We Overestimate the Extent to Which Economic Factors Cause a Price Crash

We Overestimate the Extent to Which Economic Factors Cause a Price Crash
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There are two types of factors that can cause stock prices to crash. Buy-and-Holders focus on economic factors. The coronavirus has caused major economic disruptions. Most reports on the recent price crash point to that factor as the primary cause. But Robert Shiller’s Nobel-prize-winning research shows shifts in investor emotions can also play a big role. Is there a way to estimate how much of a role each of the two types of factors are playing in bringing on a particular crash?

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Q4 2019 hedge fund letters, conferences and more

What Causes A Price Crash

It’s an important question. If we know what causes price crashes, we can do more to prevent them or to halt them and thereby diminish the human misery and economic disruption brought on by them.

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The amazing thing in my assessment is that rarely do we hear experts in this field even attempt to specify to what extent a particular crash was caused by a particular factor. Price drops take place all the time and there are always explanations offered in the newspapers on the following day. But the explanations are always maddeningly unscientific. A report might state that “investors fled stocks in fear as reports that the coronavirus might cause more trouble than expected were issued” without any examination of whether the price drop for that day seemed to be what was proper given the news developments of the day. The idea seems to be that the market always gets it right -- however much prices dropped is the amount that prices should have dropped.

Other factors

I find that way of thinking about the matter entirely unsatisfactory. It begs the question. The purpose of a report on why prices dropped is to inform investors of the cause why their holdings are now worth less than they were a day before. Identifying a cause supplies a small amount of information. But failing to investigate whether the price drop was proportionate to the extent of bad news delivered negates the value of the report.

To say that the market always pulls prices down by the amount that they properly should have been pulled down is to say nothing. It would be more efficient to just run the same words in every day’s newspaper -- “stock prices fell or rose today by the amount that they should have given what was going on in the world.” It’s a meaningless statement. But it is not much different from the specifics-lacking explanations that appear in respectable newspapers on a daily basis.

The Effect Of The Psychological Factors

I am not able to say to what extent it was shifts in investor emotion that played a role in the recent price crash. I don’t think it is possible for anyone to do this today regardless of how well he or she is informed about the far-reaching implications of Shiller’s research. But I think it is entirely possible and appropriate to suggest that psychological factors played a role. Shiller’s research shows that psychological factors always play a role in setting prices. So it seems to me that we should at least be making some efforts to quantify the effect of the psychological factors.

The biggest clue we have as to the extent of the role played by psychological factors is the CAPE value that applied at the time the price crash commenced. If Shiller is right, then stock prices are backed by hard economic realities so long as the CAPE is near its far-price value of 16. The farther the CAPE strays from fair-value levels, the more it is true that temporary investor emotions rather than hard economic realities are holding prices up.

When the CAPE is near 30, as it was in the days before the coronavirus became a major concern, the entire market is essentially a house of cards waiting to be toppled by the next gust of wind. We never can know in advance when that gust of wind will appear. But we know that the risk of a big price drop is much greater when prices are high than it is when they are reasonable.

Valuing Stocks For The Long-Term Return

Another mind game that we play on ourselves is to forget that the possibility of a negative event like the appearance of a coronavirus is always with us. There is of course no way for anyone to know the specifics of what negative or positive economic effects await us down the road a piece. But the reality of stock market history has always been that things go up and things go down and there are positive and economic effects accompanying the ups and downs.

Rational investors price these things in. Rational investors knew before it arrived that something like the coronavirus might be coming on the scene. They certainly did not know how bad that something would be. But they knew that there was at least a small chance that it would be quite bad indeed. So they cannot say that they were entirely surprised by what happened. And they know from history that bad events are eventually followed by positive events that cancel out much or all of the effect of the bad events. People don’t invest in stocks just for the returns that they will generate in the short term.

Price crash and value stocks

They value stocks for their long-term return, which has for a very long time been something in the neighborhood of 6.5 percent real annually in the United States. So it would have to be a very bad economic event for a rational stock investor to lower his valuation of stocks by a large amount because of one negative economic event like the coronavirus.

I believe that the price crash going on today was precipitated by an economic event. But I do not believe that the negative economic consequences that may follow from a coronavirus panic would be likely to cause by themselves a price drop of more than 20 percent. If the price drop ends up being a good bit larger than that, it will be my inclination to attribute the larger portion of the crash to the high valuation levels that existed before the coronavirus became a problem. The economic factors are real but the shift in investor emotion caused by those economic factors is likely to play a much bigger role in pulling prices down dramatically.

Rob’s bio is here.

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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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