Valuation-Informed Indexing #389
By Rob Bennett
When people hear the name “Robert Shiller” mentioned, the thought that comes to mind is that he’s the fellow who say that stock investing becomes dangerous when valuations rise too high. That much is certainly so. But Shiller’s insights are more far-reaching than most people realize. The subtitle of his book describes his work as “revolutionary.” The thing that makes Shiller’s work revolutionary is that he challenges our most fundamental beliefs about how economics works. Yes, he has revolutionized our understanding of how stock investing works (or at least he would have if we all had been listening carefully and had taken his words to heart). But he also has revolutionized our understanding of how economics works, and economics is of course the bigger thing,
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That’s Shiller’s message, is it not?
What makes it a controversial message?
When Shiller says that valuations matter, he is challenging Adam Smith, the father of Classical Economics. Smith is the fellow who came up with the Rational Man concept. Almost all economic arguments begin with an assumption that people act to pursue their self-interest. If that were so, valuations wouldn’t matter because overvaluation and undervaluation would not exist. It is in the best interest of investors to price stocks properly. Buy-and-Holders get this; this is why they don’t worry about valuations — mispricing cannot be a problem in a world where investors are rational. When Shiller says that valuations matter, he is saying that Adam Smith is wrong, that the decisions of investors (and all other economic actors) are rooted in emotion as often as they are rooted in the rational pursuit of their self-interest.
The passage that i find most compelling in Shiller’s book Irrational Exuberance is this one: “If, over some interval in the first decade or so of the twenty-first Century, the U.S. stock market is going to follow an uneven course down, as well it might — back, let us say, to its levels in the mid-1990s or even lower — then individuals, foundations, college endowments and other beneficiaries of the market are going to find themselves poorer, in the aggregate by trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.”
He doesn’t say “the promotion of Buy-and-Hold strategies will have caused losses equal in value to the destruction of all the homes in the country” but that’s the (clear, in my eyes) implication). He is saying that the Buy-and-Holders are wrong to believe that investors are rational and that the injunctions of the Buy-and-Holders to ignore the irrationality that was taking place before our eyes in the late 1990s caused valuations to rise so high that a return to fair-value prices required losses as large as the destruction of all the homes in the country. Another way of saying it (I have never heard Shiller put it this way but I put it this way often) is that the promotion of Buy-and-Hold strategies caused the economic crisis of 2008, an economic crisis that an article in the Wall Street Journal once worried might lead to a Second Great Depression and that arguably brought on much of the political frictions that we have seen appear in recent years.
Shiller is not an investing analyst. He is a professor of Economics. He was not awarded a Nobel prize for managing a mutual fund. He was awarded a Nobel prize for discovering things about how the economy works that we had not known before he came along. His focus is investing. But he did not show that valuations affect long-term returns with the aim of helping his clients earn an extra point of annual return. He went about his work with the idea of learning how the economy works. He studied stock investing because stock investing is part of the economy. We cannot understand the economy fully without coming to a better understanding of stock investing.
If Shiller is right, it’s not a bad economy that causes stock prices to fall, it’s falling stock prices that cause a bad economy. Shiller is saying that the portion of stock prices that is caused by irrational exuberance is not rooted in economic realities, it is cotton candy nothingness that is fated to disappear into the mist in time. If that’s so, then millions of investors lose trillions of dollars in buying power when stock prices crash and it never comes back (because it never existed in a real sense in the first place). How could the loss of trillions of dollars of consumer buying power not cause a recession, or in cases of extreme overvaluation, a depression?
We are talking economic now, are we not? We have passed out of the micro realm of investing strategy (don’t go with as high a stock allocation when prices are high as you do when they are low) to the macro realm of economics (don’t cause businesses to fail and workers to lose their jobs by failing to pay attention to stock prices and by failing to encourage your friends and neighbors and co-workers to do the same).
The full power of Shiller’s work is not widely recognized today. In the investing realm, he is one voice among many and of course he is telling us things that we don’t want to hear, so he is one largely ignored voice. But his work changes our understanding of how our economy works in a fundamental way, in a way that promises to enhance all of our lives in a big way once we come to appreciate the depth and the reach of the message.
Rob’s bio is here.