Valuation-Informed Indexing #288
by Rob Bennett
The last four columns examined a recent article by Michael Kitces (Should Equity Return Assumptions in Retirement Projections Be Reduced for Today’s High Shiller CAPE Valuation?) that advances the highly counter-intuitive and yet entirely accurate claim that: “The ideal way to adjust return assumptions…[may be] to do projections with a ‘regime-based approach to return assumptions. This would entail projecting a period of much lower returns, followed by a subsequent period of higher returns.”
At the end of October, the value investor Mohnish Pabrai gave a presentation and took part in a Q&A session at Boston College and Harvard Business School on the Uber Cannibal Investor Framework, which he has developed over the past decade. Uber Cannibals are the businesses “eating themselves by buying back their stock,” the value Read More
This changes everything that we once thought we knew about how the stock market works. The old (and still dominant) belief was that stock prices fall in the pattern of a random walk because price changes are caused by economic developments. If what Kitces is saying is so (I strongly believe that it is), prices do not fall in a random walk at all. They play out according to a highly predictable long-term pattern. For about 20 years, valuations rise (with short-term drops mixed in). Then, for about 15 years, valuations drop (with short-term rises mixed in). It is investor emotion that is the primary determinant of stock price changes. Investors can reduce risk dramatically while also increasing return dramatically by adjusting their stock allocations in response to big valuation shifts and thereby keeping their risk profile roughly constant as one “regime” is replaced with another.
Many far-reaching implications follow. The most important is that it is stock crashes that cause economic crises, not economic crises that cause stock crashes. If stock market price changes are caused by economic developments, it follows that recessions cause price drops. But if stock-market price changes are caused by shifts in investor emotion, as Kitces’ price-regime concept suggests, the gains earned in bull markets are cotton-candy nothingness fated to be blown away in the wind when investor confidence falters. When the pretend gains disappear, consumer buying power evaporates and the entire economy slips into recession.
A recent article at Slate — Could Our Cruddy Stock Market Cause a Recession? — examines the question.
Jordan Weissmann explains that: “UCLA economist Roger Farmer has been arguing for some time that the stock market does, in fact, sway the real economy. The man is generally something of a contrarian but is also respected for his “fearsome math skills and deep understanding of how modern [economic] models work,’ as Bloomberg View’s Noah Smith has put it. Last year, the professor published a paper titled “The Stock Market Crash Really Did Cause the Great Recession.”
However, research by Robert Shiller, Karl Case and John Quigley throws cold water on the idea, finding “at best weak evidence of a link between stock market wealth and consumption.”
Weissman finds the Shiller research more persuasive than the Farmer research (while obviously being sufficiently intrigued by the Farmer research to write an article about it), saying that the Shiller finding that stock crashes have little to do with causing recessions “makes sense when you consider that stock ownership is concentrated among relatively well-off households who can often keep spending like normal when the economy turns rocky. Middle-class Americans care a lot about home values, since that’s where their money is tied up, not the S&P 500.”
I find the Farmer conclusion more persuasive.
It is of course true that the wealthy need not cut spending when the size of their stock portfolios diminish. But it goes against my understanding of how most people decide how much money to spend to believe that they would not do so. The wealthy do not buy everything that they are financially able to buy; they set mental limits on their spending by considering how much they would like to see their accumulated wealth grow each year. When their portfolio values drop dramatically, they need to cut spending to meet their targets. They might well be able to ignore the effects of the stock crash and continue spending as before but they might not feel comfortable spending at the same levels all the same.
And it is not right to suggest that middle-class Americans care only about home values and do not experience financial anxieties when their much smaller portfolio amounts diminish. If anything, middle-class people experience greater anxieties over the smaller losses because they have far less slack in their financial plans. To a middle-class person who has only 40 percent of his wealth in the stock market, a 50 percent drop in stock prices represents a loss of 20 percent of accumulated wealth. That’s a big deal to most middle-class people struggling to accumulate enough assets to be able to retire at age 65.
Finally, it is important to understand that stock crashes cause housing price drops. If the price-regime concept properly describes how the stock market works, the pretend gains of bull markets disappear into thin air when price crashes hit. When pretend gains disappear, all investors have less money available to finance purchases of real estate. That pulls real estate prices down. So, even if middle-class people care more about real estate losses than stock price losses, stock crashes should cause them to cut spending in response to the real estate losses that usually should follow from stock price losses.
This is a big deal. Smart people disagree on this important topic. It should be getting far more attention than it has received thus far.
Rob Bennett’s bio is here.