Valuation-Informed Indexing #255

by Rob Bennett

I am writing this column on Thursday, July 9, 2015. There’s been a lot of talk this week about the Greece debt problem and its effect on U.S. stock prices. I thought it might be helpful to write an article exploring the differences in how Buy-and-Holders and Valuation-Informed Indexers think about how economic and political developments affect stock prices.

Buy-and-Holders believe that it is unforeseen economic and political developments that determine stock price changes. The effects of foreseen developments are priced in at the moment that they are perceived to be on the horizon. It is changes in perceptions that cause stock price changes, according to this model. For example, a interest rate announcement that differs from the announcement that was expected could cause stock prices to increase or decrease. Investors’ perceptions of the long-term return that will be obtained from ownership of their shares changes and thus the value placed on ownership of those shares changes.

It all sounds plausible enough.

But Valuation-Informed Indexers possess a different understanding.

We agree that economic and political developments have an effect. But we believe that that effect is secondary. Investors possess emotions and thus it is ultimately emotions that determine where stock prices are set. The economic and political developments pass through an emotions filter before they determine whether prices rise or fall and by how much. Emotions are the dominant factor, not the economic or political developments that set them off.

This changes everything. Because it means that the only way to assess the effect of an economic or political development is to take into consideration the valuation level that applies at the time the economic or political development comes into play.

Say that a drop in interest rates is considered a good thing for stock investors. Under the Buy-and-Hold Model, this means that an unforeseen drop in interest rates will cause stock prices to increase by the amount that the drop in interest rates increases the present value of the stock shares held by investors. It doesn’t work that way under the Valuation-Informed Indexing Model.

It is investor psychology that determines the size of the price change, according to Valuation-Informed Indexers. Say that stocks are priced at two times fair value and that investors are trying to silence fears that prices are about to crash but also experiencing fears that they will miss out on additional gains. An interest-rate drop that increases the fear of missing out on additional price increases could cause prices to increase far out of proportion to the level of increase justified by the economic plus just realized.

The other side of the story is that even a small interest-rate increase that comes about in such circumstances could cause prices to fall to a far greater extent than the fall justified by the small economic negative. Buy-and-Holders assume rationality on the part of investors. Valuation-Informed Indexers do not. There is a certain logic present in the irrational behavior of investors just as there is a certain logic present in all emotion-induced human behavior. But it would be a mistake to try to find too strong a rational correlation between economic and political developments and the stock-market price changes that follow from them. The process by which price changes are achieved is at a fundamental level irrational.

Our understanding of how human psychology affects stock prices today is primitive. So I am skeptical of the claims of experts as to where stock prices are likely headed if we see certain economic or political developments take place. However, there is one important exception to this rule. There is one factor that we can look at that tells us with a good degree of reliability where prices are headed.

That is the valuations factor.

Say that stocks are priced at two times fair value. There is only so much higher they can go. We cannot say when the market will fall, it might take a few years. But once prices hit two times fair value, we can say with a high degree of confidence that the odds favor a big price drop over a big price increase. You might see a year or two or rising prices following a time when prices hit two times fair value. But the odds are against you being able to retain those gains. The odds are strong that all of those gains are going to be lost and that the market price is going to continue falling hard at least until it has hit fair-value levels. Buying stocks when prices are at two times fair value is betting against the house; all wins are temporary.

The opposite is of course true when prices are at one-half of fair value. At that price level, even the worst economic news tends to push prices up. Why? Because all the bad news imaginable is already priced in to the market price. Things cannot get any worse in the minds of investors. So bad news bounces off investors like bullets off of Superman’s chest. Prices can only go so low. Buy stocks when prices are low and you are purchasing the proverbial sure thing. Valuation levels might remain the same for a time, in which case you still earn the average long-term average return of 6.5 percent real. Or prices might rise, in which case you do better than that. In the event that you see a price drop starting from a time when the market is selling at fair-value prices, it is highly unlikely that that price drop will remain in place for long.

Human psychology can be perverse. When prices are low enough, negative economic and political events can cause prices to rise. Negative news can signal to investors that years of price drops have come to an end and that it is time to start believing in the market again because the bad stuff has been worked out of its system.

Stocks are a scary investment choice today. Not because of the Greek debt crisis. Because prices are so darn high. Stocks are today priced at levels that always signal poor performance. Stock prices can only move in one direction from where they stand today. If the Greek debt crisis is not the thing that brings them down, it will be something else.

Rob Bennett’s bio is here.