Yesterday’s blog entry reported on an e-mail sent to me by Academic Researcher Wade Pfau on December 3, 2011. I responded the same day I said: “That sounds super.”
My next e-mail from Wade arrived the following day. Wade reported that his article on Valuation-Informed Indexing had officially been accepted at Applied Financial Economics and would be appearing in print within 18 months. I responded the next morning, offering Wade my congratulations.
I next heard from Wade on December 10, 2011. He reported that: ” I ended up writing a new paper on valuations after all.” He attached a copy to the e-mail and said that he would provide a link in a few days and that he had submitted the paper to the Journal of Financial Planning.
He also said: ” I just made a blog post about something you suggested to me months ago. It also came up independently as well at a seminar I gave at Texas Tech University in October. Any thoughts about the result?
I looked first at the blog post. I will comment on the paper later.
I am very interested in the concept you are exploring. I don’t entirely understand what you did. So anything I say must be viewed as being the product of an exceedingly tentative observation.
My impression is that the red line really is a good bit more stable than the blue line. It is not flat. But it is a good bit flatTER.
From 1900 through 1970, the red line follows pretty much the same path as the blue, but with lower tops and higher bottoms. It could be argued that that’s the truer picture since the blue line in time always “catches up” to the red line. If you were using the red line to inform your decisions as to how much wealth you possess, you would be using a better guide because you would avoid temporarily extreme assessments in both directions. That’s a good thing, no?
There’s a big drop in 1970 that makes the red line seem not at all flat for a time. However, in comparison to the blue line, it is flat even then. The drop for the blue line is even steeper. This was the stagflation of the 1970s, which was caused by the bull market of the 1960s. What is happening in a bull market is that we are borrowing money from future investors. What is happening in a bear market is that we are paying back the debt we incurred. I (tentatively) think you could say that
the bull/bear cycle causes real economic damage. So there was more wealth accumulation in the 1960s than there was in the 1970s. But the market numbers exaggerated this reality. The red line shows a drop in wealth accumulation but a less dramatic and more realistic picture than the blue line.
Assuming that the blue line is going to come down and touch the red line (and probably then drop well below it) in coming days, the red line will again prove to be more flat in the post-1990 period.
There’s a very important policy prescription that follows from this (presuming that I am on the right track re what I am seeing). When the blue line next drops below the red line, consumers/investors are going to become convinced that they have far less in the way of wealth than they really do possess (according to the more accurate red line). This is going to cause a greater contraction of consumer spending, which in turn is going to cause a worsening of the economic crisis. If consumers/investors were made aware that it is the red line that matters for the long run, they would find the blue line numbers less frightening and would be less inclined to reduce their spending even more. That is, persuading millions of middle-class investors that the red line is the accurate wealth assessment line would constitute an EFFECTIVE spending stimulus, something we may very much need in days ahead as the blue line continues to work its way downward.
Please note that the blue line ended up a good bit lower than the red line at the end of the last bull/bear cycle (1982), as it did in 1920 and 1950 (my rough approximations of the ends of the two earlier cycles). If this pattern repeats, we are going to see a blue line (what people believe is their wealth) a good bit below today’s red line. That is going to frighten lots of people.
The question is — Which is the real number? Will people’s fears be genuine or inappropriate? My contention is that the fears will be exaggerated and that the last thing we should be doing in an economic crisis is reporting numbers that cause
people’s fears to be heightened beyond what is justified by the bad-enough realities (the red line).
My overall sense is that bull markets move wealth from one time-period to another. They increase wealth in a current time-period by borrowing from the future. But the net effect is not a neutral one. The shocks delivered to the economy by this
artificial shifting of wealth destroys wealth (because of the inefficiencies connected with having tens of thousands of businesses fail and millions of unemployed workers). So we are all poorer as a result of bull markets. The red line gives investors a better sense of where they stand than does the blue line. If we persuaded investors to pay more attention to the red line, we would diminish the economic shock delivered by the bull market and thereby limit the diminishment of wealth suffered because of it.
I would love to hear about any feedback on the chart provided by others.