Yes, Stocks Can Become Overvalued

The Socratic Method Friday's column advocated self-awareness. The stock market's movements seem to be meaningful, but their signals are spurious. Therefore, investment wisdom consists of learning to avoid the temptation to trade. The investor who acknowledges his ignorance is better off than the investor who does not.

That argument, of course, was not invented here. From Plato's "The Apology": I am wiser than this human being. For probably neither of us knows anything noble and good, but he supposes he knows something when he does not know, while I, just as I do not know, do not even suppose that I do. I am likely to be a little bit wiser than he in this very thing: That whatever I do not know, I do not even suppose I know.

Socrates, perhaps, overstated his claim. (As demonstrated by his suggestion that his death sentence for heresy be changed to one of receiving lifetime free meals, the Great Man cannot always be taken at face value.) If pressed, he might have conceded that some things were good. Similarly--if such a word can ever apply to your columnist and Socrates--my claim was overly strong.

A reader, Marvin Menzin, noticed. "Your advice implies that investors should buy and blithely hold. It ignores the possibility they might want to reduce your exposure because of excess stock-market valuations. I think it would be an excellent column if you were to address when investors should rebalance to lower-risk portfolios, especially when it's a retirement account and taxes are not germane. Investors are told to stay the course. The Titanic stayed the course!"

Well, Mr. Menzin, this is that column. Although I must confess, the "when" is exceedingly rare. Since World War II, I can think of only one clear and obvious occasion when U.S. stock investors should have reduced their exposure.

The Mechanics of Rebalancing To start: A portfolio's stock position should indeed be traded regularly, through mechanical rebalancing. If stocks perform well, such that a portfolio that was initially 60% stock/40% bonds becomes 70/30, then it's logical to return to the original allocation. After all, nothing changed from the initial decision.

Rebalancing, however, is more easily said than done, because while maintaining a consistent asset allocation makes economic sense, it's not much fun to implement. Selling winners feels good if stocks then decline, but if they do not, the opportunity cost can sting. Worse yet is the opposite situation. Mr. T had one word to describe how people feel after they buy equities when the headlines are urging otherwise, only to see stocks fall further. Pain indeed.

Thus, rebalancing is best done automatically: Establish a trading rule; follow its instructions devoutly; and suffer no regret if the transaction turns out badly. After all, the decision was the model's, not yours.

Judgment Time Unfortunately, I do not see how mechanical processes can guide investment strategies that are based on stock-market valuations. Those who have tried--most famously by using the Shiller CAPE P/E Ratio, which examines stocks' cyclically adjusted price/earnings ratios--have failed. Such measures work well in hindsight, but they have not been useful predictors. Their explanatory power has been academic rather than actual.

The discrepancy occurs because, well, things change. Implicit in every market indicator is the concept that the past repeats itself. The stock market's fluctuations--and the breathless stories that accompany those gyrations--create a false impression. They suggest that this time is different, when in fact it is not. The average, unbeknownst to the forecaster, has moved.

When devising their indicators, researchers face no such problem. They obtain a date set, determine its mean, study the deviations, and discover signals that explain the patterns. Within their constructs, the signals cannot help but to inform. They were, quite literally, built to succeed for the evidence that they examined.

There is no such stability in the real world. It may be that future conditions remain similar to those of the past, in which case the newly released indicator will likely prove valuable. But often, that is not so. For example, owing to many reasons (including a low inflation rate, the lengthening of the economic cycle, and, in recent years, record corporate profit margins), the price ratios for U.S. stocks have been higher during the past 25 years than they were before. That has played havoc with stock-market price indicators, the Shiller CAPE Ratio included.

Historical Assessments Which leaves those wishing to avoid an overpriced equities market depending on judgment. For 20 years following the conclusion of World War II, there was no judgment to be applied. Remaining in equities was the correct decision.

Then came 15 terrible years, through the mid-1980s, when the stocks were devastated by inflation. For that stretch, investors would indeed have done well to avoid equities. However, making that choice involved understanding the economy, not judging the level of equity valuations. It wasn't that stock prices were particularly steep. It was instead that inflation spiked far higher than it had been, and also far higher than it would become.

Since the early 1980s, stocks have crashed three times.

Two of those occasions, I believe, were almost impossible to anticipate. Black Monday in 1987 came out of nowhere; even in hindsight, it is difficult to understand why. The 2008 financial crisis, on the other hand, happened for well-documented reasons. But once again, the determinants were economic. Across the globe, banks collapsed and housing markets sunk. No stock-market indicator could have anticipated that.

The one occasion in which judgment served was during the "New Era," when technology stocks posted valuations that still exceed all subsequent levels. Sentiment was equally overheated. That truly was a time to slash one's stock-market exposure. Even then, though, the timing needed to be right. Those who sold equities in 1996 fared worse than those who stayed the course and held through the worst of the downturn.

In short, Friday's column overstated its case. Sometimes stocks do cost too much. But recognizing when that situation arises, and profiting from the knowledge, is a severe task.

Are Readers Smarter Than Me? Several readers disliked Tuesday's headline, "Are Millennials Smarter Than Us?" Their argument: In that construction, "than" serves as a conjunction, meaning that the headline should have been "Are Millennials Smarter Than We?" (Or perhaps, "Are Millennials Smarter Than We Are?")

As this article explains, and as my editors maintain, that argument is...overstated. Although "than we" is technically correct, and is the approved version from high-school English teachers everywhere, "than us" has a long literary history, and is considered an acceptable alternative by style manuals.

Plus, it sounds better. And that should matter for something.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.