My last two articles here have examined comments by Jeremy Grantham arguing that we can no longer count on fair-value stock prices to reassert themselves as quickly as they always did prior to the mid-1990s. Grantham believes that prices will eventually revert to their historical mean rather than the new, higher mean that has applied for the past 20 years. But he believes that it may be some time before what has become the old normal again prevails.
He cites five factors that he believes may have played a role in establishing the temporary new normal higher stock prices: (1) Federal Reserve policies; (2) lower interest rates; (3) an aging population; (4) slower growth; and (5) increased political and monopoly power for corporations. The suggestion is that it is only when the power of these five factors to keep stock prices high is overcome will we once again see CAPE values drop to (or below) the long-term median CAPE value of 16 for an extended period of time.
Seth Klarman: Investors Can No Longer Rely On Mean Reversion
"For most of the last century," Seth Klarman noted in his second-quarter letter to Baupost's investors, "a reasonable approach to assessing a company's future prospects was to expect mean reversion." He went on to explain that fluctuations in business performance were largely cyclical, and investors could profit from this buying low and selling high. Also Read More
I have a somewhat different perspective.
I don’t have a problem agreeing that the factors cited by Grantham explain a sustained time-period of high stock prices or that prices will fall hard only after those factors no longer possess the same level of influence. However, I question whether it is entirely right to try to explain sustained high prices solely by reference to rational factors. It is of course true that the Federal Reserve can act to keep stock prices high and that lower interest rates can keep stock prices high and so on. But I question whether such factors are the true cause of high prices. The ultimate cause of high stock prices in my assessment is always investor emotion. Market prices get out of control because investors want prices to get out of control and market prices remain out of control for as long as investors want prices to remain out of control.
Consider the matter of Federal Reserve policy. It was then Federal Reserve Chairman Alan Greenspan who coined the term “irrational exuberance.” Robert Shiller testified to the Federal Reserve in 1996 about his research showing that it is investor emotion that causes high stock prices and Greenspan gave consideration to the idea of using Fed policies to pop the price bubble that had formed at that time. He ultimately elected not to do so. I consider that a great missed opportunity. Greenspan would have likely brought on a recession had he popped the bubble in 1996. However, his failure to act only made the problem worse. The bubble of 1996 became the super bubble of 2000. And the super bubble of the 2000s played a big role in bringing on the economic crisis of 2008, a much worse economic setback than the one we would have experienced had Greenspan acted to deal with the relatively modest irrational exuberance that concerned him and Shiller in 1996.
Why did Greenspan elect not to take action in 1996?
He gave reasons. He said that high CAPE levels do not always signal near-term economic collapses. And that is of course so. Greenspan probably saw it as his job to prevent recessions and I believe that there is a good chance that he would have brought one on had he taken steps to push stock prices closer to fair-value levels. So Greenspan had good reason to experience doubts over whether it was good policy to pop the developing bubble. My view is that it is best to pop a bubble sooner rather than later. But it is harder for the person in position to influence events to make that call than it is for an observer of the scene to do so. Greenspan would have caused a lot of hurt for a lot of businesses and for a lot of people had he acted in 1996. I wish that he had. But I cannot say that I am not sympathetic re his reluctance to do so.
Greenspan was responding to political pressures when he elected not to pop the bubble. I don’t mean direct political pressures. I don’t mean that policymakers applied pressure to persuade him not to act. I am here using the phrase “political pressures” in a broad sense. I mean that Greenspan was considering all of the possible gains and all of the possible losses that might follow from taking action when he considered whether to do so or not. He was in a sense speaking for the people of the United States when he decided to permit the high stock prices of the day to remain in place.
There were too many factors in play for Greenspan to have made a purely rational choice. His decision was largely emotional. He certainly employed reason in assessing the importance of the various factors. But his ultimate choice was an emotional one. He knew that a sharp drop in stock prices would likely cause a recession and he knew that a recession would cause large numbers of people great pain and he made an emotional choice (informed by rational considerations) to let the high stock prices remain in effect.
This is the sort of thing that Shiller is getting at when he says that high stock prices are caused by emotion rather than reason. It’s not just Greenspan who made an emotional choice favoring high stock prices in 1996. So did the editors of newspapers who published articles celebrating the out-of-control bull market. So did investment advisors who warned their clients not to run the risk of missing out on further gains by lowering their stock allocations in response to the crazy price increases. So did the millions of investors who worried that the bull market could not continue forever and yet elected to bet their retirement money on the belief that stocks are always the best investment choice all the same.
Humans are the rational animal. Shiller does not question that. His insight is to note that humans are also the rationalizing animal. We think. But we are not data-processing machines. Our emotions dictate where we permit out logic to take us. We are capable of understanding that high stock prices cannot be sustained forever. But we are also capable of tuning out what we understand when the temporary rewards of high stock prices possess more emotional appeal that we are willing to pass up.
The factors cited by Grantham are real. I agree with him that the power of those factors will eventually be overcome and that it is when that happens that we will see stock prices return to reasonable levels. But I believe that it is investor emotion that rules the day.
Grantham believes that the prolonged period of high prices has hurt us in serious ways. I believe that too and I believe that that hurt will someday grow strong enough that our hearts will change and we will no longer see it as imperative that high prices remain in place. It is when the emotion turns that all of the factors that have been keeping prices so high for so long will be overcome. It is not so much that the Federal Reserve will change its policy as it is that the people of the United States will come to favor a change in Federal Reserve policy and the members of the Federal Reserve will detect that change in spirit and will make the policy changes needed for the next price crash to take place.
Rob’s bio is here.