Friday, July 09, 2010 Posted by Shattered Paradigm
I want to tell you some disturbing facts about the stock market that the people usually identified as “experts” on stock investing are never going to tell you.
There are four times since 1900 when stock prices rose to two times fair value.
There are also four times since 1900 in which the United States has experienced an economic crisis. Those four times all followed shortly the times at which stock prices rose to two times fair value. We have never experienced an economic crisis that was not preceded by a time at which stock prices rose to two times fair value. The correlation is perfect.
It makes sense, doesn’t it?
Something that is overvalued is selling at an artificial price, a price that cannot be sustained. When stocks are overvalued, they always within ten years or so fall back to fair value. There is not one exception in the historical record.
So we knew when stocks reached the highest levels of overvaluation on record in the late 1990s that we were going to be seeing over the next 10 years a huge loss of consumer wealth. You don’t want to know what the number is. But I am going to tell you anyway.
That’s how much stocks were overvalued in January 2000. We know that the amount of wealth represented by stock overvaluation always goes “Poof!” over the course of the following 10 or 15 years. This economic crisis was predictable. And avoidable. We caused this economic crisis by bidding stocks up so high. The investing experts who told us that we should continue buying stocks no matter how high prices went of course bear the greatest responsibility.
Think what this means on an individual basis. Stocks were actually priced at three times fair value in 2000 (we had never gone that high before). So those who follow stock investing knew that each investor portfolio was likely to lose roughly two-thirds of its value over the course of the next 10 or 15 years. Those with $100,000 in stocks were going to end up with $35,000. Those with $300,000 in stocks were going to end up with $100,000. And so on.
Why didn’t they warn us? Why didn’t they let us know that there comes a time when stocks are so overpriced that they are no longer worth buying?
It’s not a good marketing message.
They admit this themselves. I created the first retirement calculator that includes an adjustment for the valuation level that applies on the day the retirement begins (it is thus the first retirement calculator that gives accurate numbers -- to fail to factor in valuations is to get the numbers wrong). I asked Dallas Morning News Columnist Scott Burns to write a column about the calculator and he did so. He explained in that column why most “experts” in this field don’t bother to tell us about the effect of valuations on long-term returns -- “It’s information that most people don’t want to hear.”
Do you understand what he is saying? The experts are experts in selling first, second, third and fourth. They don’t tell us what we need to know about stocks but only what we want to know about stocks. We all wanted to think that those insane prices could continue indefinitely. That was of course a hopeless dream. But the experts did not want to be the ones to let us know. They wanted us to like them. They wanted to complete the sale.
Economies don’t crash for no reason. But economies always crash once stock prices rise to insanely dangerous levels. As stock prices work their way back to fair value, we all lose large percentages of the money we were planning to use to finance our retirements, Naturally, we panic. Panicked consumers don’t buy goods and services. When buyers disappear, businesses fail. When businesses fail, people lose their jobs. It all makes sense.
The $12 trillion number is not even the worst of it. That number is the amount our economy was fated to lose as prices worked their way back to fair value. But on the three earlier occasions when we went to two times fair value, prices didn’t return to fair value and then stop. They kept falling until they had gone down to one-half fair value. That’s a price drop of about two-thirds from where we stand today.
Why do prices always drop to one-half fair value after having gone to insanely high levels? It’s that panic factor I mentioned above. Insane enthusiasm always leads to insane hatred of stocks after it destroys millions of lives.
We need a new type of investment expert. We need investment experts who urge us not to permit stocks to become so overvalued rather than cheering the overvaluation on. If people knew how poor the value proposition for stocks is when prices are high, they would sell in response to overvaluation. That would make market prices self-correcting. But Buy-and-Hold is what sells. Buy-and-Hold is the marketing slogan that brought the world’s strongest economy to its knees.
We cannot get the $12 trillion back. It never existed in the first place. it was cotton-candy puffery, the product of overly aggressive sales talk. What we can do is to insist that the experts start delivering some straight talk on stock investing so that this sort of thing can never, never, never happen again. If we don’t we are going to lose our free market economy. The middle-class cannot take too many more big financial hits. And, if you go by how stocks have always performed in the past, we are still in the early stages of working through the damage done to our economic system by the reckless promotion of Buy-and-Hold strategies in the late 1990s.
Rob Bennett writes the “A Rich Life” blog. His bio is here.