Valuation-Informed Indexing #341
by Rob Bennett
The election results of November 2016 came as a shock to most of us. Much of the commentary focused on the idea that members of today’s “elite” are living in a bubble. Great Britain would not elect to leave the European Union because that sort of thing is just not done. Donald Trump could not win the Republican nomination because he said things that no one had dared say before. He could not win the Presidency because he had less money to spend and he had not built a good ground game and he had not won many Senate endorsements.
The “bubble” being referred to here is not the kind of bubble that we talk about when stock prices reach high levels. The idea here is that the elites live in a thought bubble. They only speak to other elites and all elites say the same things. When non-elites don’t behave as expected, the elites are left dumbfounded. People voted for Donald Trump? Who are these people? If they exist, why have I never met one of them?
It’s a different kind of bubble that applies in the investing realm. There the idea is not that there is a transparent film blocking out other modes of thought. The stock bubble is a balloon that gets inflated to a point where it stands ready to pop.
But the two uses of the word “bubble” are in fact referring to similar phenomena. Stock bubbles are caused by thought bubbles. We couldn’t have stock bubbles if we did not have thought bubbles. A good way to define “stock bubble’” is as “a physical manifestation of the thought bubble made possible in the investing realm because stock prices reflect investor irrationality reduced to numbers.”
A P/E10 value of 15 (the fair-value P/E10 level) is telling us either that there are no thought bubbles present in the stock market at the time, or, if there are, the thought bubbles that are pulling prices irrationally down are matched by thought bubbles exerting on prices an equal irrational force in the opposite direction.
A P/E10 value of 8 is telling us that there is a big thought bubble pulling prices down irrationally. There is no rational explanation for why stocks should ever sell at one-half of their true value.
A P/E10 value of 30 is telling us that there is a big thought bubble pulling prices up irrationally.
Eugene Fama, who believes that the stock market is efficient (that is, properly priced), often challenges those who believe in valuation-informed strategies to define “bubble.” My view is that Fama misunderstands the case for the belief that investors must adjust their stock allocations in response to big shifts in stock valuations. He is asking that valuation-informed investors identify the P/E10 level at which prices are so out of hand that a crash in imminent. Using that test, valuation-informed strategies fail because there is no one price level that always signals an imminent price crash.
Fama’s mistake (in my view), is in trying to apply strict logic to an irrational phenomenon. Investors who at one time in history were spooked by a P/E10 of 25 might at another time in history tolerate a P/E10 of 40. And there might not be any particularly persuasive explanation for the variance in behavior. Mispricing is irrational by definition. It is not reasonable to demand of a man who insists that he is the king of England to show papers proving the case. Craziness doesn’t respect evidence. Investors who can rationalize a P/E10 level of 26 can rationalize a P/E10 level of 39. Irrational exuberance is not bound by the laws of logic.
Fama is being irrational in being comforted by his observation that mispricing should not exist. The fact is that it does exist. The decision by many smart and good people to ignore that scary reality makes the reality even more scary. Nothing fuels overvaluation like a belief that it doesn’t matter.
It is the transparent film that keeps out unwelcome ideas that causes the inflated prices. I often engage in back-and-forth discussions with Buy-and-Holders that end with a declaration on their part that valuations cannot be as important as I say because the vast majority of investors say that they are not. It’s the very fact that investors don’t believe that valuations matter that permits them to rise so high! If most investors believed that valuations matter, prices could never get too out of hand.
And the Buy-and-Holders’ solution to the problem of people like me pointing to the 36 years of peer-reviewed research showing that valuations matter a great deal indeed is to ban us from discussions with them. The only way to get prices down is to persuade more investors that prices matter. But once prices are so high that they matter a great deal the majority of investors cannot bear to listen to the case for why prices matter. So they ban those discussions, pushing prices higher yet.
I’ve read several articles reporting that Hillary Clinton’s husband, a man who is widely recognized as knowing more than a thing or two about politics, advised her campaign to spend some time campaigning in Wisconsin. He was patted on the head and told that he was an old man with old ideas, the new guys had this one in the bag. They believed it was so. Inside the bubble, victory was certain. Why hear out a fellow making points that came from outside the bubble? So it is with stocks. Those who have new ideas about how stock investing works are perceived as threatening to those who have built their careers around promotion of the old ideas. Should I stop sharing my thoughts about how stock investing works because they are not popular? That argument does not compute for me. It is the unpopularity of my ideas that makes them valuable, in my assessment. They come from outside the bubble.
My critics tell people asking about me that I have been banned at over 20 sites. They do it to shame me. It is my view that the bannings reflect poorly on Buy-and-Hold. If Buy-and-Holders were confident in their strategy, challenges to it would not provoke bannings. When the Buy-and-Holders themselves have come to believe that the strategy can survive only for so long as it is protected in a bubble, why should any of us who have not yet drunk the Kool-Aid be impressed?
Rob’s bio is here.
