Nobel laureate Robert Shiller’s research reveals that irrational exuberance drives stock prices above their true value
Irrational exuberance is a thing. Robert Shiller was awarded a Nobel prize for his research showing this to be so – that valuations affect long-term returns.
The only way that that could be so is if gains produced by overvaluation do not have the same staying power as gains produced by economic realities. When investors push stock prices above the fair-value CAPE value of 17, they create not real economic gains but phony and non-lasting irrational exuberance.
Irrational exuberance hurts investors. We need to know the true value of our portfolio for all sorts of financial planning purposes. Irrational exuberance deceives us. It leads us to believe that our stock portfolio is worth 2x when it is really only worth 1x. Then, at some point, it suddenly crashes down to its real value of 1x. It’s not a fun thing to live through.
The perils of irrational exuberance
The people who developed the buy-and-hold strategy are responsible for many powerful insights into investing successfully in stocks. But they dropped the ball on the irrational exuberance question.
In fairness, Shiller’s research had not yet been published at the time when buy-and-hold was being developed. So, their mistake was at least somewhat understandable. But it’s been 43 years since the Shiller research was published, and the buy-and-holders are still discouraging investors from engaging in valuation-based market timing. And valuation-based market timing is the only tool we have to keep irrational exuberance under control. The buy-and-holders have been extremely unhelpful in this regard.
It’s hard not to wonder why. The buy-and-holders advocates using peer-reviewed research to form one’s stock investing strategies. But they seem deeply unimpressed by Shiller’s research breakthrough. I have never heard a buy-and-holder point to any deficiencies in Shiller’s work. But I have also never heard a buy-and-holder make the case for valuation-based market timing. My experience is that just about all buy-and-holders ignore Shiller’s research. They act like it doesn’t exist. They continue to advise investors that it’s just fine to stick with the same stock allocation at all times, despite the 43 years of peer-reviewed research showing otherwise.
It’s a strange reality.
Here’s the thing, though. People who offer stock advice want to help their clients invest more effectively. But they want something else, too. They want to make money doing that. In the stock investing realm, the two goals can come into conflict.
Buy-and-hold strategy: Ignoring valuation for short-term gains
Say that Shiller is right. I believe that he is. If Shiller is right, then irrational exuberance is real, and irrational exuberance is bad. It’s something else too. It’s popular. Irrational exuberance doesn’t just spring from nothingness into existence. Investors create it. Investors have been creating it since the first stock market opened for business. Investors like irrational exuberance.
Investors like irrational exuberance. It offers the promise of something for nothing. Real economic gains must be earned. Irrational exuberance is the product of nothing more than an emotional desire of something for nothing. All humans have a weakness for that sort of thing.
So, a person who offers investment advice for a living faces a dilemma. If he focuses solely on his goal of doing right by his clients, he would tell them about Shiller’s research and exhort them not to treat the irrational exuberance that shows up in their portfolio from time to time as real. But if he wants to keep his clients happy, he needs to tell them just the opposite. If his clients are like most stock investors, they want to believe that irrational exuberance is real. They would very much prefer not to be told about Shiller’s Nobel-prize-winning research findings. This Shiller fellow is a drag, you know?
Today’s CAPE value is 35. The fair-value CAPE value is 17, Stocks are today prices at two times their real value. I think it would be fair to say that not too many of today’s investment advisers are emphasizing the dangers of irrational exuberance when telling their clients how to go about financing their retirement.
Buy-and-hold is what sells. Valuation-informed indexing (which is Buy-and-Hold with exhortations to practice valuation-based market timing added to the mix) is what works.
Investors don’t want to hear what the research says. They say that they do. They think that they do. It sounds good to say that you are following an investment strategy that is rooted in the findings of the peer-reviewed research. But the last 43 years of research in this field threaten to spoil all the fun. Irrational exuberance is the thing that gives stock investing the appearance of a thrill ride. Take away irrational exuberance, and there will be no more bull markets, which means that there will be no more bear markets. This means that there would likely be no more economic crises. A stock market in which Shiller’s research findings were widely discussed would be a very different stock market than the one we have become accustomed to.
The reality of today’s market: A get rich quick scheme
Irrational exuberance turns stock investing into a Get Rich Quick scheme. The market produces an amazing amount of real economic gains. Enough to support an average long-term return of 6.5 percent real. So it would not be fair to refer to the market as a Get Rich Quick scheme and nothing else. But, if Shiller’s research is on the mark, half of today’s market value is fluff-fated to be blown away in the wind in not too much more time. A market that is 50 percent irrational exuberance is largely a Get Rich Quick scheme. Irrational exuberance is as much a driver of today’s stock price as the real economic stuff.
Irrational exuberance makes Buy-and-hold palatable for millions of investors. I love the Buy-and-holders for their many powerful insights and especially for their admonition to investors to use peer-reviewed research for guidance. I only wish that they had taken their own advice more seriously.
But I appreciate that, if they had, buy-and-hold would probably be a good bit less popular than it is. Buy-and-hold without the injunction on valuation-based market timing would be an amazingly effective strategy. But it would not possess nearly the same short-term appeal as buy-and-hold as it is known today with its ability to light up that spot in the stock investor’s mind where he detects the possibility of getting something for nothing and to cause his heart to leap at the possibility.
