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Stock Prices Drift Upward Unless Most Investors Practice Market Timing

By robbennett. Originally published at ValueWalk.

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The most important question in stock investing is whether investors are rational and always set prices properly or valuations affect long-term returns. If it is the former, market timing cannot work; it would not be possible for any investor to outsmart an entirely rational market. If it is the latter, market timing must work because any investor who sees through the irrationality of the market could set his allocation in such a way as to benefit from doing so.

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Most investors agree that the market is not entirely rational. I have been discussing these matters on the internet for 20 years and rarely do I run into investors willing to make the case that investors are entirely rational. But few investors are open to discuss the implications of that belief. If we live in a world in which the core belief behind Modern Portfolio Theory (investor rationality) is not sound, we live in a very different world than the one for which the Buy-and-Hold strategy was developed.

The easiest way to determine whether investors are rational or not is to look at a graphic showing annual CAPE levels over time. In a world of investor rationality, the CAPE level should remain roughly constant – it should always be somewhere in the general vicinity of the fair-value CAPE of 17. But you would not expect to see a constant CAPE value in a world of investor emotionalism.

What would you expect to see?

The Benefits Of High Stock Prices

If investors permitted their emotions to get entirely out of control, you would see the CAPE value shoot up to the moon in a short amount of time. The stock market is designed in such a way as to encourage investors to give vent to their Get Rich Quick urges. Investors set the price of stocks. They can set them wherever they please. And investors reap the benefits of high stock prices, at least in the short run. There is a big incentive for investors to set stock prices at crazy high levels. To do so would be like voting themselves raises.

We don’t see that. So it is clear that investors do not entirely give up their rationality when they invest in stocks. Stock prices do not shoot to the moon in a short amount of time. But we do not see a constant CAPE level over time either. What we see in the historical record is what I would refer to as a roller coaster pattern. Stock prices rise gradually over time for many years (with brief price pullbacks mixed in) until they reach shockingly high levels and then they fall sharply and remain low for a number of years before beginning a gradual trip back to crazy high levels.

So investors clearly give in to their emotional desire to create pretend money for themselves. But they do not give in to those Get Rich Quick urges entirely. They seem to feel a need to maintain enough rationality to not cause themselves to lose confidence in the pretend prices that they want to believe are real. Prices go up over time. But it takes a long stretch of years for them to travel the path from crazy lows to crazy highs.

So the psychological reality is that it is natural for stock valuations to rise gradually over the course of time and then to drop sharply. The market is not efficient, as it was once thought to be by a large number of academics.

This is why it is of such critical public policy importance that investors be encouraged to practice market timing. If the market were efficient, market timing would not work and would not serve any important public policy purpose. Market timers would just be guessing as to where they thought prices were headed and they would get it wrong as often as they got it right, wasting money on transaction costs.

But if investors are choosing to overprice stocks more and more with the passage of time, it is critical that some means be put in place to rein in this self-destructive urge. Price crashes cause trillions of dollars of consumer spending power to disappear into the wind in a matter of days and thereby always bring on economic contractions. The only way to stop price crashes is to keep prices from getting too out of hand in the first place.

Investor Returns vs Price Increases

It’s easy to see in theory how prices could be regulated. Investor returns drop as prices increase. So in ordinary circumstances investors would sell some of their stocks each time prices got a little out of hand, bringing them back to their proper level. The problem, of course, is that most experts discourage rather than encourage market timing. Even investors who see the common-sense benefit of lowering their stock allocation when prices get too high are often cowed out of doing so by the seemingly relentless warnings not to engage in market timing. So the roller coaster inches up, up, up, to a point where the death-defying plunge cannot be avoided.

We need to do more to encourage market timing!

The entire purpose of a market is to get prices right. A market essentially “tries out” various price points until it finds the one that makes sense given the mix of upward and downward pressure points on prices that apply at a given time. This trying-out process is nixed in the stock market when market timing is discouraged. Upward price pressures always remain in place because investors of course always want to vote themselves raises. But the common-sense voice telling investors to take some money off the table when the game gets too dangerous is silenced when the majority of “experts” fail to make the case for market timing.

Price discipline is the magic that makes markets work. Market timing is the means by which price discipline is exercised in the stock market. Stock prices gradually drift upward over time without it.

Rob’s bio is here

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