Both Big Stock Market Gains And Big Stock Market Losses Are Artificial

(MENAFN- ValueWalk)

Stock prices increased 5 percent this year. Or 11 percent. Or dropped six percent.

You adjust your financial plans accordingly.

You're making a mistake.

The amount by which your portfolio value increased or diminished does not reflect the full realities.

They leave out the effect of irrational exuberance. Or, in the case of price drops, the effect of irrational depression.

Robert Shiller published research in 1981 showing that valuations affect long-term returns. How could that be? How does the valuation level that applies today reach into the future and influence the return that will apply down the line? It seems impossible. Today's price should be today's price and that should be the end of it. Tomorrow's return should be independent of today's price. What Shiller's research shows does not make sense.

Actually, it does. But to see how it does, you need to give up the conventional way of thinking about how stock investing works and see things from an entirely new perspective.

The conventional way of seeing things is to appreciate that there are hundreds of inputs determining a day's stock price change. Some have a positive effect on stock prices and some have a negative effect. Mix together all the positive and negative effects and you get the number reported on the radio as the price change for the day. That's the number that shows up on your portfolio statement for the month. It's an official number. It speaks with authority.

Shiller was awarded a Nobel prize for his research. Why? Because he achieved a breakthrough advance in our understanding of how stock investing works.

The official numbers leave something out. They leave out the emotional dimension of the story. Yes, all of the various positive and negative inputs influence prices. But that's not all that affects prices. When investors get overly enthusiastic about stocks, they make buying decisions that cannot be justified by the economic realities. The economic realities always prevail in time. So the price pushes that are purely emotional in nature do not last. They cause bigger numbers on the portfolio statements. But they do not have staying power. Irrational exuberance gains always go“poof!” in time.

It would be good to be able to distinguish gains that are real and lasting and gains that are emotion-based and temporary. We cannot do that perfectly. But Shiller provided us with a tool which is a big help. The fair-value CAPE level is 17. When stocks are priced at two times the fair-value CAPE value, roughly half of the value of the market is illusory. Price gains that are unmoored from earnings are not lasting price gains.

So a portfolio priced at $100,000 is not worth $100,000. When stock valuations are where they are today, the real and lasting value of that portfolio is $50,000. When stock valuations are where they were in 1981 (one half of fair-value levels), the lasting value of that portfolio is $200,000. There's a big difference between a portfolio worth $50,000 and a portfolio worth $200,000. Shiller taught us something important.

The true and lasting value of a stock portfolio does not change as much as the daily reported prices indicate it does. Over the long term, the value of the market increases by 6.5 percent real per year. If the official price shows an increase of 25 percent, you should be skeptical of that number. Lasting values just don't change that much. Most of that 25 percent return is irrational exuberance. It would be folly to count the full gain as money that can be used to finance an old-age retirement.

I like this new way of thinking about how the stock market works. It suggests that price volatility has been greatly exaggerated in pre-Shiller days. We see crazy price jumps and we are elated at our good fortune and then we see crazy price drops and we experience feelings of doom and gloom. Who needs the roller coaster ride? Make mental adjustments for the effect of irrational exuberance and irrational depression and you can see through all the noise that has bedeviled stock investors for as long as there has been a market to invest in. Gains of 6.5 percent real are economic-based. The other stuff is emotion-based and should not be counted as credible.

That stuff is artificial. It shows up on the portfolio statement. So it sure seems real in the short term. But the wonder of Shiller's Nobel-prize-winning research is that it points the way back to reality from the emotion-biased temporary numbers that undermine our efforts at effective financial planning. Emotion-based gains are not the same thing as economic-based gains. Economic-based gains have staying power.

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