This Wild Market
Perhaps we can figure out what’s going on in the markets today if we read between the lines. Prof. Shiller explains that “…the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. Which means that CAPE today is largely a reflection of the Greater Fool Theory of investment.
Then Mr. Shiller states that “[t]oday’s level “might be high relative to history, but how do we know that history hasn’t changed?”
I would guess that history has changed. Starting when the dollar and all other currencies became free floating in 1971, empowering central banks to create credit at will according to political dictates. This credit creation has occurred simultaneously with the expansion of the global labor supply in concert with new technology, both of which have depressed inflationary price signals, permitting central banks to continue their credit expansion at little apparent cost. It’s all good, as the shadow bankers might say.
But the less obvious result has been volatility of asset prices that we see reflected in the 30 year transition of financial markets toward trading away from new productive capital investment. This is how the hedge fund industry has blossomed.
The value of financial assets has departed from cash flow fundamentals and the result is markets that pop one day and deflate the next, depending on the sentiment of the moment, rather than underlying economic fundamentals. We’ve created greater price uncertainty in the economy that hampers productive long-term investment and concentrates the rewards in a shrinking cohort of lucky asset holders. This violates the most basic theory of financial management under uncertainty, which is stability through diversification.
This history was not inevitable, it was deliberately pursued under faulty intellectual models of our market society.
From the WSJ’s MoneyBeat:
Robert Shiller on What to Watch in This Wild Market
By Jason Zweig
You would have to be crazy to think the stock market isn’t crazy.
In three tumultuous days this week, the Dow Jones Industrial Average dived 273 points, then jumped up 275 points, then dropped 335 points.
But you might be even crazier if you think you know exactly when to get out of the market.
Few people understand that better than Robert Shiller, the Yale University finance professor who shared the Nobel Prize in economics last year for his research documenting that stock prices fluctuate far more than logic can justify—and who is renowned for telling people when to get out of the market.
Prof. Shiller predicted the collapse of both the technology-stock bubble in 2000 and the real-estate boom in the late 2000s. And he developed a measure of long-term stock valuation that many professional investors rely on.
Yet the central message that emerges from three conversations with Prof. Shiller over the past few weeks isn’t a cocksure forecast; it is a deep humility in the face of irreducible uncertainty.
Many analysts have warned lately that Prof. Shiller’s long-term stock-pricing indicator is dangerously high by historical standards.
Known as the “cyclically adjusted price/earnings ratio,” or CAPE, Prof. Shiller’s measure is based on the current market price of the S&P 500-stock index, divided by its average earnings over the past 10 years, both adjusted for inflation. It stands at nearly 26, well above the long-term average of about 16.
If only things were that simple, Prof. Shiller says.
“The market is supposed to estimate the value of earnings,” he explains, “but the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. So the long-term average is “highly psychological,” he says. “You can’t derive what it should be.”
Even though the CAPE measure looks back to 1871, using data that predates the S&P 500, it is unstable. Over the 30 years ending in 1910, CAPE averaged 17; over the next three decades, 12.7; over the 30 years after that, 15.7. For the past three decades it has averaged 23.4.
Today’s level “might be high relative to history,” Prof. Shiller says, “but how do we know that history hasn’t changed?”
So, he says, CAPE “has more probability of predicting actual declines or dramatic increases” when the measure is at an “extreme high or extreme low.” For instance, CAPE exceeded 32 in September 1929, right before the Great Crash, and 44 in December 1999, just before the technology bubble burst. And it sank below 7 in the summer of 1982, on the eve of a 17-year bull market.
Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion. So, he says, he and his wife still have about 50% of their portfolio in stocks.
On Thursday, as the Dow fell more than 300 points, Prof. Shiller told me, “The market has gone up for five years now and has gotten quite high, but I’m not selling yet.” He advises investors to monitor not just the level of the market, but the “stories that people tell” about the market. If a sudden consensus about economic stagnation forms, that could be a dangerous “turning point,” he says.
Based on new research he has done into industry sectors, he says, he is “slightly overweight” in health-care and industrial stocks.
The third edition of Prof. Shiller’s book “Irrational Exuberance,” coming out in February, will feature a chapter on bonds.
Is the bond market, as some investors have suggested, a bubble bound to burst?
“A bubble is a product of feedback from positive price changes that create a ‘new era’ ambience in which people think increasingly that prices will go up forever,” Prof. Shiller says.
Today’s bond market, he adds, “is just the opposite of a new-era ambience.” Instead, the demand for bonds is driven by “an underlying angst” about the slow recovery and pessimism about the future. “That’s not a bubble,” he says.
It also is worth considering where Prof. Shiller gets his knack for seeing what others overlook—the kind of gift that the renowned hedge-fund manager Michael Steinhardt has called “variant perception.”
Prof. Shiller is an unconventional thinker who relishes investigating ideas that other people regard as eccentric or unrewarding. “I don’t fit in so well,” he says, shrugging. “I’m socialized differently somehow.”
Prof. Shiller—and his wife, Ginny, a clinical psychologist—suspect that he has “a touch” of attention deficit hyperactivity disorder. “I’m very distractible, although I can be highly focused on tasks that interest me,” he says.
It is that intensity of thinking that leads to rare big insights—and to the recognition that, as he puts it, “a lot of fundamental problems aren’t really soluble.”
One friend recalls meeting him for lunch in New Haven; afterward, Prof. Shiller offered to give him a lift to the train station. But, the friend recalls, “Bob couldn’t find his car. He couldn’t remember where he had parked it.”
“Bob came into my office one day in the early 2000s,” his colleague, Yale finance professor William Goetzmann, told me. “He said, ‘I think we are in a real-estate bubble.’ I listened to him and said, ‘Hmm, that’s interesting,’ and when he left, I went right back to whatever research I was doing.” Prof. Shiller went on to produce the first serious warnings that the housing market would collapse.
Prof. Shiller says both stories sound right to him.
I reached him by phone earlier this month after he had missed an earlier appointment to speak. “I was awaiting your call,” he said, “but somehow never heard the phone ring.” Later he clarified that he might have left his cellphone in the next room but wasn’t sure.
It isn’t hard to imagine him sitting there, oblivious to the ringing phone and every other sight and sound, lost in contemplation of big ideas.