Valuation-Informed Indexing #244
by Rob Bennett
Yale Economics Professor Robert Shiller says that “the human brain is wired for stories.” The suggestion is that conventional investing analysts focus too much on the numbers showing whether the economy is growing or not and should focus more on the stories that investors are telling themselves about why the economy is growing or not because the stories have more influence on stock prices than the economic realities reflected in the numbers. I half agree and I half do not.
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I believe that Shiller is right that it is investor emotion that is the primary determinant of stock price changes and that the numbers reflecting economic realities are given too much stress because the human mind is able to rationalize away whatever realities they reveal when it is set on doing so. That said, I believe that Shiller’s greatest contribution is the emphasis he has placed on use of the P/E10 valuation metric. Shiller’s number is more important than any of Shiller’s story-related insights.
Investors do tell themselves stories and there is some value in trying to understand those stories and the role they play in setting stock prices. But the practical reality is that knowing that investors rely on stories to set stock prices is not an actionable insight. Say that Shiller is 100 percent right that stories play a big role. What do we do in response? There are always multiple stories being told and it is often the case that some of the stories that investors tell themselves conflict with other stories that investors tell themselves. Investors believed in the late 1990s that the information revolution was going to increase corporate profits dramatically and that that justified higher stock prices. But they also believed that the middle-class was falling behind and that America’s best days might be behind it; these ideas justified lower stock prices. Stock prices soared in the 1990s but have barely been holding steady for the past 15 years. The same stories are being told. The change is that for a time one type of story was dominant and now the other has become dominant.
Stories matter. But we need to quantify the effect of stories on prices to take advantage of Shiller’s insight that stories matter. It is the P/E10 metric that permits us to quantify the effect of stories and thereby to learn how to make use of Shiller’s breakthrough findings to become better investors.
Investors believed in the information revolution all throughout the 1990s. But in the early 1990s and mid-1990s valuations were at levels at which going with a high stock allocation continued to make sense. That was no longer so by the last four years of the 1990s. In January 2000, stocks were priced at three times fair value, according to the P/E10 metric. That meant that the long-term return for this asset class had been dramatically reduced (the likely long-term return on stocks when the P/E10 value reaches the level it reached in January 2000 is actually a negative number). Even if you believed that investors were telling themselves a bad story, there was no need to lower your stock allocation until 1996. At the tail end of the 1990s, it became imperative to do so. The same story had a different effect on stock prices at the end of the 1990s than it had at the beginning of the 1990s or in the middle of the 1990s.
P/E10 is a number with seemingly magical powers. It tells us how emotional investors are at any given point in time. This is the most important thing to know about stocks. The non-emotional factors (all of the factors revealed by metrics other than P/E10) are taken into consideration by millions of rational investors and thus are always “priced in.” P/E10 is never priced in. How do I know? The idea that overvaluation (mispricing) could ever be priced in is a logical absurdity. If there ever comes a time when P/E10 is priced in to the market price, P/E10 will not be high anymore. When investors become emotionally open to taking overvaluation into consideration, overvaluation disappears.
P/E10 doesn’t tell us what stories investors are telling themselves at any given time. But who cares? We don’t need to know what the stories are to know how to invest ourselves. What we need to know is how much the stories are throwing prices off. This P/E10 reveals. When the P/E10 level is insanely high, stocks perform poorly in the long-term. There has never been an exception in the 145 years of stock-market history available to us. When the P/E10 level is moderate or low, stocks perform well in the long-term. Again, there has never been an exception in the 145 years of stock-market history available to us. P/E10 tells us what we need to know to elect stock allocations suitable to our risk tolerances.
And, if we listened to it, P/E10 would help us keep those investor stories from getting out of hand. When Shiller tells us that investors are influenced by stories, he is telling us that investing is an emotional rather than a rational endeavor. So it is. But knowing that investors are emotional doesn’t protect us from the bull markets and bear markets and economic crises caused by such emotionalism. P/E10 does. When we provide investors with tools letting them know how poor an investing choice stocks become when priced insanely high, we will eliminate the possibility of runaway bull markets. Stock prices are self-regulating in a world in which all investors are informed of the effect of valuations on long-term returns.
I agree with Shiller that investors are highly influenced by the stories they tell themselves about stocks. But I agree with the Buy-and-Holders that the best investing insights are quantifiable, action-orinted investing insights. P/E10 is the number that makes Shiller’s story-telling insights actionable for real-world investors. P/E10 is the number that tells the tale on us when we permit our inclination to tell stories about stocks to get dangerously out of hand.
Rob Bennett recorded a podcast titled Jeremy Grantham Tells the Truth (Straight, No Chaser) About Stock Investing. His bio is here.