Sometimes I am in a bookstore and I take a look at the personal finance section. Robert Shiller’s book Irrational Exuberance is on the shelves. I always wonder how my Buy-and-Hold friends react to seeing the two words of that title.
Keeping Irrational Exuberance In Check
Does exposure to those two words scare them? Those two words tell the story of stock investing that Buy-and-Holders prefer to ignore. Irrational exuberance cannot possibly be a good thing. Everyone gets that.
Q2 2022 hedge fund letters, conferences and more
If irrational exuberance is a real thing (why would Shiller have written a book about it if it were not?), we should all want to do our best to rid ourselves of it.
How would we go about doing that? There’s only one possibility. When stock prices got too high (higher than the price level that generated a CAPE level of 17, the fair-value CAPE level), we would all lower our stock allocations a bit.
The diminished demand for stocks would bring the price level back to its proper place and the irrational exuberance problem would be solved.
So irrational exuberance is an easy problem to solve. But that thing where investors respond to crazy high price levels by lowering their stock allocation is market timing. That’s not permitted, according to the Buy-and-Hold dogmas. No market timing! No way, no how.
So what are we supposed to do about irrational exuberance? Is there any other way to keep it in check? There’s nothing that I can imagine.
Market Timing Is Always Required
The idea that market timing is not required was developed at a time when there was a widespread belief that the market is efficient. The idea there is that investors act rationally in pursuit of their own self-interest.
If that were so, we really wouldn’t need market timing. If investors were rational, they would never misprice stocks. Overvaluation and undervaluation would not exist. So market timing would not be needed and it wouldn’t work if anyone tried it.
That’s not the world we live in, of course. Shiller showed with his Nobel-prize-winning research of 1981 that the market is not efficient, that valuations affect long-term returns. So market timing always works and is always required.
Shiller was awarded a Nobel prize because he turned our old understanding of how stock investing works on its head. That’s why the word “revolutionary” appears in the subtitle of Shiller’s book. He changed everything.
In theory.
In practical terms, he changed very little. People still invest in stocks in the way that they did in the days before Shiller came on the scene. Most investors fail to engage in market timing. Most investors are not even aware that there is anything wrong in that.
They celebrate all price increases, even price increases that take the CAPE level above 17. They count their nominal stock gains as real. They invest as if irrational exuberance were not a thing.
That’s why I wonder if seeing those two words on the cover of a book that was a best-seller sends a little shock wave through the brain cells of my Buy-and-Hold friends.
They very much want to believe that Shiller never published his research, that his book does not exist, that he was never awarded a Nobel prize.
On some level of consciousness, they know that the book exists. Ask them about Shiller and they will say “smart man, smart man” because that’s the thing that you are supposed to say about a fellow who is awarded a Nobel prize.
But, when it comes to stock investing, the world that we live in is the same world as the one we would have lived in had Shiller never been born.
The Secular Bull Market
There is more irrational exuberance today than there was at any earlier time in U.S. history. The highest CAPE level that we ever saw in the years before Shiller published his research was the “33” that we saw in the days before the beginning of the Great Depression.
We hit “44” in early 2000. The secular bull market that began in the early 1980s is still going strong today. We have seen more years of high stock prices in recent decades than we saw at any earlier time-period.
Shiller’s warnings about the consequences of letting irrational exuberance get out of control have not so much as rendered a dent in our collective consciousness.
Will things ever change? I believe that things will change. The Buy-and-Holders have managed to ignore Shiller for 41 years since his research was published. But it gets harder and harder to do that all the time.
There’s the research. There’s the book. There’s the Nobel prize. There was that economic crisis that we experienced in late 2008. There are annoying people like me who try to launch discussions of the far-reaching how-to implications of Shiller’s research when they post on internet discussion boards and blogs.
If Shiller’s Nobel-prize-winning research is legitimate research, it reflects the realities of stock investing. The realities of stock investing have our Buy-and-Hold friends pretty much surrounded at this point in time.
You don’t need to read the book to learn the story. You don’t need to examine the research. All that you need to know to know that some changes in how we invest in stocks are required are those two words – irrational exuberance.
Irrational exuberance cannot possibly be a good thing, We should all want to keep it in check. And there’s only one tool available to us to do that. The thing that the Buy-and-Hold strategy forbids as its first order of business.
Rob’s bio is here.
