Valuation-Informed Indexing #264

by Rob Bennett

Yale Economics Professor Robert Shiller was awarded the Nobel Prize two years ago. So it is widely understood that his 1981 finding that valuations affect long-term returns “revolutionized” (Shiller’s word) our understanding of how the stock market works. However, the full reality is that the implications of Shiller’s finding extend much farther than his most ardent supporters (and perhaps even Shiller himself) appreciate today.

I have made this point on numerous occasions and have never been successful in generating much feedback. So I was happy to see a Letter to the Editor written in response to Shiller’s recent article (Rising Anxiety that Stocks Are Overpriced) that makes the essential point succinctly and yet compellingly. The comment was posted on August 31 by a fellow named “Ken” from Sydney.

Ken writes: “One of the problems that Professor Shiller ignores is that bubbles, in generating apparent wealth, have effects in the wider economy. As their asset values increase, they [investors who own stocks] tend to spend more, which increases the income of others in the economy. Seeing their increased income, they borrow more, pushing up asset prices.”

It is a simple point. And yet it is such a powerful one. If overvaluation is real (Shiller showed that it is), then the numbers on our portfolio statements are inaccurate. When stocks are priced at three times fair value, as they were in early 2000, portfolios that are nominally worth $600,000 possess a true and lasting value of $200,000. Our Buy-and-Hold fantasies cause us all to believe that we are much farther along in our effort to finance our old-age retirements than we in fact are.

People don’t like to hear that. On the surface it is a depressing message. But I wish that people would look deeper. The deeper meaning of Shiller’s finding offers great encouragement re the future of our economic system.

Some people love capitalism. I count myself in that group. I naturally would like to persuade the many people who do not love capitalism of its virtues. The biggest hang-up that many of those who are skeptical of capitalism have about it is that it is scary. There are times when things are going good when capitalism seems to be lifting all boats in a wonderful way. But there are other times when the entire system collapses, causing people to lose hope. This has been going on so long that even those of us who love capitalism have come to accept it as a reality that will always be with us. One of the many exciting things about Shiller’s research findings is that they point us in a new direction in our understanding of how capitalist markets work, one that suggests strongly that the crazy ups and downs that we have become accustomed to are optional and not at all a necessary part of the story.

We have had four economic crises since 1870, which is as far back as we have good records of stock prices. Each of the four occurred in the same environment, an environment in which stock prices rose to insanely high levels and then crashed, wiping out massive amounts of consumer buying power in the process. Could it be that, by teaching investors to lower their stock allocations when stock prices rise to dangerously high levels, we could not only provide them with higher returns at lower risk but also smooth out the ups and downs that have made capitalism a terrifying economic system for so many and for so long? I think that’s so. I think that Shiller has showed us how to control the excesses of the capitalist economic system by controlling the excesses of stock investing.

People don’t believe me when I say such things. I don’t think it’s because there are powerful arguments showing that I am wrong; at least I can report that no one has ever offered any powerful arguments in response to earlier articles that I have written about this aspect of Shiller’s work. I think that the cause of the skepticism is that what I am saying sounds too good to be true. If there really were a way to smooth out the excesses of capitalism, someone would have jumped on it long ago and even Shiller is not currently making the case (as Ken from Sydney notes in his letter to the New York Times).

What people don’t get is that Shiller’s finding that valuations affect long-term returns stood our understanding of how the stock market works on its head. We used to believe that it was unforeseen market developments that caused stock-price changes. Shiller showed that it is investor emotions that cause price changes and that economic developments play only a secondary role by causing changes in investor emotion. Here’s the magic trick: We cannot control economic developments but we can to a large extent control investor emotion.

What if every web site on the internet told its readers on a daily basis the true value of their portfolios (that is, the value those portfolios have after a valuation adjustment is applied)? Then investors would know that it was in their self interest to lower their stock allocations when stock prices reached insanely high levels. Every tick upward in valuations would cause stock sales and the stock sales would pull prices back to fair-value levels. If we all talked openly about the implications of Shiller’s work, stock prices would quickly become self-regulating.

No more bull markets.

No more bear markets.

No more economic crises caused by the loss in consumer buying power resulting from stock crashes.

We are almost there. We are on the one-yard line.

We need to see more people work up the courage to write the sorts of Letters to the Editor that Ken from Sydney worked up the courage to write.

And the rest of us need to work up the courage to give those letters our serious consideration and then to do what we can to help launch a national debate on this new way of understanding both how stock investing works and of how our economic system works.

It’s heady and exciting stuff.

Rob Bennett’s bio is here.