Valuation-Informed Indexing #401
By Rob Bennett
The stock market should produce gains of 6.5 percent real every year.
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That sounds crazy. I get it. The stock market has been around for a long time. And there has obviously never been a time when it produced slow, steady gains. There have always been bull markets and bear markets. I am suggesting that at some future time we might be able to do away with both
I believe that this is an implication of Robert Shiller’s “revolutionary” (his word) 1981 finding that valuations affect long-term returns. What Shiller really showed is that it is not economic developments that cause stock price changes (if it were, stock prices would play out in the pattern of a random walk, both in the short term and in the long term) but shifts in investor emotion. If it is shifts in investor emotion that cause stock price changes, long-term returns are both predictable (prices are always headed in the direction of the fair-value return, the return that would apply if the P/E10 value were 15) and controllable (by educating investors about where returns are headed, we can persuade them to counter the effects of emotion by investing more heavily in stocks when emotion is causing long-term returns to be super good and by investing less heavily in stocks when emotion is causing long-term returns to be super poor).
If we are going to control returns, we need to identify the best possible return. It seems clear that the best possible return is the fair-value return. To permit returns higher than that is to borrow from the future, reducing consumer spending power in years when returns will be lower and thereby causing an economic contraction in those years. To permit returns lower than that is to cause needless economic deprivation in the short term. It makes little sense to choose either of those two options. The best course is to do what we can to keep stock prices as close to fair-value levels, which requires an annual return of 6.5 percent real.
Would it be difficult to pull this off?
On first impression, it would certainly seem so. We have never even come close to pulling it off before. But of course we never before had available to us 37 years of peer-reviewed research showing that valuations affect long-term returns. There is a reason why the subtitle to Shiller’s book refers to his 1981 findings as “revolutionary.” There’s a reason why Shiller was awarded a Nobel Prize in Economics. He changed our understanding of how stock investing works in a fundamental way. We shouldn’t be shocked to see that big changes will follow when more of us come to accept the far-reaching implications of his work. We should be expecting to see big changes.
A broader acceptance of the significance of Shiller’s findings would render market prices self-regulating. He showed that the long-term value proposition of stocks drops a bit with each price increase and that the long-term value proposition of stocks rises a bit with each price drop. If we teach that, smart investors will sell a small bit of their holdings each time prices rise (with the aim of keeping their risk profile stable), pulling prices back to fair-value levels. And they will increase their holdings a small bit each time prices drop, again pulling prices back to fair-value levels. Neither bull markets nor bear markets will be able to gain much steam once most investors have been educated as to the meaning of Shiller’s Nobel-prize-winning research.
But wouldn’t the economy continue to have its ups and downs? Wouldn’t economic booms push stock prices upward faster than normal and wouldn’t economic slumps push stock prices downward faster than normal?
I am not so sure. Economic booms and busts have been with us as long as capitalism has been with us. But they have never been a good thing. I think it would be fair to refer to the boom-and-bust cycle as the curse of capitalism. Capitalism produces great growth. But it would be far better for everyone concerned if that growth were produced in a more regular and steady fashion. Booms cause both businesses and individuals to become over-extended and then to suffer from becoming overextended when the inevitable bust follows. Busts are just pointless pain. In economic busts, people spend less than they can afford to spend and businesses grow less than they can afford to for no reason other than the influence of an irrational fear (which was brought on by the collapse caused by the preceding boom).
Economic booms and busts serve no good purpose. But are they not an inevitable part of our system? They certainly have been in the past. But isn’t it the purpose of economic research to teach us new things and thereby to make it possible for us to live better lives? Shiller published important economic research. He thereby made it possible for us to rein in the emotional impulses that have played a big role in causing booms (the creation of trillions in pretend money through the crediting of phony stock market gains on our portfolio statements). Why should we not believe that, if we learn the lessons his research points to, we can make a future very different and very much better than our past?
Why is it that, despite the huge bulls and bears of the past, the annual average return has always eventually reverted to 6.5 percent real? It’s because that’s the economic gain that our economy produces each year. Numbers on our portfolio statements indicating that the gain for the year was larger or smaller are temporary illusions. We can extinguish these illusions by thinking more clearly about the realities behind the numbers. When gains are higher than 6.5 percent real, we are borrowing from the future and, when gains are lower than 6.5 percent real, we are paying for borrowings made in earlier days. The real gain is always 6.5 percent real (at least that has always been the case this far into our history). The more we learn about how our market works, the more confidence we will have in that number and the less we will have in the numbers that appear on our portfolio statements and that are more the product of irrational exuberance or depression than of the underlying economic realities.
Rob’s bio is here.