Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
“there has never yet in U.S. history been a secular bear market that ended with a P/E10 of more than 8”
But markets don’t consult history books when deciding where to move. There’s never been an *infinite* number of scenarios – until they happen.
There are millions of price patterns out there (“Apple stock has never dropped 20% when there’s been a drought in Texas”). But hunting for them and guessing they’ll reoccur is just silly. Markets have no memory.
I like this comment a lot, Anonymous. I don’t agree with your conclusion. But it is my view that the point that you are making is an important one and a helpful one.
I 100 percent agree with you that markets don’t consult history books. This goes to the mistake that short-term timers make. They look for patterns in the history books and they proceed on the assumption that these patterns are going to repeat. My view (and it is my very strong sense that you agree with me re this) is that these people are fooling themselves. Buy-and-Holders have a great distaste for the search for historical patterns. I generally share this distaste.
I say “generally” because I obviously find some significance in the pattern that I referred to in the comment to which you were responding. I say that we always drop to a P/E10 value of 8 before seeing the end of a secular bear market. If that is so, we are all (including those of us not even in the market) going to see a lot of pain in days to come. But you are of course correct that markets don’t consult history books. So why do I even bother pointing out this pattern? Patterns don’t matter. Why be concerned about it?
The reason why I give a small number of patterns a significance that I do not give to the sorts of patterns cited all the time by short-term timers is that I believe that Shiller did more than just point out a particular pattern (that’s really all he did — he showed that there is a correlation between the P/E10 value that applies today and the stock price that applies 10 years down the road –that correlation creates a return pattern that plays out over time). It’s not the pattern that Shiller pointed out that is so all-important. That pattern is interesting. But the existence of the pattern suggests something far, far more important. The existence of the pattern suggests that the Buy-and-Holders were wrong in their core assumption re how markets work.
The Buy-and-Holders believe that it is economic developments that cause price changes. This is a core belief. If this is not so, everything that the Buy-and-Holders have ever said is called into question. Shiller ripped our understanding of how stock investing works apart. This is why I always note that he called his 1981 research findings “revolutionary.” And this is why he was awarded a Nobel prize. Shiller did not just point to one particular pattern that has always applied. He challenged the fundamental premise of the entire Buy-and-Hold project. If the market is efficient /rational, as the Buy-and-Holders believe, then prices should play out in the pattern of a random walk. Shiller showed that they do not. Shiller showed that the market is not efficient/rational.
If the market is not efficient/rational, then what is it?
Shiller’s answer is that it is emotional. It is investor emotions that set stock prices, not economic developments. That’s why the title of his book is “Irrational Exuberance.” Shiller says (he doesn’t say it directly because he does not not want to be attacked by emotional investors but this logically follows from lots and lots of things that he does state directly) that you cannot trust the numbers on your portfolio statement — they are the product of investor emotion, nothing more, and emotions can change dramatically overnight. To say that you have enough to retire because your portfolio statement sets forth a certain number should give you little confidence because the number reflects cotton-candy nothingness (emotions), nothing more.
That’s not 100 percent true. That’s not quite the entire story. There is another element to this story.
The other element is that the stock market always does reflect the economic realities in the long term. If it was only investor emotion that matters, stock prices would go up and up and up and up and never come down. We would all vote ourselves instant retirements and our scheme would work because the numbers on our portfolio statements would support our scheme. We the investors comprise the market and the market determines what the numbers are on our portfolio statements and the numbers on our portfolio statements determine when we can retire. So we decide when we can retire. We can retire tomorrow if we want to. All we need to do is to persuade all of our investor friends to engage in the same fantasies that we want to engage in. Since the fantasies work to their benefit as well, this is not hard to do. The result is what we call a “bull market.” Except it never works. There is some other force that always causes bull markets to go “pop.”
This other force is common sense. We all have it. We cannot escape it. We all possess a Get Rich Quick urge and that is why we have bull markets. And we all possess common sense and that is why all bull markets end badly. It is the tension between our Get Rich Quick urge and our common sense that determines the numbers on our portfolio statements, not the economic realities. But our common sense longs for the economic realities to apply and so there is indeed a connection between the economic realities and the numbers on our portfolio statements. It is just that that connection applies only in the long term. Prices are always moving in the direction of the economic realities but it takes 10 years or sometimes even a little more than that for them to get there. Overvaluation can remain in place for significant stretches of time. But the economic realities always asset themselves in the end and those who take the numbers that temporarily appear on their portfolio statements too seriously make a very big mistake.
I care about the pattern that I cited because it shows how stock investing really works. I don’t care about the specifics of it because I don’t trust historical patterns any more than you do. But I care deeply about getting the numbers right. And it is not possible to get the numbers right if you ignore this tension between the Get Rich Quick urge that we all possess and the common sense that we also all possess that decides where stock prices are going to end up in the long run.
I want to get the numbers right. I take note of the patterns that I need to take note of to get the numbers right. I don’t take it beyond that. I don’t make precise predictions because I don’t trust historical patterns to tell me what I need to know to get precise predictions correct. But I refuse to ignore historical patterns that reveal to me the basics of how stock investing works in the real world and that warn me never, ever, ever to accept those portfolio statement numbers at face value. I adjust the emotion-rooted numbers to bring them more in line with the economic-reality-rooted numbers that would apply if we investors had better control of the Get Rich Quick urge that for many years now has made stock investing a risky enterprise (but that no longer needs to do so now that we know what the last 36 years of peer-reviewed research in this field teaches us).