Who Says This Stock Market Is Overpriced?
As the 30th anniversary of the 1987 stock market crash neared, Robert Shiller, the Nobel laureate and Yale University economist, mused on why today’s seemingly overpriced market continues to sleepwalk higher. The cyclically adjusted price/earnings, or CAPE, ratio that he and John Campbell devised in the 1980s is at its highest level ever, with two exceptions: shortly before the 1929 crash, which set the Great Depression in motion, and shortly before the dot-com bust. (The CAPE, which is based on average inflation-adjusted earnings over the trailing 10 years, stands at 31, versus 32.5 in 1929 and 44 in late ’99.) Investors’ behavior today, Shiller says, is shaped by a number of narratives that keep them in the market, including fears that robots will displace jobs and hopes that the Trump administration will stoke the economy.
Shiller was early to the study of behavioral economics, a field for which his friend Richard Thaler won the Nobel Prize in economics last week. Lately, Shiller has been investigating how narratives help shape sentiment. Keep reading to learn more about narrative economics, long-term returns—and the importance of the 1890s depression.
What are your thoughts as the 30th anniversary of the 1987 crash nears?
It seems like yesterday. One parallel is that most people think the stock market today is overpriced. I mailed out questionnaires a few days after the Oct. 19, 1987, drop, trying to probe what institutional and individual investors thought on the day of the crash and leading up to it. They thought the market was overpriced. And the P/E ratio wasn’t at all as high then as it is now. It’s a matter of perception. You have to focus on what people think. I’ve emphasized the importance of stories.
How about today?
You can compare today with 1929, a boom year before the market peaked. Clarence Barron believed the experience of World War I strengthened people psychologically. He said, “Every war stimulates the energies of the people, increases their daring, their spirit of adventure, and takes away the fear of borrowing. The result is that business conservatism is thrown to the winds, and borrowing and construction continue on the basis of hope.” Irving Fisher wrote glowingly of technological progress and more-efficient industry. But the other side was that the market was getting pricy. People called it a casino.
In 1929, trying not to be alarmist, the Federal Reserve issued a carefully worded statement that the extent of margin was excessive. There was more fear that there would be a major correction.
Today, people have heard it said enough times that the market is unambiguously overpriced. The CAPE ratio is now at 31. The 10-year forecast based on CAPE is positive, but not a whole lot above zero. We’re in a different social environment. The narrative today is Donald Trump. It is a pro-business narrative, which I infer from his books, such as Trump: How to Get Rich. People aren’t in the frame of mind that we should worry about a crash.
Is it time, then, to discard the CAPE as a predictive tool?
Well, I wouldn’t. It may yet do that [be correct]. Today, there’s the idea that you can ride through the ups and downs of the market and do great. There’s also a new narrative that’s rapidly gaining strength about robotics and artificial intelligence as fearsome forces. That has people wanting investments that will survive the robotic stage. That makes them interested in the FANGs and tech stocks, because they are grasping for something to help them survive, what with voice-recognition software, translating programs, and driverless cars; and now they are developing crewless ships to sail cargo across the ocean.
These narratives may not dissipate fast, and people get repeated shocks of new technology that scare them. One perfect narrative is Bitcoin: It encourages people to want to master cryptography and math. Young people are identifying with it.
What is narrative economics, and why is it important?
The economics profession likes to be able to forecast gross domestic product and unemployment and interest rates and all those things without looking at psychological forces. It’s considered a mathematically precise discipline. John Maynard Keynes argued that we should also consider animal spirits. I wrote a book with George Akerlof with that title. Narrative economics says that animal spirits change through stories, especially in human-interest stories.
““One parallel is that most people think the stock market today is overpriced….And the P/E ratio was not at all as high then as it is now. It’s a matter of perception. You have to focus on what people think.” –Robert Shiller”
For example, you’re probably tired of hearing about Trump. I was reading recently about Williams Jennings Bryan and the 1890s depression. Bryan was a brilliant speaker, like Trump. Newspapers in the 1890s used almost that wording, that all people want to talk about is William Jennings Bryan. Some people said that he was an idiot, that his facts were wrong, and that the people who believed in him were riffraff. The self-styled intellectuals supported McKinley.
Right now, there’s still optimism about Trump, that he will cut corporate taxes and support business. That could go on, unless it starts to look like he doesn’t have the touch that he described in The Art of the Deal.
Why is the depression of the 1890s germane?
It had the same fractious split in the population, with urban Easterners accusing rural Midwesterners of stupidity, and because the Midwesterners and Westerners tended to go for Bryan, just as they now go for Trump. Bryan took over the Democratic Party, many said then, without regard for its values, just as Trump has with the Republican Party.
Where do you see the economy going?
Interest rates are at such extreme lows for longer than ever before. The other time short rates were very low was the Great Depression. That ended with World War II, so it doesn’t provide a helpful example. The Fed has embarked on a slow process of raising interest rates and of unwinding quantitative easing. It is turning out to be very slow. We don’t know what will happen in this unwinding. There could be a crash in the bond market, though I don’t know how to forecast things like that. Rates have been declining for 30 years. The best they can do is stay low.
The idea of secular stagnation, coined by [economist] Alvin Hansen in 1938, may be right. Trump has stimulated our animal spirits, but that could revert back. People could start cutting back on their spending, and that would bring on another recession. There could be a new narrative that I can’t predict, maybe just new stories about artificial intelligence and robots that may make people worry and cut back spending.
What will cause the next bear market?
The next big crash occurs when people think other people are changing their minds. I don’t have a precise way of forecasting. It could come soon. Stock-price volatility is lower on average in the year leading up to the peak month in the previous bear markets. The volatility picks up as a bear market develops. And earnings growth has been strong over the past year. That doesn’t mean you should be confident about the market. Earnings growth was almost 20% in the year before the 1929 peak. Also, 1929 was a year of high earnings growth and somewhat low volatility, and it didn’t make any difference.
How about the housing market?
The S&P Case Shiller Home Price Index is above its previous peak, but not in real terms. It has been going up pretty strongly since 2012. The enthusiasm doesn’t seem the same as the enthusiasm around the real estate boom in 2004. I did surveys of home buyers around ’03, ’04, ’05. Their expectations for annual home prices were in the double-digit range going out 10 years. I think the fear of computers or robots today is encouraging some to buy a house or land. The American dream is also partly about home ownership.
What’s in your portfolio?
I still have U.S. stocks, including the DoubleLine Shiller Enhanced CAPE fund (ticker: DSEEX). I have European and emerging markets stocks, and not much fixed income. I have some real estate funds and REITs outside the U.S. The U.S. is highly priced relative to the rest of the world.
Is there a place for Bitcoin in a portfolio?
People say Bitcoin is a bubble. If it is, so is gold. That bubble has lasted thousands of years. Bitcoin has one fundamental problem as a medium of exchange: It’s very volatile. It’s functioning more on enthusiasm than true merit. We’ve invented fiat currencies led by central banks who appear to be quite responsible.
Thanks, Bob. – Leslie P. Norton, Barron’s, October 14, 2017