Home Featured Content How Long Will Stocks Remain Undervalued Once Prices Drop Below Fair-Value Levels?

How Long Will Stocks Remain Undervalued Once Prices Drop Below Fair-Value Levels?

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Today’s CAPE value is 33. That’s nearly two times the fair-value CAPE value of 17. So we should expect prices to either gradually or suddenly work their way down over the coming years.

Most would probably prefer a gradual price drop. That’s less scary. But of course, the price drop will continue much longer if prices fall only gradually. In any event, the psychological reality seems to be that most of a big price drop is achieved suddenly.

Once prices get high, there seems to be great resistance to price drops in investors’ minds. It is only when that resistance is broken that investors accept that prices will return all the way to fair-value levels. When that realization hits, prices drop hard. And, yes, it is scary.

The full reality is that prices don’t stop dropping when they reach fair-value levels. It takes the build-up of so much negativity to bust through the irrational exuberance that got prices to high levels and held them there for a long time, and investors do not embrace rationality when irrational exuberance disappears. They embrace irrational depression.

I would argue that insanely low prices are even more irrational than insanely high prices. At least high prices can be explained as the product of our desire to get something for nothing. Nobody wins when stocks are priced far below their real value (except for the investors who increase their stock allocations at such times). The big price drop took away so much consumer buying power that the economy is in a recession and the last thing that is needed are even further price drops. But that’s the horrible place to which bull markets inevitably take us.

It’s not possible to say when the price drop will come. Robert Shiller predicted in 1996 that investors who did not lower their stock allocation in response to the high prices of the time (not as high as today’s, to be sure!) would live to regret it within 10 years. Of course, the price crash and accompanying economic collapse did not come until 2008. So Shiller was off by two years. The historical return data supported his thought that the crash would take place within ten years.

However, it is investor psychology that determines these things, and investor psychology is not highly predictable (it follows the dictates of emotion rather than logic). So I believe that trying to identify when the price crash will take place is a foolish endeavor.

That being said, prices have been high for a very long time. After the 2008 crash, they returned to high levels by late 2009. That’s more than 14 years ago, So Shiller’s 10-year rule-of-thumb failed yet again, this time worse than the last time. So I don’t think it would make sense to say only that prices should drop hard sometime within the next 10 years. I try to be cautious in offering predictions because I have made some that have not panned out. But it seems fair that we should expect the price crash within the next year or two or three. I would not be willing to bet $1,000 that things will play out that way. But it’s hard to accept that prices will remain this high for more than another three years.

After prices fall, it will be important to reassure investors that they will return at least to fair-value levels in not too long time. It takes renewed consumer confidence for the economy to recover and most consumers are not going to feel good again about their financial future until most of their lost stock portfolio is recovered. The tricky part is that assurances that are offered and believed but not realized can undermine confidence in the market even more. Offering assurances that are backed by what the research shows about how stock investing works makes sense. Going even a small bit beyond what can be realistically anticipated is a dangerous game.

So what is likely to happen?

I think it is important to stress that a CAPE value of 17 is the fair-value CAPE. I find fault with those who treat today’s crazy CAPE as reflecting reality. I feel bound to be just as critical of crazy low CAPEs. When the CAPE is 8, we all should be doing what we can to get it up to 17. My worry is that investors won’t listen because they will remember how so-called experts were saying that a CAPE of 33 was okay when the CAPE was 33. It’s the falseness of those reassurances that make reassurance offered when the CAPE is super low sound phony even though they are not.

The most unnerving thought is that the length of the bull market may signal the length of the bear market that inevitably follows from it. This has been an astoundingly long bull market. As I noted above, prices were high in 1996. They have remained high ever since, with the exception of about 12 months in the immediate aftermath of the 2008 crash. So, if long bull markets produce long bear markets, the next bear market may be a doozy.

There’s no rational reason why a long bull market must be followed by a long bear market. I obviously hope that things don’t play out that way. There is some emotional logic to the thought that it may work that way. It’s irrational exuberance that produces irrational depression. The more exuberant we get when prices are high, the more we are inclined to go into prolonged shock when it becomes clear that the high prices are a thing of the past.

As always, I believe that the best course of action is to do everything possible to help investors understand the far-reaching how-to implications of Shiller’s research. Investors who understand why prices have fallen hard will not be shocked about it and will be better able to develop the hope for the future needed to get prices back to reasonable levels.


Rob’s bio is here: http://arichlife.passionsaving.com/2012/03/25/rob-bennett/

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