Robert Shiller recently offered comments about the factors affecting stock prices that we have seen in response to the spreading of the coronavirus pandemic. He said: “I call this a co-epidemic: One is the coronavirus, and the other is like a narrative epidemic, about our confidence and outlook for the economy. That’s a new one, it’s happening fast, and it’s very contagious. Everyone’s talking about this.”
Q4 2019 hedge fund letters, conferences and more
Factors Affecting Stock Prices
I like it that Shiller pointed out that there are two factors affecting stock prices today: the economic factors, which are compelling and obvious to just about everyone; and the psychological factors, which could end up being equally compelling but which today are receiving little attention. The psychological factors are the factors tied to the loss of investor confidence in the irrational exuberance that was propping up stock prices before the coronavirus arrived on the scene.
As Shiller often observes, irrational exuberance almost always has some sort of “narrative” associated with it. Investors don’t like to think of themselves as irrational. So they don’t openly acknowledge that “we have priced stocks at two times fair value for a time because we like to think that our portfolio values are larger than what they are in reality.” Investors concoct narratives that justify the high prices. We tell ourselves that technological advances are going to bring on big increases in productivity or that we have entered a period of peace and prosperity or whatever.
The coronavirus is causing huge disruptions to our economy. It is beyond dispute that it is those economic disruptions that precipitated the price crash and that thus far have been the driving cause of it. But, in the event that prices continue to fall for some time, the changing narrative could end up having the larger impact. The CAPE value was near 30 before the price drop began. We usually see a CAPE value of 8 at the end of a bull/bear cycle. So, if the narrative turns decidedly pessimistic, it is possible that prices could fall a long ways down.
Restoring Investor Confidence
It takes time for the narrative that we employ to explain factors affecting stock prices to change. Shiller had commented in the wake of the 2008 crash that he would discourage investors from buying stocks again until the CAPE level dropped below 10. That moment never came. The CAPE value touched 13 and then turned upward and has remained in the mid-20s to the high-20s until recent weeks. Shiller was proven wrong in that case because a new narrative did not have time to harden before the Federal Reserve was successful in restoring investor confidence enough to push prices back above fair-value levels. Investors do not stop thinking one thing and begin thinking a new thing overnight.
I suspect that, if reports were to come out soon that the effect of the virus is likely to be much less than we believe it will be today, stock prices might well rise back to where they were before the virus arrived on the scene. However, the longer we endure a slow grind of falling prices, the more that investor confidence in a price recovery will weaken. I worry that President Trump may be making a mistake in offering suggestions that stock prices will zoom back to where they were once the worst of the crisis is behind us. In the event that it does not take too long for us the light at the end of the tunnel to appear, that might be so. But, in the event that we encounter several false springs, getting investors’ hopes up now may make things worse down the line. It is more of an emotional blow in having one’s hopes raised and then dashed than there is in enduring a difficult situation with no particular hopes of when it will come to an end.
Anchoring
I believe that the biggest factor determining the setting of a new narrative is the length of time for which new, lower price levels remain in place. Behavioral finance economists refer to a phenomenon they call “anchoring.” For so long as the CAPE level is 30, we trick ourselves into believing that 30 is the right number. So long as that belief holds, we don’t worry much about a drop to 24. Something tells us that 30 or something in that neighborhood is the right number and of course we will be seeing a move in that direction soon. But it becomes hard to continue to believe that after a CAPE of 24 has remained in place for several months. At some point, 24 becomes the anchor. At that point, we develop a suspicion of claims that 30 is the right number. That’s how price drops get locked in.
People who work in this field generally try to promote narratives that cause investors to have a belief that prices will be going up again soon. There are many circumstances in which these sorts of encouraging stories have the desired effect. But they can backfire. Attempts to build narratives about what is affecting stock prices that do not succeed can have the opposite effect. Such price-building narrative might be ignored at a later time when they are more appropriate and more needed. Efforts to send prices higher become part of a negative narrative when they do not work. That’s why price crashes often bring prices down not only to fair-value levels but to levels far below that.
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