Valuation-Informed Indexing #137
by Rob Bennett
The fellow who owns the Bad Investing Advice blog once asked me a toughie.
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Mohnish Pabrai's flagship hedge fund, the Pabrai Investment Fund II, returned 29.6% in the second half of 2020. Following this performance, the fund returned 10.1% net for the year, underperforming the S&P 500 but outperforming the Dow Jones Industrial Average, which returned just 9.7%. According to a copy of the investment manager's year-end letter to Read More
I say that bull market gains are phony. Investors bid up prices not because economic realities justify the higher prices but because — well, because they can. We all want our retirement plans to be in good shape. And we collectively possess the ability to push stock prices higher. So we push them higher! That’s what is happening in years in which we see the price of stocks increase by more than the 6.5 percent real increase justified by the productivity of the U.S. economy.
The Bad Investing Advice blogger doesn’t agree with me. But he’s a good guy and a smart guy. So one day he agreed to humor me a bit and assume for purposes of discussion that I am right about that much. He still wouldn’t be able to buy into the theory behind Valuation-Informed Indexing, he told me. If investors really can push stock prices to whatever they want them to be, he wondered, why do they ever stop pushing them upward?
If we have the power to set prices wherever we want them to be, why do they ever come down? It’s a good question.
The quick response that most who believe we need to take investor emotions into consideration would offer is — We become afraid that the bull market cannot last and a good number of want to sell before the next guy sells. And that first round of selling makes more investors anxious about the future and thereby causes additional rounds of selling.
But that explanation doesn’t fully explain the phenomenon of how bull markets turn into bear markets.
Investors really believe in bull markets at the time prices are going up. If they never believed, they wouldn’t wait until the bear market began to start selling, they would sell as soon as prices got out of hand. They don’t. So they really do believe.
And yet later on they do not believe. If they continued to believe, prices would continue to go up. Something causes the polarities to reverse. The same investors cannot be stupid during the bull and then smart during the bear. What causes investors who are confident that prices are appropriate to start questioning that belief?
Have you ever known anyone to change his or her political views?
Or his or her religious beliefs?
Or to give up on a relationship that once meant the world to him or her?
Beliefs change. People who write for a living sometimes wonder whether this is so when they see their words having so little effect on so many. The reality, though, is that beliefs change. Not at all often. But it does happen.
And it rarely happens all at once. Overnight conversions are the exception.
What usually happens is that someone starts to form doubts about his beliefs on one political topic and forces himself to ignore those doubts because he senses that to explore them would down the road cause him to question all of his political beliefs. He doesn’t want to go there. We all like stability in our lives. it is scary to feel unsure about too many questions. So we stick with paradigms re which we have become comfortable.
Until we just cannot pull it off anymore.
The doubts we ignore build up over time. Our confidence erodes. Eventually, things get to a point where the old belief structure collapses all in a flash.
That’s why stock prices crash from time to time.
It’s not economic events that cause crashes. We saw a loss of $9 trillion in capital in the price crash of late 2008/early 2009. There were no economic developments that took place during those months that justified that big a loss in capital in so short a time-period.
The losses were building and building and building for years. It is the recognition of the losses that took place in a flash, not the losses themselves.
A more precise way of saying it is that the size of the unjustified gains grew larger and larger and larger. And our collective discomfort over the mispricing of course also grew. So we “knew” during the bull market that the bull market gains were not real.
At the same time that we also “knew” that they WERE real (we wouldn’t have staked our retirements in them if we did not know this).
We “knew” two opposite things at the same time.
If it sounds strange, that’s because you are expecting to see logic in a place where it is not fair to demand it. We are capable of being logical in our assessments of whether one company is likely to outperform another in coming years. We are not capable of being logical on questions of broad market overvaluation.
Why? Because broad market overvaluation is a social matter. It is all of us together that cause the entire market to be overpriced. To reject the phony prices would be to reject the society in which we must live in harmony with many others.
Can it change?
It changes when the textbooks stop telling us that it is fine to ignore overvaluation because the market is efficient and all that but instead start warning us that permitting a small bit of overvaluation today will lead to big problems (including an economic crisis!) tomorrow.
Overvaluation is a social problem. Overvaluation can be overcome by making it socially acceptable to combat overvaluation.
The only reason why this big change did not happen years ago is that too many of us still try to think of investing as an intellectual endeavor. There is no intellectual content to a society’s decision to misprice stocks. That’s emotional stuff and it is only by coming to terms with emotional realities that we can overcome the overvaluation problem.
We “knew” all along that the bull market of the 1990s was a mistake. We just didn’t “feel” that we could do anything about it. That’s what needs to change. When we come to feel that we must overcome this problem, we will instantly know what needs to be done.
Rob Bennett has recorded a podcast titled “When Stock Prices Fall, Where Does the Money Go?”. His bio is here.