Markets set prices. That’s what they do. Information comes in, it is processed by the market participants and a new price is established. So, if there is an oil shortage, demand for the oil that exists increases and the price of oil goes up. The new price is the right price for oil given the new circumstances that apply.
With most markets, new information causes new prices in not too long a time. If an oil shortage appears in the morning, a new price for oil applies that evening. Market participants do not want to be caught trading oil based on outdated information. Once it is clear that oil has become harder to come by, market participants want to protect themselves from having to pay higher prices in the future and so they rush to obtain oil at relatively low prices quickly and the increased demand moves the price up. Most markets process new information into new prices with speed.
Market Prices Reflect The Economic Realities
It doesn’t work that way in the stock market. Market prices always reflect the economic realities eventually. But it can take a long time for the two to line up. The fair-value CAPE value is 17. Except for a brief time in the immediate aftermath of the 2008 economic crisis, we have not seen 17 for many years. The CAPE value travelled to the mid-20s in the mid-90s and has remained there or higher ever since (with the exception of those few months in early 2009). That’s 25 years. One reason why it is hard for Buy-and-Holders to accept Shiller’s research findings is that they suggest that the stock market works in ways that do not apply for other markets.
Why does the stock market behave so strangely?
The biggest reason is that there are few investors who favor low prices. In all other markets, people who own the good being sold prefer that a high price be assigned to it and people seeking to obtain the good prefer that a low price be assigned. If only it were that way in the stock market! If it were, there would still be price changes because the productivity gains that we see each year justify an increase in price of 6.5 percent real. But price changes of much more than that or of much less than that would be unusual. If the price rose by more than that, people who were buying would become wary of paying the higher price because they would understand that higher prices mean reduced long-term returns. Demand would slacken, forcing lower, more reasonable, more realistic and more sustainable prices.
For prices to move in the right direction, market participants have to be sufficiently informed of what it is they are buying to act in their self-interest. Most stock investors have been trained to be price indifferent (no market timing!). So higher prices do not cause them to want to sell stocks. In a market in which most participants are either price indifferent or actually in favor of price increases (because they increase the nominal value of their portfolio), there are no forces keeping prices at reasonable levels. They increase gradually over time until they reach such high levels that even generally price indifferent investors become panicky and a price crash ensues. It can take many years for that process to play out.
Practicing Market Timing
I believe that the stock market would function better if all investors were better informed as to how the market works and encouraged to practice market timing (price discipline!) on a regular basis. Each time there is a sudden jump in prices (diminishing the long-term value of stocks), there should be a quick move to sell stocks, just as there would be in the oil market if oil became more plentiful. In an ideal world, stock price corrections could not be delayed for 25 years. They would take place within hours. Stocks would always sell at a price reflective of the long-term value proposition being offered (at a CAPE value between 12 and 20).
Market timing is the means by which improper pricing of stocks is corrected. It is the idea that market timing is not required or is in fact a bad idea that is responsible for the scary high prices that have applied for stocks in recent years. We should all want stocks to be priced fairly at all times. Both overvaluation and undervaluation are a scourge. The key to taking things to a better place is correcting the outmoded thinking that produced the idea that market timing either might not work or might not always be required.
We are the market. If we want stock prices to be set properly, we need to do our part. We need always to be aware of how price changes affect the value proposition we obtain when we purchase stocks, becoming more willing to buy when prices are low and less willing to do so when prices are high. It should not take 25 years for stock prices to come to reflect the economic realities!
Rob’s bio is here.