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The Stock Market Requires Valuation-Informed Investors To Function Properly

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Valuation-Informed Indexers increase their stock allocation when stock valuations drop to low levels, which is what happens when stocks are not popular. Then they lower their stock allocation when stock valuations rise to high levels. That’s just contrarian investing, is it not? It’s a strategy in which you zig when most others are zagging and in which you zag when most others are zigging.

It’s a contrarian strategy. But that’s not all it is. I think it helps to see that Valuation-Informed Indexing is more than just a contrarian strategy. I believe that the world would be a better place if all investors followed valuation-informed strategies. But it is obviously not possible for all investors to be contrarians. The real appeal of Valuation-Informed Indexing is that it is a strategy that makes the stock market function more like other markets. All other markets have an element of contrarianism present in them that is removed from the stock market at times when Buy-and-Hold strategies (price indifferent strategies) become popular.

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Sweaters go on sale at the first sign of Spring. Why? Because people buy sweaters to keep warm and the demand for things that help us keep warm diminishes when temperatures increase. Is the sweater market contrarian? You could say that. Someone seeking to get the best possible value from his sweater-buying dollars might hold off on purchasing a sweater in December, when all his friends are raving about how great sweaters are, so that he can take advantage of the better prices offered in March, when the demand for sweaters is low. That’s a value-focused sweater buyer. That’s a contrarian. He refrains from buying sweaters when most others are buying them and then he buys when few others are doing so.

By following different sweater-buying practices, that sweater buyer is helping the sweater market to function properly. The companies that make sweaters and the stores that offer them for sale can afford to make more sweaters available at times of high demand if they know that, should they miscalculate in their assessments of the strength of the market, they will be able to sell those left-over sweaters to the customers who put getting a good price above all else, the contrarians. Contrarians grease the wheels of commerce. They are essential to efforts to make those wheels turn around smoothly.

So it is in the stock market. The conventional view is that stock price increases are always good and stock price drops are always bad. That is of course not so. The best stock prices are those that place stock prices at fair-value levels. Stock price increases that push the CAPE value above 16 are bad and stock price drops that push the CAPE value down closer to 16 are good. So stock price contrarians play an important role in keeping the market functioning well. When there are too few contrarians, prices spin out of control. A stock market without contrarians is a fast-moving car without brakes -- plenty exciting but also plenty dangerous.

Those who invest in valuation-informed ways are not being different just for the sake of being different. They are supplying brakes to a car that desperately needs them to be able to continue to perform the function for which it was created. Cars without brakes crash and so do stock markets without contrarians.

So it is true that valuation-informed investors are contrarians. But to suggest that that is all they are is to greatly understate their importance. The contrarian investors are the ones who keep the show going. It is easy to run with the crowd, to buy stocks when they are popular and to sell stocks when they are not, The market desperately needs investors who want to sell stocks when most want to buy them and investors who want to buy stocks when most want to sell them. Valuation-informed investors enable the market to function properly. They rein in the emotions of the majority when they threaten to get out of control in one direction or the other.

A market with a CAPE value of 30 is a market in which the discussion of valuation-informed strategies has been suppressed to the point that the market has become dysfunctional and is on the road to crashing. The market functions well so long as the contrarian viewpoint is strong enough to counter the enthusiasms of the majority. A market in which the majority triumphs over the contrarians is a market in which all investors get hurt.

Is it a logical impossibility that all investors could become contrarians?

It sounds like it would be. Everyone cannot reject the majority opinion because, once that happens, there no longer is a majority opinion.

But all investors can invest in a valuation-informed way. In a world in which that were the case, the market could never go too wrong on the up side or on the down side. A market in which all investors invested in a valuation-informed way would be a balanced market, a healthy market, a non-crashing market.

Shiller is more than just a contrarian. He is that. His research shows that investors should be more enthusiastic over stocks when valuations are low (when stocks are unpopular) and less enthusiastic about stocks when valuations are high (when stocks are popular). But it is not that he is telling investors to walk the path less travelled that makes his research so important, it is that he is telling investors to invest in a more rational way. It makes sense to seek value with one’s purchases. It does not make sense to follow a price indifferent (Buy-and-Hold) strategy when buying stocks. When more investors follow sensible strategies, the entire market performs better. Stock investing is not a zero-sum game. We all benefit when more of us are persuaded to take valuations into consideration when setting our stock allocations.

Rob’s bio is here.

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