I have been sending numerous e-mails letting people know of The Silencing of Academic Researcher Wade Pfau by the Buy-and-Hold Mafia. Set forth below is the text of the response I received from Michael Brennan, a Finance Professor at UCLA Anderson School of Management:
“I read your article quickly. I fully agree with you that prices matter. I think a lot of harm was done by misunderstanding the Efficient Markets Hypothesis. I attach a couple of papers that I wrote on related topics” [The papers were titled “How Did It Happen?” and “Persistence, Predictability and Portfolio Planning.”]
Set forth below is the text of my reply:
Thanks much for your response.
Your “How Did It Happen?” article is super. You make all of the most important points, points that have been for too long ignored by far too many, in my assessment. Thanks for letting me know about this important and exceedingly insightful article.
I strongly agree with your point that the Efficient Market Theory has been the primary cause of the problem. I see a highly encouraging side to this reality.
If the Efficient Market Theory is the problem, then the answer to your question “Will it happen again?” is almost surely “No!.” The big picture here is that we are in the early days of a transition from subjective investment analyses to true data-based, research-supported analyses. The Efficient Market Theory is flawed and an unjustified confidence in it has caused big problems. But the fact that the investing public has shown itself accepting of the idea of rooting its allocation decisions in research presents grounds for great optimism re our future. As the Efficient Market Theory is replaced by a more realistic and more accurate model for understanding how stock investing works, attitudes toward investing will change in fundamental ways. We will see things we have never seen before as we see more and more research published that gets things right rather than (inadvertently) wrong.
Once investors learn of the need to change their stock allocations in response to big price swings (and once the “experts” in this field come to see it as an urgent piece of business to insist that all investors be certain always to engage in long-term timing), there can never be another bull market. Each time prices begin to get out of hand, the knowledge that this means reduced returns on a going-forward basis will lead to sales, which will pull prices back to reasonable levels. Market prices are self-regulating so long as investors do not come to believe that the market is automatically efficient!
Another way of saying that is — the market really is efficient so long as investors don’t come to believe that the market is automatically efficient! Our problem is not with the market or with the economy or even with flawed human psychology. Our problem from the early days of stock investing through today is that we have been living in ignorance of the most fundamental reality of the need for price discipline in the stock market, and that ignorance is being dissipated by the publication of fine research like yours and the gradual acceptance of the insights advanced by that research as the price associated with a failure to give full consideration to the power of those insights becomes ever more steep.
Fama was right in an important way. The market WANTS to be efficient, the market strives for efficiency. The missing piece today is the the lack of understanding of the fundamentals on the part of the human investor. The market is comprised of human investors. So long as all the human investors are pursuing their self-interests, the market really is efficient. The problem in the early days of our transition to a research-supported model for understanding how stock investing works is that we did not in the early days have Shiller’s insights available to us. So we came to believe that long-term market timing (which is nothing more or less than price discipline, the magic element that makes it possible for a market to perform its function of setting prices accurately) was not necessary. As the effects of the past bubble become more painful, I believe that we are going to see a recognition of how essential long-term timing is and that we will move to a model that will for the first time in history permit the market to become efficient not only in theory but in practical reality as well.
The key to persuading thought leaders of the need for the change is helping them to see that it was the stock bubble that caused the economic crisis. This is easy to show with numbers. The market was overpriced by $12 trillion in 2000. Even John Bogle, the King of Buy-and-Hold himself, acknowledges that prices always revert to the mean with the passage of 10 years of time or so (Bogle refers to this reality as an “Iron Law” of stock investing). So we knew in 2000 that $12 trillion or so of buying power was going to disappear from our economy by the late 2000s. There’s your economic crisis!
The problem today is that the leaders in the field are in cover-up mode. Causing an economic crisis is such a big deal that they don’t want to admit to being responsible (my sense is that a fear of lawsuits may be a big factor here). But Shiller’s research shows that we are priced today for another 65 percent crash — following every earlier secular bull, the P/E10 value continued dropping until we reached a P/E10 value of 7 or 8. I believe that this next crash will bring on the Second Great Depression and the widespread human misery we will all see will melt the hearts of the Buy-and-Holders until they “come clean” on the role they have played in holding back progress for decades now. Given that the Social Taboo on widespread public discussion of the implications of Shiller’s insights has been in place for 30 years now, we will essentially see three decades of powerful investing insights open up to us in one day!
I am greatly worried about our short-term future. But if we respond well to the next crash, I foresee us entering the greatest period of economic growth in U.S. history as word spreads that it is possible by taking advantage of Shiller’s insights to reduce the risk of stock investing by 70 percent (please see the chart that Wade provides in his research comparing the Maximum Portfolio Drawdown for Buy-and-Holders [60 percent] and for Valuation-Informed Indexers [20 percent]).
Reading your fine article brought a nice measure of cheer to my Friday afternoon. I wish you great success with the important work you do. Please let me know if there is ever any way that I can help you or any questions in your mind that I might be able to answer or to talk over with you. Keep the faith, man!