Yale professor Robert Shiller was one of a relative handful of stock-market observers who warned that the bull market of the late 1990s was a colossal bubble in the making.
Shiller's book, Irrational Exuberance, was published moments before the 2000 top, and it foretold much of the carnage that was to come.
Shiller followed up Irrational Exuberance with a book arguing that the housing market was in a similar bubble.
He thus became one of the only observers to plant a flag and call both bubbles before they popped.
We sat down with Professor Shiller in Davos to discuss the state of both houses and stocks. Shiller's thoughts on houses are here (he thinks the current optimism is premature if not flat-out wrong). His thoughts on stocks are below.
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Henry Blodget: So, on to stocks. When we had the crash, we finally did get below average on your 10-year smoothed earnings price-earnings ratio, the cyclically adjusted P/E.
Professor Shiller: Yes, in 2009.
Blodget: We never got as low as we’ve gotten in prior bear markets, and that led a lot of people like me to be stupidly waiting on the sidelines until we got to single-digit P/Es, where it would be ‘safe’ to buy, and as a result I missed a lot of the rally. As you look at, now we’re above a 20s PE again, and we have been for several years. Do you think it’s possible that something has changed and that the average will now be higher over the next 100 years than it was over the past 100 years, or do you expect that we will go back to the ~15x earnings average?
Shiller: Certainly it’s possible, but when you say that it reminds me of Irving Fisher’s 1930 book called something like The Great Crash And After, and in that book, which I think he wrote before the 1929 crash, because no one can write a book in such short order as that – there’s a chapter on a new level for the P/E ratio.
Blodget: Aha! 'This time it's different.'
Shiller: And he had a prediction for the next century, that it would be very high. And he’s a very persuasive writer. One thing he talked about was Charles Amos Dice, who wrote a famous book in the mid-20s about common stocks as investments, pointing out that stocks have always outperformed other investments, and that now a new breed of sophisticated investors understand that, and we’ll never revert to such low pricing for stocks again. Dow 36,000 made the same statement.
Blodget: Exactly. Many people made similar statements to that. So I think a lot of – one frustration a lot of people have with the cyclically adjusted P/E and others is that it’s not particularly helpful for the timing mechanism, do you think it’s good to use as a sort of projected 10-year return, where when P/Es are high the return tends to be low, and vice versa?
Shiller: John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent. Wait until it goes all the way down to a P/E of 7, or something.
Blodget: Right, perfectly safe, so then you can buy.
Shiller: But actually, the lesson there is that if you combine that with a good market diversification algorithm, the important thing is that you never get completely in or completely out of stocks. The lower CAPE is, as it gradually gets lower, you gradually move more and more in. So taking that lesson now, CAPE is high, but it’s not super high. I think it looks like stocks should be a substantial part of a portfolio.
Blodget: But probably less than the 100-year average return?
Shiller: I think predicting something like 4 percent real for the stock market, as opposed to 7 or 8 percent historically. And that looks pretty good. The other thing is, you don’t have to go into the whole market. You can go into a low-CAPE sector.
Blodget: Interesting.
Shiller: And this is just what I’ve been working with Barclays’ bank on, on products that would do this. It’s not selling well yet. Ticker symbol CAPE, which you can buy. It goes into low-CAPE sectors.
Blodget: So is this a similar screen to the famous value screen that Fama and French developed?
Shiller: No, it’s a new one. Well, it’s not new, I’ve done this for 20 years. But somehow, it hasn’t been implemented as an investment strategy. The interesting thing is, we took the Fama/French value factor and ran a regression of returns on both ours and his. And they both come in significant. So it seems like we have another measure of value that’s different from theirs, and they both work perfectly. So I’m an advocate of going into traditional value, like Fama/French value, and our CAPE.
Blodget: Are they significantly different?
Shiller: They must be, because when you put them in a regression together – I’m talking econometrics here – they both come in.
Blodget: Meaning?
Shiller: They’re both significant.
Blodget: Independent of one another?
Shiller: If they were collinear, if they were one doing the same as the other, then they would both drop out.
Blodget: I think I understand. Last question on that: can you apply the same methodology to different markets and asset classes? If you were going to build a global portfolio of diversified assets, you’d say the Australian market has a low CAPE, you’ll go overweight there – is anyone doing that?
Shiller: Yeah, we’re doing that. But we haven’t with Barclays’. We haven’t come out with a product yet, because its tricky doing things internationally. The one really big problem we had is that there’s an exchange rate problem. If you look at the relative performance of investments in other countries, exchange rate is really important. Another question is do think exchange rate means revert? So that’s what we’re working on, and I’m optimistic that we’ll have a product. But right now, we don’t. We don’t yet have it worked out.
Blodget: This is going to be an affordable product with low fees, or is it going to be a typical Wall Street product with huge fees?
Shiller: Well, our CAPE product has a 45 basis point fee.
Blodget: That’s good – better than typical fees. Thank you very much, Professor.
Shiller: My pleasure.
SEE ALSO: SHILLER ON HOUSES: All This Optimism Is Premature!
