Valuations Affect Long-Term Returns – But Why?

Valuations affect long-term returns. Shiller’s research shows that.
But WHY? We all need to understand why for this breakthrough finding to do us any good.

Getting The Prices Right

Mispricing is bad. We need a stock market that gets prices right. The purpose of market timing is to correct mispricing, to get things back to where they should have been all along, to where they would have been all along if it weren’t for our irrational Get Rich Quick urges. The appeal of Buy-and-Hold is that it provides us with a way not to have to cope with the damage we do to ourselves and to others when we misprice stocks.

Market timing fixes the market. It needs to be fixed from time to time. The confusing thing is that it can continue to operate in a seemingly okay way for a long time before it collapses. So investors come to believe that there is no great price to be paid for pushing prices up beyond where the economic realities dictate they should be. So they push them up some more. The problem continues getting worse until things are so messed up that the only way that the market can get prices right is to crash them. And we all suffer the consequences.

Think of each act of market timing as a tiny price crash. When you sell some stocks because prices have risen too high, you are crashing the market in a small way, are you not? Is it better to have tiny crashes all the time or to listen to the Buy-and-Holders and to avoid crashes until the CAPE value has risen so high that we all experience a gigantic crash?

It is so much better to have lots of tiny crashes. Nobody gets hurt in tiny price crash. While those tiny price crashes used to correct for overpricing are taking place, the stock price is still going up by 6.5 percent real each year as the result of real economic gains. So it is not as if those tiny price crashes cause us any real harm. They just make it impossible for us to live in the world of illusion that the promotion of the Buy-and-Hold strategy encourages.

Valuations Affect Long-Term Returns

Valuations affect long-term returns because the market wants to survive. If there were no penalty for Buy-and-Hold, prices would go so high that the market would collapse altogether. As horrible as it is to live through a Buy-and-Hold Crisis, that experience is one notch better than what we would have to live through if we did not have a Buy-and-Hold Crisis. The next step would be to have the entire economy collapse. Then none of our money would be worth anything. Market prices sooner or later, one way or another, need to reflect the economic realities. There is simply no way around it.

Valuation affect long-term returns because the market is trying to return to health. Your body sends you signals when you are doing something that hurts. If you lift too much weight, you get sore muscles. If you eat bad foods, you throw up what you eat. You body gives you a fever in an attempt to regulate your temperature when something has thrown it off. These reactions that your body has are not really bad. They seem bad when they are experienced. But their purpose is to pull you back to a good place.

So it is when the likely long-term returns drops below the 6.5 percent real figure that would apply if we all practiced market timing faithfully. When we get sucked in by the Get Rich Quick/Buy-and-Hold stuff, the market needs to come up with a way to get us to knock off the funny business. It tried to do that through a lowering of returns. It is only when we refuse to practice market timing despite the lowering of returns that the market resorts to the crashing of prices.

We all should be helping the market to correct prices when it makes an effort to do so. We all need to learn to tune out the Buy-and-Hold noise and invest in stocks in a way consistent with our own best interest.

Rob’s bio is here.