Most investors are aware that Robert Shiller published research in 1981 showing that valuations affect long-term returns and that he was awarded a Nobel prize for doing so because of the importance of that finding. But today’s CAPE value is 38, close to the worst that we have ever seen in history. So it would be fair to say that stock investors have collectively dismissed Shiller’s very important research finding from their minds.
Why?
It’s scary. Shiller’s research says something scary about how the human mind works.
We of course want to think that our retirement money is safe. We are counting on it to finance our future. The Buy-and-Holders offer a comforting message. They argue that market timing is not needed. That market is efficient. Investors are engaged in the rational pursuit of their self-interest. To set stock prices too high would be irrational. So we can be assured that it doesn’t happen. There’s no need to engage in market timing to correct for mispricing because mispricing is a logical impossibility.
Shiller’s research tells a more disturbing tale. Stock investors are human. That means that they are at times highly emotional. They like thinking that they are doing better financially than they really are. So they push stock prices above the levels justified by the economic realities, thereby creating irrational exuberance gains. Unlike gains justified by the economic realities, irrational exuberance gains are not real and do not last. People who count on them to finance their retirement always end up regretting it. The only way to combat irrational exuberance is through valuation-based market timing.
Buy-and-Hold and Valuation-Informed Indexing are entirely different stock investment strategies rooted in entirely different understandings of how the human investors who make up the market go about their stock purchasing decisions. Are they always 100 percent rational? Or do they at times become highly emotional, so emotional as to cause price crashes and economic collapses?
I am of the belief that investors are capable of becoming highly emotional about stock investing. I have seen it with my own eyes. I have engaged with tens of thousands of stock investors over the years and one thing I would certainly not conclude from those interactions is that stock investors are always 100 percent rational. Um…. No. It’s not a close call. Not in my assessment.
The unfortunate thing is that investors do not like acknowledging their irrationality. If they did, we could address any problems resulting from it quickly. The CAPE value tells us how emotional investors have become at a given point in time. We could all watch for changes in the CAPE value indicating things were beginning to get problematic. When prices got too high, we could encourage investors to lower their stock allocation to the extent necessary to bring prices back to reasonable levels. With open discussion of the strategic implications of Shiller’s research, the market would become empowered to self-regulate. We would all live richer and fuller and happier lives.
That’s not the world we live in. The idea that valuation-based market timing is required is “controversial.” Accepting that idea means accepting that the Buy-and-Holders got it wrong. People don’t want to believe that. A few are open to the possibility. Perhaps 10 percent of the population of investors. But many are hotly opposed even to discussion of the possibility. The Buy-and-Hold dogma that market timing is not required (or that it doesn’t even work!) is embraced as fervently as a religious dogma. A good number of Buy-and-Holders would stake their life on it (and they have of course staked at least their financial life on it).
I would like to see this change. I believe that we would see it change if we all felt comfortable discussing the implications of Shiller’s research. I find it astounding that we haven’t gotten around to doing that in the 43 years since its publication. We discuss many other sensitive subjects. This one promises to put money in our pockets. What’s the hold up?
In an attempt to understand, I make comparisons to other subjects that were not openly discussed for long stretches of time. Race relations were not openly discussed for decades. Those discussions were very much needed but very difficult. So we held off on engaging in them. The same is true of discussions of homosexuality. It’s true of lots of matters in the sexual realm, actually. We’ve experienced a sexual revolution since the 1960s. It could have happened sooner. It didn’t because we weren’t as a nation of people ready to go there. One day we were and this revolution began to take place.
I think that that’s the story with the Shiller revolution. I think we need to engage in discussions to make it happen and that we are afraid to do so. The Buy-and-Hold thought is comforting. Investors are rational. Our retirement money is safe. We don’t cause market collapses with our own choices. They descend from the sky somehow, no one really knows what brings them on; they are not our concern.
Shiller’s core insight – that human investors are at times highly emotional and must rein in their Get Rich Quick impulse to keep their retirement money safe – is not a flattering one. But it’s a terribly important one. The great irony is that it would not be at all hard to keep our retirement money safe if we were willing to keep an eye on that CAPE level and to do what it took to keep it at a reasonable level. It’s the idea that market timing is not really needed that permits valuations to get so out of control as to bring the market to the point of collapse. Market timing would never become urgently needed if it were practiced in modest ways on a regular basis.
