To Say That Stock Prices Are Determined by Investor Emotion Is Not to Say that Economic Developments Don’t Matter

stock price changesFirmBee / Pixabay

Valuation-Informed Indexing #393 on what causes stock price changes  and its connection to buy and hold theory

By Rob Bennett

There’s really only one difference between Buy-and-Hold and Valuation-Informed Indexing — Buy-and-Hold is rooted in the premise that stock price changes are caused by economic developments while Valuation-Informed Indexing is rooted in the premise that stock price changes are caused by shifts in investor emotion. Ultimately there are of course many differences between the two strategies. But that’s because the differing beliefs about the core question of what causes price changes cause different beliefs about every strategic question.

apple's valuation stock price changes

FirmBee / Pixabay

It is my belief that 100 percent of the evidence available to us supports Valuation-Informed Indexing — investor emotion has been the primary cause of stock price changes since the market opened for business and all of the historical data available to us for review shows this to be so. But of course my Buy-and-Hold friends see things just the other way around. From their perspective, 100 percent of the data available to us supports the belief that it is economic developments that cause stock price changes. Different people look at the same data and come to very different conclusions as to what it is telling us.

I believe that a big part of the confusion stems from the reality that the two possible causes of stock price changes are not mutually exclusive causes. If we were trying to figure out whether it were the sun revolving around the earth or the earth revolving around the sun that causes it to be sunny for part of the day and dark for another part, there are tests that we could perform to rule in one possible cause and to rule out the other. It doesn’t work quite that way when we try to determine whether it is investor emotion or economic developments that cause stock prices to change.

Robert Shiller showed with peer-reviewed research published in 1981 that valuations affect long-term returns. That pretty much settles it for me. If it were economic developments that caused price changes, long-term returns would play out in the pattern of a random walk. There would be times when economic developments would push prices upward and there would be times when economic developments would push prices downward, but there would not be a correlation between valuation levels and long-term returns. The fact that there IS a strong correlation between valuation levels and long-term returns shows that it is investor emotion (which is what causes all mispricing, both overvaluation and undervaluation) that is the driving force behind price changes.

That’s so simple. We’ve known about Shiller’s findings for 37 years now. Why doesn’t everyone in this field accept today that the core idea behind the Buy-and-Hold strategy has been long discredited? Why do millions of good and smart people still believe in Buy-and-Hold, and why do many believe very passionately indeed?

The trouble is that, while most Buy-and-Holders believe that the historical return data can tell us important things about how stock investing works, it is hard for the human mind to reject what common sense tells it is so. And the idea that it is economic developments causing stock price changes seems to most of us to be heavily supported by common sense. We see evidence of this every day. When the economy slumps, don’t stock prices slump too? When the economy takes off, don’t stock prices take off too? Anyone who has followed the stock market for years has personally witnessed hundreds of cases in which economic developments caused a change in stock prices.

Surface impressions can be deceiving.

Remember how the market responded to the 911 terrorist attacks? The market was closed until September 17. When it reopened, prices fell 7 percent in a single trading day. The Dow Jones Average was down 14 percent at the end of the week and the S&P index was down 12 percent. $1.4 trillion in value disappeared in five days of trading. However, within a month both the Dow and the S&P had returned to pre-911 price levels.

Many Buy-and-Holders view this price history as evidence that the market is fundamentally rational. There were legitimate reasons for concern about how many businesses would fare in the wake of the attacks. For example, it was easy to imagine people being afraid to travel, hurting airline companies or companies involved in tourism in general. But the fuller reality was that the nation remained strong and that consumer confidence could be restored and most companies could weather the storm. So the market rationally came to the conclusion that its initial reaction was overdone and prices recovered quickly.

That makes sense. I don’t think that it would be fair to reject that explanation of the price history that took place.

But I don’t think that this is the only reasonable explanation of the events that took place at the time. Clearly emotion played a role in the market’s reaction to the terrorist attacks. If the market were truly rational, shouldn’t it have been able to see from the first days that big price drops were not justified and to recover from the early price drops even sooner? It’s nice that the market pulled back from its initial emotionalism. But isn’t it possible that a market capable of ANY emotionalism is capable of a great deal of it, depending on the circumstances?

Market prices recovered quickly in the wake of the 911 attacks. Could it be that that’s because the underlying emotional mood of investors at the time was strong enough to permit emotions to swing quickly from a negative place to a positive place? What if the terrorist attacks had taken place in late 2008 or in early 2009, when investors were in an emotionally sensitive place? Would the losses resulting from the attacks have been deeper? Would they have lasted longer? Would there have been any recovery to pre-attack prices at all in those circumstances?

I believe that it is investor emotion that is the primary driver of stock price changes. It doesn’t follow that I believe that economic developments play no role. Economic developments affect investor psychology. So those of us who believe that investor emotion is the primary driver believe that economic developments are important. Our difference with the Buy-and-Holders is that, while we believe that economic developments are important and unpredictable, we do not believe that price changes are entirely unpredictable. The potential for big and lasting price drops is far greater at times when valuations are high because high valuations instill worry in investors that prices will be falling hard at some point in the future and that causes them to react differently to bad economic developments than they would at times when stocks were reasonably priced.

Rob’s bio is here.

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About the Author

robbennett
Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”

4 Comments on "To Say That Stock Prices Are Determined by Investor Emotion Is Not to Say that Economic Developments Don’t Matter"

  1. Okay, Sammy.

    I wish you the best of luck in all your future life endeavors in any event, my dear friend.

    Race-to-the-Bottom Rob

  2. Depth? You don’t have any depth. You just repeat a few tired lines. Competition? I don’t see anyone wanting to compete with your race to the bottom. We invest to have a secure retirement. Why would anyone want to repeat your track record?

  3. Valuations matter.

    Every word that I have ever written on stock investing comes down to some variation on that theme, Sammy. I don’t say different.

    It’s an important theme. It’s almost impossible to imagine how an investor who gets it that valuations matter could ever do poorly buying stocks. It’s such an amazing asset class that, if you exercise price discipline, you just cannot go wrong in the long run. On the other hand, investing in stocks WITHOUT exercising price discipline is like driving a car with no brakes. Truly scary stuff!

    And rarely do you see anyone else explore the Valuations Matter story in any great depth. Most people in this field want people to like them. They know that telling today’s investors that valuations matter is telling them that they need to divide the number on their portfolio statement by two to know the true, lasting value of their holdings. So they hold back from telling the Valuations Matter story in anything but a cursory way. Meaning that I am left with little competition.

    It’s a huge story that affects everyone alive on the planet in a big way and there’s virtually no competition in the telling of it. Hmmm, I wonder why a journalist would find that kind of story too enticing to let go of?

    My best wishes to you, my dear friend.

    Same-Old-Song Rob

  4. Rob,

    You have posted the same stuff thousands of times. Try something new.

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