Economic Developments Are Never As Big a Deal As Investment Analysts Make Them Out To Be

The old way of thinking about the stock market is that it is economic developments that cause price changes. Investors change their assessment of what stocks are worth as new information about future economic developments becomes available to them.

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But Shiller showed that investors are not entirely rational but at times highly emotional. Irrational exuberance and irrational depression greatly influence their assessments of what stocks are worth. At times like today, when the CAPE value is at two times the fair-price CAPE value, only half of the value of the stock market is rooted in economic realities. The rest is the product of an irrational exuberance that will be disappearing into the mist in time.

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The Influence Of Economic Developments

If the influence of irrational exuberance is much greater than we realized at earlier times (in the days when many academics believed that the market is efficient, it was thought that the influence of irrational exuberance was zero), the influence of economic developments must be much less. Yet the practice of explaining price changes by making reference to economic developments is ingrained in the thinking of investment analysts. We need to break the habit of assuming that economic realities drive the stock market.

Then average long-term return on U.S. stocks has been 6.5 percent real for a long time. So the assumption should be that that will continue to be the case on a going forward basis. If we could eliminate irrational exuberance altogether (I doubt that this will ever be possible), we might see very little price volatility outside of a steady, annual price increase of 6.5 percent real.

The possibility strikes the Buy-and-Hold mind as outlandish. Isn’t economic growth a roller-coaster ride of steep ups and downs? Shouldn’t stock price changes reflect that?

I don’t think so.

The Long-Term Picture Matters

Economic growth is indeed a roller-coaster ride. But the ups and downs experienced are always short-term phenomena. Investors shouldn’t be assigning prices to stocks based on how the economy is doing this month or this year. What matters is the long-term picture. Analysts that have been paying attention to how things work know that economic lows are followed by economic highs and that economic highs are followed by economic lows. For the rational stock investor, the highs counter the lows and what is left is that 6.5 percent real return. The fact that economic growth varies does not mean that real stock values cannot be largely stable.

Economic developments are just not that big a deal when it comes to assigning a value to the stock market. There are exceptions to that rule. It could be that in the future economic growth will be strong enough to support a long-term average return of 7 percent real or weak enough to support only a long-term average return of 6 percent real. The 6.5 percent real number is not locked in stone.

But even a change to 7 percent real or to 6 percent real would be a significant development. We should not lightly accept that developments of sufficient magnitude to support that sort of price change have taken place. We certainly should not lightly accept that developments of an even greater magnitude have taken place. And it would require developments of a much greater magnitude to bring on the wild price shifts that are commonplace in the market.

Most of those price changes are caused by shifts in investor psychology and have little to do with economic developments. The primary role of economic developments is to trigger investors to experience overreactions that make emotional sense but not rational, economic sense. The influence of the economic developments themselves is much less than is widely recognized today.

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