Robert Shiller: Unlike 1929 This Time Everything - Stocks, Bonds And Housing - Is Overvalued
Robert Shiller is a professor of economics and finance at Yale University. He is the author of Irrational Exuberance, which in 2000 predicted the collapse of the tech bubble and is now in its third edition. He was awarded the Nobel Prize in Economic Sciences in 2013 for his work on asset prices and financial market behavior.
In the attached interview he observes that the recent equity run-up seems to be driven more by fear than by exuberance, as a lack of confidence in the future prompts investors to save more and thereby bid up asset prices.
Below is an interview he gave to Goldman Sachs' Allison Nathan
Allison Nathan: Are US stocks overvalued today?
Robert Shiller: I think that compared with history, US stocks are overvalued. One way to assess this is by looking at the CAPE (cyclically adjusted P/E) ratio that I created with John Campbell, now at Harvard, 25 years ago. The ratio is defined as the real stock price (using the S&P Composite Stock Price Index deflated by the CPI) divided by the ten-year average of real earnings per share. We have found this ratio to be a good predictor of subsequent stock market returns, especially over the long run. The CAPE ratio has recently been around 27, which is quite high by US historical standards. The only other times it has been that high or higher were in 1929, 2000, and 2007—all moments before market crashes.
But the CAPE ratio is not the only metric I watch. In my book Irrational Exuberance (3rd Ed., Princeton 2015) I discuss several metrics that help judge what's going on in the market. These include my stock market confidence indices. One of the indicators in that series is based on a single question that I have asked individual and institutional investors over the years along the lines of, "Do you think the stock market is overvalued, undervalued, or about right?" Lately, what I call "valuation confidence" captured by this question has been on a downward trend, and for individual investors recently reached its lowest point since the stock market peak in 2000. The fact that people don't believe in the valuation of the market is a source of concern and might be a symptom of a bubble, though I don't know that we have enough data to prove it is a bubble. In general, I try to get a sense of investors' excitement and anxieties through these kinds of measures and even by just reading the news. You might say that's very unscientific, but I do what I can to understand the state of mind of investors, which I think is very important in understanding market moves.
Allison Nathan: Wharton professor Jeremy Siegel argues that using S&P 500 earnings data for the CAPE ratio inflates it. What is your response to this?
Robert Shiller: Jeremy Siegel's 2013 paper that makes this argument does say that the CAPE ratio is useful. He just wants to make an improved CAPE ratio. And he proposes an alternative based on National Income and Product Account (NIPA) earnings, which he says yields a CAPE ratio that has predicted returns better, at least over the time period for which he has these earnings data. I think it is an interesting paper. But I am not ready to endorse the switch to NIPA earnings partly because they are conceptually a little different, valuing not just publicly traded stocks but also other companies. But the critical point he makes is that NIPA earnings—at least as of 2013—were higher than S&P 500 earnings, which made the market look less overvalued. Given that market valuations have continued to rise, I think that discussion has faded somewhat.
Allison Nathan: Is the equity market a bubble today?
Robert Shiller: I define a bubble as a social epidemic that involves extravagant expectations for the future. Today, there iscertainly a social and psychological phenomenon of people observing past price increases and thinking that they might keep going. So there is a bubble element to what we see. But I'm not sure that the current situation is a classic bubble because I'm not certain that most people have extravagant expectations. In fact, the current environment may be driven more by fear than by a sense of a new era. I detect a tinge of anxiety and insecurity now that is a factor in markets, which is quite different from other market booms historically.
Allison Nathan: How else does this period of apparent equity overvaluation compare to equity booms in the past?
Robert Shiller: This time around, bonds and, increasingly, real estate also look overvalued. This is different from other over-valuation periods such as 1929, when the stock market was very overvalued, but the bond and housing markets for the most part weren't. It's an interesting phenomenon.
Allison Nathan: What explains this phenomenon of asset valuations looking high across the board?
Robert Shiller: There are multiple answers to that question. But if I had to oversimplify with just one idea, it would be what I just alluded to a moment ago—that people are not confident in their future. They remember the financial crisis, and they worry. They hear about inequality through the Occupy Wall Street Movement and in many other places, and they worry where they will fall on the inequality spectrum in a decade or so. They observe the amazing but perhaps unsettling rise of information technology (IT), and they worry. As a result of all of this anxiety, they want to save more. But given the lack of options to invest in at a high return, they end up just bidding up the prices of existing assets. That, in turn, creates disappointment, more concern, and perhaps the feeling that they might be too late because of how much the market has already risen. But they still invest in it because of their anxieties.
Allison Nathan: What does this mean for market stability?
Robert Shiller: It means that the market could keep going up like this for some time. Its been an amazing run and looks like something that can't keep going indefinitely, but it might continue for several more years. So market bulls may be right that the market runs further. I think that could happen too. But I take a different view of the drivers of these runs; I tend to view them as more irrational. I just don't know when this bull market will end. And it might end very badly.
Allison Nathan: How concerned are you about a meaningful correction in the next six months to a year?
Robert Shiller: My concern has risen with the market. There could certainly be a correction in the next year. But the problem is that a correction might not come for five years. We just don't have any way to forecast when it will come.
Allison Nathan: Was it appropriate for Fed Chair Janet Yellen to express concern about equity valuations?
Robert Shiller: I think that there is a moral imperative for Fed leadership to express some opinion about the market. They have a staff of experts—a whole research army—to study these issues, and people look to the Fed as an authority. Believers in efficient markets would say that we shouldn't care about these opinions; that the market is smarter than any individual or any research team. But I disagree. I think that the market is not smart about these sorts of things and that we do need leadership from people who study these questions. And so I applaud Janet Yellen for making that statement, which helped put the current state of the market in perspective. One reason why the boom in the 1990s went on as long as it did is that Fed Chairman Alan Greenspan made very little of worries about the market. At one point he used the term "irrational exuberance," which led to a sharp drop in markets, but he never came back to that theme.
Allison Nathan: Of all the expensive asset classes today, which looks the most convincingly like a bubble?
Robert Shiller: The bond market looks the most unusual relative to history, with real US yields just off record lows of recent years. The difference, though, between the stock market and the bond market is that historically the bond market doesn't seem to crash like the stock market. Notably, if you go back to 1929, there was a huge crash in the stock market and not much action in the corporate bond market. That might come across as a surprise, but it's history. We are now in different times, though, with a very long run of very low interest rates that has affected many countries in the world. So there could be a big correction in the bond market. I'm not forecasting that because I don't like to forecast things that almost never happen. But it could happen. And that's the problem we face.
Allison Nathan: What should investors do when so many assets look expensive?
Robert Shiller: I am not an investment advisor. But I would say that the main implication for most people is that they should save more because their portfolio probably won't do as well as they imagined. And if they're saving for some distant goal like retirement, they might be disappointed. People have learned about the power of compound interest. But what they don't understand is that if interest rates are zero, you don't get any compound interest. I think that there is complacency among investors today. People have seen how well the stock market has done over the last century. But the market might not do so well the next time. So you have to consider whether you are saving enough.
And as a general principle, I think people should diversify across assets and geographies because there is no way to predict what any one asset will do with any accuracy. I've been talking down US stocks because of their high valuation, but I would invest something into US stocks; I would just put a heavier contribution in stocks around the world, where CAPE ratios look lower. I keep coming back to the theme that there are lots of places outside of the US to invest. And I would also own bonds, real estate and commodities. Commodities are overlooked by many investors but they are an important part of an investing portfolio.
The reality is that people are not very good at diversifying. This has been documented in studies. They tend to be distracted, and focus too much on one sector or one thing that they have heard. They also tend to focus on their own country. There's no reason why one should invest only in one's own country. Quite the contrary, some people make the extreme statement you should short your own country and invest only elsewhere. I wouldn't go to that extreme, but it is a plausible argument.
Allison Nathan: But is the strong US growth story relative to elsewhere enough to warrant buying US stocks?
Robert Shiller: The US looks pretty good and in some ways brilliant. The exciting news about technology seems to come largely from the US. For example, fracking, which is predominantly a US technology, transformed the energy market, and just within the last five years or so. And many electronics and IT advances are also coming from the US. So there is reason to believe in this country.
But I think that we also have to understand that we tend to be biased. One sees and appreciates one's own country; that's human nature that one has to correct for. Amazing things can happen elsewhere as well. You see that in much of the developing world; over the last half-century, there's been remarkable economic progress and growth. And we're going to see more and more advancement in those countries. So maybe the high US CAPE ratio is partly justified. But I think we have to nourish a healthy skepticism as investors and not get swayed too much by the idea that we're living in a new era here.
