Few macroeconomic prognosticators have been as correct as publicly at crucial moments as Yale’s Robert Shiller, whose first and second editions of the Irrational Exuberance laid bare, with remarkable timing, the speculative bubbles forming first in the Internet-crazed stock market and next in residential real estate. Shiller is a professor of finance at Yale and the co-founder of investment firm MacroMarkets LLC. He recently teamed with Nobel laureate George Akerlof to write Animal Spirits: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism .
This interview was conducted on July 9 at his office in New Haven by Dan Richards.
I want to first talk about an article that appeared in the Wall Street Journal on March 9 featuring you and Jeremy Siegel. I know he’s a longtime friend and colleague of yours, and that your views differ somewhat on how the market is valued. At that time you suggested that the market was expensive. Can you talk a little bit about what led you to that conclusion?
I like to take a long historical perspective. On my website, I plot the price-to-earnings ratio going back to 1881 on the Standard & Poor’s index. I calculate the price divided by the ten-year average of earnings, which is a better price-earnings ratio.
And the reason you do that over 10 years?
Short-term earnings fluctuate rather rapidly. They are tied up with recessions and are not a good sign of fundamental value. We had a negative quarter of S&P earnings recently. If that ever goes on for a year, we won’t be able to even define the price-to-earnings ratio.
So it normalizes the short-term fluctuations?
Yes. In my work with John Campbell, we find that, going back to 1881, that ratio seems to predict future ten-year returns. It is not predicting returns for the next day or the next month. It is long-term. When the ratio has been very high, like it was in 1929 or 2000, it did badly afterwards. When it was very low like it was in 1920, 1933, or 1980 and1982, those were times when the market did very well. It’s simple.
What is the long-term average price-to-ten-year-earnings ratio?
It’s about 15. It depends on the time period chosen. If you based your sample on the years up to 2000, it would look higher than that. The ratio got up to 46 in 2000. That is when I wrote my book, Irrational Exuberance. I thought something was amiss.
I don’t like to make forecasts like this all the time. But when it gets so wild and crazy, it is time to write a book with a strong forecast.
What is the long-term ratio today?
It’s about 22. So it’s high, but it’s not super high.
I was at Wharton yesterday and I talked to Jeremy Siegel. He acknowledges your research analysis. But he makes a couple of points. One of them is that the earnings over the last 10 years have been distorted to the downside by massive write-offs by companies like AIG and some of the other financial firms. To what extent do you think that skews your results?
Earnings have been exceptionally volatile recently. As I just said, we actually had a quarter of negative earnings. But I think it’s a little bit difficult to be systematic in correcting for that, because, going back 100 years, it’s happened before. There have been write-offs. They’ve done funny things. I don’t know that anyone can really be authoritative in making judgments like that.
The second point that Siegel made related to the interest rate environment. His comment was that in periods of high interest rates, the multiples have historically been much lower. In periods of low interest rates such as we have today, the multiples have been significantly higher, and he thinks we should be adjusting for that in terms of what a fair value is. What is your view on that?
This is a complicated point. One thing is whether we look at nominal or real interest rates. I assume that Jeremy is looking at real rates like TIPS in the US or other inflation-indexed rates, but we don’t have a history of that going back before 1997.
If you look at nominal long-term rates and compare them to the price-earnings ratio back to 1881, there were periods when it looked like Jeremy was right, but he hasn’t been consistently right. So I think that’s a half-truth.
The other thought is that long-term interest rates are very low now, so that would seem to say the stock market is valued very high, and also commodities and everything else should be high. There’s some truth to that, but the other question is, how reliably are those long rates going to stay low? The real question that people really want to know is how do we forecast the market? Nobody has found that long-term rates offer a significant way of forecasting the market.
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