My last three articles here have examined comments by Jeremy Grantham arguing that we can no longer count on fair-value stock prices to reassert themselves as quickly as they always did prior to the mid-1990s. Grantham believes that prices will eventually revert to their historical mean rather than the new, higher mean that has applied for the past 20 years. But he believes that it may be some time before what has become the old normal again prevails.
I find Grantham’s comments compelling for three reasons.
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One, he has a long history of making the case that valuations matter; no argument can be made that Grantham possesses any bias against the Valuation-Informed Indexing strategy. That cannot be said of the vast majority of experts in this field. Most are Buy-and-Holders. That biases them even if they do not intend for it to do so or even if they are not aware of the bias. Those who are not Buy-and-Holders are friends or associates of Buy-and-Holders. So they possess a natural reluctance to challenge the strategy too severely. Grantham possesses no pro-Buy-and-Hold bias whatsoever. I have seen cases in which he spoke out in opposition to Buy-and-Hold in stronger terms than I ever have. The number of experts re whom I can say that is very small indeed.
Two, Grantham’s comments at least on the surface represent a major challenge to the Valuation-Informed Indexing strategy. He said: “We have actually spent all of six months cumulatively below trend in the last 25 years!…The market has been acting as if it is oscillating normally enough but around a much higher average P/E.” The premise of the Valuation-Informed Indexing strategy is that stock returns are highly predictable in the long run. Grantham is raising doubts about that premise. If stock returns are no longer predictable in today’s environment, the strategy does not make much sense.
And, three, the point that he is making — that stock prices have in recent years remained at very high levels for much longer than has ever before been the case in U.S. history — is solid. It is the one thing that makes me doubt my relentless advocacy of the strategy. Grantham’s challenge hit a nerve!
But the Alfred Hitchcock twist to this story is that Grantham has not converted to the Buy-and-Hold side. He stills believes that valuations matter, he believes that the mean CAPE level will continue to apply in the future. He believes that, in a small-picture sense, it will continue to be different this time for at least some time to come. But he also believes that, in a big-picture sense, the fundamental rules ultimately will apply. Buy-and-Holders have enjoyed high stock prices for longer than they ever did before. But their enjoyment will come to the same tearful end to which it has always come in the past. Stock investors cannot create pretend wealth just by the act of bidding up stock prices and insisting that their irrational exuberance be respected as something possessing economic significance.
The question is — Did the Buy-and-Holders get away with one by keeping prices high for so long?
I do not believe that they did. Presuming that Grantham is right that stock prices will eventually fall to their historical norms, the Buy-and-Holders only hurt themselves by putting off the day of reckoning. The mispricing of stocks hurts stock investors. The longer the mispricing continues, the more it hurts them.
Grantham makes an interesting point when he talks about the two times that today’s high prices were subjected to serious stress points. He notes that: “After the bursting of the tech bubble, the failure of the market in 2002 to go below trend even for a minute should have whispered that something was different. Although I noted the point at the time, I missed the full significance. Even in 2009, with the whole commercial world wobbling, the market went below trend for only six months.”
The bursting of the tech bubble and the collapse of the real estate market are economic developments that in ordinary circumstances would have brought market prices to their knees. It didn’t happen that way this time. It’s important to think through why that is. A Buy-and-Holder would cite the fact that prices did not fall hard and remain low for a long stretch of time as evidence that there is no need for historical norms to reassert themselves. A Valuation-Informed Indexer would offer a different interpretation.
We believe that stock prices are determined by investor emotion. So the reason why the tech bubble did not bring prices down as much as expected and the reason why the real estate crisis did not bring prices down as much as expected is that the emotional resistance to a devastating price drop was just too strong. It’s not a good thing that we avoided the day of reckoning on those two occasions, it’s a bad thing. The basic job of the market is to get prices right. Sooner or later it is going to get the job done. The more resistance there is that is offered, the more painful will be the overcoming of that resistance.
Stock prices have remained high for a longer period of time than they ever have in the past. It’s too bad for stock investors.
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