Stock Prices Are More Predictable In The Long Term Because Rationality Comes To Play A Bigger Role

Stock Prices Are More Predictable In The Long Term Because Rationality Comes To Play A Bigger Role
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The weird thing about Robert Shiller’s Nobel-prize-winning research showing that valuations affect long-term stock returns is that stock prices become predictable only after the passage of ten years or so. You would think that it would be easier to predict what is going to happen a month out or two months out or three months out. But it is only distant return predictions that work. What’s up with that?

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Getting Stock Prices Right

There are two things that investors need to get stock prices right.

One, rationality. Investors need to want to get stock prices right to get them right. If their emotions cause them to desire a different price than the one that properly applies, rationality goes out the window and they make up some rationalization to explain the improper price they desire more.

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Two, information Even entirely rational investors cannot get prices right if they do not have the information available to them to determine the proper price. An efficient market is one in which all investors want to get prices right and in which they have available to them the information needed to pull off this trick.

Take a look at today’s CAPE value if you harbor any illusions that today’s market is efficient. It’s wildly inefficient. Investors are not entirely rational. And they do not have available to them the information they would need to get prices right even if they were.

There’s only so much we can do about the investor irrationality problem. Investors are humans. Humans are capable of rationality but are also highly emotional creatures. It’s hard to imagine how that is ever going to change. So stock mispricing is always going to be with us.

I believe that the way to attack the irrational exuberance problem is by supplying investors with information that they do not possess today. Specifically, we need to make investors more aware of their own irrationality. It is stunning how little of this is done today. Shiller wrote the book on irrational exuberance. And not one time in his book does he assert that we need to get the Buy-and-Hold retirement studies (which lack valuation adjustments!) corrected as soon as possible. We all feel funny telling the Buy-and-Holders how far off the mark they are in their understanding of how stock investing works. So we hold back on reporting on the far-reaching how-to implications of Shiller’s amazing research out of a worry that it would upset the Buy-and-Holders. Which of course encourages their self-delusions.

Rationalizing The Crazy Prices

We should speak more bluntly about the dangers of price indifferent strategies. Doing that would not transform the emotional humans into entirely rational investors. But it would make it harder for them to rationalize the crazy prices that they sometimes assign to stocks. That would be a huge step forward. The harder it is to rationalize improper prices, the closer prices will be to where they should be.

What happens under current conditions is that the rationalizations get crazier and crazier as time passes. Investors test somewhat inflated prices. When bad consequences do not follow, they feel free to test even more inflated prices. As time goes on, the prices get so crazy that those of us who are concerned about mispricing begin to feel even more intimidated about saying anything because the dangers have reached a point where the mispricing has become truly embarrassing. The time to do something about irrational exuberance is before it gets too out of hand.

The background reality is that sooner or later the market has to get prices right. That’s what markets do. We can ignore the realities for a time. We can concoct all sorts of elaborate rationalizations for our collective decision to ignore the realities. But common sense always retains a voice at some place in our consciousness. There comes a time when the rationalizations do not work for a number of us and that fear of the reality principle spreads as prices begin to move in the direction of the fair-value price.

It can take 10 years or even a bit longer for that process to play out. That’s why long-term predictions are so much more effective than short-term predictions. Investor emotion can remain dominant for a long stretch of time. During the stretch of time in which we are all working hard to remain ignorant of the realities, any price that we all decide on can apply. Logic doesn’t matter. Research doesn’t matter. Reason doesn’t matter. Emotion controls. And emotion is not predictable.

Emotion has never yet managed to remain dominant indefinitely, however. The reality principle always returns to dominance in the end. So long-term return predictions really do work.

Confidence In Irrational Exuberance Gains

What if we told people that more frequently? Investors are sufficiently rational to want to know the true value of their retirement portfolios. What if as a society we made it a practice to tell them on a daily basis? Many would prefer the Buy-and-Hold mumbo jumbo to research-based descriptions of what is going on in the market. But on some level of consciousness the research-based descriptions would be heard all the same. Those descriptions would leave a mark. It is hard to maintain an easy confidence in irrational exuberance gains when that confidence is being assaulted on a daily basis by descriptions of the research-based realities.

Shiller is trying to help investors to grow up. Believing in irrational exuberance gains is childish. Most investors prefer living in a fantasy world for as long as that remains possible. But Shiller’s research would not exist if there were not a good number of us who possessed a desire to develop a deeper understanding of this important subject. Those of us who believe that Shiller’s research is legitimate need to be firmer in our efforts to have the research-based understanding heard even by those whose initial reaction to it is to put their fingers in their ears.

Rob’s bio is here.

Updated on Jul 26, 2022, 9:33 am

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