Valuation-Informed Indexing #192
by Rob Bennett
The Brad Delong blog recently published extensive text from an interview that Yale Economics Professor Robert Shiller did with PBS on his recent award of the Nobel Prize in Economics. As is always the case with Shiller interviews, the PBS interview is filled with insights. However, I also believe that there are several cases in which Shiller made questionable or unfortunate statements.
What does value investing really mean? Q1 2021 hedge fund letters, conferences and more Some investors might argue value investing means buying stocks trading at a discount to net asset value or book value. This is the sort of value investing Benjamin Graham pioneered in the early 1920s and 1930s. Other investors might argue value Read More
Shiller sums up the Valuation-Informed Indexing difference well when he says that: “The whole idea that the stock market reflects fundamentals is, I think, wrong. It really reflects psychology. The aggregate stock market reflects psychology more than fundamentals. This is where maybe I really do differ from Gene Fama. I don’t think he would say that.”
That changes everything. If stock prices are determined primarily by investor emotions and if we have a metric (P/E10) that permits us to assess how emotional investors are at any given point in time, we have a means to predict long-term stock prices. Once stock prices become predictable, timing becomes not just a good idea but a requirement of those hoping to have a realistic chance of long-term investing success. If we can tell in advance how risky stocks are, we must be sure to lower our stock allocations when risk increases or else permit our risk profiles to go wildly out of whack.
So I love that statement. With one caveat. Shiller is an extremely nice guy. It comes through in every interview I have seen. He is genial and has a generous, non-arrogant spirit and makes a serious effort to see where the other guy is coming from. Which is all wonderful. He just takes it too darn far on occasion! When he says that Fama might not agree that stock prices are determined by investor psychology rather than by economic fundamentals, he is understating the point to a comical extent. Fama would have popped a blood vessel if he had been sitting in the studio next to Shiller when he made that statement.
There is a horrible statement made in a Business Insider report on the interview that is not entirely (but perhaps partly) Shiller’s fault. The Business Insider article states that: “Shiller reminds us that the CAPE model is not good for timing the market, a point he’s reiterated in the past repeatedly.” Yes and no. Shiller has of course on many occasions made the point that short-term timing does not work. But he has of course never said the same of long-term timing, which has been working very well for the entire 140 years of U.S. stock market history available to us.
I am tempted to blame the reporter for not making this point. I doubt that the reporter is aware of the distinction between the two types of timing.
But it’s not all the reporter’s fault. Even many experts make this mistake. Shiller should be doing more to make people aware of the distinction. He knows (or should know) that people make this mistake over and over again. He has a responsibility as the fellow who first made the distinction to do what he can to correct the misimpression obviously carried in many investor minds today that there is research somewhere showing that long-term timing (price discipline) either is not required or might not produce good results on some occasions.
I am not troubled that Shiller said that his stock allocation is at 50 percent stocks. That’s high, given today’s P/E10 level. But it is always possible for effective stock pickers to find good values, even at times when price levels are in dangerous territory. Shiller is exceedingly well informed. I don’t doubt for two seconds that he is capable of picking individual stocks or funds that will perform better in coming years than the market as a whole. Thus, it makes sense for him to go with a stock allocation of higher than the 30 percent that I would recommend for the typical middle-class investor.
I am more troubled by Shiller’s suggestion that many ordinary investors, especially younger ones, might reasonably go with stock allocations of a bit more than the 50 percent allocation he has chosen for himself. Most investors are not nearly as informed as Shiller and are taking big risks either trying to pick stocks effectively or going with that high a stock allocation while investing in broad index funds.
There are lots of Buy-and-Holders recommending stock allocations in excess of 50 percent. There is a particular danger in someone like Shiller doing the same. Many investors who are currently going with stock allocations in excess of 50 percent but who are worried that their allocations might be too high will find comfort in Shiller’s words and may suffer devastating losses as a result in days to come. Shiller has predicted a stock crash for 2014. How can the same person predict a stock crash and yet offer assurances that a stock allocation in excess of 50 percent is fine?
I was also troubled by Shiller’s comment that: “What is the economy going to do next? We just went through the biggest housing bubble in U.S. history. It’s off the charts. And now it’s starting to go up again. What to make of that? I mean, are we going back into another bubble economy? I don’t see how anybody knows that.”
That’s that winning non-arrogance again!
But again I think Shiller goes too far with the humility that comes naturally to him. No one knows anything for sure. That much is certainly so. But the full reality here is that Shiller’s work has helped us to become far better able to predict economic developments than we were before we had access to his research. If it is human psychology that drives stock prices and investor emotions remain out of control (as both the P/E10 metric and the discussions I participate in on discussion boards and blogs indicate to be the case), our economic future is more troubled than those who follow Fama’s way of thinking portray it to be.
There are things we can do today to ease those economic troubles that we will not be able to do if we wait until there is another price crash to try them. I would like to see Shiller spelling out in more detail what his findings suggest re our economic future and what steps we should be taking to steer things in the right direction.
Most investing experts are too arrogant and the few who aren’t have an inclination to be too humble!
Rob Bennett has recorded a podcast titled They Used Our Natural Risk Aversion Against Us. His bio is here.