I’ve posted Entry #493 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called The Narrative That We Use to Make Sense of Stock Prices is Changing.
Juicy Excerpt: I believe that the biggest factor determining the setting of a new narrative is the length of time for which new, lower price levels remain in place. Behavioral finance economists refer to a phenomenon they call “anchoring.” For so long as the CAPE level is 30, we trick ourselves into believing that 30 is the right number. So long as that belief holds, we don’t worry much about a drop to 24. Something tells us that 30 or something in that neighborhood is the right number and of course we will be seeing a move in that direction soon. But it becomes hard to continue to believe that after a CAPE of 24 has remained in place for several months. At some point, 24 becomes the anchor. At that point, we develop a suspicion of claims that 30 is the right number. That’s how price drops get locked in.
People who work in this field generally try to promote narratives that cause investors to have a belief that prices will be going up again soon. There are many circumstances in which these sorts of encouraging stories have the desired effect. But they can backfire. Attempts to build narratives about what is affecting stock prices that do not succeed can have the opposite effect. Such price-building narrative might be ignored at a later time when they are more appropriate and more needed. Efforts to send prices higher become part of a negative narrative when they do not work. That’s why price crashes often bring prices down not only to fair-value levels but to levels far below that.
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