What Is the Meaning of the Word “Overvaluation”?

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We all know what the word “overvaluation” means. But we all pretend not to know. If we didn’t, the CAPE value could never rise to the level where it resides today, 35.

The Meaning Of Overvaluation

That’s two times the fair-value CAPE level of 17. If we permitted ourselves to think about what the word “overvaluation” means, we would be aware that when stocks are overvalued they are mispriced and do not offer as strong a long-term value proposition. So we would sell some of our stocks. That would bring the CAPE value down until stocks were no longer overvalued.

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I am the person who discovered the error in the Buy-and-Hold retirement studies. They lack a valuation adjustment. There are a group of Buy-and-Holders who visit my blog on an almost daily basis. One of them recently advanced a comment stating: “If only there was someone who could put together a convincing argument that a valuation adjustment is required.” My response was: “If valuations affect long-term returns, as Shiller showed in his Nobel-prize-winning research, then it's a logical impossibility that the safe withdrawal rate is the same number at all valuation levels.”

Is that not so?

The problem is that it is not only that that is so. If the word “overvaluation” means what it appears to mean, the entire Buy-and-Hold Model is rooted in error. In fact, the entire Modern Portfolio Theory on which the Buy-and-Hold Model is based is rooted in error. The Modern Portfolio Theory posits that investors are rational and that stocks are thus always properly priced. If that’s so, then the existence of any overvaluation shows that the theory does not hold water.

You can have overvaluation or you can have market efficiency. You can’t have both. If the market is not efficient, there is no reason to believe that it is not possible to time the market. All that an investor who wanted to time the market effextively would need to do is to lower his stock allocation at times when the market is overvalued, as long-term returns would obviously have to be less at such times. He would do the thing that the Buy-and-Holders say cannot be done – outsmart the market. A market that misprices stocks is not terribly hard to outsmart.

It’s not that there are not enough I.Q. points being directed to getting stock prices right. There are lots of very smart people working hard to set stock prices properly. The flaw in the system by which stock prices are set is that all of those smart people are humans and thus possess human emotions.

Human emotions have the power to overcome reason and logic. Those who have read novels or who have loved ones attending 12-step programs have known this for a long time. Those who work in the investment field only learned it in 1981, when Robert Shiller published his Nobel-prize-winning research showing that valuations affect long-term returns. And for those 40 years they have been resisting suggestions to talk about it. So they both know and do not know this fundamental reality of stock investing.

Improper Stock Pricing

To say that stocks are overvalued is to say that the humans who invest in them are stupid. It suggests that they permit their emotions to get the best of them and to cause them to price stocks improperly.

Here’s the exciting part –

Now that we know how it works, we can make the changes that are needed for it to work better. We would save ourselves an awful lot of trouble if we could develop the ability to hold onto our rationality and price stocks properly. Prices do not crash in a properly priced stock market. Trillions of dollars in spending power are not lost overnight in such a market. So hundreds of thousands of businesses do not go under. Millions of workers do not lose their jobs.

What change would we need to make? We would need to encourage market timing instead of discouraging it. Market timing is a rational process in which investors consider the long-term value proposition being offered by stocks when making stock allocation choices. Add rationality to the system and you have a counter to the investor emotionalism that for many years has earned stocks a reputation as a risky asset class.

It all sounds so easy. Why didn’t we make this change years ago?

I think it is because stock investing is so important. It is scary to think that we got such a fundamental aspect of the stock investing project so terribly wrong. So we have not given ourselves permission to think through the far-reaching implications of Shiller’s Nobel-prize-winning research for over 40 years now.

But we could do that. There’s nothing stopping us but our fear of coming to terms with the reality that we did not come to earth with an owner’s manual telling us how to invest in sticks but have had to pick up pieces of knowledge about the subject gradually over time as the people doing research in this field revealed them to us.

Overvaluation is bad. When we see it, we should do something to overcome it. The very first thing that we need to do is to acknowledge that it is evidence of irrationality. The idea that the market could be automatically rational without investors having to do anything to make it so is a very dangerous idea.

Rob's bio is here.