Robert Shiller has some very different ideas about how stock investing works. Not all stock gains are real, according to his Nobel-prize-winning research. Some are, of course. Historically, the U.S. stock market produces economic-based gains of 6.5 percent real each year. In years in which the nominal gains appear to be greater than that, those gains are not real and lasting. They are the product of irrational exuberance. They cannot be relied on to finance a retirement.
Shiller’s finest moment, in my assessment, was when he published a paper in 1996 warning investors who had a high stock allocation that they would live to regret it within 10 years if they did not lower their stock allocation in response to the crazy prices of the day. Shiller’s research has been widely praised. But rarely does anyone point out the essential how-to point. If irrational exuberance is a thing, it is a very scary thing, and stock investors should do everything in their power to combat it. The obvious thing to do is to practice valuation-based market timing. Irrational exuberance can only get so out of control if, every time more of it is created, investors sell stocks and thereby apply downward pressure on stock prices.
I say that that was Shiller’s finest moment because he illustrated with that paper the powerful economic advance achieved through the publication of his research. Price crashes cause economic collapses. I understand that the Buy-and-Holders claim that the causation works in the opposite direction, that bad economic times cause stock prices to go wobbly. But, if there is such a thing as pretend stock gains, which is what irrational exuberance is, the sudden disappearance of those gains must cause a great diminishment of consumer buying power. Creating pretend gains is a bad idea all around. It, of course, wipes out retirement plans. But it also puts the entire economic system at risk. We would all be better off knowing the genuine value of our stock portfolio.
What Shiller predicted in 1996 took place in 2008. That’s when we saw the price crash and the resulting economic collapse. Some will find fault with Shiller for being off the mark by two years in saying the crash would arrive within 10 years of the day in 1996 when he advanced his prediction. I find it exciting that he was able to predict that economic collapse so far in advance. Had we only taken that paper more seriously, we could have worked together to get the CAPE value down before that economic collapse took place. A lot of people were hurt in that collapse. It has been argued that both the Tea Party movement on the right and the Occupy Wall Street movement on the left had their origins in the turmoil suffered in those dark days.
However, the price crash did not remain in place for long. By the end of 2009, stock prices were back at high levels, and they have remained at high levels ever since. That’s nearly 15 years, a lot longer than the 10-year time period covered by the prediction offered in Shiller’s paper. Shouldn’t prices have fallen again? What’s taking so long?
I cannot give clear answers. Irrational exuberance is an emotional phenomenon. So, it does not obey the dictates of logic. Irrational exuberance can not remain in place indefinitely. If it could, investors could vote themselves raises by pushing stock prices higher, and those gains would be as permanent as the gains backed by economic growth. Irrational exuberance is always vulnerable to shifts in investor emotion. When Shiller ventured that prices would crash within 10 years, he was basing his estimate on the historical return data. According to the stock market history available to us at that time, it was unlikely to take longer than that.
Now we know better. It can take 15 years. Theoretically, it could take longer. We may see a crash in the near future. But I’ve been saying that for a long time now. I’m sick of hearing myself say it. The truth is that we don’t know when the next crash will come.
Is there any limit to how long it could take?
The only limit is the limit imposed by the human desire to apply reason to the investing project. For irrational exuberance to remain in place, we need to delude ourselves as to the true value of our stock holdings. It’s obviously not a good idea to continue to do that for too long. All sorts of economic efficiencies result from millions of people not knowing the true value of their stock holdings. At some point, we collectively give up the fight. As of the mid-1990s, there had never been a time when we managed to continue the collective self-deception for longer than 10 years running. Now, we’ve figured out how to keep a bull market going for 15 years. Today, we don’t possess a clear and deep enough understanding of human psychology to say how much longer it is possible to stretch things out.
I have a theory for how we have managed to keep the con going for so long this time. High prices had been in place for a long time when the crash of 2008 hit. On some level of consciousness, we were expecting a long and drawn-out bear market when it arrived. When those fears were not realized, we developed a level of confidence that we had never possessed before that the piper never needed to be paid and that there would only be short-lived price drops that would cause no serious pain for those who followed a Buy-and-Hold strategy. So long as confidence in the bull remains strong, it can continue.
There’s a dark side to this theory. If the next price crash hits hard enough to overcome these new heights of confidence, it could come as a shock. The longest bull could be followed by the longest bear. Let’s hope not. I’d like to see prices return to more reasonable levels. But extremes are bad news.
