When stock prices return to fair-value levels, we call it a “crash.” Crashes are violent events. Why don’t prices work their way downward in a gentle gradual manner?
It’s because the event that caused prices to rise to crazy high levels was also not gentle and gradual. We call that event a “bull.” Both bulls and bears are unnatural. The natural thing is for markets to process information as it develops.
Prices should slowly go up or slowly go down with none of the sudden, bold leaps and drops that we all think of as being characteristic of the stock market as it now exists. It’s because investors are human that we have this strange inclination toward violent and erratic movements in stock prices.
Rationalizations For Stock Price Increases
The market wants to be rational. That’s a human inclination too, of course, and the market is just a collection of humans. What is going on when a market goes into a bull market is that the market is giving up some of its human desire for rationality and replacing it with a human desire of something for nothing.
It’s not easy for the market to do this. This is why you see so many rationalizations for stock price increases that explain them economically. It was a change in interest rates that caused the CAPE to go to 25, not irrational exuberance! You hear that sort of thing all the time. It is a daily occurrence.
The market (that’s us!) very much wants to believe that sort of thing. The market hates thinking that a large portion of the wonderful gains it produces is backed by nothing more than temporary shifts in misguided emotion.
But the side of the market that is drawn to rationality is never entirely killed. The higher prices rise, the more that side demands recognition in a behind-the-scenes, subconscious way.
Eventually, some precipitating event (this really could be a change in interest rates or something of that nature that on its own would be significant enough to cause only a small change in prices) causes the suppressed rational information bits to break through to consciousness.
It is this breakthrough event that is responsible for the violence of the price change that follows. Information that should have been reflected in gradual price changes is suppressed, suppressed, suppressed and then in a brief amount of time exploded into consciousness and prices react in what seems like crazy ways.
I say “seems like crazy ways” because the extent of the price change makes no sense given the relatively minor economic development that served as the precipitating event. The craziness had been taking place all along as information that would have taken prices back to real-value levels was suppressed.
Turning off the suppression is by itself a rational act. A drop in the CAPE level from 33 to 17 is a good thing. But the violence of it does horrifying things to the lives of millions of people. So bear-market moves in the direction of rational price levels are perceived as crashes, inexplicable damaging events that arrive suddenly from nowhere.
Permit The Market To Process The Information It Craves
The way to avoid crashes is to take away the crazy energy that fuels them. To take away the suppression! If the market is permitted to process the information that it needs to get prices right, it will get prices right in a gentle, natural way and violent crashes will become a thing of the past. Permit honest posting re the peer-reviewed research and there will be no more crashes! It sounds so easy.
The stock market is an information processing machine. That’s what it does – it takes in information about goings on in the world that affect the value of the companies in the stock market and it adjusts the prices of those companies to reflect it. The information about the far-reaching how-to implications of Shiller’s research is important information. We should have been permitting the market (us!) to process that information going back to 1981. We haven’t been.
The market craves that information because it needs it to do its job. It will gain access to it sooner or later if the market continues to perform in the future anything at all as it always has in the past. When it does, we all will get hurt in serious ways.
It’s a futile endeavor for us to deny the market the information that it wants and needs. We have shown that we can do it for remarkable lengths of time. But the market (us!) always wins in the end. We are human. So, yes, we get insanely emotional at times.
But our desire for rationality can never be entirely killed. It always comes back to life in time. That’s what Shiller showed. That’s the research. That’s the Nobel prize. That’s the “flakey” stuff that makes Valuation-Informed Indexers appear to be unprofessional in the eyes of confirmed Buy-and-Holders.
They should put a footnote on the CAPE level at times when it reaches crazy levels saying: “this is the price assigned by the market for the moment but the research shows that the market is craving access to information that would cause it to violently jerk that price downward.”
The market craves reality. That craving is not a bad thing. We should let the market have it before it feels a need to grasp it with such hurtful violence. We should give the market what it wants – honest posting re the peer-reviewed research in this field.
Rob’s bio is here.
