We are as a people still in the process of coming to understand how stock investing works. I believe that the publication of Robert Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns was a big step forward.
Shiller’s research showed that we cannot trust the reported stock price to represent the true value of the market. The reason why valuations affect long-term returns is that the valuation level tells us the extent to which we have priced stocks either above or below their fair-value price.
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When valuations are high, the long-term direction of the stock price will be down because the market’s core job is to get prices right. Gains that are the product of irrational exuberance always disappear in time.
The economic implications are far-reaching.
The Changing Economic Realities
Throughout history, we have thought that high stock prices signaled good economic times. If stock prices were an accurate reflection of the economic realities, high prices would be a sign that investors had studied the economy and concluded that good times were on their way.
But if investor emotion is the driving force behind high stock prices, those high prices are not backed by anything of real substance. Prices rise because investors like to create pretend money out of thin air and they pushed them up.
The inevitable disappearance of irrational exuberance of course contracts the economy. Investors who see less accumulated savings reflected on their portfolio statement naturally make an effort to cut back on spending. Which causes business failures and job losses. The economy reacts to a changing stock market more than the stock market responds to changing economic realities.
So –
The Creation And Disappearance Of Irrational Exuberance
Much of the economic upturns and downturns that we experience are just the product of the creation and disappearance of irrational exuberance. If we all were careful to adjust our stock allocation in response to valuation shifts, going with a lower stock allocation when the CAPE rose to a level that put our risk profile out of whack, stock prices would stabilize. We would no longer see runaway bull markets or scary bear markets.
Which means that the stock market would no longer be pumping pretend money into the economy to push it forward or taking pretend money out of the economy to hold it down. A more stable stock market would translate into a more stable economic system.
Our flawed understanding of how the stock market works has conditioned us to think that the economy is frequently taking wild swings upward or downward. Shiler’s research suggests that that perception is rooted in an illusion.
There are of course times when the economy is doing a bit better than usual and times when the economy is doing a bit worse than usual. But the small genuine changes are magnified by the effects of irrational exuberance getting out of control and then disappearing into thin air.
The economic crisis of 2008 was for the most part the result of stock prices getting too high and then collapsing. Take out the effect of irrational exuberance and there is no reason to believe that there were any big economic effects at play. The same is true of the Great Depression and of the stagflation of the 1970s. The true cause of those economic crises was the runaway irrational exuberance that preceded them.
How do we stop irrational exuberance from causing such mayhem? By encouraging stock investors to engage in market timing whenever prices begin to rise too high. The Buy-and-Holders got it precisely wrong! Not intentionally, to be sure. But still….
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