Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
“It’s true that math isn’t my thing. And it’s true that the math supports what I say 100 percent.”
Your understanding of the math begins and ends with “yup, that’s a dang high PE10.” Since that’s the only thing you understand, you stubbornly insist that that’s the only thing that matters.
But if it mattered that much, why isn’t the second highest PE10 in history enough to get Shiller to even issue a warning? (Today. Not in 1996.)
The obvious answer (to everyone but you) is that it doesn’t matter that much. Shiller has learned that the market isn’t that simple, so he moved on. Moving on is even less your thing than math.
It’s not that the P/E10 is high that concerns me so much. I 100 percent accept that you can have have a very high P/E10 number and not see an immediate crash, that you can even see 30 percent or 40 percent or 50 percent annual gains starting from a high P/E10 number. That’s not my focus.
My focus is what Shiller’s 1981 finding tells us about how the market sets prices. If the market is efficient, as people believed it to be in the days when Buy-and-Hold was being created, then prices are set through a rational process. It is unforeseen economic developments that cause prices to rise or fall. If that is so, then Buy-and-Hold is the ideal strategy. If that were so, I wouldn’t care what the P/E10 was, I would just follow a Buy-and-Hold strategy.
What Shiller did that was so important was to test this core Buy-and-Hold belief. Is it really unforeseen economic developments causing prices to rise and fall? That was never proven, it was an assumption. The thing that you do in science is that you test things. Is there a way to test that assumption?
There is. Shiller was the first person to test the assumption. If the assumption is correct, prices should fall out in the pattern of a random walk. There’s no pattern that should apply with unforeseen economic developments, sometimes they are going to take prices up and sometimes they are going to take prices down. This is why Fama was awarded a Nobel prize. He seemed for a time to have proven that the assumption is correct. He showed in his research that stock prices do indeed play out in the form of a random walk in the short term (up to 10 years).
Fama didn’t even think to test whether prices play out in the form of a random walk in the long term. Long-term timing was not a practical option in the day when Fama did his research. Long-term timing only works with index funds and index funds did not exist in the 1960s, when Fama did his most important work. Bogle formed Vanguard in the mid-1970s. Then Shiller became the first researcher to test long-term timing in 1981.
He found that it always worked. He found that market prices do NOT play out in the form of a random walk. He found that the core assumption on which our understanding of how investing works was in error.
If it is not unforeseen economic developments that cause stock price changes, what is it? It is investor emotion. That is the theory that Shiller puts forward and it is the only one that I have heard that makes sense and that is consistent with the peer-reviewed research of the past 36 years. That changes everything. That is a “revolutionary” finding. That finding merits a Nobel prize.
Not because we know now that a P/E10 of 30 means that a crash is coming next week or next month or next year. We don’t know that. Shiller didn’t show that. That’s not the point.
The importance of Shiller’s research is that it shows us that stock price changes are caused by shifts in investor emotion, not by unforeseen economic developments. We cannot say that there is going to be a crash soon just because the P/E10 is 30 because emotional investors might just ignore the high P/E10 level and push prices up to 35 or 40 or 45. Shiller didn’t give us information that helps us to predict short-term price changes.
What he did was to give up information that tells us that some stock price changes are rooted in real economic stuff and some are rooted in ephemeral emotions. Prices are caused by shifts in investor emotion. They follow a clearly defined pattern that has remained in place since the first day that stocks were offered for sale. The primary driver is the Get Rich Quick emotion. So the P/E10 level gradually increases over time. First it is 8, then a few years later it is 12, then a few years later it is 17, then a few years later it is 21 and then a few years later it is 26 and so on. The secondary driver is the Common Sense emotion. The Common Sense emotion causes people to feel fear over the long-term value of their emotion-generated returns. The Common Sense emotion causes prices to crash back to 8 so that the gradual-upward-movement part of the long-term pattern can reassert itself. The market always brings overpriced stocks back to fair-value levels or lower. There has never once been an exception.
Today’s P/E10 level is insane. But we cannot say that we are going to see a crash next week or next month or next year. Next year’s P/E10 level could be even more insane that this year’s P/E10 level. We just don’t know.
What we DO know is that stocks are a lot more risky today than they were the last time they were selling at reasonable prices. The more emotion there is present in the price at which stocks are selling, the more pressure there is for sharp downward movements in prices. The more risky stocks are, the less your stock allocation should be if you are seeking to maintain a steady risk profile. Stocks are insanely risky today. Prices might go higher. Then they would be even MORE insanely risky.
The question is — Do you want to gamble that prices will continue moving upward from these insanely risky levels? I do not want to gamble. I don’t care if prices double from where they are today before crashing back to a P/E10 level of 8. I am a long-term investor who does not believe that it is possible to engage in short-term timing successfully. So I don’t believe that I will know when to get out to avoid the crash that is inevitably going to come. So the only way to diminish the effect of the crash is to lower my stock allocation not when I think that the crash is about to arrive but when risk gets so high that stocks no longer represent a strong long-term value proposition.
It doesn’t make much difference to a long-term investor whether stocks crash next week or double in price from here and then crash a few years from now. The investor loses all his phony gains in any event. So why spend so much mental energy trying to figure out when the crash is coming? I don’t think it can be done. I just try to keep my risk profile roughly stable. If I do that, I am covered in all possible circumstances.
I think you are focused on the wrong thing, Anonymous. You don’t want to “miss out” on temporary gains. I focus on whether the gains are permanent or temporary. I don’t fret about temporary gains one way or the other. I just don’t care. I naturally don’t want to miss out on permanent gains. That’s where I direct my attention. I focus on distinguishing temporary from permanent gains.
Gains that are supported by the economic realities are permanent. There has never in the history of the market been a time when those went away. Yes, the market price can do down below fair value just as it can rise above fair value. But it always comes back when it does. That’s the beauty of it. If you focus on the real value of your portfolio, you always know where you stand and you always know what direction prices are moving in the long term. It makes financial planning about 50 times easier than it is when you are pretending that it is unforeseen economic developments driving prices rather than the crazy emotions of human investors.
What I learned from Shiller is that high prices are caused by investor emotion. That tells me to go easy on stocks when investor emotion gets too out of hand.
Shiller hasn’t “moved on.” If the Buy-and-Holders would drop the criminally abusive behavior, he would be 100 percent happy to talk these things over with you and to tell you everything he believes in a calm and clear and detailed way. There are some things he doesn’t know. He would learn those things over time by talking things over with you and with lots and lots of others. He is not able to do that today because you do nuts when anyone even suggests that the Buy-and-Holders might have made a mistake in earlier days and then failed to correct it for the 36 years since it came to light.
When the behavior of the Buy-and-Holders changes, our knowledge of how stock investing works will advance by leaps and bounds. We have 36 years of peer-reviewed research that we have not permitted ourselves to explore. That will change following the next price crash. We will explore the many far-reaching implications of Shiller’s research in days to come. I of course wish that we had begun those explorations back in 1981. We would have prevented a mountain of human misery by playing it that way. But the full reality s that the good news here is 50 times more good than the bad news here is bad. So we will just have to take the good with the bad and “move on,” to quote a phrase.
My best wishes.