We Should Want Stock Prices to Move to Fair-Value Levels Gradually

We Should Want Stock Prices to Move to Fair-Value Levels Gradually
mohamed_hassan / Pixabay

Do I want to see a stock price crash?

Yes and no.

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The CAPE value on the day I write these words is “26.” That’s too high. That number is not just a little off. It is crazy high. The fair-value CAPE is 16. Stock prices could drop by one-third and the market would still be overpriced. A Buy-and-Holder came to my blog the other day to mock me for a headline to an article that I wrote a few months ago in which I noted that stock prices are out of control. Because prices have fallen a bit in recent days, he had come to believe that stocks were no longer overpriced. But of course they are. It’s just that our irrational exuberance plays tricks on us. Stocks are so overpriced that prices can fall hard and stocks can remain overpriced all the same. Our minds cannot keep up.

Fair-Value Of Set Stock Prices

So I would like to see prices fall. I believe that the best stock price is the fair-value price. When stocks are priced fairly, we all know the true and lasting value of our stock holdings. That permits us to plan our financial futures more effectively. When we know the true value of our holdings, we know whether we need to be saving more or not and whether or not we can afford various goods and services that we might want to purchase. Plus, price crashes cause economic distortions. Prices don’t fall hard starting from fair-value price levels. So we rule out all the economic horrors of price crashes -- businesses going under, workers losing their jobs -- when we price stocks properly.

So I would like to see stock prices take the hard drop required to get them to reasonable levels for the first time in a long, long time. Stocks haven’t been priced below fair value since the economic crisis of 2008.


Coronavirus Health Crisis

We are obviously as a nation going through a lot of troubles right now. The coronavirus health crisis is scary. And dealing with the health crisis has required us to shut down much economic activity. The economic shutdown has sent stock prices falling, making the entire situation even more frightening. It’s hard to view reports that prices have fallen even further as good news in this environment.

My biggest concern from an investing standpoint is that the price drop will not stop when the CAPE level hits “16.” Shiller’s research teaches us that it is investor emotion, not economic developments, that play the biggest role in setting stock prices. Irrational exuberance produces the crazy high numbers that have been in evidence for many years now. But irrational exuberance never gives way to a period of reasonable prices. Emotional highs lead to emotional lows. Irrational exuberance becomes irrational depression. CAPE values of 26 do not give way to CAPE values of 16 but to CAPE values of 8.

We can’t take a CAPE value of 8. The CAPE value was 30 before the coronavirus crisis hit. A drop from 30 to 8 would destroy too many businesses and too many family budgets. Wanting to see stocks priced more reasonably is one thing. Wanting to see an economic collapse is something altogether different. We cannot take economic collapse on top of our other problems. So I pray that we do not see the CAPE value drop to 8.

Investors Act Emotionally To Set Stock Prices

The trouble is -- It is hard for someone who believes that Shiller’s Nobel-prize-winning research is legitimate research to believe that there is a way for the CAPE value to drop to 16 and to not continue dropping all the way down to 8. Buy-and-Holders believe that investors act rationally to set stock prices where they should be, given the economic realities of the time. Valuation-Informed Indexers believe that investors act emotionally to set stock prices where they want them to be regardless of what the economic realities dictate. Today’s CAPE value is 26 not because that makes intellectual sense but because it makes emotional sense.

If we see a CAPE value of 16 in the not-too-distant future, it won’t be because we suddenly became rational creatures and set stock prices where they should be rather than where we want them to be. It will be because a new set of emotions came to control our price-setting choices. And that new set of fearful emotions will not be satisfied bringing the CAPE down to 16. If stocks continue to perform in the future anything at all as they always have in the past, the emotional shift that would be required to bring the CAPE down to 16 will bring it all the way down to 8.

Mixed Emotions About New CAPE Level

I don’t want that. I cannot bear the thought of that. So each day when a new CAPE level is announced, I feel mixed emotions. I view it as a positive when prices move in the direction of a CAPE of 16 because in itself that is indeed a positive. The closer the CAPE is to 16, the more stable the stock market and indeed our entire economic system finds itself. However, I cannot kid myself that we are seeing these price drops for rational reasons. We are seeing a move in the direction of more rational stock prices. But we are seeing that move because investors are reacting emotionally to the loss of a massive amount of pretend wealth that in a better world they never would have been misled into believing was real in the first place.

We all would benefit from lower stock prices. But we all should want those lower stock prices to be put in place gradually, not as part of some out-of-control fearfulness that could cause us in the near future to become as crazy in our pricing of stocks on the low side as we were crazy in our pricing of stocks on the high side in the recent past.

It’s not moderate stock prices that are the goal. It is rationality in the setting of stock prices that is the goal. The rational thing to be hoping for today is a gradual drop in stock prices to more reasonable price levels than what we have seen in recent years.

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