The Hill-and-Valley Return Pattern Explains High Stock Valuations

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Robert Shiller recently published an article in the New York Times (“Gut Feelings Are Driving the Market”) pointing to the Trump phenomenon as an important explanation of today’s high stock prices. He attributed today’s high stock prices to “the rise of an explicit belief in irrationality”, saying that “there is reason to think that respect for science has been diminishing over the past decades.”

I wrote an article here a few weeks ago offering a different explanation. I believe that it is confidence in the Buy-and-Hold strategy that keeps value investors from worrying as much as they should about high stock prices. Additionally, I argued that it is the continued belief in the long discredited science behind Buy-and-Hold rather than a diminished respect for science that is the real source of the problem.

The Science Behind Buy-And-Hold

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There is no way to know for sure, of course. We cannot see into the minds of investors. All that any of us can do is speculate.

But the point that I would like to advance today is that it may not be necessary to offer any particular explanation at all for the investor irrationality that produces high stock prices. The core point of Shiller’s research is that stock investing is a highly emotional endeavor. People who are acting emotionally are often unreliable narrators. We certainly like to think that there are reasons for our behavior when we are acting emotionally. But as often as not we possess only a dim understanding of our true motivations.

Shiller presents a graphic in the early pages of his book Irrational Exuberance. It shows that stock prices have been playing out in a hill-and-valley pattern for as far back as we have records of them. That graphic played a big role in causing me to lose confidence in the Buy-and-Hold project and to begin devoting my energies to understanding on a deeper level the import of Shiller’s findings. If the market were efficient, as the people who developed the Buy-and-Hold Model believed, prices would play out in the form of a random walk not only in the short term but in the long term as well. The hill-and-valley pattern suggests that something other than rational assessments of economic developments is the driving force behind stock price changes.

Today's High Stock Prices: How To Apply A Hill-And-Valley Pattern

All that is needed for a hill-and-valley pattern to apply is for investors to possess a Get Rich Quick impulse within them. Investors possess the power to set stock prices wherever they want them to be and higher stock prices make them feel more wealthy. So why wouldn’t investors always push stock prices upward regardless of the economic realities?

Of course, the upward movement eventually comes to an end when prices have been pushed so high that a significant portion of the investing population loses confidence that it can continue. Then we enter the valley portion of the hill-and-valley pattern. And, when that is exhausted, the more natural upward movement begins again.

Price swings

I question whether there is a need for any particular explanation beyond those inner motivations possessed by all investors. It would make sense that particular factors could play the role of a catalyst for either upward or downward price swings. A feeling among investors that recent technological advances are going to cause a surge in productivity could bring a long bear market to an end and a concern over political turmoil could pop a bubble. But I am inclined to believe that the hill-and-valley pattern would evidence itself regardless of these events.

We like today's high high prices. We like bull markers. So we push stock prices upward. And we fear the loss of wealth that we have accumulated over a long period of time. So there comes a time when common sense asserts itself and we lose confidence in the bull market that we created in earlier days. Outside events like political disruption and productivity surges and a diminished respect for expert opinion and all the rest play only a secondary role by establishing the timing of market turns that would have taken place regardless sooner or later.

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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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