The median CAPE value is 16. That means that, for as far back as we have good records of stock prices, there have been as many months in which we have had a CAPE value below 16 as there have been months in which we have had a CAPE value above 16. The CAPE value today is 30. It will come as a shock to most investors when we next hit 16. It will come as an even bigger shock if we drop below 16 and then remain there for a good amount of time. But the history of stock prices in the United States indicates that that is indeed a live possibility.
Drop In CAPE Value
We dropped below 16 for a few months in early 2009. Before that, you have to travel back in your time machine to the early 1990s to find a time in which stock prices dropped below fair-value levels. Prices have remained either at high levels or at super-high levels for nearly three decades running. That’s good news to the ears of a Buy-and-Holder. It means that the economy has been generating enough productivity gains during that time to justify such amazing price levels. However, Shiller’s research shows that super high prices are the product of irrational exuberance, not economic realities. So those of us who find his Nobel-prize-winning research persuasive don’t see anything encouraging in the long run of high CAPE levels.
There is no rule that says that, because prices have remained high for a long stretch time, we will soon be entering an era in which they will remain low for a long stretch of time. But there is logic supporting the thought that things could play out that way. If stock prices are the product of investor emotion, it would make sense that years of high positive emotion would be followed by years of high negative emotion. Stock price drops cause investors to turn sour on stocks. The higher prices go and the longer they remain at high levels, the greater is the disappointment felt by investors when the good times come to an end.
Stock princes would need to fall by nearly 50 percent for the CAPE to hit 16. In the short term, investors would continue to use today's 30 CAPE value as an anchor to their thinking of where prices would be headed in the future. But, if prices did not recover quickly, the mental anchoring process would be transformed.
An Anti-Stock Mindset
For a time, there would be some mental negotiating taking place, in which investors would tell themselves that perhaps counting on a return to 30 would not be realistic but that surely a return to 22 or higher was in the cards. When more time passed and the CAPE level remained stuck in the neighborhood of 16, more investors would sell at least a portion of their stocks and would commit to the negative thinking that was holding the downturn in place. Then even more investors would switch to an anti-stock mindset as strong in intensity as the pro-stock mindset responsible for today’s CAPE and we would see a drop below 16. At that time, the mental anchor might be a number below 16 as the length of time at which stock prices had been behaving badly persuaded more investors that stocks would never again deliver good news for a sustained period of time.
The Buy-and-Hold response to this sort of thinking is: “Oh, there will be price drops but they never last, stock prices are always headed upward in the long run.” That’s certainly true. But those who offer those reassuring words never specify how far out we have to go to reach the long run. If someone had told me in 1996 that the CAPE would still be in the high 20s more than two decades down the line, I would have dismissed that possibility as extremely far-fetched. There is no earlier time in the history of the market when prices remained that high that long.
So I ask myself: “If that can happen on the high side, can it not happen on the low side too?” I don’t deny my bias. I believe that valuations matter. I believe that high prices are irrational prices. The longer high prices remain in effect, the less I trust the market to behave rationally. So I wonder whether we will next see a long string of years with CAPE values lower than 16. Can you imagine where we would be after nearly 30 years of below-fair-value stock prices?
The Median CAPE Value As A Stock Price Indicator
I’m not predicting it. I am certainly not wishing for it. I would be happy to see three decades of a CAPE value of 16. It is my belief that we all are better off when stocks are priced properly, neither too high nor too low, and I believe that the median CAPE value is our best indicator of the proper price point for stocks. But I would be horrified if we were to see prices stay far below 16 for as long as we have seen them stay far above 16. Irrational depression is worse than irrational exuberance. When we set prices absurdly low, we are tossing away productivity gains that are rightly ours.
The purpose of the mental exercise is to assess the extent to which recent history alters one’s perspective on what stock price is right. For me, the entire history of stock prices needs to be taken into account. So I think of a CAPE value of 16 as being the right price and of any deviation from that number as being a misfortune. Given how long it has been since the CAPE dropped below that level, I can see why most of today’s investors have a very different idea about what price level is proper. Many of today’s investors would think of any CAPE value below 25 as being on the low side. As strongly as I feel about these matters, I cannot say with certainty that that viewpoint is in error. It has certainly been vindicated by real-world results for a long stretch of time now.
The scary thing is that, if Shiller is right, it is those investor perceptions that determine stock prices, not the economic realities. Once perceptions change, there is nothing to hold prices up where most of today’s investors know in their hearts they really should be.
Rob’s bio is here.