Overvaluation That Is Not Quickly Addressed Becomes Locked In to Stock Prices

A recent article at the Of Dollars and Data site argued that No, This Isn’t a Repeat of the Dot.com Bubble. The idea is that investors should not be too alarmed by today’s high stock valuations. I disagree. I thought that it might be helpful for me to respond to a number of points made in the anti-alarm case by showing how alarm really is justified.

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I don’t agree with this way of looking at things. To my way of thinking, bubbles can be seen in advance. The fair-value CAPE level is 16. When the CAPE level goes above 20, investors should begin to feel a bit uneasy. When the CAPE level hits 25, they should become outright alarmed. And when the CAPE level hits 31, where it resides today, we are in a bubble and that’s that.

Now --

What Nick Maggiulli, the author of the article, is getting at is that, market environments in which the CAPE level goes very high but in which investors heavily invested in stocks do not suffer huge losses as a result are not generally classified as bubbles. If we do not see a price crash within the next year, most will conclude that those who saw a bubble were wrong. The proof of whether a bubble exists or not is the appearance of the price crash that causes investors to worry about bubbles.

I do not know whether we will see a price crash within the next year or not. Shiller’s research does not provide guidance on that question. The research tells us when the risk of a crash is high and that is certainly the case today. But it is not at all uncommon for the CAPE level to reach these levels and for no crash to immediately appear. That shows that the bubble did not burst. It does not show that a bubble did not exist.

Identifying Risk

I am not aware of any other field of endeavor in which we identify risk in the manner in which we do in the stock investing field. If someone bought a house in a flood area, their property insurance rates would reflect the risk that they were taking on by doing so. If twelve months later, no flood had materialized, no one would say that they were due a refund on grounds that there had never been any risk to speak of.

We are at bubble-level prices today regardless of whether we see a price crash within the next year or not. A positive outcome will not mean that the bubble did not exist, only that it was averted. Investors trying to perform nn effective risk analysis need to be sure to make this distinction. We are in a bubble today. Period.

The obvious question is -- Why do we try to talk ourselves out of recognition of this reality by writing and reading articles of the type under discussion here? Investing is a highly emotional endeavor, that’s why. If investors were rational, as the Buy-and-Holders believe, they would acknowledge that it is more risky to invest in stocks today and would lower their stock allocations a bit to bring their personal risk profile back to the level where it stood before stock prices rose so high.

But we want there not to be a bubble, we want to feel comfortable sticking with the same old stock allocation. So we tell ourselves that it is not clear yet whether there is a bubble or not, that this will only be made clear with the arrival of a price crash, at which time it will of course be too late to take steps to protect ourselves from the higher level of risk. The choice makes emotional but not intellectual sense.

Gauging Tech’s Role In The Economy

Maggiulli writes: “Investors in the late 1990s bid up prices very high, very quickly because they believed in a future where tech companies would dominate the economy and transform productivity and society. I don’t necessarily think these investors were wrong, but they were far too early. Today’s investors have a more reasonable gauge of tech’s role in the economy, and stock prices reflect this rationality.”

I agree that today’s investors are more rational. Because today’s CAPE value is lower. But the difference is a matter of degree. Today’s CAPE value is only a notch below the CAPE value that produced the Great Depression, which was the highest CAPE value ever seen until the late 1990s. It’s damning today’s investors with faint praise to observe that they are not quite so out of control as the most out-of-control investors in the history of the U.S. market.

The article argues that today’s CAPE value “is far below the high of 44 in December 1999, suggesting that stocks are only somewhat expensive relative to historic trends.” This is the problem with irrational behavior. It causes one to lose perspective. Yes, today’s stock prices are not as bad as the worst prices in history. But they are still far above what they would be if investors had their emotions under control, they are double what they would be if stocks were priced properly.

Overvaluation Becomes Locked In To Stock Prices

Overvaluation that is not quickly addressed becomes locked in to stock prices. The world did not come to an end when we permitted the CAPE value to hit 44. So the feeling today is that a CAPE value of 32 is not so bad. We have become so accustomed to overvaluation that it no longer frightens us. That’s when it becomes most dangerous. We should be frightened. We should resist the urge to resist that feeling. Research showing the dangers of overvaluation do us no good if we do not permit its message to enter our consciousness.

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