“If, over some interval in the first decade or so of the twenty-first Century, the U.S. stock market is going to follow an uneven course down, as well it might – back, let us say, to its levels in the mid-1990s or even lower – then individuals, foundations, college endowments and other beneficiaries of the market are going to find themselves poorer, in the aggregate by trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.”
What does value investing really mean? Q1 2021 hedge fund letters, conferences and more Some investors might argue value investing means buying stocks trading at a discount to net asset value or book value. This is the sort of value investing Benjamin Graham pioneered in the early 1920s and 1930s. Other investors might argue value Read More
Chapter on topic in Shiller's book removed
I noticed recently that the passage does not appear in recent editions of the book. That makes a certain amount of sense. The book was published in March 2000. At that time, the end of the first decade of the 21st Century was in the future and so it was natural for Shiller to consider how things might go in that time-period when trying to make his point that a big drop in stock prices would cause us all great harm. Today, that time-period is in the rear-view mirror. So it seems a bit silly to offer predictions as to what might happen in it. And it is at least arguable that Shiller’s speculation that a price crash suffered in that time-period might cause us all great harm did not prove out.
We did indeed suffer a price crash that for a time looked like it would cause great harm. But prices shot back up after the passage of only a few months of time and so the pain suffered was not nearly so great as the words quoted above suggested it might be.
That said, I think it is unfortunate that these words have been dropped from the book. I quote the passage frequently because I think that it makes a point that is of supreme importance and that is rarely advanced in discussions of Shiller’s work. Shiller’s research showing that valuations affect long-term returns advances our understanding of how stock investing works in a fundamental way. It’s not just that Shiller showed us a way to predict future stock returns, which of course offers us a way to enhance our lifetime stock return while diminishing the risk we take on when investing in stocks.
The reason why today’s CAPE level does a good job of predicting the return that will apply over the next 10 years is that the core job of all markets is to get the price right and, if stock prices are often comprised largely of irrational exuberance, the inevitable move in the direction of a fair-price CAPE level requires a big price drop. Shiller taught us not to trust the nominal stock price at times of overvaluation.
At such times, the nominal price is not real -- it is comprised largely of cotton-candy nothingness fated in not too long a time to be blown away in the wind.
I do not know of another passage from Shiller’s work or from the work of others who believe that valuations matter that conveys the essential message so clearly. When Shiller says that “the real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country,” it sends a chill down my spine. He is coming close in those words to describing a Second Great Depression.
And, indeed, there were articles in respectable newspapers like the Wall Street Journal in the days following the 2008 crash speculating that we might be headed into a second Great Depression. So that scary possibility was a live possibility for a few months. It was the relentless promotion of the Buy-and-Hold investment strategy, which posits that it is not necessary for investors to lower their stock allocations no matter how high prices rise, that made the crazy price levels that brought on that crash inevitable.
That’s why I view it as an urgent matter of national business that we all open ourselves to hearing more challenges to the merit of the now dominant model for understanding how stock investing works.
Shiller was right to remove the passage as written from editions of the book appearing after the time-period discussed in the passage had passed. I wish, though, that it had been replaced with a discussion of what happened instead. We did see the big price drop. What we did not see was the the horrible destruction that would have followed had stock prices not returned to very high levels within about six months. According to Shiller’s theory, it is investor psychology that keeps stock prices high when they are high.
Once investor psychology crashes, it usually stays crashed for a good bit of time. The very word “bubble” suggests this. Once a bubble pops, it is not possible for it to be unpopped. But we did see an apparent unpopping of a bubble in 2009. Prices crashed from very high levels to fair-value levels and then rose again in not too much time to very high levels.
How does that happen? How is irrational exuberance restored without the investors experiencing the irrational exuberance enduring the irrational depression (marked by CAPE levels well below fair-value CAPE levels) that we have experienced with the unpopping of all earlier long-time price bubbles?
It is my sense that as a nation we scared ourselves when we saw Shiller’s prediction coming true and acted to restore the bubble before the unpopping of it became permanent. Which of course was a positive economic development for a time but which caused the permanent unpopping of that bubble to be put off for a number of years; we still have not seen it ten years later. I would like to hear Shiller and lots of other informed parties address this question. Have we avoided the pain that Shiller foresaw in March 2000? Or have we merely put it off for a few years and thereby possibly prolonged it by doing so?
Rob’s bio is here.