Valuation-Informed Indexing #241
by Rob Bennett
Yale Economics Professor Robert Shiller made a troubling claim in a recent presentation to the Credit Suisse Asian Investment Conference. He said, according to a report on the presentation (the words being quoted here are from the report on the presentation, which summarize Shiller’s claim rather than quote him directly) that “as much as we might like to subject asset bubbles to a rigorous statistical study, there simply haven’t been enough of them to draw meaningful conclusions.”
The words are literally true. And Shiller is making a valid and important point. Researchers in this field have only 145 years of historical return data available to them. During those 145 years, we have seen four secular bull/bear cycles. The same general patterns have evidenced themselves in each of those cycles. But Shiller is of course entirely correct that we can only be so confident of any findings reached by examining four cycles. Given the importance of getting investment recommendations right, we would prefer to have forty cycles to examine rather than four. The data available to researchers in this field is severely limited. Everyone should be careful when making research-based claims to be sure to note this caveat when doing so.
My concern is that Shiller’s comment can fairly be read as suggesting more than the need to state a caveat when presenting research-based findings. His words can be interpreted as saying that we cannot build on his “revolutionary” (this is Shiller’s word) finding of 1981 that valuations affect long-term returns until more data is available. I strongly disagree with any such suggestion. In fact, I think that it would be exceedingly irresponsible to fail to do so.
In an ideal world, researchers would not make any claims until they had so much support for them that they could state them with 100 percent confidence. That’s not the world we live in. We once thought that the market was efficient (that is, that valuations didn’t matter). We now know that it is not. I think it is a terrible tragedy that in the 34 years since we achieved this critical advance in understanding of how markets work, researchers have hung back from exploring the many far reaching implications of the breakthrough findings. We very much need to be studying bubbles, how they form, how to stop them from forming, and what damage they do to us both as individual investors and as a society.
No, we don’t have enough data to state conclusions with perfect certainty. But we must make the effort to learn as much as we can while being sure to express our conclusions with all the necessary caveats. Investors cannot wait another 145 years or another 290 years to learn how to invest. We all have money to invest today for retirements that will be beginning within a few decades. This is not a case where we can put our financial planning on hold while we wait for more years of historical return data to accumulate. We are better served with imperfect research on bubble-related questions than with a lack of additional research on these matters.
We don’t have as much data as we would like to have. That’s perfectly true. But that hasn’t stopped the researchers who do not focus on bubbles from generating mountains of research. Most of today’s investors have no idea how dangerous bubbles can be. A regression analysis of the historical data shows that stocks purchased at the height of the recent bubble were likely to provide a negative long-term return. Most investors have roughly 40 years to finance a retirement. If the bubble of the 1990s is going to cause us to see negative or low positive returns for the 20-year period from 2000 through 2020, we all need to know that so that we can get about the business of relying on asset classes other than stocks to finance our retirements during this low-return time-period. We need research to know how much to lower our stock allocations and when to increase them again. If the unfortunate reality is that we cannot have perfect research, we need good-enough/best-efforts research. We need something. We need guidance on how to prevent and avoid price bubbles.
Say that there were research in the medical field showing that eating certain foods could permit us to avoid getting cancer but that the evidence was not strong enough to justify a claim that this was with certainty the case. Would the researchers be justified in holding off on reporting these findings for many decades while more evidence accumulated? I say “no.” Researchers should certainly not overstate their findings. Researchers certainly should note caveats that apply to their work product. But I would be upset if a loved one died from cancer when he could have lived many more years if only research had been published telling him what foods he needed to eat to increase the likelihood of doing so.
I believe that we need a national debate on Shiller’s findings. I would like to see hundreds of researchers exploring the scores of implications of Shiller’s work that have been brought to light in recent years. If researchers hold back from doing such research, they do harm to millions of people by doing so. If bubbles hurt us all as much as Shiller’s findings suggest they do, we need to know everything that can be known about them. Knowledge is a positive. Even imperfect knowledge is a positive.
I don’t mean to say that researchers should only be producing research showing that bubbles are a negative. Research arguing that bubbles are less of a problem than some of us believe them to be is also of great value. We need to have both sides doing the best they can to generate new insights that help us all over time come to a more complete and more balanced understanding of the realities.
More research! On more questions! More! More! More!
Learning new things is the one true free lunch.