Valuation-Informed Indexing #344
by Rob Bennett
Shiller showed that stock prices are determined not by economic developments but by shifts in investor emotion. And the P/E10 metric provides us a tool to identify how emotional investors are at any given point in time.
Philip Carret was an investor and founder of Pioneer Fund, one of the first mutual funds in the United States. Carret ran the mutual fund for 55 years, during which time an investment of $10,000 became $8 million. That suggests he achieved a compound annual return of nearly 13% for his investors. Q1 2021 hedge Read More
The general rule is that, the farther the P/E10 number is from the fair-value P/E10 figure of 15, the more emotional investors (and thus the market as a whole) are. Investors must become emotional for the P/E10 number to reach 18, they must become very emotional for the P/E10 number to reach 24 and they must become insanely emotional for the P/E10 number to reach 30.
I think we can say more than that with the benefit of the 36 years of experience we now have of seeing investors react to Shiller’s transformational insight. It was in the early 1990s that the P/E10 level first approached the danger zone that it did not actually enter until 1996. We now can say that there are two changes in investor emotion possible when the P/E10 level becomes exceedingly dangerous: investors can become fearful, as most valuation-conscious investors predicted they would in 1996. Or they can become even more irrationally exuberant, pushing valuations to levels never seen before in U.S. history.
If we are going to describe the investors of 1996 as highly emotional, we need stronger language to describe the investors of late 1999. By the time the market topped in early 2000, a regression analysis of the historical return data showed that stocks were likely to provide a negative 10-year going-forward return. That’s some irrational exuberance! I use the adjective “insane” to describe the excesses of the late 1990s. I don’t get the impression that I win many friends by doing so. But I feel a need to distinguish the relatively mild case of irrational exuberance achieved in 1996 from the historic form of the virus experienced a few years later.
Some would say that investors were more emotional in the wake of the 2008 crash than they were in early 2000, when the P/E10 value was much higher. I view that as a surface perception. If you interviewed both sets of investors, you would have heard more expressions of worry from the investors of early 2009. I know that to be so because I was sitting in on lots of investors’ conversations via internet discussion boards at the time. But I can report that the investors of the early 2000s were “crazier” in important senses, based on interactions that I had on internet forums that I visited in those days.
In the early days, the strong surface impression was that Buy-and-Hold was working great. But the psychological reality clear to any soul seeking to discern it was that investors were scared to death even in those sunny days that things were not going to play out in the real world according to the academic theories that did so much to fuel the biggest bull market of our nation’s history.
How do I know that investors of that day were more scared than they let on? I challenged their thinking about how stock investing works. They did not respond with the calm confidence that comes with following a strategy that one truly believes is rooted in research. They responded with a seething anger. Not all of them, to be fair. Many tried to keep their cool in public. But there were a good number who said things that I have never seen said in internet discussions of the most hot-button political issues. And most of those who did not themselves explode in hate supported those who did, suggesting sympathy for the views about stock investing held by the exploders if not sympathy for their unfortunate debate control tactics.
I see more reasonable behavior today. I am still banned at over 20 sites. I don’t expect that that will still be the case when the P/E10 level has reached reasonable levels. But I haven’t received a death threat in my e-mail in-box in a long time. Emotions are less raw today. The proudest Buy-and-Holders were humbled by the 2008 crash and then relieved when prices shot up again and now seem to have achieved an emotional state in which they cannot yet quite accept that bull market gains are not real but in which they are also coming to a gradual acceptance that perhaps it is not all true. My sense is that a lot of today’s Buy-and-Holders are preparing for a day when they will need to acknowledge that we have not as a society yet achieved quite a perfect understanding of how this stock investing thing works.
Valuations offer a quantification of the level of investor emotion present in the market at a given point in time only in a gross sense. Investors are in a general sense a lot more emotional when the P/E10 is 30 then they are when the P/E10 level is 15. But I don’t think that the emotional state of most investors living through a 15 being seen on the way up can even be compared to the state of most investors living through a 15 on the way down. When we next touch 15 (it will happen!), investors will be feeling very down, very emotional. It will be a very different emotional than the hopeful 15 we saw when we crossed that line moving in the other direction back in the 1980s.
To fully appreciate the emotional state of investors, we need to look at the stock market history that produced it. Investors cannot help but take their personal financial circumstances into consideration when forming an emotional take re the P/E10 level that applies at any given point in time. When we last saw 15 on the way up, it signified a big advance from the P/E10 of 8 that applied in the early 1980s. In those days, the number “15” represented the realization of a dream imagined at a time when most of us dismissed the idea that stocks would ever again be priced fairly as unrealistic. A “15” experienced a year or two or three from now will signify to most the loss of hopes for future happiness that have been crushed by a brutal reality.
We’ve never been through a time-period in which we saw valuations rise as high as they did in the late 1990s. So the trip down to the less-than-fair-value prices that presumably lies ahead of us will be the most emotional time-period in U.S. stock market history. We were intensely emotional in the early 2000s. Today we are less intense in our dogmatism but are feeling a wider array of emotions — a mix of pride (that we have done as well as we have despite what common sense tells us), regret (that the party cannot last much longer), anger (that the experts sold us out and that we bought into their stories) and fear (that we really do not know what lies on the other side of this big black mountain).
If Shiller is right, Buy-and-Holders should be feeling intensely emotional today. And we are.
Rob’s bio is here.