Valuation-Informed Indexing #380
By Rob Bennett
Are increases in stock prices a good thing for stock investors?
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
That’s an easy one. Price gains are an obvious positive. Asking if stock price increases are a good thing is like asking whether it is a good thing to learn that you are getting a raise this year. What’s the downside?
Whether there is a downside or not depends on where the stock price increases come from. If the price increases are caused by economic developments, they are a pure positive. But if the price increases are caused by shifts in investor emotions that have a long history of always shifting back in the other direction in time, there is a real downside to price increases. For one thing, the gains are not real; they don’t last. For another, the temporary gains cause poor financial planning; investors who think their stock portfolios are worth more than they really are worth buy things that they can’t afford and then need to cut back on spending dramatically when the temporary gains disappear.
It seems to me that what Shiller showed in 1981 when he showed that valuations affect long-term returns is that price increases of more than the 6.5 percent real return that is the average long-term return are caused by investor emotion. Otherwise, how could today’s P/E10 level predict the return that applies in 10 years or in 15 years or in 20 years? The P/E10 metric cannot see into the future; it cannot contain information about economic developments that will take place in future days. The P/E10 level is able to predict future returns because it shows how irrational investors are being at a given point in time. If the market must ultimately get the price right (that is the core job of all markets), mispricing on the up side is always going to lead to poor long-term returns and mispricing on the down side is always going to lead to very strong long-term returns.
Shiller revolutionized our understanding of how stock markets work because he showed that it is investor emotion that determines stock prices, not economic developments. If that is so, then upward movements in prices are not necessarily a good thing. They are a good thing when stocks are underpriced and when the upward movement thus pushes prices closer to fair-value levels, And then are a good thing when stocks are priced at fair-value levels and the upward movement is not more than the 6.5 percent real annual return that is justified by the economic realities. But upward price movements beyond that are not a good thing at all. Upward price movements beyond that hurt stock investors by making financial planning more difficult than it needs to be and by making our economic system less stable than it would otherwise be (price crashes cause recessions by dramatically reducing consumer buying power).
So price gains are not always a good thing. The best thing for stock investors would be if prices always remained somewhere near fair-value levels. Price gains that push prices well beyond fair-value levels are in fact a negative.
Most investors view this way of looking at things as an absurdity. Could that ever change?
I think it can change. The key is that investors need to hear this new perspective explained and referred to on a daily basis. When we hear that stock prices have gone up and the voice conveying the news is conveying it in excited tones, the idea is implanted that price increases are a good thing. When no voices are ever heard offering an alternative perspective, the message conveyed is that there is a widespread consensus that price increases are always a positive, that this is one belief that is beyond reasonable dispute.
All of the work that I have done in the investing realm is aimed at questioning the widespread belief that stock price gains are always a good thing. I see Shiller’s 1981 finding as a finding of “revolutionary” import (Shiller in fact uses that very word in the subtitle of his book). I believe that the reason why it is only a small percentage of the population that has not yet incorporated the implications of Shiller’s research findings into its thinking about how stock investing works is that the ideas are not discussed frequently enough for them to take hold of the imaginations of most stock investors. All marketing experts know that repetition possesses a greater persuasive power than logic.
I have experienced a lot of frustration trying to persuade investors that price gains are often not a good thing. The trouble is that most investors are smart enough to perceive a threat to their well-being implicit in the claim. The suggestion is that some price gains are not real at times of overvaluation. It follows that we cannot count the full amount reflected in out portfolio statements when determining how much we have in the way of life savings. Stocks are priced at two times fair value today. I am telling people that they need to divide the amount on their portfolio statements by two to know the true value of their stock investments. Not a clever way to win friends and influence people!
But what happens after a stock crash takes away the excess gains? Then investors will be seeking explanations for why their financial futures are not shaping up to be what they had been led to believe they would shape up to be. Then Shiller’s understanding of how stock investing works will make sense at last.
Stock gains are not necessarily a good thing. Accepting that that is so will change just about everything that you have ever believed about how stock investing works. I think it is so. I certainly think it is an idea to which every investor should be giving serious consideration. Once you accept that not all stock gains are a good thing, all kinds of strategic possibilities — some of them very exciting indeed — open up to you.
Rob’s bio is here.