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It's Human Emotions That Swing Wildly, Not The Economy Or The Value Of The Stock Market Shiller's amazing research findings changed everything. The word "revolutionary" appears in the subtitle of Shiller's book and his ideas about how stock investing works live up to the grand claim....

By robbennett

entrepreneur daily

This story originally appeared on ValueWalk

sergeitokmakov / Pixabay - Valuewalk

Shiller's amazing research findings changed everything. The word "revolutionary" appears in the subtitle of Shiller's book and his ideas about how stock investing works live up to the grand claim.

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There's really only one idea that Shiller brought to the table. But it's a biggie. It's that valuations affect long-term returns. Forty years on we have barely scratched the surface of coming to terms with the far-reaching strategic implications of that one.

Investor Emotions Swing Wildly

The thought in pre-Shiller days was that investor emotions are stable. It is the Efficient Market Theory that is at the core of the Buy-and-Hold Model. The Efficient Market Theory posits that investors are always engaged in the rational pursuit of their self-interest. Hence, stock prices reflect the economic realities of the day. Hence, prices are always set properly and timing cannot work (no single investor can know more about how stocks will perform in the future than the market as a whole).

In the pre-Shiller era, investor emotions were stable but the economic realities and the stock values that reflected them were not. Shiller turned those understandings of how things work on their head. It's investor emotion that is swinging wildly from irrational exuberance to irrational depression. Knowing that that is so, we no longer can assume that stock price changes reflect changes in the value of the underlying stocks. It could just be that investors are assigning inappropriate prices because of their emotionalism.

And changing stock prices no longer need be taken to signify changing economic circumstances either. Changes in the nominal value of millions of stock portfolios obviously affect consumer spending, which in turn affects the strength of the economy. When irrational exuberance appears on the scene, the economy temporarily appears to be humming. It may not be doing any better in a real sense. But the temporary surface appearance suggests a time of economic growth.

So part of the task of coming to terms with Shiller's findings is understanding that our focus has been on the wrong things. We place too much emphasis on stock prices, which to a large extent are the product of the investor emotionalism of the day, and on economic growth, which is also to a large extent the product of the investor emotionalism of the day. And we apply too little focus to the investor emotionalism of the day, which is the driver of both stock prices and of the economy.

A Positive Story

It's unsettling to think that we have been getting things so wrong for so long. But the story is ultimately a positive one. If it really is the case that it is investor emotionalism that matters most, we have a promising new way to manage both stock market volatility and economic growth – by managing investor emotion!

If the CAPE level remained at fair-value levels (17) at all times, stock market volatility (which is the thing that makes stocks a risky asset class) would be a thing of the past. And economic growth would be achieved far more smoothly in a world in which investors were not at some times pushing stock prices up insanely and then at other times pushing stock prices down insanely.

The encouraging thing is that we can rein in investor emotionalism if we try. A world in which neither irrational exuberance nor irrational depression exist is a world in which stock prices increase by 6.5 percent real each year. That's less than what we often see during out-of-control bull markets. But it's not at all bad. So we can have an asset class that performs very well in a world in which investor emotionalism is a thing of the past.

And it's not hard to imagine how we could persuade investors to become less emotional in their thinking about stocks. Stocks offer a better long-term value proposition when prices are low than they do when prices are high. Investors obviously want to obtain the best value that they can obtain. So if we were to begin publicizing how poor a buy stocks become at times of super high prices, investors would lower their stock allocations at such times. That would bring prices down! Stock prices are self-regulating in a world in which information on how valuations affect long-term returns is widely available.

Market Timing

What's holding us back?

It's the taboo on market timing, nothing else. Market timing is the means by which price discipline is achieved in the stock market. The rational thing is for investors to practice price discipline when buying stocks just as they do when buying everything else they buy. Take market timing off the table, as the Buy-and-Holders have, and it becomes impossible for investors to think rationally about the stock investing project. That leaves us with the sort of CAPE value that applies today and that has applied for a good number of years now.

Shiller's contribution was to show why market timing is essential to the achievement of a functioning stock market. I have never heard Shiller himself say it quite that way. But I believe that the logic chain for that remarkable claim is strong given the things that Shiller has said.

Rob's bio is here.

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