Valuation-Informed Indexing:
Why Financial Regulators Cannot Do the Job and How to Fix the Problem

reminiscences of a stock operator pdf

by Rob Bennett

Whenever financial systems crumble, talk turns to regulation. But the biggest problems are beyond the reach of regulators. Former Federal Reserve Chairman Paul Volcker explained why in a recent speech to the Federal Reserve of Chicago. Here are his words:

“It’s the hardest thing as a regulator in my opinion…when things are really going well, the economy is going well, the market is not disturbed, but you see developments in an institution or in markets that is potentially destabilizing, doing something about it is extremely difficult.”

Precisely so.

Stock prices reached insanely dangerous levels in 1996. That was the year when Yale Professor Robert Shiller used the phrase “irrational exuberance” in testimony to the Federal Reserve. So the regulators knew. But they didn’t act. How come?

Everyone answers to a boss. The good thing about regulators is that they do not answer to the same bosses that the leaders in the industry being regulated answer to. This is why we say that regulators are “independent.”

But regulators are not independent on all questions. They can properly be referred to as “independent” only on questions re which the industry has a self-interested take and the public (which elects the politicians to whom the regulators answer) has a general take. If an industry is trying to do something that voters would not want it to do, regulators can step in and put a stop it. But that’s as far as it goes.

Economic instability being brought on by stock overvaluation cannot be addressed effectively by regulators. This is a case in which the public itself enjoys the benefits of the “fraud” being practiced. Stock overvaluation is experienced when prices go up, up, up. Who doesn’t like that? How many angry letters did our elected representatives receive complaining that stock prices were just going up too darn fast and something had to be done about it pronto? Put another way, how many angry letters would the politician who tried to do something about it have received had he stuck his neck out?

President Clinton was in office in 1996 and the years immediately following. He was struggling through the Monica Lewinsky scandal at the time. One of the reasons he survived it is that the economy was going gangbusters and voters did not want to see the fellow responsible for their good fortune removed. Had the Fed acted to bring stock prices down, and had Clinton felt the reins of power slipping away as a consequence, is it possible to imagine that he would not have found some way to get the message to the Fed that it might consider putting some other pressing issues higher on its priority list than the task of bringing stock prices back to earth?

We need to find  a way to keep stock prices from getting out of control. We are all paying a huge price for failing to have had such a mechanism in place in the late 1990s. But it is unrealistic for us to believe that government regulators are going to be able to do the job that needs to be done. There is no such thing as a 100 percent independent government regulator. Bringing overpriced stocks back to fair value always threatens a recession. And there is never a good time for even the threat of a recession in a politician’s playbook.

So we’re doomed to repeating the same mistakes over and over again?


We need to look for free market solutions to Volcker’s pro-cyclicality problem.

Consider another problem that regulators would handle poorly if they were asked to handle it.

Businesses that for a time serve consumers often stop doing so for any of dozens of possible reasons. In socialist countries, it is left to government bureaucrats to address the problem. They do a poor job. Popular businesses often have lots of money and lots of friends and that translates into them enjoying lots of influence. Poorly performing businesses cannot be effectively removed through regulation.

In free market economies, we handle this problem through something called “Creative Destruction.” We don’t ask any regulator to identify poorly performing companies and put them out of their misery. Millions of us “vote” them out of existence by pursuing our own self-interest and taking our business elsewhere.

This is the answer to Volcker’s pro-cyclicality problem. Yale Professor Robert Shiller has shown us that valuations affect long-term stock returns. That is, stocks do not offer an equally appealing value proposition at all times. At some P/E10 values, stocks offer an amazing deal.  At other P/E10 values, stocks are likely to provide lower long-term returns than certificates of deposit. We need to get the word out about this!

Once most investors learn that highly priced stocks offer a poor long-term value proposition, stocks will never again become overpriced. Each time prices go too high, investors will sell stocks until prices return to fair value. Stock prices are self-regulating! But only in a world in which investors understand that they must change their stock allocations in response to big price swings. This can never happen in a world in which Buy-and-Hold Investing is heavily promoted.

Government regulators cannot stop the market from becoming insanely overvalued. But investors, acting in their self-interest, can. We just need to work harder to inform investors about the dangers of Buy-and-Hold Investing and of the need for us all to shift to valuation-informed strategie

Rob  Bennett views Buy-and-Hold Investing as a well-intentioned mistake. His bio is here.

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2 Comments on "Valuation-Informed Indexing:
Why Financial Regulators Cannot Do the Job and How to Fix the Problem"

  1. Thanks very much for sharing your thoughts, Chipper.


  2. It’s a nice idea, but good luck trying! How do you get people not to be envious when the dot com bubble is zooming up?

    I would argue that the cause of every single major stock market bubble and crash over the last 100 years is the Federal Reserve. The Federal Reserve is actually the first institution of central planning in the US. The Fed causes money for loans to be more available. Banks have always had a hard time controlling themselves from making risky loans when they had no one else to lend to. Some of that money ends up in the stock market. This causes a bubble.

    The Federal Reserve has had a strong hand in every single stock market bubble and crash. 1929, 1974, 1982, the dot com bubble in 2000, and 2008. In 4 of these cases, the Fed lowered interest rates for prolonged periods of time, causing people to have more borrowed money than they knew what to do with. Some of this money found it’s way into the stock market, causing temporary artificially high prices. In some of the crashes, the Fed actually worsened the effects by making money harder to borrow.

    Should the Fed be abolished? I don’t know. Is it going to be abolished? I don’t think so. Why? Because how could you abolish the Fed? The US government increases the “money supply” about 7% a year on average by “printing” money. If that money stops coming in, which expenses does the government cut? Which taxes does it raise? Both are not popular. So I don’t think that the Fed will be abolished unless someone comes up with a better way for the US government to print money.

    As for financial regulators in general, many people would say that regulators should not be allowed to make up the rules as they go along. Unfortunately, those people are not in power now. (See the book, ‘The Road to Serfdom’ by Hayek – it should be required reading for every American).

    However, fair financial laws may be a good thing. In the original (and maybe still the best) pro free markets book, ‘The Wealth of Nations’ by Adam Smith, he actually argues in FAVOR of FINANCIAL regulations. Banks have always had a tendency to collapse otherwise, even without the ‘help’ of the Fed.

    Some sensible financial laws that apply to everyone equally, can be a good thing. (For example, in Berkshire Hathaway’s 2008 Letter, Mr. Buffett explained how they avoided most of the sub-prime crisis (even while lending to people with very low credit scores) by following a couple of simple rules for their mortgages.

    If financial laws would be made years in advance before they actually take effect, they would have a shot at being somewhat sensible, and with a longer-term focus. Such a system should lesson the need for lobbyists to get involved, it would therefore have less politics and less favoritism.

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