Stocks

Today’s Stock Price Is an Illusion

Valuation-Informed Indexing #386 on the topic of long-term returns and CAPE ratios

By Rob Bennett

Today’s stock price is an illusion.

That’s what Yale Economics Professor Robert Shiller really showed in his peer-reviewed research of 1981 ostensibly showing that valuations affect long-term returns. If valuations affect long-term returns, then the stock price that applies at any given point in time is — not right.

Long-term returns
geralt / Pixabay

Is that not so?

If today’s valuation level effectively predicts the return that will apply for 10 years and for 15 years and for 20 years, there is something wrong about today’s price. What should happen is that the prediction of the long-term return should be incorporated into today’s price, causing it to drop in cases where the prediction is for poor long-term returns and to increase in cases where the prediction is for exceptionally good long-term returns. But of course that is not what happens. We investors permit both overvaluation and undervaluation to remain in place even though we know what both signal regarding the long-term value proposition offered by the stocks we buy.

Which is another way of saying that today’s stock price is an illusion. The true price (that is, the one that reflects all that is known about the value of stocks at a particular point in time) is influenced by the valuation level (since the valuation level affects the long-term return). But for the valuation level to influence the price would be for the overvaluation or undervaluation to disappear. So, whenever overvaluation or undervaluation is present, the stock price that applies is illusory. It is a pretend price, a price that remains in place not because it makes sense but only because we investors prefer it emotionally to the real price.

Now I’d like to mention an aspect of this question that blew my mind when I figured it out a number of years ago.

I got involved in writing about stock investing as the result of my participation a good number of years back at a discussion board that was formed to help people plan early retirements. My focus was on saving strategies and my work was extremely well-received by the board community. There was a fellow at the board who had posted a safe withdrawal rate study at his web site that reported that the safe withdrawal rate is always 4 percent Thousands of my fellow community members used this study to plan their retirements. It troubled me because it did not seem to me to be possible that the study could get the number right given that it did not include an adjustment for the valuation level that applied on the day the retirement began.

I put up a post noting this concern in May 2002. The post generated two types of reactions . There were hundreds of community members who reacted with great enthusiasm, saying that the discussion that followed was the most exciting discussion ever held at the board. And there were hundreds of others who reacted with intense dismay to these positive reactions and who worked hard (and ultimately successfully) to get the discussion shut down. This struck me as very strange. We all of course would benefit by knowing the accurate safe-withdrawal-rate numbers. Why were some of us so opposed to having the discussion that we needed to have to learn them?

Over time, I figured it out.

What was going on at that board community is going on in every discussion held by every stock investor and indeed by every stock investing expert.

Say that my board community engaged in the discussion that I favored. Say that we talked the issue through, listening carefully to the viewpoints expressed by community members coming at the issue from every possible angle, We would in time have come to a consensus that valuations really do affect long-term returns and thus safe withdrawal rates (since long-term returns obviously affect safe withdrawal rates). Then we would have acted on that information. Then we would have spread knowledge of what we had learned together to our friends at other discussion boards and eventually to the entire community of stock investors.

What would happen to the price of stocks in that event?

The price would come down.

How far?

It would come down until it reached fair-value levels.

Both overvaluation and undervaluation are emotional phenomena. Rationality is a threat to both of them, Add rationality to stock investing discussions and both overvaluation and undervaluation disappear. Today’s P/E10 level doesn’t just tell us how overvalued or undervalued stocks are at this point in time. It tells us how emotional we investors are at this point in time. Today’s stock price is an illusion and today’s P/E10 value tells us how much work it is going to take to pop the illusion.

This is discouraging news in one respect. If explains why it has been so hard to persuade investors to price stocks properly. This is not something that can be done solely through the use of rational argument. Investors who are inclined to let their emotions rule them are going to ignore rational pleas to do otherwise no matter how firmly those pleas are pressed.

It is encouraging news in another respect. Say that as investors we decided that we wanted to start being more rational than we have ever been before. With Shiller’s research and the 36 years of peer-reviewed research that confirms his findings, we now have the power to do that. It is the illusions of stock investing that from time immemorial have made stocks a risky investment choice. We now have the tools we need to pop the illusion. Which means that we now have the tools needed to greatly diminish the risk associated with stock investing.

Rob’s bio is here.