http://funds-newsletter.com
Copyright 2013 Tom Madell, PhD, Publisher
Nov/Dec 2013. Published Oct. 28, 2013
By Tom Madell
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:
Further, the committee goes on to state:
There is much more that can be said to help clarify Shiller's views. For example, in his aforementioned 2000 book he states:
Also, as recently quoted in the New York Times shortly after the award announcement:
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.)
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:
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.
---
Due to prior commitments, there will be no Dec. 1 Newsletter. If warranted, any necessary updates may be published on the site in mid-December. Emails will be responded to throughout Nov. although there may at times be several days delay.
---
To sign up to receive notification of new Newsletter postings as well as infrequent, but crucial, investment Alerts, click here.
---
If you found this article helpful, consider pasting this link to it in an email to a friend:
http://funds-newsletter.com/nov13-newsletter/nov13.htm