Stock prices always return to fair-value price levels. Never in the history of the market has there been an exception to this rule.
So, if prices go to two times fair value, you can know that they are going to come down hard. Eventually. Of course, there is no way of knowing when. Prices might remain at high levels for only one or two years. Or they might remain at high levels for two decades. The P/E10 level reached the mid-20s in 1996 and it is just a nick below 30 today; outside of a few months immediately following the September 2008 economic crisis, we have never been at fair-value level prices or lower in all that time.
Does it matter how long high price levels continue to apply?
I don’t think that there is any benefit to be had from living through a time when prices remain high for many years. There would be a benefit if prices could remain high indefinitely. You would have more money. But presuming that prices are sooner or later going to come down, what is the benefit? You get to enjoy a feeling of being wealthy for a longer stretch of time. But what good is that feeling if it does not last? You end up in the same place as if prices had returned to fair-value levels much earlier.
The exception, of course, is if you sell your shares before prices drop. If you plan to drop to a much lower stock allocation when you retire and prices remain high until you retire, you benefit from the high prices. But outside of that, there is no benefit to the investor in living through a time when stock prices remain high for a long stretch of time.
It might seem like too obvious a point. Logically, I think that’s so. Emotionally, though, I don’t think it is. High prices create positive emotions in investors that make them feel good about their stock ownership even when their minds tell them that the high prices are a temporary phenomenon.
It’s a psychological trick that we all should be thinking about today because we are today living through the longest stretch of high-price years that we have ever seen in the U.S. market. There was a fellow who used to visit my blog on a regular basis in the days before the 2008 crash who ridiculed me on several occasions for saying that prices would someday drop to fair-value levels. He once offered to make a bet that we never again would see a P/E10 value of under 20. He stopped visiting my site after we (very briefly) dropped to a P/E10 value of 13 in the days following the 2008 economic crisis.
That price drop didn’t amount to much because it was so short-lived. But someday we will drop to fair-value price levels and remain there for some time. I don’t get the sense that most of today’s stock investors spend much time thinking about that reality. To see a drop to fair-value price levels would be to watch half of one’s life savings disappear. It’s hard for me to imagine that that’s not going to come as a shock to millions of people.
The full reality is even worse. If Shiller is right that high prices are caused by irrational exuberance rather than by economic realities, we should be expecting a price drop of more than 50 percent. A 50 percent drop would be rational — we need a 50 percent drop to get back to fair-value price levels. But on the three earlier occasions in U.S. history when stock prices travelled to insanely high levels, the irrational exuberance that caused those high prices was eventually replaced by an irrational depression that brought prices down to one-half of fair value. So it is possible that millions of us will live to see 75 percent of our life savings disappear.
I’ve been saying this sort of thing for a long time. And prices have remained high. So many of my critics feel that I have been proven wrong. The question that I am trying to get at in this article is — Is it so? If prices eventually drop dramatically, does it really matter how long it took for it to happen?
There is one important respect in which it matters. An investor who moves out of stocks can probably not match the 6.5 percent real return that is the average long-term return for stocks (the return that is the product of economic realities rather than irrational exuberance). If you take a good portion of your portfolio out of stocks for a long period of time, you pay a big price for doing so. That’s a good reason for being cautious about exercising price discipline when buying stocks. Other asset classes generally do not offer equally appealing returns.
But it seems to me that it is a mistake to altogether ignore the reality that prices will be returning to fair-value levels. There is some risk attached to lowering one’s stock allocation. But there is also some risk attached to not doing so. Should you be more worried that you will suffer big losses when prices return to fair-value levels or that you will suffer a long series of small shortfalls in return during the years that you go with a smaller stock allocation than usual?
There is a judgment call that needs to be made. My concern is that too many of today’s investors don’t perform a risk analysis. Staying heavily invested in stocks has become the default position for many investors in the Buy-and-Hold Era. I don’t think there should be a default position.
It would make sense for there to be a default position if stock risk were a constant, as was believed to be the case before Shiller published his Nobel-prize-winning research showing that the market is not efficient and that valuations affect long-term returns. Shiller showed that stock investing risk varies with changes in valuation levels. So I think that investors should be thinking these issues through before they find themselves facing circumstances that they never anticipated and for which they are not prepared.
Rob’s bio is here.
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