Where Greenspan Went Wrong In Doubting His Ability to Contain Irrational Exuberance


Valuation-Informed Indexing #350

by Rob Bennett

Alan Greenspan once explained his decision not to act on Robert Shiller’s suggestion that the Federal Reserve quell the stock market bubble of 1996 on grounds that the models used by valuation-informed investors to warn of coming prices crashes had predicted eight of the last three market plunges. It’s a true enough point and one that should be kept in mind by all who attempt to put Shiller’s powerful research insights to practical use. But Greenspan’s observation is rooted in a widely believed fallacy, in my assessment.

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Red lights deliver warnings to drivers not to proceed into an intersection because there is a good chance that cars will be speeding through the intersection from the other direction at the same time. Say that research showed that, out of every eight times that a driver elects to ignore a red light and continue blithely into the intersection, he ends up in a car accident in only three of them. Would any reasonable person conclude that that evidence offers a good case for ignoring traffic lights?

Greenspan is a very smart man. I am of roughly average intelligence. It took me all of five minutes to develop this rejoinder to the Greenspan observation after I was reminded of it by an article on him that I recently happened to come across while investigating an unrelated subject. My rejoinder is easy to understand. I don’t think that the claim that I am making about traffic lights would inspire even a tiny bit of controversy if I offered it in any context other than a discussion of Greenspan’s decision to let the irrational exuberance of 1996 get even more out of hand in the years that followed. Yet, in the investing context, my claim is controversial indeed.

It’s a puzzle. And I am a believer in the idea that it is by solving puzzles that we achieve big advances in our thinking about a subject. Why is it that Greenspan and so many others believe that valuation-based warnings can be ignored on grounds that there is a good chance that they will not prove out quickly? Why are investors so focused on the short-term and so unwilling to consider the long-term effects of their decisions?

The trouble here is that the idea that the current day’s stock price rather than the current day’s stock price adjusted for the effect of overvaluation or undervaluation reflects properly stocks’ lasting real value is reinforced on a daily basis by all that we hear about the stock market. Stock prices change daily. And every day explanations are given as to why they moved in the direction in which they did. The explanations given are “just so” stories. They always sound plausible. But they are never subject to scientific verification.

Could it really be that stock prices went up because interest rates were cut? Sure. But it could also be that, had prices gone down on the day of an interest rate cut, that the price drop would in some way have been attributed to the rate cut as well. There is no definitive way to know why prices move as they do. So we accept seemingly logical explanations out of a deeply felt need to make sense of what is happening to our store of retirement money.

Greenspan is saying that, had the Federal Reserve acted in 1996 to quell the irrational exuberance that he and others suspected had become a problem, he might have caused damage to the overall economy and it might not have been necessary to do so. It might be that the flashing red lights being transmitted by the high P/E10 level of the day could be ignored without sending the investing car into a crash. That’s true. Greenspan did not act to quell the irrational exuberance of 1996 and stocks did not crash as a result. At least not for several years. To the contrary, stock prices zoomed in 1997 and 1998 and 1999. The valuation-based warnings were wrong.

They weren’t really wrong. The warnings were valid and much-needed warnings and we all would be better of today had Greenspan acted on them. Greenspan held back because he was worried that we all might “miss out” on economic growth that we otherwise could have enjoyed if he took action to quell the irrational exuberance. That’s why millions of investors ignore Shiller’s research and stick to the same stock allocation no matter how high prices rise. They fear missing out on gains that the market has been known to deliver even starting from times when market prices are in the stratosphere.

I have a calculator at my web site (The Investor’s Scenario Surfer”) that permits me to test how big an issue the possibility of “missing out” is in the real world. It permits me to test how various allocation switching strategies perform in an unlimited number of return-pattern scenarios. It shows that investors who follow reasonable valuation-informed strategies rarely “miss out” on anything.

I have performed hundreds of tests. Valuation-Informed Indexing strategies have outperformed Buy-and-Hold strategies in 90 percent of them. In the cases in which the Valuation-Informed Indexing strategies prevailed, they generally prevailed by large amounts while, in the cases in which the Buy-and-Hold strategies prevailed, they usually prevailed by small amounts. In many of the cases in which the Valuation-Informed Indexing strategies prevailed, I despaired mid-way through the test of being able to catch up to the Buy-and-Hold strategy. Buy-and-Hold strategies often outpace Valuation-Informed Indexing strategies for long stretches of time. But practicing price discipline possesses a counter-intuitively great power to overcome short-term setbacks.

We think that what mattes is what our portfolios statements say today. Those numbers seem real to us. They are tangible. We embrace them. We tune out claims that valuation-based strategies could deliver something better, we dismiss those claims in deference to our fears that “missing out” on short-term gains will cause us to miss out permanently.

Common sense tells us that it is not so. Common sense tells us that practicing price discipline must be a good thing. And the entire historical record confirms that what common sense tells us is so really is so. Our fear of “missing out” is an irrational one. Perhaps those of us who have been taken in by this fear to our financial detriment can obtain some comfort in the knowledge that people as smart as Alan Greenspan have been taken in as well.

The secret to effective investing is not being smarter than the other guy, it is being more emotionally balanced than the other guy. And the literature in this field is only beginning to offer advice on how to achieve emotional balance when investing in stocks for the long run.

Rob’s bio is here.