Valuation-Informed Indexing #44:
We Need to Discourage Bull Markets to Stabilize the Economy

reminiscences of a stock operator pdf

by Rob Bennett

There have been years when we have seen very high stock returns. We have seen years when stock prices went up by 10 percent or 20 percent or even 30 percent. There also have been years when we have seen very big losses. We have seen 10 percent and 20 percent and 30 percent losses too.

The stock market is a proxy for U.S. productivity. The earnings paid to stock investors are the product of the wealth-generation activities of the companies that comprise the market. In years when we see big stock gains, the companies are generating earnings like crazy. In years when we see big losses, the companies are not generating earnings.


I don’t think that’s right.

The reason why I don’t think that’s right is that we don’t see big differences in long-term returns. For the 30-year time-period from 1940 through 1969, the annualized return was just over 6 percent real. For the 30-year time-period from 1950 through 1979, the annualized return was just under 5 percent real. For the 30-year time-period from 1960 through 1989, the annualized return was again just under 5 percent real. For the 30-year time-period from 1970 through 1999, the annualized return was just over 8 percent. And for the 30-year time=period from 1980 through 2009, the annualized return was 7.4 percent real.

It’s always something in the neighborhood of 6.5 percent real, not too much higher than that and not too much lower than that. There are variations in the 30-year return. But the size of the variations we see in 30-year returns are nothing close to the size of the variations we see in 30-year returns.

Why not?

If it is good news about corporate earnings that causes gains and bad news about corporate earnings that causes losses, it wouldn’t turn out like that. If it were poor corporate earnings causing poor stock returns, we would not see a bad return in one year of a 30-year time-period always being matched with a good return in another year of the same 30-year time-period, so that the 30-year returns all in the same general neighborhood.

Earning reports are separate events. A bad earnings report is just a bad earnings report. There is nothing in it that should cause earnings in a subsequent year to be good. But stock returns for different years are connected events. Good returns today cause bad returns tomorrow. Bad returns today cause good returns tomorrow.

The proves that earnings reports are not what determine stock returns.

What does?

Investor emotion.

If investor emotion causes stock returns, then we’ve got everything backwards. We note that stock returns are poor in bad economic times and conclude that it is those bad earnings reports that are bringing stock prices down. Once we give up the idea that earnings reports determine stock returns, new possibilities rush to mind.

If investor emotion causes stock returns, it might be that the reason why bad economic times and low stock returns are connected is that investor emotions turn sour when stock returns are poor. When stock prices drop, investors perceive themselves to be poorer. They become afraid to spend. The spending cutback causes businesses to fail and workers to lose their jobs.

We don’t need an economic stimulus. The economic fundamentals are fine. The problem is that investors no longer have confidence in their personal financial futures because they are so far behind where they hoped to be today because of the Lost Decade for stocks. We need to give investors a psychological boost.

But how can we reassure investors? The Fed has been trying to do just that with its QE2 pump-priming and investors seem to be becoming less confident over time rather than more so.

You can’t force an emotion. If someone turns down your invitation for a date and you press, it’s a turnoff. The smarter approach is to accept the realities and perhaps try again later. Investors don’t today respond to attempts to lift their dark mood. They don’t trust good news. Stock prices are going to continue to fall (in a long-term sense) until that fundamental psychological reality changes. The historical data suggests that it will take a 65 percent price drop from today’s levels for that change to take place.

Investor psychology changes at its own pace. There are times when investor psychology changes in accord with what you would expect to see in response to economic changes taking place. And there are times when the two sorts of changes proceed on very different tracks. We need to stop assuming a connection that often does not exist.

It is bull markets that causes investor fears. Bull markets are times of mass delusion and all investors possess a commonsense understanding that mass delusions never end well. So, once a bull market takes place, there is nothing that can be done to stop the souring of investor moods that always follows from a bull and the economic collapse that always follows from a souring of investor moods. The constructive thing to do would be to stop bull markets before they get out of control and thereby avoid the souring of investor moods that causes economic collapses.

Could it really be that ending recessions and depressions could really be that simple?

I think so. If you consider the dollar impact of a fall to fair-value stock prices following a runaway bull, you see that bull markets make economic collapses inevitable. Stocks were overpriced by $12 trillion in January 2000. The strongest economy in the world cannot take a $12 trillion hit and remain standing.

There has never been a time when we have made it a public policy imperative to stop bull markets in their tracks. My guess is that, if we did, we would see not only a far more stable stock market but also a far more stable economy. There would no doubt be blips up or down from time to time. But the blips down would cause rising companies to take advantage of lower prices and the new economic activity would bring about an upward blip that would keep things running smoothly forward.

It would be a better world.

No more bull markets!

Rob Bennett warns that there is such a thing as reverse compounding returns. His bio is here.

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About the Author

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.”

3 Comments on "Valuation-Informed Indexing #44:
We Need to Discourage Bull Markets to Stabilize the Economy"

  1. KenFaulkenberry | Jun 2, 2011, 1:36 am at 1:36 am |

    Thank you for the explanation Rob.

  2. I know you are against this kind of manipulation. But would not “discouraging” a bull market be just as bad? I wish there would be no manipulation of either bull or bear markets. Let the market rule as long as they are fair (without fruad).
    Thanks for your question, Ken. You have always been exceedingly kind (and intelligent) in your comments on my work. You are asking a question of core importance here.

    I agree 100 percent with your comment that the market should rule so long as it is fair (without fraud). A bull market is a fraud market. That’s the problem.

    I understand that there are many smart and good people who will be shocked by that comment. But that is my sincere belief.

    What does it mean to say that we are in a bull market? They don’t call it a bull market if stock prices go up by 6.5 percent real each year (the price increase justified by the genuine economic gains for the year), do they? No. For it to be a bull market, there needs to be massive overvaluation. That’s by definition, right?

    Now, what is overvaluation? It is mispricing, is it not? Is mispricing not fraud? If you were charged $90,000 for a car with a fair market value of $30,000, you would be calling the police, right? But millions of people paid three times fair value for stocks in 2000 and the police were never called. This is the problem. This is why we are in an economic crisis today.

    We live in a free market system. But the market cannot function properly when the fraud/overvaluation/self-deception reaches the level it reached in the late 1990s. Those of us who believe in free markets need to speak out when we see that sort of thing happening. We need to write articles letting people know how dangerous Buy-and-Hold is, explaining how much damage the widespread promotion of it does not only to our economic system but to our political system. We need to provide people with tools that help them invest effectively for the long term. We need to do what we can to get things back on track as quickly as possible.

    If we do not, the system collapses. This has happened four times in our history. Buy-and-Hold Investing (not paying attention to price when setting your stock allocation) has become popular four times in U.S. history and on each of those times it caused an economic crisis. When we got to a P/E10 level of 33, it brought on the Great Depression. We went far, far beyond 33 in the late 1990s.

    A free market works only when there is free speech. Market participants cannot make informed choices when the information they need to do so is not available to them. How many articles have you seen warning people of the dangers of Buy-and-Hold. How many web site do you know of where honest and informed posting is permitted on safe withdrawal rates? There are a few. Not many. No large ones.

    If investors cannot access realistic reports of what the academic research says, they cannot invest effectively. The market is us! When we mess up, the market messes up. We need to help the market function effectively. We need to educate ourselves about the realities of stock investing to do so. The internet is the logical place for us to do this wonderful thing, in my assessment.

    I hope that helps a little but, Ken. I am all for the free market. My view is that the promotion of Buy-and-Hold is destroying the free market. We need to find a way to get realistic investing advice out to millions of middle-class people to have any hope of seeing our free market economic system survive into the future. The other side of the story is, that if we do find a way to do that, the free market will not only survive but thrive. We could be entering our best days. I believe we are. But we have to all work up the courage to start talking in realistic and honest and balanced and life-affirming ways about how stock investing works in the real world. I view this as a critical piece of business.

    Sorry for the sermon. I’ve seen lots of good people hurt by all the Buy-and-Hold mumbo jumbo. I thing of these people as friends. So this economic crisis has a personal element to it for me.


  3. Ken Faulkenberry | May 31, 2011, 8:26 pm at 8:26 pm |

    You know I love your writings and agree with the valuation process you promote. However I have to take issue (or ask for an explanation) with your title and assertion that “we” need to discourage bull markets. What “we” need to do is let the market do what its going to do. “We” the government, right now are pushing up stock prices, creating a bull market, by printing money. I know you are against this kind of manipulation. But would not “discouraging” a bull market be just as bad? I wish there would be no manipulation of either bull or bear markets. Let the market rule as long as they are fair (without fruad).

    Thank you for being such a crusader for value investing!
    Ken Faulkenberry

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