Valuation-Informed Indexing #391
By Rob Bennett
The big mystery in the stock investing realm is how Eugene Fama and Robert Shiller could both be awarded Nobel prizes on the same day for developing completely different models for understanding how stock investing works. Fama says that stock prices are determined by investors making rational decisions about economic realities, suggesting that individual investors who think they can outsmart the market are fooling themselves. Shiller says that at times of overvaluation prices are determined largely by emotion, suggesting that investors who keep their heads when the market as a whole is losing its head can profit by doing so.
I certainly am in the Shiller camp. I have seen evidence of runaway emotion in just about every discussion of stock investing in which I have participated over the past 16 years, a time-period during which prices were at levels suggesting that runaway emotion should have been clearly in evidence. But I believe that Fama merited his Nobel prize as much as Shiller merited his. My take is that our collective understanding of how the stock market works was just not terribly advanced prior to the publication of Fama’s important research of the 1960s and that Shiller probably could not have made the huge contribution that he made in 1981 had Fama not in earlier years laid the foundation on which Shiller built. But those who base their stock investing decisions on Fama’s work alone are playing a dangerous game.
Fama built us a beautiful-looking car with a powerful engine. What’s not to like, right?
But he made one terrible mistake. He failed to put brakes in the car! Without brakes, a good-looking car with a powerful engine is a good-looking death trap. Cars need brakes! Shiller is my favorite investing analyst because he is the one who realized the need to add brakes to the vehicle.
In other markets, there are natural limits on how high prices can go. The people who sell us sweaters and bananas and batteries would love to see the prices charged for those items go up and up and up. But the reality is that if any seller of sweaters or bananas or batteries gives in to the temptation to charge a very high price, he will soon find himself out of business. In other markets, there are always pressures pulling prices down to counter the pressures pulling prices up. In other markets prices are set through a battle between the sellers who want them to rise as high as possible and the buyers who want them to drop as low as possible.
It doesn’t work that way in the stock market. In the stock market, buyers love, love, love high prices. When stock prices go up, we all pay more for the shares we buy each month. But we tend not to focus on that side of the story. We are happy to pay higher prices for the new shares we purchase because it means that the shares that we have held for a long time are priced higher too. The stock market is the only market that I can think of in which both buyers and sellers possess the psychology of sellers. Both buyers and sellers like to see prices headed up, up, and up some more. There is no natural resistance to higher prices in the stock market.
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There’s common sense. We all have a voice of common sense telling us that prices can only rise so high before they tumble. That causes us to become gun-shy when prices have risen too high too quickly. So there is a force that causes occasional price retrenchments. But price retrenchments are generally short-lived. In not too much time we get over our feeling that prices have risen too high too fast and return to the usual mode of cheering on ever rising price jumps. Until —
Things reach a point at which the only way that the market can perform its core function of setting prices properly is by crashing them. And then lots of people get hurt in very serious ways.
Shiller showed us the way out. His research shows that, while it is true that short-term timing never works, that’s not because the market is rational and incapable of being outsmarted, as Fama supposed, but because it is highly emotional and therefore highly unpredictable. The big change is in seeing that a market that is highly unpredictable in the short term because it is so emotional is highly predictable in the long run because the emotion must be flushed out in time if the market is to continue to function. So highly priced markets are always going to go down hard in the long run. We can never say when a price crash will come (because they are brought on by investor emotions, which are unpredictable) but we can always say that one will indeed come eventually to a market in which prices have gotten out of control. So we can say that stocks are a lot more risky when they are high-priced than they are when they are fairly priced.
Shiller put the brakes on the car. Shiller provided us the means to become more rational.
Once we come to accept that high-priced stocks are more risky than fairly priced stocks, we will naturally want to go with higher stock allocations when prices are reasonable than we do when prices are insanely high. There’s that resistance to rising prices that has been lacking in the stock market and causing so much trouble for stock investors for so many years! Once investors understand that stocks represent a better value proposition at some times over other times, prices become self-regulating — high prices cause sales, which bring on more reasonable prices.
Stocks were risky in earlier days because we didn’t know how the stock market works. Now we do. At least intellectually. Once we are able to spread the word about the many far-reaching implications of Shiller’s research, we will be able to appreciate the good-looking and powerful car that the Buy-and-Holders provided us a lot more than we have until now. Because driving powerful cars is so much more fun when you have available to you a way to stop it other than crashing it and getting yourself killed or hospitalized in the process.
Rob’s bio is here.