When it comes to investing irrational exuberance and depression are the same thing.
Robert Shiller’s book Irrational Exuberance was published in March 2000. We saw the highest CAPE value in the history of the U.S. market in January 2000. So it was certainly appropriate that the title of the book reflected a concern over high stock prices. But the reality is that Shiller’s research does not only warn of the dangers of high stock prices. The point of his work is to show that the nominal price that we assign to stocks often does not do a good job of reflecting the real, lasting value of the market. It is every bit as possible for stocks to be priced crazy on the low side as it is for them to be priced crazy on the high side.
The market has been priced crazy high for nearly the entire 20 years since publication of the book. We entered a bear market shortly after the book was published. But the amazing reality is that the CAPE value for the S&P500 never dropped below 20 at that time. 20 is a long ways down from 44, to be sure. But in historical terms a CAPE value of 20 is high. It’s a weird sort of bear market that takes you all the way down to a high CAPE value. The dominance of the Buy-and-Hold Model for understanding how stock investing works has messed with our minds so much that we are no longer even able to get a clear fix on whether the market is priced low or high.
Outside of the questionable bear market of the early 2000s, the only time during the last two decades in which we saw anything that might be characterized as irrational depression rather than irrational exuberance was in the days following the 2008 economic crisis. All of the talk in those days was that stocks were “on sale.” Were they? It would be fair to say that stocks offered a compelling long-term value proposition in those days. But the CAPE level never dropped below 13 at that time. That’s not much below the fair-value CAPE number of 16. Stocks offered a great value at that time because they were priced properly, not because much of a discount applied.
So Shiller has come to be perceived as a “perma-bear.” He is the guy who argues that stock prices should be lower and probably will be soon. The term “perma-bear” even appears on the copy for the back cover of my edition of Shiller’s book. That one drives me a little nuts. To say that someone is a “perma-bear” suggests that he always believes that stock prices should be lower. Shiller doesn’t believe that at all. He believes that stocks should be properly priced and that the proper price for stocks is not the price that nominally applies but the price that would apply if the CAPE value were at its fair-price level of 16.
The reason why this matters is that we may soon be entering an extended period of time when stock prices will be irrationally low rather than irrationally high. Shiller’s research shows that investor emotion plays a big role in setting stock prices, often a bigger role than the economic developments that Buy-and-Holders point to as the explanation of stock price changes. Investor emotion works in two directions. It has kept stock prices insanely high for several decades now. But, if the stock market continues to perform in the future anything at all as it has always performed in the past, it will be keeping stock prices insanely low for some time after prices next crash.
Irrational depression and valuations
Stock valuations don’t go high or low for no reason. They go high because we all have a Get Rich Quick impulse residing within us. We like free money; surprise, surprise, right? It’s harder to understand why stock prices would ever drop to insanely low levels and then remain there for a significant stretch of time. But they do. This is not an uncommon phenomenon. In fact, it always happens in the wake of a long bull market.
The deflated expectations that investors feel re their future financial prospects when stock prices come crashing back to earth causes them to under-estimate the value of their stock holdings for a long time to come. In the three earlier bull/bear cycles in U.S. history, the bear cycle did not come to an end until the CAPE value reached 8. That’s a price drop of more than 70 percent from where we stand today.
A big reason why Shiller’s work has not become more popular is that most people do not see the harm in high stock prices. When prices remain high as long as they have remained high in the current bull market, high stock valuations really do seem to produce free money for everyone. What’s the complaint? The complaint is that irrational exuberance begets irrational depression. Every time. There has never in the historical record been a single exception. And the sorts of price drops that are produced by irrational depression cause a lot of unnecessary human misery. When we collectively pretend that our stock holdings are worth only one-half of what they really are worth, we hurt ourselves in very big ways.
Shiller is not an advocate of lower stock prices. He is an advocate of reasonable stock prices. When the CAPE value is once again residing somewhere well below its fair-value level, Shiller’s research will be making a case for an increased stock price, not a diminished one. And that case will be much needed at that time.
Both emotional extremes are dangerous. Irrational exuberance is not dangerous in an obvious way because it brings on good times. The worst thing about irrational exuberance is that in time in brings on irrational depression. Irrational depression is dangerous in a direct way. It pulls the economy down. It makes all of our lives smaller. When we get there again, we are going to be in desperate need of something to pull the economy back up. I believe that we will see an enhanced appreciation of the wisdom of Shiller’s perma-moderation at that time.
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