By robbennett. Originally published at ValueWalk.
Today’s CAPE value is 31.
Did you even know that? It is my sense that most investors do not pay close attention to stock valuations. Most appreciate that valuations are high today. But stock valuations have been high for 25 years. So that’s hardly a shocking reality. I don’t get the sense that most investors fret too much over whether the CAPE is 25 or 30 or 35, or heaven help us all, 40, as it was in the late 1990s. Stock valuations are high. So what? Stock valuations are always high. It’s no biggie. There’s no news value in that reality.
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CAPE Value Is A National Scandal
It is my view that today’s CAPE value is a national scandal. The CAPE value tells us how much irrational exuberance is present in the stock price. The fair-value CAPE value is 17. So the CAPE value of 31 is telling us that nearly half of the value of the stock market is not rooted in economic realities but only in a temporary emotional mood of investors that will be disappearing into the mist in not too much more time.
When the CAPE value returns to normal levels, we will be seeing millions of failed retirements. Businesses that depend on consumer spending will be going out of business because people who have lost money in the stock market will not feel comfortable spending as much as before. Millions of people will lose their jobs when those businesses go under. Political frictions will be exacerbated when so many people lose their jobs. Not a good scene.
When it’s hurricane season, there are hysterical reports on all of the television stations warning people who live in the areas likely to be hit to evacuate immediately. We don’t just watch the hurricanes work their destruction without making an effort to protect the people in their path. But isn’t that what we do with stock price crashes? We know what causes them – high stock prices. But we encourage people to continue buying stocks even when prices are already at frighteningly high levels. There are no news reports urging investors likely to see their lives blown to pieces to “Get Out Now!”
Why?
The conventional view about price crashes is that there is nothing that can be done to prevent them or to avoid them. They are seen as an act of God to a greater extent than hurricanes are seen as an act of God. Hurricanes are seen as an act of God that we can warn people about. Price crashes are something that happen every now and again for no known reason. We cannot issue warnings because we do not know when they will arrive.
That view of price crashes is out of date. It’s true that we don’t know precisely when they will arrive. Sometimes it takes a CAPE value of 25, sometimes a CAPE value of 35, sometimes a CAPE value of 45. Price crashes are an emotional phenomena and human emotions cannot be predicted with precision. But the rest of the rationalization for not warning people about price crashes is no longer valid.
Reason Behind Price Crashes
Price crashes are not acts of God. Price crashes result from price indifference on the part of investors. Stocks provide lower returns when prices are high. So the natural thing would be for investors to lower their stock allocation when prices reach crazy levels. But most experts in this field discourage market timing. They tell people that they should stick with the same stock allocation no matter how high prices rise, taking the one weapon available to us to do battle with irrational exuberance out of our hands. Thereby ensuring that a price crash will inevitably follow.
This should not be. People have their retirement money invested in the stock market. We should be making efforts to keep them up to date on how great the risk is of a price crash. Such reports should be a regular feature on the news. Such reports are rare today. In the unlikely event that people are told that their money is at risk because of high stock valuations, another party is brought on to the program to assure them that that is not really the case. Robert Shiller tells the story of how he was told by the host of a television program that he had better be careful not to say anything that would shake investors up and thereby cause a price crash. I don’t get the impression that the experts who tout Buy-and-Hold strategies are ever given such warnings although the cause of crashes is not warning people of the dangers of high prices.
Price crashes affect everybody. Even people who do not have money invested in stocks suffer when the economy contracts or collapses. We should all be doing all that we can to keep stock prices at levels where price crashes are unlikely. We should all be doing what we can to encourage market timing as a means of keeping stock prices under control at all times.
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