Why I Am Obsessed With The Topic Of Stock Valuations

Why I Am Obsessed With The Topic Of Stock Valuations
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I am obsessed with the topic of stocks valuations. Prior to May 13, 2002, I never wrote about stock investing. I wrote about effective saving strategies and I was an extremely popular poster on the internet. From May 13, 2002, forward, I have written only about stock valuations and I am so unpopular that I have been banned just about every place. That’s obsessive behavior. I admit it.

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The Topic Of Stock Valuations Is Important

It is my belief that obsession is justified in this particular case. The topic of stock valuations is a hugely important topic. If we all came to understand it better, it would not just make us better investors. It would make our economic system function more smoothly. It would even make our political system more stable. Those are amazing claims. But I believe that I can back them up.

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The old belief was that the market is efficient, that investors are rational. If that were so, economic developments would be the driving factor behind stock price changes. Everything that the textbooks say about how stock investing works is rooted in that premise.

But Shiller showed that the premise is false. If the market were efficient, stock prices would play out in the pattern of a random walk (since there is no reason why economic developments would play out in any particular order). But a random walk does not apply. Not over time-periods of 10 years or 15 years or 20 years. There is a strong correlation between the CAPE value that applies today and the stock return that applies for the next 10 years and the next 15 years and the next 20 years. It’s not economic developments driving stock price changes, it’s shifts in investor emotions.

How Stock Investing Works

That changes everything. It puts us, the investors, in charge of our fate. Under the old understanding of how stock investing works, we had to hope for positive economic news. We of course still want to see the economy do well. But Shiller’s research shows that economic developments are not the primary factor driving stock price changes. The bigger factor is shifts in investor emotion. That should be our focus.

In fact, Shiller’s research suggests that the economy is much more stable than our old understanding of how stock investing works led us to believe it was. Stocks have been producing a long-term average return of 6.5 percent real for a long, long time now. The return is a reflection of the productivity of the economy. The fact that the return has been stable suggests that economic productivity has been stable. The crazy ups and downs that the economy seems to be going through are the result of the crazy ups and downs of stock prices. Irrational exuberance pushes them up to unjustified highs and then irrational depression pushes them down to unjustified lows.

Our belief that it is economic developments causing stock price change has been highly misleading. If that were so, bull markets would be awesome developments. Big stock price increases would mean that we were seeing highly positive economic developments play out, economic developments that would enrich all of us. But, if big price gains are just irrational exuberance, they don’t help us at all. They make it hard for us to get a handle on how much real, lasting wealth we possess. If irrational exuberance is a thing, we are all better off if stock valuations stay near fair-value levels and we all enjoy just the 6.5 percent annual price gains caused by economic productivity.

Price Changes Are Caused By The Emotion Shifts Of Investors

Understanding that stock price changes are caused by the emotion shifts of investors rather than by economic developments puts us investors in charge. We hurt ourselves if we let prices go too high because prices always revert to the mean and sudden drops from high places can be painful experiences. The primary goal of investment advice in this new world is to train investors to resist the urge to push stock prices up too high. Instead of cheering on bull markets, we should be cheering on moves in the direction of the fair-value price level (a CAPE of 16).

Our political system would be more stable in such a world. A lot of lives are destroyed in the nasty price crashes made inevitable by Buy-and-Hold (price indifferent) investing strategies. Think of the entrepreneur who devotes 20 years of her life to building a business and then sees it wiped out when a price crash destroys so much irrational exuberance that her customers are no longer able to afford her goods and services. The employees of that company would lose their jobs in that scenario. High unemployment rates do not make for political stability.

Shiller showed two things. One, that much of the wealth that the stock market generates during bull markets is phony stuff, And, two, that the phony stuff, the irrational exuberance, always disappears into thin air in time. My thought is that we would all live better lives if we never created the phony irrational exuberance in the first place. We all need to learn to resist the Get Rich Quick/Buy-and-Hold urge that makes stock investing more risky and less profitable than it should be.

Rob’s bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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