I wrote here last week about an interview in which Robert Shiller expressed a lack of alarm over today’s stock prices. In contrast, Jeremy Grantham, another expert often characterized as a “perma bear,” expresses a great deal of alarm in this YouTube video.
My own view is somewhere in the middle of the perspective offered by Shiller and the perspective offered by Grantham. I found the Grantham video somewhat gratifying because he talks about things that I view as serious problems that are rarely mentioned by others in the field.
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Markets Are Irrational
One issue that he focused on is that even people who become skeptical about investing in stocks on grounds that prices are too high frequently recommend moving one’s money into other asset classes that are also experiencing bubble prices. I view this way of thinking about things as an outgrowth of the idea that the stock market is efficient (that is, that investors are engaged in the rational pursuit of their self-interest).
This is an idea that people in the investing field seem to find it almost impossible to shake. It’s scary to think that markets are fundamentally irrational. So we refuse to go down that path. We insist that they are regardless of how much evidence accumulates that this is not so.
Grantham makes clear that numerous asset classes can be in bubbles at the same time. There is simply no reason to believe that there is always one asset class worth investing in. It’s not hard to understand why this would be so.
Bubbles are irrational. If investors are irrational enough to cause one bubble, they are irrational enough to cause multiple bubbles. There is no referee in the sky who steps in to declare: “Sorry, investors, you already have created one bubble, that’s all that is permitted.”
Creation Of Bubbles
Irrational investors can create as many bubbles as they please. If you think about it, the creation of one bubble makes the creation of additional bubbles more likely. Bubbles create pretend wealth. So of course they bring satisfaction to the investors who created them. Those same investors often have money invested in other markets.
Once their bubble-creating efforts in one market have caused them to feel better about life, why wouldn’t they engage in the same sorts of behavior in the other markets in which they invest?
There is no limit to the number of markets that can be in a bubble at the same time. The downside, of course, is that, just as the creation of one bubble encourages the creation of other bubbles, the popping of one bubble often causes the others to pop as well. Bubbles are emotional phenomena.
Investors who experience the pain that is associated with the end of bubble pricing in one market are likely to become emotionally down about all of their investments, not only the one that has experienced a price crash. So the other bubbles are put in jeopardy of coming to an end as well.
The Dangers Of High Stock Prices
Listening to Grantham always cheers me because he is about the only investment expert who I have found who feels as strongly about the dangers of high stock prices as I do. I am actually a bit less alarmed about stock prices than Grantham.
He appears to believe that bubbles will always be with us, that they are the result of human nature and that human nature cannot be changed. I do not share this view.
I certainly agree that bubbles are the result of an unfortunate Get Rich Quick impulse that resides within all of us (this includes me – I was once a proud Buy-and-Holder). And I don’t believe that our flawed human nature can ever be entirely reformed.
However, I believe that the Get Rich Quick/Buy-and-Hold urge that has made stock investing risky for as long as the stock market has existed can be reined in. I think that we are close to achieving a breakthrough in our understanding of how stock investing works that will permit us to greatly diminish bubble creation in the future.
The key, in my view, is more discussion of these issues. We all have a desire to create bubbles. That much is so. But I think it is possible for people who possess the level of awareness of the harm done by bubbles that Grantham possesses to overlook the other side of the story. There is also something in human nature that causes us to pop bubbles!
Has there ever been a bubble that lasted forever? There has not. We already possess within us the cure for high stock prices. We all have within us a common-sense urge that could act as a counter to our Get Rich Quick urge.
Flaws In The Modern Portfolio Theory
I have seen the common sense urge in action on internet discussion boards up close and personal on numerous occasions. When I first pointed out the error in the Buy-and-Hold retirement studies (they say that the safe withdrawal rate is always the same number regardless of the CAPE level that applies on the day the retirement begins), there were numerous people at the discussion board at which I was posting who applauded me for kicking off the most worthwhile discussion ever held at that board.
Those people were eventually silenced by the most strident Buy-and-Holders. But they existed! They were Buy-and-Holders too. But they had doubts about the dogmas. They wanted to learn. Those people (they are a majority of the Buy-and-Hold community) are our hope.
I once ran a Google search to identify flaws in the Modern Portfolio Theory. The article that came up identified two potential flaws: (1) investors may not be entirely rational; and (2) investors may not have access to all of the information they need to make good decisions. I believe that these two flaws are related.
Investors are NOT rational because they are human; emotions are forever compromising the rationality of the humans. And they do NOT have access to all the information they need because they silence those who cast doubt on the Buy-and-Hold dogmas (people like me!) because it makes them uncomfortable to think that their preferred investment strategies may be terribly flawed.
What if that changed? What if the bursting of multiple bubbles caused us all to be a bit more open to the 41 years of peer-reviewed research showing us how dangerous it is not to practice market timing (price discipline!) at all times? There’s your change in human nature! From that day forward, the stock market would be a very different and far less risky place in which to invest one’s retirement money.
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