Emotion and Economic Developments Combine to Set Stock Prices

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A recent Associated Press article reported that the Fed Chair Sees China Virus as Possible Risk to World Economy. When I see an article like this, I think about what the article is suggesting re whether stock prices reflect economic developments, as the Buy-and-Holders maintain, or whether it is investor emotion that is the primary determinant of stock price changes, as the research of Yale Economics Professor Robert Shiller shows.

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I believe that the primary appeal of Buy-and-Hold is that in a surface sense it seems so sensible. A spread of the virus would certainly be a bad thing. It would destroy wealth. It would make the economies that it affected less productive. So simple logic tells us that it would cause stock prices to fall. Case closed. The Buy-and-Holders are right.

Economic Developments Affect Stock Prices

Not so fast. Shiller does not deny that economic developments affect stock prices. They obviously do. What Shiller did was to add a new element to be considered. It is not only economic developments that matter. Stock prices are set by humans. Those humans are influenced by the economic developments that they see take place before their eyes. But their consideration of those economic developments takes place in a context that is not at all the same at different times. The spread of a virus could have a very different effect on stock prices if it took place at a time when valuations were low from the effect that it would have if it took place at a time when valuations were high.

Say that stocks were priced today at one-half of their fair-value price instead of at two times their fair-value price. The spread of a virus would still have a negative economic effect. It would still be destroying productivity. But the context in which this negative development was taking place would be very different. When stocks are priced at one-half of their fair value, investors are irrationally depressed. They have given up on the future. The historical record tells them that stocks are as inherently as valuable an asset as they have always been (the long-term average return of 6.5 percent real for U.S. stocks has applied for a long time). But the stock market’s performance in recent years has convinced them that the long-term record doesn’t matter, that stock performance in coming years will be much worse than what the use of reason would lead one to believe.

Economic Destruction

When stocks are priced at one-half of their fair value, the negative effect of the spread of a virus has already been priced in. Thus, the economic destruction would not necessarily cause a further price drop. In the right circumstances, it might even cause a price increase. There is no rational case that can be made for the spread of a virus increasing the value of the companies that comprise the market. But Shiller’s work shows that investors are not entirely rational but instead highly emotional.

From an emotional standpoint, it is possible that investors could take note of one more piece of bad news and conclude that this was the last piece of bad news that had to be experienced before a long stretch of positive developments could come into effect. Emotional investors could elect to push stock prices up in response to reports that a virus was about to cause large amounts of economic destruction.

When most discussion of the stock market presumes rationality, as it unfortunately does today, it is easy to become blinded to the realities taking place before us. We think of economic developments and stock price changes as being correlated and we conclude that stock price increases are good news. If positive economic developments cause stock price increases, how could stock price increases not be good news? We all naturally want to see as many positive economic developments as possible.

The Emotional Element

Shiller’s research points us to the presence of a wild card in the deck. Economic developments and stock price changes are certainly correlated. But not always in a rational way. Positive economic developments can cause stock prices to fall when stock valuations are out of control on the high side and negative economic developments can cause stock prices to rise when stock prices are out of control on the low side Yes, there is a correlation between economic developments and stock price changes. But the emotional element that enters the picture whenever prices get out of whack can turn everything upside down and cause economic developments to bring on price effects that make no logical sense.

This is why I think that we all should be rooting for fair-value stock prices at all times. Pushing stock prices above fair-value levels gives the temporary high that comes with the illusion of greater wealth. But it comes at the price of undercutting the positive price effect that will be experienced in response to future positive economic developments. I would prefer to enjoy in the present only the price gains that are truly justified by economic developments and then be permitted to enjoy the full effect of the positive economic developments of the future.

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About the Author

robbennett
Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”

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