Return Predictions Rooted in Factors Other Than Valuations Do Not Work

Return Predictions Rooted in Factors Other Than Valuations Do Not Work

Buy-and-Holders do not believe that it is possible to predict future stock prices. They follow a model rooted in a belief that it is economic developments that cause stock price changes. Economic developments cannot be known in advance. It follows that stock price changes cannot be known in advance either.

Robert Shiller’s research offers a very different view of how the stock market works. According to Shiller, it is shifts in investor emotion that are the dominant influence on stock price changes. Investor emotion is reflected in the Cyclically Adjusted Price/Earnings (CAPE) ratio. When the CAPE is high, future returns are likely to be low. When the CAPE is low, future returns are likely to be high.

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Shiller recently authored an article examining whether it would have been possible to have predicted the boom in stock prices that we have seen from early 2009 forward (“Was the Stock Market Boom Predictable?”). He observes that “the conventional wisdom is that it is never possible to ‘time the market’” but observes that “moves as big as these, it might seem, must have been at least partly foreseeable.” However, he concludes that: “the problem is that no one can prove why a boom happened, even after the fact, let alone show how it can be predicted.”

I view the topic as being of great importance. To the extent that stock returns can be predicted (and Shiller’s research presents compelling evidence that returns can be predicted to some extent), the risk of stock investing is diminished. However, return predictions have an extremely problematic track record. Shiller has advanced several long-term return predictions that have failed to play out. I have done the same.

I find Shiller’s attempt to explain the post-2009 price boom worthy of consideration but ultimately not entirely persuasive and possessing little practical value. He argues that investors were in 2009 over-reacting to low earnings reports and thus became excessively pessimistic for a time. When this pessimism was overturned by better-than-anticipated earnings reports, investors were sufficiently reassured to then err on the optimistic side. Investors came to possess a new confidence in business heroes, leading to the popularity of a biography of Steve Jobs and to the success of Donald Trump’s reality television programs and then to his presidential campaign.

Shiller acknowledges that his explanation of what drove the price rise is speculative. As noted in his comment quoted above, he does not believe that we can ever know for sure what factors caused stock prices to change. Instead of offering an explanation rooted in a rational assessment of the economic realities, as our Buy-and-Hold friends would, he offers an explanation rooted in an understanding of human psychology. We really do often become excessively optimistic after a pessimistic take has been proven wanting. We really do permit our fascination with business heroes to influence our thinking on how stocks should be priced even though the logical connection between the two things is tenuous.

My take is that Shiller is overthinking the matter. He is right that we can never know in a precise and clear way why stock prices went up or down. The Jobs biography was popular. Had a book reporting on scandals affecting business figures been popular, would that have caused large numbers of investors to push stock prices in the other direction? That seems just as likely a scenario and there was no way to know in 2009 which scenario was going to be the one to take place in the real world. Hillary Clinton came close to victory over Trump in the Presidential election. Would a Clinton victory have caused stock prices to fall by undermining the narrative of an age of business heroes that Shiller suggests played a role in driving the stock price boom?

I agree with Shiller that it is generally not possible to know why stock prices rise or fall. Where I part company with him is in his apparent belief that it is necessary to offer an explanation. My view is that there is only one factor that we can understand with some confidence and that all of our efforts to predict stock prices should be tied closely to that factor. When prices are high, they must drop hard (because it is the core job of any market to get prices right). And, when prices are low,, they must rise dramatically. That much is always so. The particular considerations that affect investor psychology in a given case don’t really make that much difference.

The popularity of a book on business scandals might have caused stock prices to rise even more than they did. A Clinton Presidency might have caused stock prices to rise even more than they did. Human psychology is often a paradoxical force. We just do not know how things are going to go until the trip is completed. And at that point it doesn’t do much good to develop explanations.

But high valuations always lead to poor returns and low valuations always lead to superior returns. That’s the one thing we can count on. Investors develop their narratives explaining price changes after the changes have taken place. The thing that matters is the direction in which prices move. And that can be known in advance (not perfectly, to be sure, but to a significant degree). High prices always lead to low returns because high prices rooted in investor emotion (irrational exuberance) rather than in economic realities cannot be indefinitely sustained.

We cannot know in advance how or why high CAPE values will come to leave investors in tears, only that they almost certainly will do so.

Rob’s bio is here.

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