Investors Never Possess Full Confidence In Irrational Exuberance

Investors Never Possess Full Confidence In Irrational Exuberance
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Irrational exuberance is off the charts today. The CAPE value on the day I write these words is “30.” Since the fair-value CAPE value is 17, that means that nearly half of the value of the stock market is rooted in nothing more than investor emotions. People tell themselves that “I have a portfolio worth $500,000” and they don’t stop to think that the true and lasting value of that portfolio might be something between $250,000 and $300,000.

So we believe.

But we don’t fully believe.

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When Irrational Exuberance Goes Poof

If we fully believed, the irrational exuberance portion of our portfolio wouldn’t always disappear into nothingness in time. What makes that happen? There’s not some outside force that causes irrational exuberance to go “Poof!”. The Buy-and-Holders pretend that there is. When irrational exuberance goes “Poof!”, they attribute the price drop to negative economic developments. But if it were economic developments that determined stock price changes, there wouldn’t be a correlation between valuation levels and long-term stock returns. It is a change in investor psychology that causes CAPE levels to return to fair-value levels.

Why don’t investors just let high stock prices remain in place? We like the feeling of getting something for nothing or else there never would be out-of-control prices in the first place. So why give it up? What makes us want to see irrational exuberance disappear?

It’s that we never entirely believe in it in the first place. We want to believe in it. We want prices to be higher than what is justified by the economic realities. We like that feeling of getting something for nothing. But we don’t truly believe. Our Get Rich Quick impulse is not the only thing that drives us. We also have a common sense impulse within us. No matter how high stock prices go, it never goes away.

There is a tension between these two forces. We always want to send stock prices higher because doing so creates money for nothing. But we also always want to hold onto the common sense impulse that tells us that sending prices too high is dangerous. We let the Get Rich Quick impulse have some play. But eventually the price run-up that follows scares us and we pull back a bit. Some time has to pass before we are willing to let the Get Rich Quick impulse run free again. Eventually, though, that happens. The more time it is that passes before the Get Rich Quick impulse causes serious negative consequences, the more we feel that we can permit it to run free. One series of price gains gives us the confidence we need to permit another series of price gains.

Investor Emotion vs Rationality

The common sense urge is always lurking in the background, however. It never goes away. It is part of us. We tend to celebrate bull markets and curse bear markets. But the reality is that they are the same thing, the triumph of investor emotion over investor rationality. If rationality were dominant, there would be no bull markets. Prices would go up by enough to support the 6.5 percent real gains that are the result of the economic realities. And, if there were no bull markets, there would be no bear markets. If prices were not artificially inflated, there would be no reason for them to crash.

I believe that those of us who offer investment analysis should be devoting a lot more effort to understanding this tension between the Get Rich Quick impulse and the common sense impulse. It is the undiscovered continent of stock investing. What makes it difficult to reach a deeper understanding is that bull markets are always standing on a shaky foundation. We tell ourselves that it is economic realities that are the cause of our inflated portfolio values. But we know that that is not entirely so. We always know or at least suspect. So it always makes us uneasy to be exposed to discussions of the role that investor psychology plays in persuading us that our portfolios are worth more than what they really are worth.

We are better off knowing. That’s my take. The more we know, the fewer bull markets there will be and the less prices will get out of control during those bull markets. But of course the other side of the story is that, the less things get out of control, the less harsh will be the price drops that are needed to return prices to reasonable levels. I see that trade-off as being one that would work very much in favor of all stock investors.

Rob’s bio is here.

Updated on Aug 16, 2022, 10:33 am

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