There are many who feel there’s a tragedy of epic proportions brewing in the stock market. The problem is we humans tend to have short memories and therefore expect the future to replicate the recent past.
Research done by market economist Robert Shiller of Yale shows there’s a striking correlation between market performance and the consensus opinion of what constitutes a best investment at a given point in time. In other words, if things have been going up, people seem to collectively expect them to continue to go up. If things have been going down, people expect that trend to persist, too.
Sometimes it seems things go up simply because there’s a perception that things are going up. Investor caution is thrown to the wind and previously rational people take unnecessary risks simply because they no longer perceive risk the way they did before. People follow along and go with the flow. Behavioural economists call this herd behaviour.
In Shiller’s latest book, Narrative Economics, he shows how good stories become accepted as conventional wisdom simply because they captured the zeitgeist of their times. Facts were secondary. What really mattered was that those listening to the story were gullible enough to believe those telling it, even if that belief was rooted in motivated reasoning and confirmation bias. It’s as if saying ‘something is so’ is enough to make it so in the eyes of others.
The Canadian and American stock markets hit cyclical lows on March 9, 2009, and despite a close call in Q4 of 2018, have not had a pullback of 20 per cent or more until the 33 per cent pullback in early 2020.
After that short-lived scare, the government-induced upward trajectory for capital markets resumed. Investors are feeling bulletproof, emboldened by the mistaken assumption that somehow central banks have made bear markets impossible.
The alarm bells are flashing red, but many people seem too caught up in the euphoria of surging markets to care. By mid-April, the Shiller CAPE (cyclically adjusted price earnings) ratio on the S&P 500 stood at over 37. The historical average is less than half that. Stated differently, and based on readily available market valuation levels, the prices of U.S. stocks could drop by about 50 per cent and still be priced fairly.
If something could stand to drop by 50 per cent and still be reasonably priced, that’s a clear indication that the current price is likely dangerously high. In fact, throughout history, only the dot.com bubble had higher CAPE readings.
To make matters worse, bonds and real estate are almost certainly just as overpriced. That leads to a different kind of problem: TINA — There Is No Alternative. When everything is expensive, then nothing is expensive, because there’s nothing available that’s a cheap alternative. People have to invest in something, right?
To be sure, there is no widely accepted definition of what constitutes a bubble. Furthermore, there is no reliable way to time when bubbles will “burst.” No one knows why or how or when. Shiller acknowledges as much himself. This may be semantics, but given the inherent unknowability of market behaviour, is it possible that people are prepared to endure what might objectively be called a bubble simply because they are confident this bubble won’t burst?
Much like death and taxes, market pullbacks are a near certainty. They have been going on throughout history. Few reasonable people would suggest that there will never be another meaningful pullback. Why then, do so many people seem to be investing more aggressively than they have at any point since the last bubble?
Considering the state of markets today, how should one invest to avoid the herd?
The first thing to do is to be purposeful. The best piece of advice is to stop and reflect on your own perceptions and values. Many people in my line of work insist markets are benign. They cite a rebounding economy and generational lows on interest rates (with promises to keep them low) as factors that will allow the bulls to run for much longer.
Think for yourself. I’m not going to try to persuade you one way or another. All I am saying is that I have gone through the exercise and concluded that it is a time to be cautious. Maybe nothing needs to change for you at all. But if you think a review might be in order, consider the lessons of Prospect Theory. Daniel Kahneman is a pioneer in the field, a Nobel Laureate and a bestselling author. Like Shiller, he is an authority on the behavioural side of investing. He has shown that people feel the pain of a loss about twice as acutely as the joy of a gain. Given the emotional consequences, it might do some good to contemplate your reactions before the experience becomes all too real.
Say you start with $1,000,000. How would you feel if it grew to $1,100,000 or if it dropped to $900,000? Let’s raise the stakes by increasing volatility. How would you feel if it rose to $1,200,000 or if it dropped to $800,000?
Since risk and reward are related, think about the binary outcomes: $1,100,000 or $900,000? $1,200,000 or $800,000? This kind of exercise can focus the mind. If you conclude that you’ll be more upset with a drop than you previously thought, consider the following options:
- Re-balance your portfolio back to your target mix (60/40, for example);
- Consider re-balancing to a tactically more conservative stance (50/50, for instance);
- Re-position stocks toward a value bias;
- Re-position bonds to the short end of the curve or toward higher credit quality;
- Consider using non-correlated assets as alternatives (these come in many shapes and sizes) to reduce risk.
I have one more thought exercise. Go through the imaginary situational analysis one more time. Start with $1,000,000. This time, the best-worst combination is $1,300,000 and $700,000. If we really are in a bubble, then a 30 per cent drop is entirely possible — even for a balanced portfolio.
Do what is right for you. Don’t let other people tell you what to do, including me.