Eight Implications of Shiller’s Finding That Valuations Affect Long-Term Returns

Valuation-Informed Indexing #383

By Rob Bennett

Yale Economics Professor Robert Shiller showed with peer-reviewed research published in 1981 that valuations affect long-term returns. That changes everything. If Shiller is right (none of the research published in the 37 years has discredited supports his finding), just about everything that we once thought we knew about how the stock market works has turned out to be wrong.

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Set forth below are brief descriptions of eight important and far-reaching implications of Shiller’s “revolutionary” (his word) finding, work for which he was awarded a Nobel prize in 2013.

1) The market is not efficient.

An efficient market is one in which factors that affect prices are reflected in prices quickly. If today’s P/E10 level does not affect the price that applies one year from today or two years from today, but does affect the price that applies 10 years from today and 20 years from today, factors that bear on price cannot be said to be reflected in prices quickly. The most important factor influencing the price of stocks is reflected in the price only very slowly.

2) Investors are not rational.

The reason why we once believed that the market is efficient is that we believed that investors rationally pursue their self-interest when they make investing decisions. It is best for stock investors if stock prices reflect reality at all times. But they don’t. The market is not efficient. The only explanation is that investors are not rational. Inefficiency of market prices shows that investors make self-destructive emotional choices when pricing stocks

3) Valuation levels reveal the amount of emotion present in stock prices at a given time.

The P/E10 level tells us how off the mark stock prices are at a given time. Another way of saying it is that the P/E10 level tells us how much emotion is present in the stock price at a given time. This is valuable information. It is only by learning of their emotion that investors can overcome it. The P/E10 level provides investors with self-awareness.

4) Stock investing risk is not static but variable.

If the long-term return on stocks changes with changes in the P/E10 level, the risk associated with buying stocks is not static but variable. Stocks are far less risky when prices are low and a good long-term return is virtually guaranteed than they are when prices are high and a poor long-term return is virtually guaranteed.

5) Stock investing risk is not nearly as great as it was once widely believed to be.

If stock investing risk is variable, investors who care to can minimize their lifetime investing risk by investing in stocks to the same extent as Buy-and-Hold investors over the course of a lifetime but investing more heavily in them at times when risk is low and by investing less heavily in them when risk is high. Stock investing risk is to a large extent optional for investors open to taking valuations into consideration when setting their stock allocations.

6) Buy-and-Hold strategies increase risk while diminishing return.

If investors who take valuations into consideration are thereby able to increase their lifetime return while minimizing risk, the converse must also be so — investors who are not willing to adjust their stock allocations in response to big valuation shifts diminish return and increase risk by failing to do so.

7) A decision to go with the same stock allocation at all times is not a neutral decision.

Much of the appeal of a Buy-and-Hold strategy is that it appears on first consideration to be a neutral choice to remain at the same stock allocation at all times. The Buy-and-Holder adopts the humble position of acknowledging that he cannot make use of information about the market to engage in effective market timing. But if stocks are more risky at some price levels than they are at other price levels, a decision to avoid market timing is a decision to adopt a different risk profile at different times for no good reason. A decision to follow a Buy-and-Hold asset allocation decision is not a decision to take a neutral stance in the face of the unknown but a decision to deliberately cause one’s risk profile to get out of whack by ignoring changes in the value proposition offered by stocks that can be easily revealed to all investors.

8) The valuations factor is unlike all other factors bearing on stock prices.

While the market is not in an overall sense efficient, research published by University of Chicago Economics Professor Eugene Fama showed that in all other respects the market is efficient. As a general rule, investors really do pursue their self-interest in a rational way and thus factors bearing on price are taken into consideration quickly. What makes the valuation factor different is that mispricing (overvaluation or undervaluation) is the result of investor emotion. It is tautological that investors cannot take valuations into consideration in a rational way. Mispricing is irrational; the rational thing to do would be to not engage in mispricing in the first place, in which case it obviously would not need to be taken into consideration. The only rational way to respond to mispricing is to increase or lower one’s stock allocation from what it would be if the mispricing were not present, which of course acts to eliminate the mispricing.

Rob’s bio is here.