I’ve posted Entry #333 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Overvaluation Is “Sticky” Because Investor Emotion Is Sticky.
Juicy Excerpts: The idea at the root of the buy-and-hold strategy is that price changes are determined by unforeseen economic developments. Unforeseen economic developments should not follow any pattern at all. If prices were determined by unforeseen economic developments, today’s P/E10 value would tell us nothing about where prices will land in future days. But just about everyone now acknowledges that the correlation between today’s P/E10 value and long-term returns is robust. We have won the battle over whether P/E10 is telling us something. The fight that remains is in persuading the buy-and-holders that there is a profit to be made by changing one’s stock allocation in response to the signals sent by changing P/E10 values.
The stickiness of P/E10 values argues against the idea that price changes are determined by unforeseen economic developments. In a market in which prices were determined by unforeseen economic developments, valuations would not be sticky; they would change rapidly as new information arrived to influence the decisions of perfectly rational investors. It is emotions that are sticky, not reasoning. The stickiness of valuation levels tells us that prices are determined primarily by shifts in investor emotions, not by unforeseen economic developments.