How Valuations Affect Long-Term Returns (And Why It's A Big Deal)

(MENAFN- ValueWalk) Robert Shiller published research in 1981 showing that valuations affect long-term returns. It's hard to appreciate why it's such a big deal, but let's try.

There's a sense in which it is acknowledged as a big deal. Shiller was awarded a Nobel prize. He wrote a best-selling book explaining his research findings. Former federal Reserve Chairman Alan Greenspan came up with the term“irrational exuberance” to identify the breakthrough aspect of Shiller's findings. If valuations affect long-term returns, then not all stock returns are equal.

Some are rooted in real economic developments; some are just pretend gains that investors temporarily treat as real for emotional reasons. I don't know anyone who denies that Shiller accomplished something important.

That's only with part of our minds, however. Today's CAPE level is 36. The fair-value CAPE level is 17. So, our stock portfolios are priced at two times their real, lasting value today. As a nation of people, we pat Shiller on the head and praise him for doing good work.

Then we go right back to investing as we did in the days before this amazing, Nobel-prize-winning research appeared on the scene. Irrational exuberance, irrational exuberance. We like big numbers on our stock portfolio. So what if the research shows that they will disappear in time? We like that thrill we experience for the time in which they remain big.

It takes time for big advances to kick in.

The industrial revolution was around for a long time. The steam engine. The factory. The telegraph. The locomotive. All sorts of things. The way it worked is that one discovery led to another. Someone thought“it might be more efficient to produce things via an assembly line” and at first the general reaction was“that's nuts.” It had never been done before.

But eventually some stubborn individual came along who did it anyway and it worked. Then in time everyone did it that way. Even farther down the line someone thought“why not make hamburgers in assembly-line fashion?” No one saw that one coming in the early days of the Industrial Revolution. After McDonald's made a good bit of money with the concept, lots of people kicked themselves for not having embraced the advance sooner.

I believe that there will come a day when we will look back at the investment advice of today in wonder. The research shows that all of our portfolios are worth only half of what we pretend they are worth. It's important to know the true and lasting value of a portfolio.

It's not possible to engage in effective financial planning without using the correct numbers in your calculations. But life goes on with most investors neglecting to make adjustments for irrational exuberance when determining how much wealth they have accumulated. I have a hard time imagining that that will forever remain the case. When it changes, people will look back at our behavior of today and ask themselves:“What took them so long?”

I don't know what day of the week it was when Shiller published his research. Say that it was a Tuesday. Given its importance, the logical thing would have been for everyone to have adopted new investment strategies by Wednesday morning.

Of course, it never works like that. People stick with what's comfortable until something comes along that provides strong motivation for making a change. We have not experienced a lasting price crash since 1981. We had one in 2008.

People were shook up by that and I believe that had prices continued to drop hard and then stayed down for a good bit of time, we would have seen interest in the far-reaching how-to aspects of Shiller's research grow dramatically.

But prices were back at high levels within a year's time and interest in learning about new ways to invest died out. We find ourselves back where we were before Shiller's invention of the cotton gin.

But for how long? Today's stock prices are scary high. It's not possible to say when prices will crash. But if the market continues to perform in the future anything at all as it always has in the past, they will indeed crash somewhere down the line.

I believe that the horrors that people will experience during that economic collapse (the massive loss of wealth experienced in a stock price crash always brings on an economic collapse in its wake) will bring on a widespread rethinking of basic questions re how the stock market works.

So we will get there in time. That's what I believe. Shiller's research is a wonderful thing. If we talked about it openly, it would do away with bull markets. This is another way to say it would do away with bear markets. This is another way of saying that it would do away with economic collapses.

Good stuff. If valuations affect long-term returns, stocks do not offer the same value proposition at different price points. If the buyers of stocks engaged in the same amount of price discipline when buying stocks as they do when buying everything else they buy, prices would self-regulate. Higher prices would bring on sales, which would pull prices back to reasonable levels.

Stock investing would no longer be a roller-coaster ride. Millions of portfolios would stabilize and so would the economic system as a whole.

We don't know today what's on the far side of this revolution. We know that it will be good. Because learning is always good, we will learn more, we will invest more effectively, and we will live richer lives as a consequence.

It's happening at a slow pace today in the background of what they talk about in news reports. Because revolutions take time to build up enough speed to be noticed.

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