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Stock Market is Currently Overvalued and Irrational According to 2013 Nobelist

Everyone undoubtedly has seen the following happen so many times: Ordinary investors are convinced that stocks are so high they can't possibly go any higher, yet they do - much higher. Or harking back to the last decade: "We're in a terrible bear market, so how can I possibly even think of buying right now?" Yet, in hindsight, it would have been a great time to invest. Or, perhaps worst of all, while stocks are charging ahead, many experts say most signs point to further gains, enticing many to chase the bull's tail; yet 6 months later, all the major averages are down.

While stocks don't always act in what appears to be an irrational manner, these anomalies seem to happen enough to make the typical investor dubious that the stock market is indeed understandable through a rational analysis. Just looking at the current market, it may be hard to reconcile the fact that the underlying economic fundamentals that typically drive the stock market have been mostly weakish to mediocre at best, yet under such conditions, the market has been more or less accelerating for years.

All these examples demonstrate how hard it is to predict stock prices. In fact, it's almost as though whatever evidence is out there seems almost worthless when attempting to make profitable decisions, or somehow, diabolically, actually lead investors to make a completely wrong decision. It is for these very reasons that many have come to the conclusion that it is indeed impossible to predict future stock prices.

It is with this backdrop in mind that investors were greeted in October with the announcement of the 2013 Nobel Prizes in Economics to three Americans whose contributions have attempted to come to grips with these very issues.

One of these economists conducted research that showed that the financial markets always reflect all the fundamental information known to investors; that is, asset prices are always an accurate measure of the sum total of publicly available data. And since the markets as a whole incorporate that information so quickly, individual investors have no chance of "beating" the markets. These notions were central in formulating what became known as the efficient market theory. This approach helped to popularize index funds and most of today's ETFs, since if outperformance is not possible, one might as well own merely a cross-section of all assets at the lowest possible cost. This economist generally is not well known, but for those readers interested, his name is Eugene Fama.

The second of this trio of Nobel-winning economists showed through his research a far different side of how stock and other asset prices tend to move. Over time, he found such prices can move up or down irrationally to levels that do not correctly reflect what an accurate appraisal of economic fundamentals should suggest. Through his work, he was able to successfully predict both the severe crash of stocks in the early 2000s and the subsequent crash of home prices in 2007.

This economist's ideas were highly influential in the development of a new approach, becoming one of the first individuals to use his research to incorporate psychology into the study of economics. Such an approach would not take for granted that in the marketplace, individuals operate totally by efficiently and rationally processing information. This branch of economics has become known as behavioral economics, or how psychological attributes such as emotions, group dynamics and other "biases" can collectively influence financial markets. This Nobelist, Robert Shiller, may be somewhat better known to readers, largely due to his book "Irrational Exuberance" where he forewarned of the above-mentioned asset crashes.

Back at the start of the 2000's, approximately when I began writing my Newsletter, I myself (as a former psychologist) was interested in researching and writing about what role psychology might play in either helping or hindering mutual fund investors. I even began work on a book called "How to Outperform the Pack: Using Psychology to Improve Your Mutual Fund Results." More about this later.

Back to the Nobelists, one might wonder how could it be that the above two men, with such apparently contrasting views, could be recognized for their contributions by the awarding to each of a share in the Nobel Prize, along with a third economist whose views fall somewhere in between the other two. Let's focus on what may appear to some to be eye-opening statements by the Nobel Prize committee in the press release that announced the prizes:

  • There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year's [Nobel] Laureates... . (Note: For all quotes cited, any emphasis shown has been added by me. See http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2013/ for the source of these quotes and much more detailed information.)
  • If prices are nearly impossible to predict over days or weeks, then shouldn't they be even harder to predict over several years? The answer is no, as Robert Shiller discovered in the early 1980s. ... This pattern holds not only for stocks, but also for bonds and other assets.

Further, the committee goes on to state:

  • While prices of financial assets often seem to reflect fundamental values, history provides striking examples to the contrary, in events commonly labeled bubbles and crashes.
  • Shiller's ... studies on longer-term predictability provided the key insights: stock prices are excessively volatile in the short run, and at a horizon of a few years the overall market is quite predictable. On average, the market tends to move downward following periods when prices ... are high and upward when prices are low.
  • The finding that stock and bond returns are more volatile in the short term than in the long term implies that returns are "mean reverting," i.e., above-average returns tend to be followed by below-average returns and vice versa. This also implies that future returns can be predicted from past returns.
  • The findings of excess volatility and predictability are challenging for the notion that prices incorporate all available information. ...Shiller ... argued that the excess volatility ... seemed difficult to reconcile with the basic [efficient markets] theory and instead could be indicative of "fads" and overreaction to changes in fundamentals.
  • Shiller argued that stock prices are particularly vulnerable to psychological biases because of the ambiguity in the true value of a stock, due to the lack of an accepted valuation model...

There is much more that can be said to help clarify Shiller's views. For example, in his aforementioned 2000 book he states:

  • The high recent valuations in the stock market have come about for no good reasons. The market level does not, as so many imagine, represent the consensus judgment of experts who have carefully weighed the long-term evidence. The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom.

Also, as recently quoted in the New York Times shortly after the award announcement:

  • [T]he efficient-market theory is a half-truth. ... Where the theory goes wrong is that it says you should just assume that there's no point in trying to beat the market... [Market bubbles] ... happen all the time. Most of the action in the aggregate stock market is bubbles.

How This Applies to Mutual Fund/ETF Prices

I must admit prior to now, I have never read a single thing written by Shiller. Interestingly though, my Mutual Fund/ETF Research Newsletter as well as my subsequent research in which I developed an empirical tool to help determine over-, under-, and relatively fair valuation of stock mutual funds and ETFs, seem to have independently paralleled the behavioral economics approach. Although I had become somewhat aware of behavioral economics about when I started my Newsletter (and therefore it becomes difficult to say that I wasn't at all influenced by it), I arrived at my own conclusions about the importance of psychology in investing primarily as a result of my many years of experience in the fields of psychology and research acquired over a 20 year career.

Here are some relevant quotes from my aforementioned book manuscript that I wrote in 2002. (The book remains unpublished as I decided to devote all my writing effort to work on my Newsletter instead.)

  • Back in the '80s ... I had primarily learned the view of investing success that the consensus held and still does today. This view, in a nutshell, is if we are to do well in investing, we should pay attention to the economic factors that determine how well various alternate investments will do.
  • My own experience as an investor began to suggest that something critical was missing from this picture and from the way most investors, including myself, were in fact doing their investing. In reality, our ability to transcend our present experience of events is somewhat limited, "locking" us into our perceptions of the immediate far more than our ability to anticipate the future might suggest. As a result, we tend to be influenced by short-term happenings, emotions, and ideas far more than we often acknowledge.
  • The markets seem to "behave" mainly on the basis of short-term factors. But, unfortunately, the reality is that far too many investors wind up shadowing these movements rather than adhering to a long-term plan that might better serve their interests.
  • I could find [little in analyses of the markets] that warned me, or even better, helped me to counteract the fact that so many of the short-term conclusions that were suggested turned out later to have led to just the opposite of what would have been smart long-term moves. To fill the void, I found myself starting to apply my own knowledge of individual and group psychology.

More recently, in developing my above mentioned investor tool for helping to make crucial buy, sell, or hold decisions as quoted from my July 2008 Newsletter, I applied essentially the exact same principles enunciated by the Nobel Prize committee above regarding the predictable way above average returns revert back to a lower level of returns:

  • [A]s a whole, stocks that have outperformed their long-term averages will eventually underperform so that their results will return to their former averages. This is known technically as "regression to the mean". The idea is that a group of stocks cannot keep outperforming forever. Aside from a mere mathematic explanation, we know that the economy tends to run in up and down cycles.

I have mainly applied the same notion of longer-term predictability to an analysis of which categories of mutual funds or ETFs are the most or least undervalued but I also have emphasized it with regard to the stock and bond markets as a whole. I too have found and told readers that asset prices are essentially unpredictable in the short term (usually periods of less than one year) but much more predictable over the longer term (usually periods ranging from one to five years.)

So if readers hopefully won't assume I am being presumptuous, it appears that the Nobel Prize committee's findings, particularly as they reflect the work of Shiller, seem to help provide further substantiation that the techniques used in my Newsletter have a strong empirical foundation.

Given Shiller's new rise to the stock prediction limelight, readers might be interested in what his research suggests to him now. In an interview on Bloomberg.com aired Oct. 15th, Shiller sounded somewhat cautious: He regards the US as having a "pretty high" priced market, but still not "that overpriced." The interviewer summed up Shiller as saying the market was "overvalued but not at the silly levels of 2000." Additionally, in an interview on cnbc.com on Sept. 12th, he said, according to the accompanying article, he "sees the Dow ending 2014 'just 1 percent higher than it is now, 2 percent higher -- something like that.'" Since those interviews, stocks have risen even more. (Incidentally, he added that "looking at the alternatives, [they] should still be a part of your portfolio.")

But it should be noted that back around mid-June, 2011, according to an article on www.moneynews.com, Shiller said even then that stocks were looking pricey against historical standards. Shiller stated: "I'm thinking that if you're just looking at Treasurys and stocks in a portfolio, you probably want more Treasurys than stocks, depending on your circumstances." Since then, the S&P 500 has climbed another 40% or so per cent while the average Treasury fund has perhaps produced a return equal to about five percent per year.

In contrast, back around that same time, my Stock Model Portfolio for July, 2011 recommended that Moderate Risk investors have 62.5% in stocks vs. only 30% in bonds. Further, just a few weeks later, I issued one of my rare Alerts recommended that investors buy almost all categories of stock funds. Obviously, then, Shiller's approach to predicting asset prices differs quite a bit in the specifics from mine in spite of the overall similarities regarding the importance of psychology in investing.

As you can see, even Nobel Prize economists cannot always be correct with regard to predicting asset prices. That said, Shiller may still be proven correct over the years ahead. It is somewhat reassuring to me, at least, that his projections of stocks currently being overvalued agree with my now current view, and that in spite of this overvaluation, it still makes sense to continue to hold stocks as part of a portfolio. It is not so reassuring though that his recent projections going back over more than two years would have lead investors to be seriously under-invested in stocks for about half of the current highly profitable bull market.

To quote another investing "genius," Warren Buffett, one should be "greedy when the market is fearful, and be fearful when the market is greedy." Greed appears to be setting into the stock market, and according to one website "[market] greed commonly leads to extremely irrational behavior." Buffett too sounds like he's not overly enthusiastic about stocks now although, like Shiller, somewhat equivocal. In early October, he is quoted by forbes.com as saying "[Stocks] are probably more or less fairly priced now. We don't find bargains around, ... "[b]ut we don't think things are way overvalued either. We're having a hard time finding things to buy." Got that?

Investors who wish to follow the advice of Nobelist Shiller, legend Buffett, and yes, fund aficionado me, should heed the yellow flags currently being waved. Although no one can predict when the stock market will start to go the other way, rationally thinking investors will not be putting more into the stock market, but rather, reducing their positions now. While there's no guarantee that stocks won't continue to go higher, there's really no good excuse not to act. I predict, although obviously I could be wrong, that procrastinators, or just those who just choose to buy and hold, will eventually suffer. While these investors may eventually wind up OK, they will not enjoy the ride going from point A to point B to get to point C, assuming that point B will be where the market may be say in the next year or two, but perhaps even sooner.


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