Valuation-Informed Indexing #322
by Rob Bennett
Gates Capital Management's Excess Cash Flow (ECF) Value Funds have returned 14.5% net over the past 25 years, and in 2021, the fund manager continued to outperform. Due to an "absence of large mistakes" during the year, coupled with an "attractive environment for corporate events," the group's flagship ECF Value Fund, L.P returned 32.7% last Read More
There’s something that happens in the wake of every price crash that floors me. People are of course upset that a large portion of their life savings has disappeared into thin air and they spend time commiserating about their shock and dismay. Then someone pipes up with a compelling question that stumps even those who in earlier times had confidently proclaimed their own expertise: “Where did the money go?”
Where indeed? Investors lost trillions of dollars of spending power in the 2008 crash. No one stole it. It’s not as if thieves came in the night and transferred money from one set of hands into another set of hands. But the money really did disappear. It was there one day, being used to finance millions of prospective retirements, and then a few hours later it was gone. Where the heck did the money go?
If I were king of the world, no one would be permitted to invest one penny of real money in the stock market until he could answer that question with a high degree of confidence. The time to wonder where the money goes in a crash is before it disappears. It is the answer to that question that should be determining how investors manage their money in the days before a crash. Once the crash has come, it is of course too late for the answer to the question to provide useful guidance.
I saw a few brave souls venture forth in the days following the 2008 crash with explanations of where the money went. It was a sad thing to watch the slow appreciation of the realities taking place in the eyes of those looking to learn the answer to the question. It never existed in the first place? What do you mean it never existed in the first place? I planned all my financial affairs out of a belief that that money was real. And now you are telling me that it never existed? It’s comic in a way. Except its too sad to be truly comic. No, it never existed in the first place. Money created through overvaluation is Pretend Money, cotton-candy nothingness fated in time to be blown away in the wind. It’s not something that any responsible person should count on in the planning of a retirement. No one told you? It’s kind of an inside joke. Telling would ruin the fun. You do understand?
Here’s my question. What if we told? What if we ruined the joke by just telling. Not after crashes. Before bull markets form, when it is a lot easier to kill them.
The obvious good here is that we would no longer see millions losing most of their life savings in crashes once we did that. That’s a pretty darn big obvious good.
But the good stuff just keeps on coming. If we told people how stock investing works before letting it ruin their lives, we would change how stock investing works in a fundamental way. We would greatly diminish volatility, the one bad feature of the stock investing class. People have come to believe that insane levels of volatility are a given in the stock market. But it’s just not so. Not if Shiller is right that valuations affect long-term returns.
If valuations affect long-term returns, then overpricing is a real phenomenon and the market is not efficient at all. If overpricing is real, then it is investor emotion and not economic realities that drives bull markets and the bear markets that inevitably follow from them. It’s bull markets and bear markets that produce most price volatility. End bull markets and bear markets by teaching investors the realities (that the Pretend Money created in bull markets doesn’t exist in a real and permanent sense), and you do away with most stock-market price volatility.
It sounds like a fantastic dream only because we have not yet had a time-period in which we both had access to peer-reviewed research showing that it is so and to a general willingness to explore the far-reaching practical implications of that research. Prior to 1981, we did not have Shiller’s research. So long as we did not know how to avoid volatility, it was just one of those things we had to accept. Then, shortly after Shiller’s findings became available to us and before we worked up the courage to take on the task of rewriting the textbooks to reflect this “revolutionary” (Shiller’s word) research, the greatest bull market in history developed and a powerful resistance to the idea of acknowledging what Shiller showed (because it would mean accepting that our portfolios were not as big as we had been led by pre-Shiller thinking to believe them to be) developed.
Following the next crash, neither of the two factors that have long been holding us back will apply. So the insane levels of volatility that we have come to accept as an unavoidable part of the stock investing experience will go “Poof!” No? Volatility should be low. The U.S. economy is not an internet start-up whose value can increase or decrease 50 percent in a year because of a few lucky or unlucky turns of the wheel of fortune. Our economy is big and long battle-tested. It’s value should be a largely stable thing, certainly more stable than the values we see reflected in the crazy stock market prices assigned to it both in bull markets and in bear markets.
The problem, of course is the Buy-and-Holders. Their reputations are riding on their ability to persuade those of us who appreciate the far-reaching implications of Shiller’s findings to keep it zipped and to persuade millions of investors that they knew all there is to know about how stock investing works long before Shiller arrived on the scene. Grrrr.
Rob’s bio is here.