There was a time when people smoked in offices and in restaurants and even in elevators. Everyone accepted it; it was just the way things were. Then the evidence that smoking causes lung cancer brought on an anti-smoking movement that in time got smoking banned in elevators and in offices and in restaurants. Today, people would react with shock if someone tried to smoke in an elevator. It’s not done. The point here is that social expectations change with the times. Things that seem normal at one time can at a later time come to be perceived as intolerable. I think that it would be a good thing if stock price crashes of 50 percent or more came in time to be viewed as intolerable.
Einhorn’s FOF Re-positions Portfolio, Makes New Seed Investment In Year Marked By “Speculative Exuberance”
It has not just been rough year for David Einhorn's own fund. Einhorn's Greenlight Masters fund of hedge funds was down 3% net for the first half of 2020, matching the S&P 500's return for those six months. In his August letter to investors, which was reviewed by ValueWalk, the Greenlight Masters team noted that Read More
The first reaction that most people are going to have to that statement is that there is nothing we can do about it. Smoking can be banned. Price crashes are beyond our control. No one wants price crashes, they just happen. We are going to have to tolerate price crashes of all sizes whether we want to or not. There is just nothing that can be done about them.
I don’t buy it.
It’s true that we cannot ban price crashes by putting up a sign that reads “Price crashes of more than 50 percent prohibited on these premises.” But the reality is that Shiller’s research tells us much of what we need to know to at least make price crashes of 50 percent or more a lot less common in the future than they have been in the past. Shiller showed that stock gains that result from overvaluation are the product of irrational exuberance rather than of economic realities. We can cut back or eliminate altogether big price crashes by working harder as a society to warn investors of the dangers of irrational exuberance and by providing them the tools needed for them to see that it is in their interest to invest more rationally than has been the custom in the past.
At the top of the bubble, stocks were selling at a P/E10 level of 44. A regression analysis of the historical return data shows that the most likely 10-year annualized return for a stock purchase made at that price level is a negative 1 percent real. Treasury Inflation-Protected Securities (TIPS) were at the time offering a return of 4 percent real. Each dollar that an investor removed from the stock market and put into TIPS would have likely increased his annual return for that dollar by 5 percentage points. At the end of 10 years, the investor who moved his entire stock portfolio to TIPS would have earned an added return of 50 percent of his starting-point portfolio value. An investor with $100,000 in savings would gain $50,000 over 10 years by making the change. An investor with $500,000 would gain $250,000.
How often did you read a magazine article recommending that investors lower their stock allocation? I don’t ever recall seeing it happen in a mainstream publication. I remember seeing a cover-story article in Kiplingers that aimed to offer advice to investors who were behind on financing their retirements as to how they could make up the shortfall. One bit of advice was to go with a higher stock allocation than what is normally recommended on the thinking that stocks offer a higher return. Investors who were already in bad circumstances were being advised to ignore an asset class paying a risk-free return of 4 percent real and to shift more money into an asset class priced to offer a negative long-term return.
That’s Buy-and-Hold! That was the conventional investing wisdom of the day. And that sort of advice remains the conventional investing wisdom today, perhaps a bit tempered as a result of our experience of the 2008 crash. Stocks are always a good buy, we are told. Stocks are the only thing available for purchase that can never be priced so high as to offer a bad deal. Market timing never works. Stocks for the long run.
I think that’s bad investing advice. But I am saying something more here. I am saying that it is bad public policy to permit stocks to be so wildly oversold. Stock investors need to accept that stock prices may sometimes fall by 10 percent or 20 percent. Stocks are a volatile asset class and occasional price drops are just a part of the wonderful game. Price drops of 50 percent or more are something else, however. Price drops of 50 percent or more don’t just damage investors’ portfolios. They damage our economic system because they subtract so much buying power from the economy that they cause businesses to fail and workers to be thrown out of their jobs. Price crashes of 50 percent or more are a serious public policy problem.
Large price drops even diminish confidence in our political system. Bread-and-butter issues are the issues that most citizens care about the most. People are of course happy to see the value of their stock portfolio soar. So most of us cheer on the price increases that eventually make big price crashes inevitable. But when people see their hopes for a decent old-age retirement disappear in a price crash that they do not understand, they see their own lives diminished in a serious way. That’s their stake in the system. It shakes people to see 50 percent or more of their life savings disappear in a flash. We shouldn’t let it happen if it can be avoided. With the publication of Shiller’s Nobel-prize-winning research, I think that there is a lot that can be done to see that it happens a lot less frequently in the future than it has happened in the past.
John Bogle once said: “The market goes up and the market goes down. It’s never failed to recover from one of those 50 percent declines. I went through one in 1973-1974; I went through one in 2001, 2002, 2003; I went through another one 2008-2009. They’re kind of scary -- often terrifying -- but it’s typical.”
That’s too glib. Stocks are a wonderful asset class. They shouldn’t typically be producing terrifying consequences for millions of people. People who love the market -- I certainly do and I know that Bogle certainly did -- should not be tolerant of 50 percent stock crashes. Big crashes are where smoking in elevators and offices and restaurants was 50 years ago -- they have been around for so long that we have come to think that, as terrible as they are, there’s nothing that we can do about them. I don’t think that’s right anymore. I think that Shiller’s research changes things. I think that we need a movement to educate investors as to the dangers of the extreme overvaluation that brings on price crashes of 50 percent and more.
I can be done. We just need to get alarmed enough to see the need to stick our necks out and demand change. I believe that the next big price crash is going to increase the feeling of general public alarm re this matter considerably.
Rob’s bio is here.