I believe that Robert Shiller’s Nobel-prize-winning research revolutionizes the field of investment advice. Shiller showed that irrational exuberance is a thing. During the Buy-and-Hold Era, we treated all investment gains the same. Now we know that some stock gains are the product of economic productivity and thus are of lasting significance while other gains are only the product of investor emotion and thus will disappear when emotions shift.
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The Practical Benefits Of Shiller's Research
Knowing this puts me ahead of Buy-and-Holders. It permits me to plan for my financial future more effectively. I know when the risk of a price crash is high and so I lower my stock allocation at such times, aiming to keep my risk profile constant over time. And I am not surprised by price crashes. Since irrational exuberance always disappears in time, Valuation-Informed Indexers know better than to count on gains greater than those that would apply if the CAPE value were at fair-value levels. The practical benefits of Shiller’s revolutionary advances are many.
But not anything like what they will be in days to come, when the entire world has become aware of how Shiller changed our understanding of how stock investing works!
The most important benefit that those of us who believe in Shiller's research have not yet received is the more stable economy that will someday be viewed as its greatest contribution. Today’s CAPE value is 40. The fair-value CAPE is 17. So a return to fair-value prices would bring on a price drop of 60 percent. That would translate into a loss of consumer buying power in the trillions of dollars and a severe economic contraction. Hundreds of thousands of businesses would go under. Millions of workers would lose their jobs.
Even investors who suffer only small losses in their own stock portfolio because they have lowered their stock allocations in deference to Shiller's research findings will not be doing well if we see an economic contraction of that magnitude. Political frictions will increase. Many of the businesses that will go under are today providing valuable goods and services. Losing access to those goods and services will diminish the enjoyment of life for all of us, Buy-and-Holders and Valuation-Informed Indexers alike. The world will be a less optimistic place in the days following the loss of so much spending power.
What Shiller showed is that stock investing is not strictly an individual activity but to a large extent a community endeavor. No one individual causes a bull market. Bulls are achieved when the entire society goes more than a little bit nutso. And of course we all suffer together when prices find their way back to earth. The stock market is in many respects a public resource, like clean air and clean water. Overvaluation of stocks is a form of pollution that ruins things even for those who are fully aware of how dangerous it is.
And it may be that we are not fully aware.
The Dangers Of Overvaluation
I think of myself as being aware of the dangers of overvaluation and most other Shiller believers feel the same way. But my guess is that we will all come to possess a fuller appreciation of all of the ways that overvaluation causes human misery when the people who today believe in Buy-and-Hold are sharing their thoughts on the question. No one person can know it all. We learn from each other. Unfortunately, the percentage of the population that today takes Shiller seriously is small. When the number that appreciates the horrors of irrational exuberance grows from 10 percent to 90 percent we will all be able to come to a more complete and nuanced understanding of the phenomenon.
We will become better market timers in those days too!
Shiller’s work shows the necessity of market timing. If irrational exuberance is a thing, then stocks obviously offer a better long-term value proposition when the amount of irrational exuberance is small and a worse long-term value proposition when the amount of irrational exuberance is large. So market timing is required. But how is one to go about it? Short-term timing really doesn’t work. So we would all benefit from widespread investigations of how best to engage in long-term timing.
Most of the minds that could be participating in those discussions are not open to contributing to discussions of market timing today. “Time” is a four-letter word in the Buy-and-Hold lexicon. That will change after prices fall and the Buy-and-Hold mind becomes less defensive concerning the argument in support of market timing. It’s not just the Buy-and-Holders who will benefit from that change. So will the Valuation-Informed Indexers. We will be learning from our Buy-and-Hold friends.
Shiller advanced the ball in a very important way. But the benefits of his research have been time-delayed. For his research insights to gain their full power, they need to be extensively discussed. For them to be extensively discussed, we need more reasonable price levels to assert themselves. At the moment, Shiller’s insights raise too many sensitive points for calm and reasoned discussions to take off. That sad reality leaves all of us a bit poorer than we would be in a world in which we all were thinking clearly about these matters.
Rob’s bio is here.