Robert Shiller issued a paper in July 1996 saying that investors who stuck with their high stock allocations would live to regret it within 10 years. There was a sharp price drop in late 2008 and early 2009. But in not too long a time the CAPE level returned to super high levels and it has remained at such levels ever since. Stock prices always return to fair-value levels sooner or later. But it can take a long, long time for it to happen.
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How Stock Investing Works
This fact does not generally support the Valuation-Informed Indexing strategy (a strategy that posits that investors who seek to keep their risk profile constant over time must engage in market timing to do so because stocks are more risky when prices are high). Market timing seems like a dubious idea when stock prices are stuck permanently on “high.” But there is one sense in which the reality that irrational exuberance can remain in place for long periods of time does lend some support to Shiller’s model for understanding how stock investing works.
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In the Buy-and-Hold Model, things work quickly. Investors learn something new about the economy and overnight that new knowledge is reflected in stock prices. Buy-and-Hold is a logical model, if nothing else. It describes how things should be. Investors have their retirement money tied up in stocks. When they discover some new information that affects the value of their assets, they should want that information to be reflected in the price of those assets as soon as possible.
I believe that the Valuation-Informed Indexing Model offers a better description of what is going on, though certainly a less logical one. Stock price changes are determined not by economic developments but by shifts in investor emotion. The investor emotion that has been keeping stock prices up for 24 years now will eventually fade and prices will come down to earth. But that will not happen when it should happen, which was back in 1996 when Shiller wrote about the possibility in his paper. It will happen when investors give up their fight to block it from happening, which obviously is going to turn out to be a lot later than Shiller and I imagined possible.
Predictions For The Fair-Value Price Levels Of Stocks
Stock prices can remain at crazy levels for a long time because investors can remain irrationally exuberant for a long time. It doesn’t matter that there is no good reason for stock prices to be so high. Investors like the high prices more than they like rationality. So high prices they will have. Only investors can turn this around and investors who once rejected rationality to send stock prices to the moon can continue to reject it to keep them there. Not indefinitely. The market cannot continue to function if it doesn’t return prices to fair-value levels eventually. But it will not be pressed. Predictions that fair-value prices will eventually apply are always proven right. Predictions that fair-value prices will arrive on a specified time schedule have a bad track record.
We are dealing with emotions. That’s the thing that the Buy-and-Holders have a hard time letting in. There are times when it is hard to write about this stuff in a coherent manner. The normal way to construct a narrative is to say that investors are likely to do “x” or “y” for such and such a reason. But that doesn’t work when the premise of the article is that investors are behaving irrationally. If investors behaved pursuant to logic, there would be no irrational exuberance. If there were no irrational exuberance, the stock prices that apply today could not exist.
What will cause stock prices to fall?
It will not be something that makes intellectual sense. It will be something that makes emotional sense. Investors have had concerns about the high stock prices for as far back as Shiller had those concerns. They wanted to shake off those concerns and they managed to do so. At some point events will conspire that will make investors feel that it is no longer possible to perform the magic trick and a downward rolling process will commence.
Justifying The Stock Price Drop
There will certainly be some sort of rational justification given for the price drop. We humans like to think that we are in control of things and so we ascribe reasons to things that happen to us, especially when it is scary things that happen to us. But there have been many times over the past 24 years when there were good reasons for prices to fall and it hasn’t happened in a significant and long-lasting way. The development that causes stock prices to finally collapse will not necessarily be something of greater economic significance, it will just be something that will be scary enough to impress itself on the emotions of the investors trying with their minds to tune it out.
I don’t care to guess what that will be. I wish that we were not in these circumstances. I find the phenomenon of irrational exuberance endlessly fascinating to examine and explore. But I also worry very much about the effect that it will eventually have on all of us. I fear the price drop that I believe one day will arrive.
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