By Rob Bennett
I often argue in this column that both overvaluation and undervaluation are irrational phenomena. It is my view that the words themselves suggest this. To overvalue something is to misprice it. To undervalue something is to misprice it. The rational thing is to price things properly.
So stock prices should go up by 6.5 percent real per year.
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In good economic times. And in bad economic times.
We’re not accustomed to thinking about market prices that way. In the Buy-and-Hold Model, it is economic developments that cause price changes. Positive economic developments give rise to price increases. Negative economic developments give rise to price drops.
Under the Valuation-Informed Indexing Model, it is shifts in investor emotion that give rise to price changes. Economic developments don’t matter (except to the extent that they cause shifts in investor emotion). If you took emotion out of the equation, we would have steady increases of 6.5 percent real or something close to it. In good times. In bad times.
On first consideration, this does not seem to make sense. The intuitive thought is that the market price should be higher when it appears likely that earnings will be higher in coming days and lower when it appears that earnings will be lower in coming days.
I don’t think that the first thought stands up to scrutiny. I think it ultimately makes sense for the market value to increase by a steady 6.5 percent real each year.
The question here is — What is it that the ownership of an index fund share represents? It represents partial ownership of the productivity of the U.S. economy. Should a share in the productivity of the U.S. economy be viewed as more valuable during good times than it is during bad times?
The ownership share does not have a duration of one year or two years or three years. it is a perpetual ownership share.
Good economic times do not increase the productivity of the U.S. economy indefinitely. Productivity has remained sufficiently strong to support an average stock return of 6.5 percent real for as far back as we have records. Each time there were a number of especially good years they were followed by a number of especially bad years. There is no reason to believe that good economic times will in a permanent way increase the value of the ownership share beyond what it has always been in the past.
It is of course possible that the U.S. economy is changing in fundamental ways that will make it more or less productive in the future than it has ever been in the past. The 6.5 percent average long-term return is not written in stone.
But isn’t it the best default bet, given that this number has applied for so many years?
Shouldn’t the best default bet be the one that rational investors use to assign a price to the market?
We humans are emotional creatures. We see good times and we feel better about owning stocks. We push prices up. We see bad times and we feel worse about owning stocks. We push prices down.
But our feelings are not backed up by the economic realities. At least they never have been so far in U.S. history. Over and over again we have pushed prices up in good times only to see them fall enough in bad times to bring the long-term average return back to 6.5 percent real. Over and over again we have pushed prices down in bad times only to see them rise enough in good times to bring the long-term average return back to 6.5 percent real.
Is it rational to continue thinking that good times or bad times make a difference? Wouldn’t the more rational thing be to accept the historical verdict that an ownership interest in the productivity of the U.S. economy is going to pay out a return of about 6.5 percent per year regardless of how the economy happens to be doing at the particular moment? And that different returns become possible only because irrational investors sometimes price stocks higher or lower than their fair-value price?
Rob Bennett says that the Efficient Market Hypothesis is a big bunch of hooey. His bio is here.