Stock prices are at a level today (this article was posted in October 2007) that virtually assures that people will be asking in days to come why stocks crashed. When the price crash comes, we will all be caught up in whatever disaster it is that is being widely cited as the cause of the stock price crash. I thought it would be better to write my explanation of why stocks crashed now, when I can think more clearly about the factors that made the upcoming (who knows when!) price drop inevitable.
The first reason why stocks crashed is that stock prices rose too high in earlier years.
There are two big factors that determine stock prices. One factor is economic value. Stocks are worth something, and whenever the going price goes too far above or too far below fair value, the fair-value price exerts a magnetic pull on the going price until the going price reverts to the mean (the fair-value price). The other factor is investor emotion. Emotional investors can for a time push stock prices wildly above or below fair value. The economic-value price always prevails in the end, but it can take some time for this to happen. Emotional prices have been known to remain in place for 10 years or even a bit longer.
Given these realities, you can pretty much rule out seeing a a stock price crash when prices are low; where are prices going to fall to when they are already low? You can also pretty much (but to a lesser extent) rule out having to worry about why stocks crashed when you buy stocks at moderate prices. There could be a fall from a fair-value price to a low price. But given the reality of reversion to the mean (or reversion to fair-value), soon after stock prices fall from moderate levels to low levels there is going to be pressure building up for them to return to fair-value levels. Questions about why stocks crashed and then stayed crashed come up only after stocks have traveled to very high levels.
The fair-value stock price is a P/E10 level of 14. The P/E10 level of the S&P 500 was 44 in early 2000. A price crash of major proportions became all but inevitable at that point. Even after eight years of poor stock returns we are today at a P/E10 level of 29. People really shouldn’t be asking why stocks crashed when we find ourselves back at more reasonable price levels. The better question is why stocks didn’t crash a lot sooner.
The second reason why stocks crashed is that people grew weary of the self-deceptions needed to keep prices from falling hard.
We set ourselves up for a stock price crash way back in July 1995, when the P/E10 level went to 23. That’s when the bull market went positivlootingly bonkericious. The historical data has been available both to investors and to the experts who advise them for all the years since. So how is it that only now are we asking why stocks crashed?
It’s because stock investing is primarily an emotional endeavor and only secondarily a rational one. When stock prices are high, investors want to be told that that’s not a problem. Experts primarily concerned with maintaining their popularity with investors are generally willing to tailor their message to respond to customer demands. Starting in 1995, we developed new ways of interpreting what the historical data says, ways less accurate than those generally employed at times of moderate prices but more reassuring to investors enticed by the big price jumps into going with stock allocations far above what the historical data reveals as prudent at high price levels.
We told bigger lies. That’s what I am saying in the paragraph above when you boil away all the excess verbiage.
Human are the deceitful animal. We are liars, it’s always been so and it always will be so. We are not only liars, however. We are truth-tellers too. That also has always been so and also always will be so. Whenever you develop too much confidence in your fellow humans to tell the truth, you set yourself up for being taken in by a whopper. Whenever you become so cynical as to expect from your fellow humans nothing but lies, you set yourself up for being surprised by a show of George Washington-like honesty.
We’ve all been telling lots of big lies about stocks for a long time now. We’ve grown tired of it and have come again to see the appeal of looking at stock investing in honest ways. That’s why stocks crashed.
The third reason why stocks crashed is that we got ahead of ourselves in our economic expectations.
When stock prices crash, experts often point the finger at some economic development or another. The reality is that the causation often runs in the opposite direction. When we tell lies about what stocks are worth, we are also telling lies about what our portfolios are worth. When stocks are selling for a price double their fair value, the fellow with a portfolio properly valued at $300,000 is receiving a portfolio statement in the mail telling him that his stocks are worth $600,000.
He spends more.
Wouldn’t you spend more if you came to believe that your portfolio value was $300,000 greater than what it was in reality?
When we all spend more, the wheels of economic growth turn faster. But the artificial spinning of the wheels of commerce brought on by inflated stock prices cannot last. Telling tall tales about the value of our stock portfolios is a temporary fix to our economic troubles.
The longer the temporary fix continues, the more dependent we become upon it. Eventually, we can’t keep things going forward even with the benefit of the artificial stimulus. At that point, thing begin to slip into reverse. When the artificial stimulus is as big as the one we employed in the wild bull of the 1990s, there’s a lot of reverse movement possible.
The correction of the artificial push becomes a big artificial obstacle to economic growth. The economic downturn caused by a loss of confidence in high stock prices becomes a cause of even lower stock prices, which becomes a cause of even lower economic growth. And so on. The happy cycle of higher stock prices and faster economic growth becomes an unhappy cycle of lower stock prices and slower economic growth once the tipping point is reached.
The fourth reason why stocks crashed is that many middle-class workers need stocks to offer strong long-term returns once again.
Why not just call the whole thing off?
Stock price crashes are universally hated. Why not just continue the process of deceiving ourselves about the realities? Why not leave stock prices where they are when they are high? Why not leave the artificial economic stimulus in place?
There’s a very good reason.
You like to see a strong long-term return on your investing dollar, don’t you? At normal prices, U.S. stocks offer a long-term return of about 6.5 percent real. At the prices at which stocks sold in October 2007, that is lowered to about 3.5 percent real (assuming no price drop). If you pay double what an asset is worth, you obviously cannot expect to see the same return from it as you would see if you paid fair value.
The only way to get the long-term return for stocks back to where it needs to be for today’s middle-class investor to be able to finance a comfortable retirement by age 65 was for prices to fall hard. That’s another reason why stocks crashed.
The fifth reason why stocks crashed is that some economic or political event took place which served as a plausible justification for a crash.
I suggest above that the economic or political event that most experts cite when explaining why stocks crashed is not the true cause of the price crash. The reality is that the price crash was inevitable once we allowed prices to get out of control. A price crash was an accident waiting to happen.
All that is so. It does not follow that the event commonly cited as the reason why stocks crashed did not play a role in the price crash.
Say that the cause being cited is a recession. A recession really does cause companies to generate less earnings. Lower earnings translate into lower stock prices. It’s not that what the experts are saying is entirely not so. It’s that they are not telling the story in the way you need to hear it to know how to invest effectively in the future.
When the P/E10 level is 29, the coming of a recession almost surely causes a price crash. When the P/E10 level is 14, the coming of a recession might cause a moderate price drop. When the P/E10 value is 8, the coming of a recession might not have any effect at all. The coming of a recession might even have a positive effect at a time when the P/E10 level is 8; that price level is so low that it is almost impossible for prices to go too much lower and the outbreak of a recession at that price level might persuade investors that every bit of possible bad news had already been experienced and that prices from that point forward could only go up. That spike in confidence about future stock prices could be the cause of an immediate price jump as investors competed with one another to get back in early.
When a drunk slams his car into a lamppost, it could be said that the cause of the accident is that a lamppost happened to be placed in the spot where his car was headed. It would not be entirely untrue to say that the lamppost caused the accident anymore than it would be entirely untrue to say that the recession (or whatever) is what caused the stock price crash. The deeper reality, though, is that a drunk driver is going to end up in an accident of some sort sooner or later. And a P/E10 level of 29 is going to drop hard in a price crash of some sort sooner or later.
We cannot avoid recessions (or terrorist attacks, or oil shortfalls, or housing slumps, or whatever development is being widely cited as the cause of the price crash). However, we can avoid recessions causing big price crashes by doing what we can to see that stock prices never again travel to the crazy levels we collectively permitted them to travel to in the late 1990s.
The sixth reason why stocks crashed is that the stories told to justify the excessive prices of earlier years grew increasingly unbelievable.
Stock prices got so high in the late 1990s that they just couldn’t go up anymore. The money used to finance those outsized gains wasn’t printed up by Milton Bradley. It was borrowed from the investors going with high stock allocations in subsequent years and receiving returns far less than what it appropriate for those investing in a high-risk asset class.
For a time, most investors pretended not to notice. Memories of the wild bull were fresh enough to keep them from asking hard questions about the half-truths that caused the absurd price leaps. We continued to believe in the conventional approach to buy-and-hold even though it didn’t seem to be working so well anymore. We continued to believe that stocks are always best for the long run even though our common sense was putting troubling thoughts into our heads. We continued to believe that long-term timing does not work despite occasional feelings of doubt as to whether we should stick with such high stock allocations.
Until we didn’t.
Things changed. The middle-class went crazy for stocks because stock prices went crazy. When prices dipped to levels that were not quite so crazy, our confidence in the crazy salesperson slogans used to con us in earlier days weakened. Stock prices built on an emotional foundation do not last. That’s why stocks crashed.
The seventh reason why stocks crashed is that enough became persuaded that a crash would not happen to make it possible.
The roots of the stock price crash lie in the excessive confidence we came to have in stocks in the middle and late 1990s. So long as we were wary that a crash was coming, prices remained at reasonable levels. When we stopped worrying that a price crash was possible, we made one inevitable.
When you stop worrying that you will experience car trouble if you don’t regularly check the oil, you get car trouble. A moderate amount of worrying can be a good thing. It’s easy to overlook the value of worry. A healthy worry can keep bad things from happening. I feel more at ease seeing that an investor is a bit worried than I do seeing that she is totally carefree.
The eighth reason why stocks crashed is that that’’s what they are supposed to do.
Winter follows summer.
It’s a cycle.
That explanation of why stocks crashed probably sounds glib if you are one of those who lost large amounts of accumulated wealth in the big price drop. I apologize for sounding glib.
There’s a point to my simple and straightforward explanation, however. The true reason why stocks crashed really is that the price drop is part of a natural cycle. The “experts” who are more concerned with being popular than with telling it straight misled you. I cannot get you your money back. The best that I can do is to tell you the true simple and straight story so that you can avoid having this sort of thing happen to you again. Please try not to get too angry at those trying to help. Your anger is better directed at the word games regularly practiced by those that the conventional media put forward as investing “experts.” It’s the garbage they have been feeding us for a long time that is the cause of the suffering now causing us to view plain statements of straightforward truths as glib and unfeeling gibes.
Extreme bull markets are not a good thing. They are a deception. Deceptions hurt people. You are one of the people who got hurt. You are a victim of the most out-of-control bull market ever experienced in U.S. history. The lesson you need to learn is never again to trust the nonsense gibberish put forward by “experts” when stock prices go to Koo Koo Cloudland. You’re too smart to be taken in by that sort of thing.
Don’t give up on stocks. That would be a mistake. Stocks are a wonderful asset class.
All that you need to give up on is the fantasy view of stock investing that became popular during the wild bull. The U.S. economy has been strong enough to support an annualized real return for U.S. stocks of about 6.5 percent for a long time now. There’s a good chance that a return somewhere in that neighborhood is going to continue to apply in the future.
When you see returns going far above that, know that something is up. Know that things have gotten out of hand and take some money off the table. Then you won’t get burned when the natural and inevitable cycle of stock prices that has always applied in the past applies again in the future.
Stock prices go up, stock prices go down. Change your stock allocation accordingly, and you won’t find yourself asking the next time we all experience this natural and inevitable cycle why stocks crashed.
That’s what stocks do. That’s why stocks pay so well for those who have learned how to navigate the emotional minefields.