One of the most dependable rules of investing is that stocks as a whole revert to their mean price-earnings ratio over time. When stock prices are high compared to company earnings, on a historical basis, you can count on prices to come down in the long run.
Is the barrier to permanently higher price-earnings ratios a physical or psychological one?
If the barrier is physical, what might it be? During times of stock bubbles I never see stories about a physical limit being hit.
So the limiting factor to upward price-earnings growth, once you are beyond the historical mean, must be purely psychological, right? If everyone bid up the price of stocks and agreed to keep them high, prices could stay there indefinitely.
For this discussion we can’t ignore alternative investment opportunities. It only makes sense to own stocks if the alternatives are worse. So the alternatives exert an invisible hand to keep stocks modestly priced in the long run.
I’ll accept a 3% tax-free return on a safe investment such as a municipal bond, but I want an 8% return on something risky such as stocks. So as long as the risk-reward ratio of bonds stays put, it limits how much the rational investor will be interested in stocks. I would take a medium-sized risk for a potential 8% return but I wouldn’t take a gigantic risk for that kind of potential payoff.
So stocks are anchored by peoples’ risk-reward reflexes and a sense of the alternatives. But in theory, if the risk of owning stocks became lower for any reason, people would perceive a better risk-reward ratio and bid up the price of stocks.
And that means that if we humans can figure out how to remove any risk from stock picking, the value of stocks will increase, and stock owners will become wealthier with no other change to the environment.
So what makes stock investments so risky?
Answer: professional investment advisors
An investment advisor needs to justify his pay, and that means pretending to have stock-picking magical powers that science has never discovered. Every study on the topic shows that the professionals generally don’t beat the market average over time. But they do cause a lot of churn that causes a lot of unnecessary taxpaying on gains. And the professionals charge enough to take perhaps 25% of your potential annual gain in fees.
Meanwhile, wise people such as you buy your market index ETFs and avoid all of the risks injected by the professional investment advisors. But your potential stock gains are suppressed because so many other people are using professional advice and losing money. That makes the category of “investing in stocks” look riskier than it is.
So my suggestion for permanently lifting the value of the stock market to new sustainably high price-earnings ratios is to pass a law making it illegal to offer financial services without disclosing the truth – that they are mostly a waste of your time.
The reason it is legal to open a palm reading shop is that the public understands it to be entertainment and not prediction. Investment advice should be the same situation: You can buy investment advice if you want it, but not until you sign a document acknowledging that science says no one has magical stock-picking skills.
I know you don’t like big government getting involved when it isn’t needed. But the financial industry as it stands now is the world’s biggest scam, and most of us agree that the government is the right agency for rooting out crime, pyramid schemes and the like. And I think most people would agree that putting warning labels on cigarettes, and nutrition information on food, has served us well. It’s time to do the same with investment advice.
I think the government could do for investment advice what it did with the food pyramid. Ignore for the moment that the food pyramid was done wrong because we didn’t understand the science; the idea of the food pyramid was excellent. We don’t have the food pyramid problem with investments because the science of stock picking is settled: It doesn’t work. So I believe the government could produce a simple investment chart for the public that shows most people should own broad market ETFs under a certain set of simple conditions. Or perhaps the government could develop twenty-or-so example portfolios for different family situations and you just need to pick one that is similar to your situation. That would be far better than today’s system in which people either get no investment help or they pay an investment advisor who actively harms them.
Once society gets rid of the risk of professional investment advice, stocks should go to a permanently higher price-earnings ratio. Given the massive dollar amounts in the investment economy, this instant increase in the value of stocks would have an enormous impact on humanity.
Let me boil this down to one question: Do you think the government should require investment advisors to disclose to customers that their services are proven by studies to be harmful to your wealth?
UPDATE: By one measure (CAPE) stocks have been historically overpriced for the past 20 years. One could argue that being overpriced for 20 years means stocks have moved to a new and somewhat “permanent” higher value. The past 20 years also correlates with the biggest improvement in small investor knowledge, specifically the knowledge that ETF and index investing is better than hiring stock-pickers. This is merely correlation not causation, but according to my hypothesis in this post one would expect to see permanently higher stock values as investor ignorance – and the risk that comes with it – is reduced.
Co-founder of CalendarTree.com
Author of this book
P.S. Sorry about the formatting of the post. Technical problems today.