A friend of mine has maintained for two decades that the US stock market is substantially overvalued and that stocks are not a good investment. As I understand it, he subscribes to the simple argument that you pay much more for a dollar of corporate earnings than you used to: The price-to-earnings ratio is high compared to the long-term average (roughly, you used to pay 10-20$ for a dollar of profit; in recent years you pay more like $20-30).
After two decades, the claim that “stocks will eventually have to crash” is no longer an interesting prediction. Across two decades, stocks will experience major reversals, and they have done so in the last 20 years. The largest drawdowns – provoked by the credit-fueled Global Financial Crisis and the Covid pandemic, respectively – are not events whose timings are predictable. But they aren’t really exotic occurrences, as any student of history knows.
Both times, my friend believed the overdue crash had finally arrived; both times, the markets recovered their prior values and went on to new highs.
Through all of this – and against my friend’s warnings – I have invested my savings predominately in stocks. Early on, I did so before I really understood stocks’ value proposition. I invested in stocks – naively – because I had understood that stocks have historically offered better returns than the other (liquid) asset classes (cash and bonds).
As I learned more, I came to understand my friend’s argument. It’s solid. Yes, stocks may have delivered good returns in the past. But if everyone believes that naively – as I did – then they will buy stocks and that will drive up the price to a level such that stocks will not be able to deliver as good a return in the future.
People in the 1950s had less collective experience in stock markets to look back on, hence their confidence in the stock market was lower. They were willing to pay less for a dollar of corporate earnings, keeping stock prices low. Later, as people gained confidence in the stock market, their buying behavior bid up the price of stocks, giving investors from the 1950s great returns from price appreciation. Historical stock performance since the 1950s looks good because of the earlier lower confidence in the stock market. Ironically, greater confidence leads to higher prices, leading to future performance that is lower than the historical average. From my friend’s point of view, this realization just hasn’t set in yet.
This dynamic – where beliefs about probabilities in a system actually shape the probabilities in the system – lies at the heart of the Ruminathans. But contrary to my contrarian friend, I have so far continued to invest in stocks. Not because I disagree with his analysis. I’m expecting lower returns. But I don’t see great alternative ways to save.
Instead, my continued willingness to invest in stocks rather than the alternatives (credit, cash, and real estate) rests on three main pillars.
- People will tinker to find ways of creating more with less. We will find new, surprising ways to delight each other and we will find ways to do so while consuming fewer resources (including our own time).
- You can’t bet against the institution of private property. It’s not that I believe private property is intrinsically sacrosanct and that humanity won’t reconsider it. It’s just that if we jettison the institution, then no asset class is a safe store of value.
- Markets will continue to be organized within a rules-based institutional framework in which people by-and-large speak the truth to each other because they believe everyone else is doing so, too.
In recent years, I have invested in stocks not because I hope to earn their historical rates of return. I have invested in stocks because I’ve been betting on human ingenuity and willingness to find cooperative solutions in the many strategic games we find ourselves locked into playing.
I have not invested in stocks because I expect to get 6% average annual returns after inflation. I have invested in stocks because people will continue to find new ways to create value, and in a rule-based political economy with private property, stocks are the best way stake a claim on that newly created value.
There are no iron-clad laws of nature that guarantee these conditions. It’s just that a world in which they no longer obtain is so different that it’s not clear what remaining ways there might be to store value.
However, recently I’ve been thinking about whether generative artificial intelligence is chiseling away at all three pillars.
- If generative AI does much of the work, will we still have the desire to tinker towards innovation? Will we have the skills to do so? Will we even develop the values that silently underwrite the very notion of “improvement?” Will an alien intelligence share those values and create things that we recognize as improvement?
- The great leaps in productivity and innovation came from extending the old – and not always progress-oriented – notions of private property in land to property in ideas. What happens when ideas are not generated by people, and when people’s property in ideas is cavalierly exploited without compensation by algorithms?
- If the vast majority of the information is no longer generated by people, how effective can our existing punishment and reward frameworks for maintaining trust between strangers still work?
I hope to explore each of these threats to the pillars of stock investment in coming Ruminathans.
The Ruminathans 