Valuation-Informed Indexing #39:
Stock Prices Are Cyclical — Here’s Why

<i>Valuation-Informed Indexing</i> #39: <br>Stock Prices Are Cyclical — Here’s Why

by Rob Bennett

I showed in the last two columns that stock prices do not in the long run fall in the pattern of a random walk. Stock prices are cyclical. They go up over time. They continue going up until they reach insanely high levels (a P/E10 value above 24). Then they go down until they reach insanely low levels (a P/E10 level of 7). Then they start moving upward again.

There are of course many short-term moves down while valuations are climbing and many short-term moves up while valuations are falling. So it is entirely fair to say that a random walk pattern applies in the short term. But there is nothing even a tiny but random about the long-term pattern. Valuations go up for perhaps 20 years and then valuations go down for perhaps 15 years. No other long-term pattern has evidenced itself in 140 years of U.S. stock market history.

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What is it about the boom-bust cyclical pattern that has made it so dominant for so long?

I believe that there are two competing forces at work: (1) the Get Rich Quick impulse that exists in the heart of every human (and, thus, every investor); and (2) the economic realities that must exact financial pain on those who fail to rein in their Get RIch Quick impulses if the market is to continue to function.

The natural direction of stock valuations is upward. Why? Because the stock market is the ultimate Get Rich Quick scheme. Investors always have it in their power to vote themselves raises just by working collectively to push stock prices higher. Absent powerful forces insisting that they rein in their self-destructive tendencies, investors will bid stock prices up to insanely dangerous levels.

Such forces are always present to a greater or lesser extent. The greatest force working in opposition to the Get Rich Quick urge we all carry within us is our common sense. An inner voice tells us that it cannot possibly be as easy to make money in stocks as it appears to be during wild bull markets.

There are times when common sense exerts a considerable constraining influence and there are times when common sense is ignored with relative ease. For example, in the years following the Great Depression, most investors had personal experiences of family members whose lives had been destroyed by their decision to give in to the Get Rich Quick urge. But in the Buy-and-Hold years, memories of the Great Depression had become foggy while claims of mysterious “studies” showing that there is no need for long-term investors to consider valuations when setting their stock allocations were widely publicized. In that environment, the ability of common sense to keep stock prices from getting out of hand grew weak indeed.

Prices don’t shoot straight up because common sense can be weakened but never entirely defeated. Common sense is every bit as much a natural component of the typical investor’s psychology as is the desire to give in to the Get Rich Quick urge. An investor willing to ignore the voice of common sense during a move in the P/E10 level from 18 to 20 might not be willing to continue to ignore it during the following move from 20 to 22. In circumstances in which that is so, the move to 22 will fail to hold. But common sense can be gradually eroded with time. After seeing that nothing dramatic happens with a rise to a P/E10 level of 20, the investor whose common sense at one time could not tolerate a move to 22 comes to find it not so troubling after all. And the next move to 22 holds.

Eventually, though, common sense always comes to dominate over the Get RIch Quick urge. Investors do not abandon their common sense during the years when they permit stocks to become dangerously overpriced: They silence it. Sooner or later, silenced common sense works up the courage to reassert itself. That’s when prices crash.

Crashes don’t take place all at one time either. They are achieved in stages. As valuation levels are falling, it is the Get Rich Quick urge that is being gradually silenced. At some point prices have fallen so insanely low that they “crash” upward. The cycle begins anew.

Can the cycle be stopped? Not many think so. Many do not see the cycles or do not care to consider their significance. But even most of those who acknowledge the importance of stock cycles say that they are attributable to laws of humans nature that cannot be changed. We are stuck with booms and busts and all the financial pain associated with them, according to this line of thought.

I don’t think so.

I believe that the cycles can be stopped by our becoming more aware of the human psychology that drives them. We are often advised that we can avoid angry outbursts by counting to ten. Why can’t we avoid giving in to the Get Rich Quick impulse by becoming more aware of how it causes our hopes for financial freedom to self-destruct?

The very first step is talking openly about the reality of stock cycles. That of course requires an open and widespread acknowledgment that the idea that stock prices fall in the pattern of a random walk is a myth.

Rob Bennett believes that Buy-and-Hold is dead. His bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”

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