Financial Times Senior Investment Commentator John Authers talks to Noble Laureate Economist Robert Shiller. Shiller is well known for predicting the market crashes of 2000, 2007 as his PE valuation showed the markets to be too expensive. Eight years later and Shiller is once again calling the top of the market. Authers caught up with the well-known economist, at the Connecticut campus of Yale University. A fascinating interview which may scare a few investors off. – Stuart Lowman
Robert Shiller is famous for many things but perhaps above all, for the so-called Shiller PE multiple, which he has used to put valuations on the US stock market and showed that it was wildly overvalued ahead of the crashes of 2000 and 2007. More recently, it’s become much more controversial because it’s been saying (incorrectly) that you should be getting out of the US stock market for several years now. Robert what are the limits of the PE multiple.
The reason Cape ought to work to predict the market is that earnings have always been constructed by accountants as some measure to indicate fundamental value of a company and so, price is high relative to earnings. That’s a bad sign but we’re clearing out. The significant problem of earnings is that they’re volatile from year to year, so let’s average them over some years. That gives a better indicator of fundamental value. When John Campbell and I studied it, we found that it substantially, predicts returns over the next decade. If not tomorrow, at least over the longer term.
One of the criticisms that have been made is that accounting conventions have changed over time, which means that it’s not directly comparable, that it may not be as expensive, relative to history, as it looks. Do you think that’s a fair criticism?
It’s a problem. I don’t know that it’s a serious problem, partly because accounting standards have changed in response to developments. I think we’re better off with the changed accounting standards than if we ignored all the things that have changed since 1871. I have had trouble, finding experts on the history of accounting. It must be somewhere. I haven’t found any. People are not interested. It’s just like they used to throw away data on trades. We didn’t have a computer tape of stock prices until the 1960’s, so I can’t be sure that the changes in accounting definitions are for the good, as I imagine they are so yes, there’s some guesswork. By the way, some people who have the philosophy that ‘I will only use data that I can really verify’, are limiting their scope of history and history is the main teacher of lessons about financial booms and busts.
One other criticism that people, who are trying to explain away the high level of Cape at the moment make, is that there was this extreme fall in earnings – very dramatic – during the financial crisis. Is that a reasonable concern, that that stays in the multiple?
Well, I don’t see any reason to exclude it because it was in response to a serious recession. The response tended to happen suddenly, partly because companies like to take write-offs right away, during a recession and blame it on the recession and then the earnings can recover from there. It’s a little bit of manipulation in there but if I average it over ten years, I don’t see that that’s a problem, and I think we want to reflect the actual losses that companies made.
Okay, now let’s get to the present. We’ve just had what is, at the very least, a correction in stock markets. Certainly, the Cape measure implies that we need rather more than the correction we’ve had so far. How can we work out whether we have much further to fall? How much further to fall, could we have?
Well, that’s a difficult question.
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It’s an impossible one.
You’d like me to answer it, though. I’ll tell you that I know I’m better known for Cape but I have also, for years, been constructing my own Confidence Indexes and I’ve been studying both stock market and real estate. In the United States, a loss of confidence in valuation of the market: both are individual and institutional investors. The question I ask is, “Do you think the stock market is overvalued, undervalued, or about right?” and I can construct a Confidence Index from that. That index is at lower levels than it has been since the peak of the market in 2000. This is why I think that what I called the millennium boom was a bubble because people – increasingly – as the 1990’s went on, has lower and lower confidence in the valuation of the market, but they were still buying and bidding at prices. That’s a sign of a bubble. It looks (to me), a bit like a bubble again with essentially, a tripling of stock prices since 2009 in just six years and at the same time, people losing confidence in the valuation of the market.
Ultimately, that suggests that this is not over, just yet.
The problem is the short-run thing of saying ‘when will it turn’. Does anyone have a good way of saying that? The thing is that when we see a correction, an increase in volatility, and an increase in the VIX Volatility Index; that shows that people are thinking something – worried thoughts. It suggests to me that many people are re-evaluating their exposure to the stock market and we could see aftershocks of the correction – maybe not right away, but in six months to a year. I’m not being very helpful about market timing, but I could easily see aftershocks coming. I think the investor’s demand is a little bit insecure. I wish I knew better, how to time from that, but I think that there is a concern about a major bull market developing. A concern, but not a clear forecast. I’m sorry. I don’t know.
Thank you very much indeed.
My pleasure.
