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Merrill Lynch launched a television commercial in 1971 asserting that “Merrill Lynch is bullish on America.” I am bullish on America. I think our best days are yet to come. But I don’t like bull markets at all. What gives?
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According to the old way of thinking about how stock investing works (the Buy-and-Hold Model, rooted in the research of Eugene Fama), it is economic developments that determine stock price changes. If that were so, it would be hard to argue that bull markets are not a very good thing indeed. When we see stock prices rising rapidly, we are learning that the economy is booming. A rising tide lifts all boats. So bull markets mean good times for all, according to this model, which remains the dominant one today.
I believe that Robert Shiller’s “revolutionary” (his word), Nobel-prize-winning research of 1981 changes all that. According to Shiller, it is investor psychology that is the primary influence on stock price changes (economic developments obviously play a secondary role since they can affect investor psychology). If this is so, we cannot trust rising stock prices to be telling us anything meaningful about how the economy is doing. Good investor psychology might cause rising stock prices at a time when the economy is performing poorly and poor investor psychology might cause falling stock prices at a time when the economy is performing well.
And it’s not just that bull markets can be misleading, that they can signal a strong economy even when the economy is not strong. If Shiller is right about what causes stock price changes, bull markets can cause bad economic conditions. Bull markets hurt us.
Think about what happened in the last four years of the 1990s. The S&P index rose 126 percent over that time. Does anyone seriously believe that the value of the underlying companies more than doubled over that brief time-period? That seems like an absurd possibility to me. But those big price increases were almost universally cheered. I cannot remember any newspaper headlines warning us of the dangers we were causing ourselves by letting stock prices get so out of hand.
Capitalism is an economic system that uses signalling to send messages to economic actors as to how they should be allocating their financial resources. It is important that these messages be accurate ones. When the messages are inaccurate, financial resources are misallocated. In those cases we see a lowering tide that at least partly sinks all boats.
Let’s say that the proper price increase for the last four years of the 1990s was 26 percent, the price increase you would see if the average annual gain of 6.5 percent applied. That would mean that the phony 126 percent price gain created by the bull market would be off by 100 percentage points. Having the stock market deliver a signal off by that much hurts us all in very serious ways.
One of the purposes of the signals sent by changes in stock market prices is to let entrepreneurs know what sorts of businesses need to be formed at a particular point in time. When the prices of the sorts of companies that do well in economic boom times rise rapidly, a signal is being delivered that we need more of those sorts of companies to be formed for our economic system to operate at maximum efficiency. If a false signal is sent -- if the stock market tells us that we need more of the types of companies that do well in boom times at a time when we really need fewer of those types of companies and more of the types of companies that do well in economic down times -- lots of companies that should not have been formed are formed and then lots of those companies fail when the economic realities reveal themselves and dispel the bull market illusions.
Consumers are also victims of the false economic signalling that takes place in bull markets. Say that in early 1996 you were at an age at which you needed to have $300,000 in savings to be on track to achieve your retirement goals but that you in fact had only $250,000 put aside. That would probably prompt you to make an effort to increase your saving percentage a bit. But consider what happens as a result of the false bull-market signaling. By early 2000, you would have had over $500,000 in your portfolio even if you saved not a single dollar during those four years. The message you would be receiving would be -- time to ease up on the saving. Since you would have had far more saved at that time that you would have needed to have saved at that time, the sensible course of action would have been to direct more of your earnings to consumption. That is, that would be the sensible course of action if the bull market were not deceiving you as to the true, lasting value of your portfolio.
Bull markets hold us all back. Our economic system is a big part of what makes our country great. Those of us who are bullish on America should be doing all we can to rein in bull markets when we see them developing before our eyes.
Rob’s bio is here.