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.
Rob
“If the assumption is correct, prices should fall out in the pattern of a random walk.”
That’s absolutely false. The economy moves in cycles, and financial asset prices follow those. Doesn’t mean anything irrational or inefficient is going on.
We disagree, John.
Please take good care.
Rob
I reread this one this morning and thought that perhaps I should add a few words of explanation.
Say that it is true that the economy moves in cycles and that financial asset prices follow those. If that’s so, then the fact that the economy moves in cycles would become known to investors and the cycle factor would be reflected in prices as soon as it became apparent that a particular cycle was in place. Changes in stock prices would not take place as the cycle played out. They would take place as soon as the cycle became evident. Today’s stock price reflects today’s realities as well as tomorrow’s realities to the extent they are known today. It is only UNFORESEEN economic developments that affect stock prices according to the Efficient Market Hypothesis.
UNFORESEEN economic developments do not follow a pattern. They play out in the form of a random walk. Obviously they can form patterns that can be detected afterwards. This cycle reality could cause stock prices to play out in a certain way over and over again in a predictable pattern. But once that pattern became known, the information causing the price changes would be available to investors at an earlier time in the cycle and thus the price changes would take place sooner than they did at the time when the cycle effect was not known to investors.
Additions to knowledge change the pattern of returns. As knowledge grows, it becomes possible to foresee developments and to have them reflected in prices sooner.
Shiller gave us knowledge of an important pattern. Stock prices ALWAYS return to fair-value price levels. There has never been one exception in the history of the U.S. market. Prices can rise to price levels far, far above fair value and remain there for a time. But they always. always, always return. This is known. So this should be reflected in the stock price immediately. Rational investors would not wait for the stock crash to accept that prices are going to drop 50 percent. They would let that reality in today and then plan their financial futures accordingly.
But look at what happens to prices if they do that. If investors let in what Shiller taught them with his “revolutionary” (Shiller’s word) research findings of 1981, they would lower their stock allocations because they would understand that stocks do not represent as strong a long-term value proposition as they represented back at the time when they set the stock allocation. That would bring prices down. Stock market prices are self-regulating in an efficient market. They can never get too high because investors know that high prices mean low returns and they naturally lower their stock allocations when the long-term stock return gets so low that safer asset classes offer a stronger long-term value proposition. There can never be crazy levels of overvaluation in an efficient market.
Today’s stock market is obviously not efficient. But why isn’t it? An efficient market is one in which investors act in their self-interest. Investing is important. Don’t people want to invest in their self-interest? Aren’t people rational creatures?
People are CAPABLE of rational action. That’s why we have seen thousands of our fellow community members put their lives on the line and speak up in opposition to the intimidation tactics of you Goons. People want to invest rationally themselves and people want to help their friends invest rationally. So, yes, the market is INCLINED to rationality or efficiency.
But people ALSO have a Get Rich Quick impulse in them that makes them want to tune out the 36 years of peer-reviewed research that shows that valuations affect long-term returns. We are capable of rationality but we are also capable of FIGHTING our rationality, of containing it, of holding it back. That’s where you Goons come in. Your death threats help us remain ignorant of the far-reaching implications of the last 36 years of peer-reviewed research in this field. Your demands for unjustified board bannings help us remain ignorant. Your thousands of acts of defamation help us remain ignorant. Your threats to get academic researchers fired help us remain ignorant.
You are giving us what our inner Goon wants — continued ignorance of the realities of stock investing. So long as we remain ignorant, the 50 percent price drop that is coming remains unforeseen to us and thereby remains unreflected in stock prices. The stock crash will come as a big surprise to Buy-and-Holders even though those who follow the peer-reviewed research in this field have been telling them about it for 36 years now. You can never know something that you absolutely refuse to take in. The human will determines what humans know to a greater extent than the human mind does. Buy-and-Holders are perfectly smart people but they WILL not to know how stock investing works for emotional reasons (they want to believe that the numbers on their portfolio statements are real and accurate).
The battle being fought is a battle between reason and emotion. For reason to prevail in human life, we have to put certain guardrails in place. We have to place limits on the use of death threats and demands for unjustified board bannings and acts of defamation and threats to get academic researchers fired from their jobs. Acts of intimidation are ANTI-SCIENCE. Acts of intimidation hold back human progress. Acts of intimidation make it impossible for human investors to understand why they need to make the changes in their stock allocations necessary for market prices to become efficient.
We want to act rationally. We long to do so. But we need to be able to talk things over with others and ask questions to be able to develop our understanding of the last 36 years of peer-reviewed research sufficiently to be able to do so. And we fear what the Buy-and-Hold Goons will do to us if we insist on our right to do so. So for now prices remain higher than what they would be if they reflected what we all should have learned about how stock investing works from the last 36 years of peer-reviewed research in this field. By electing as a society to remain ignorant of the realities of stock investing, we are also electing to miss out on the financial gains that we would experience from the last 36 years of advances in this field. We are choosing to impoverish ourselves.
It is fine to say that the market has an inclination toward efficiency. It does. But it is also important to point out that criminally abusive behavior on the part of some can block efficiency for a time. The Campaign of Terror against our board and blog communities is hurting us all. We need as a society to work up the courage to take action to bring about enforcement of our laws against financial fraud. These are good and necessary laws. This issue is public policy issue #1 for today. We should be talking about it daily at every investing site on the internet and at a good number of the non-investing sites too. It is by talking it through that we can help each other to work up the courage to stand up to you Goons and to open up access to those 36 years of empowering investing insights that we have denied ourselves until today.
This is my sincere take re these terribly important matters, in any event.
My best wishes to you.
Rob