some people are deliberately saying the opposite of what they feel as part of an effort to deceive others or perhaps even themselves.

Shiller is pointing us to a more mature and sophisticated and realistic way of understanding how markets work. We are not a nation of economists studying each Fed pronouncement to identify where the economy is headed and then adjusting our portfolios to “exploit” what we anticipate will be the developments coming our way. The reality is far more human and more interesting and at times more scary and at times more encouraging than that. We are a nation of nut cases reacting in crazy ways to all sorts of events we can neither anticipate nor understand and somehow making the best of a stressful situation. That is, investors are living human beings, not mechanical processors of incoming information bits.

The Efficient Market Theory has failed. It doesn’t offer a believable explanation of why stock prices change. We have been reluctant to give up our old ways of thinking about stocks because there is no new way of thinking about them in which we can today have complete confidence; there are obviously lots of things we do not know about how the emotional market operates.

Still, we are better off moving forward to a way of thinking about stock prices that permits us to get things at least partly right than sticking stubbornly to a way of understanding that we know to be in error. The Efficient Market Theory simple does not do the job — it does not explain crashes and yet crashes are an obvious reality, one that responsible and serious people may not elect to ignore.

I believe that we are on the threshold of coming to a better understanding of how stock investing works than any people who came before us was able to develop. It’s scary because the new model is so different from the old one. I think that the thing to do is to focus on the insights that will come with the development of a better understanding and appreciate that the reward for opening up to some new ideas will be economic growth that will come to benefit all of us in time.

Rob Bennett developed a unique asset allocation calculator. His bio is here.

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