I am writing these words on the afternoon of March 9, 2020. Stock prices fell hard again today. They have generally been falling for two weeks now. Most analysts put the blame either on the coronavirus panic or on problems in the oil markets.
Q4 2019 hedge fund letters, conferences and more
I don’t buy it.
I certainly accept that those two problems precipitated the price crash. What I question is whether economic events are the primary causes of stock price crashes. It seems to me that, if Robert Shiller’s Nobel-prize-winning research is legitimate research, it is far more likely that it is shifts in investor emotion set off by economic developments that are the primary causes.
The Correlation Between High CAPE Value And Its Future Return
The old way of thinking about how stock investing works (the Buy-and-Hold Model) posits that investors are rational and that they readjust prices to reflect new economic realities. It is a plausible theory and one accepted by millions of good and smart people. But, if it really were economic developments that caused stock price changes, prices should play out both in the short term and in the long term in a random walk pattern. They do play out in the pattern of a random walk in the short term. But in the long term there is a strong correlation between the CAPE value that applies today and the return that will apply for the next 10 years (a high CAPE value today signals a low return over the next ten years).
That result is not possible in a world in which it is economic developments that cause stock price changes. Shiller’s research shows that high stock prices are largely comprised of “irrational exuberance,” the product of temporary investor mood swings rather than of hard economic realities. In this world, stock prices are always at risk of tumbling hard once they reach the high levels that applied before the coronavirus scare appeared on the scene.
The Fair-Value Prices Of Stocks
Say that the coronavirus problem is sufficiently severe to cause stocks to be priced for a time at 20 percent their fair-value price level. That is a CAPE value of 13. So, if the problem entered the scene at a time when stocks were selling at fair-value prices (a CAPE value of 16), we would see a price drop of 3 points of CAPE value. However, if the problem occurs at a time when the CAPE value is near 30 (as it was a few weeks ago), the appearance of the problem could cause prices to fall by 17 CAPE points (from 30 to 13).
That big of a price drop could transform the irrational exuberance that had been dictating stock prices in earlier days into an irrational depression, which could continue to push them all the way down to a CAPE value of 8. That’s a total drop of nearly 22 CAPE points, a loss in portfolio value of nearly 70 percent.
A 20 percent loss is a significant event but certainly not a devastating one. It is the sort of loss that one has to accept as just the cost of owning stocks. But a 70 percent loss would be terrifying to most investors. That sort of loss would cause a huge contraction in consumer spending, causing hundreds of thousands of businesses to go under and millions of workers to be thrown out of their jobs.
Economic Events And Investor Emotion Shifts
Rarely do we see analysts in this field attempt to separate the effects of economic events and investor emotion shifts when assigning blame for price crashes. I view that as an extremely unfortunate reality. There is a big difference between the two factors. There is nothing that any of us can do about negative economic events; they are going to show up on our doorstep from time to time and that’s all there is to it. But as a people we have a great deal of control over the emotional shocks that generally play a far bigger role in causing frightening price drops.
The way to stop irrational exuberance from giving out and becoming transformed into irrational depression is to see to it that it never gets too out of hand in the first place. We could do this by showing investors how stocks offer a far better value proposition when they are priced reasonably and urging them to lower their stock allocations when prices rise too high in an effort to keep their risk profile roughly constant over time. Stock prices would become self-regulating in a world in which most investors engaged in long-term market timing.
I could live without price crashes of this sort! I believe that millions of other investors could manage to get by without them as well.
Rob’s bio is here.