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Full Text and Video: Robert Shiller Interview with Consuelo Mack

Full Text and Video: Robert Shiller Interview with Consuelo MackCONSUELO MACK: This week on WealthTrack, Financial Thought Leader Robert Shiller forecast the bursting of the tech and housing bubbles. As he tracks the behavior of consumers, home prices, and markets, what does this visionary Yale economist see in our future? We’ll find out next on Consuelo Mack WealthTrack.

Full text and video below:

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Remember the days of the so called “great moderation,” during the Greenspan years of the 1990s and into the last decade when policy makers, CEOs, Wall Street pundits and many investors believed we had tamed the boom and bust economic beast and were forever destined to live in a Goldilocks economy of steady growth, low prices and near full employment? Did we ever really believe that? We sure did.
This week’s WealthTrack guest, Yale professor and noted behavioral economist, Robert Shiller wrote about it in a recent New York Times column, as quote “the origins of the current economic crisis… a particular kind of social epidemic, a speculative bubble that generated pervasive optimism and complacency.” As Shiller, who predicted both the tech and credit bubbles in several editions of his book, Irrational Exuberance told me, markets are driven by stories and word of mouth contagion.
The market story is far different today than it was a decade ago. This week alone we have more evidence of decelerating growth and nervous reaction to it. Revised second quarter GDP turned out to be slower than initially reported and below consensus forecasts. And more recent reports from several regional Federal Reserve banks are showing spreading weakness in business activity. In a much anticipated speech in Jackson Hole, Wyoming on Friday, where Federal Reserve Chairman Ben Bernanke announced his quantitative easing, or QE2, policy a year ago, the Fed chief acknowledged the economic deterioration, but did not announce any new initiatives to try to stimulate the economy.
Longer term, the markets are already reflecting the change in economic narrative. The S&P fell 16% from July 22 through August 19th, the biggest four-week loss since the market lows of March 2009. And price volatility is still with us, on both the up and downside. I began our interview by asking Professor Shiller to describe what he calls the “malaise” that we are experiencing.

ROBERT SHILLER: Not everyone will agree with this, but I think that there is some sense of hostility at the rich, hostility at our institutions like government, there is a sense of protracted disappointment. We’ve been in a slow period for five years, and there is some impulse to do finger-pointing and blame someone, and I think there is some deterioration in kind of our social compact that’s holding us together, which makes it harder to do business, and then it becomes, to some extent, a self-fulfilling prophecy.

CONSUELO MACK: Let me ask you about that. I know one of the things that you had told me when I had talked to you a couple of weeks ago was that when the S&P downgrade of U.S. Treasury debt occurred, that you felt that it actually damaged our national pride.

ROBERT SHILLER: Right. The pride that we have in this nation is very important, and by the way, it is supported by people in other countries. Other countries respect the United States, they may criticize it, they may be angry with it, but they respect it, as shown by the fact that they send their money to be invested here, even at low yields.

CONSUELO MACK: You’ve talked many times on WealthTrack about the importance of human psychology and attitudes, and so the complacency and optimism that we had prior to the financial crisis, for instance, so we’re seeing a change in that, and that kind of the cultural zeitgeist has changed. So how significant is that change, and is there anything- I mean, how easy is it to reverse it, and to bring at least the optimism in this country back, which is so important to the economy, right?

ROBERT SHILLER: We do have confidence indexes, which are low, but not super low. I mean, I don’t know that they capture all of the nuances that we need to capture. The thing that is really striking is in the housing market, that the interest in home buying has just plummeted. Now that is partly because it’s difficult to get a mortgage, but it’s not offsetting, that is mortgage rates are extremely low now by historical standards, so why is it that new home sales are so down, housing starts and permits are so far down that people just are not looking at houses now? I think it’s complicated. There are other factors, for example, the household formation rate is down so that people are less likely to move out from their parent’s house and go buy a house. I don’t know that there’s any clear explanation of this, but to me it’s partly just a loss of our spirit, of our sense that the country is moving forward, and I’m going to get out and do something, and it’s a little bit weakened now. It’s hard to pin this down, but I think it’s a factor.

CONSUELO MACK: So you’ve done actually surveys of home-buyers, or home owners, or potential home owners and about, you know, what their expectations for home price appreciation are, for instance. And they’ve changed dramatically (from like five years ago, ten years ago.

ROBERT SHILLER: That’s right. That is interesting, the expectation for home price- the median expectation at the peak of the market was something around 7% a year, and…

CONSUELO MACK: In 2005, you mean in 2006, it’s the peak. Yeah.

ROBERT SHILLER: Yeah. And now the median is down to 4 percent a year. It’s sagged gradually over five years, so it’s not like people react suddenly to some event, like Lehman Brothers was an event in September 2008, and there was a sharp crisis then, but the people didn’t suddenly change their expectation. It’s been sagging for five years.

CONSUELO MACK: And what’s so interesting is I know you and a couple other economists co-authored an article called “Wealth Effects Revisited”, and which concluded that the change in housing values continue to exert a larger and more important impact around household consumption, which, of course, is 70% of our economy, than do changes in stock market values.

ROBERT SHILLER: That’s right.

CONSUELO MACK: I mean, our attitudes towards homes, and the value of our homes, right, has a huge impact on the economy.

ROBERT SHILLER: Right. I think homes are more immediate and visceral than our stocks. Often stocks are held in a retirement portfolio, and for young people that’s so far away. I mean, they don’t even feel like they own it. It used to be in the 1990s, you could borrow against your home equity, and there were competing offers coming in in the mail every day to let you do that. Now that is happening less, and people are feeling damaged, “I had this wealth, I thought I was a millionaire”, or “I thought my home would soon be worth $1 million”, but now it’s going down and so it changes their willingness to spend. I think this is a case Quigley and I concluded in our paper that it was a major, this thing, just this, the housing price decline, and the reaction of home owners to the decline is a major part of the whole financial crisis.

CONSUELO MACK: So what is the, you know, Case-Shiller Home Price Index, I mean, telling you about, you know, the future of home prices? The results have been weak for a number of years as prices have declined, so what’s the outlook from home prices?

ROBERT SHILLER: Well, you know, my company, Macro Markets, has been doing surveys of professional forecasters, and the consensus is for modest increases for the next five years, but just about keeping up with inflation, so that in real terms no change. My own personal sense is that maybe they’re a little bit optimistic. I don’t know. But I think home prices could fall further. We’re seeing a weakening economic situation now, and they’ve been falling, for the most part, for five years, and I don’t see signs, clear signs that it’s on the way up now.

CONSUELO MACK: Do we still have farther to go, or home prices, you know, kind of more historically in line with other indicators?

ROBERT SHILLER: Well, real inflation-corrected home prices, using the S&P Case-Shiller National Index, are down 40% from the peak. That’s a major drop in home prices, and it brings us close to the long-run historical trend, but it hasn’t overshot yet. And historically speculative prices, when they’re coming off a bubble, often overshoot. So I don’t see any reason why they should go down further. Now they’re back down at a good level, and with low mortgage rates, they look pretty affordable. But they could overshoot because we don’t know what’s going to happen to the confidence and psychology going forward. What’s going to happen to our financial institutions? Our Congress is re-contracting our expenditures rather than expanding them, and it’s already been four years since the beginning of the recession. We’re supposedly in recovery, but a weak recovery. It’s been a long time. So there is concern right now for the housing market and for the whole economy.

CONSUELO MACK: So how concerned are you about the economy right now?

ROBERT SHILLER: Well, I think that it’s a big unknown, where we’re going. Economists like to think of themselves as scientists. Well, they are scientists, social scientists. They do statistical analysis of historical periods. The problem is that the recent crisis is a rare event historically. To get a similar crisis, we have to go all the way back to the Great Depression.

CONSUELO MACK: In terms of what? Because I’ve talked to some other people about that, and they said, in fact, that if you look at what the unemployment rate was during the Great Depression, it’s far higher than it is now. If you looked at…

ROBERT SHILLER: I know, it is higher, but where else do you find something as high as what we have now? There was the 1981, ’82- they called it then the Great Recession, but now we’ve usurped that term for what we were going through recently. The unemployment rate did get up a little higher than it is at our peak in the 21st century, but not long-term unemployment. Long-term unemployment is much higher than it’s been. It’s looking more deep-seeded. Also the ‘81/’82 recession got over with, and it had a nice, much faster recovery than we’re showing now. So it looks like we’re in a period of languor or something isn’t picking up from the– and that, again, sounds like the Great Depression, although I’m not claiming that we’re going to be as bad as that. But I’m saying that the phenomenon has parallels that worry people. The problem with the Great Depression is that the economic confidence didn’t come back until World War II, and then we had this stimulus package that it wasn’t a stimulus, it was the war that stimulated the economy.

CONSUELO MACK: You’re famous for your predictions of the tech bubble, the housing bubble, the credit bubble. So are you seeing any extremes in the economy or the markets now, whether it’s in this country or overseas?

ROBERT SHILLER: Oh, any place where it’s a bubble right now? Well, certainly overseas there are bubbles going on in housing in China, last time I heard in Australia, in Brazil. Even Canada has been picking up a little bit. Not so dramatic. So it’s a complicated world. Not everything is in sync. In the U.S., the place that comes to my mind as a bubbly sector recently is farmland. So farmland prices, at least in the Midwest, have been picking up, and they’ve increased a lot over the same period that housing prices increased, but they’re not done yet it seems. They may continue to go up.

CONSUELO MACK: So let me ask you about the stock market, because your CAPE ratio- the Cyclically-Adjusted Price Earnings ratio, which values the market based on ten years of trailing earnings, you know, versus what everybody else says, which is estimates of future earnings- has been showing the market, the stock market as overvalued, S&P 500 as overvalued. So, you know, what do we do with that information? Number one, how overvalued does it look, and does that mean we should be selling stocks, or how do I use the CAPE ratio to my advantage as an investor?

ROBERT SHILLER: Well, the CAPE ratio is I think better than the conventional price earnings ratio. It should be hands down, don’t just look at last year’s earnings, look at a longer average. But people are conservative, and they like to do things the way they’ve done them in the past, but I think it’s actually very basic that you want to compare price to some long average. So if you look at that, the ratio recently has been around 20, which is higher. The historical average is more like 15, so the stock market looks highly priced, but not super highly priced. They got up to 46, the price earnings ratio in 2000, just before the drop in stock prices. So that ratio is discouraging to stock investors, but not overwhelmingly discouraging. And if you take into account that the stock market has been a very good investment for 100 years or more, you know, it’s not too disquieting. I think that one might make a substantial investment in the stock market now. But with full knowledge, it shouldn’t be everything, because it is risky.

CONSUELO MACK: How discouraged do you get, or how worried or frightened do you get about the kind of volatility we’re seeing in the stocks markets?

ROBERT SHILLER: Yeah, I feel upset about it, because I think that it’s a psychological phenomenon that is kind of a social epidemic that feeds into our other anxieties and animosities, and I don’t like the destabilizing influence that it’s giving. The kind of volatility that we’ve seen historically- now I can’t be statistically accurate about this because these are rare events we’re talking about- but this kind of volatility could precede big stock market drops. So for example, the biggest stock market drop in one day in U.S. history was in 1987, October 19th, 1987 drop. But if you look at preceding that, there were big record drops in the preceding week, and in preceding months, and going back to the preceding year.
We don’t remember that at all because it’s been superseded by the much bigger one in ’87. It gets people talking and a little bit on edge, but the market goes up, and people think it’s over, and everything is fine, but in the back of their mind there’s a bit of anxiety about “Maybe I should sell”, and stories that might encourage people to be a little bit more trigger-happy on getting out will then make the market vulnerable. So the thing is, my secretary asked me the other week, “Should I sell?” That’s a sign. It’s like Bernard Baruch when he heard the shoeshine boy advising him to pick some stocks, it’s the same. I hear people who don’t normally talk about stocks telling me, “Should I get out now?” That’s the kind of framework that could, I’m not saying will, but could lead to instability. It’s the sense of where our attention is more focused on the market, and we’re more thinking, especially with the recent financial news, thinking that this could be the, you know, it could really drop, and so when people think it could drop, they can make it drop.

CONSUELO MACK: So if the shoeshine boy to Bernard Baruch is saying, you know, “Give me a stock tip”, then he’s saying “Sell”, but if somebody is saying, “Gee …”

ROBERT SHILLER: That’s what Baruch said, “I’m out of the market. When the shoeshine boys tells me …”

CONSUELO MACK: Right. Out of the market. But more and more people are talking about I don’t want to be in the market, therefore isn’t that the time when we’re kind of supposed to at least…

ROBERT SHILLER: This is why I don’t know… you’re exactly right. Nobody knows what the market is going to do. I think there’s a vulnerability- this is what we call volatility, because it can go either way. But there is a real chance of a substantial drop in stock prices. I’m talking big. Especially with the anxieties that we have. Now, with the downgrading of the U.S. debt, with the European debt problems, with weakening GDP numbers, both in the U.S. and Europe, and that kind of environment with people remembering the recent volatility, it really sets the stage for… you know, you can see the mood, and you can see that it can change in a bad direction. But it doesn’t necessarily have… it’s like predicting an argument with your spouse, right? You seem to be arguing… it’s feeding back, it’s getting worse and worse, but then suddenly we make up. I can’t explain it, and suddenly we’re happy again. This is the way it is with the economy. This is a social science, it’s not a physical science.

CONSUELO MACK: A couple more questions. One is I’m going to ask you for your One Investment recommendation. So what is it that all of us should own some of in a long-term diversified portfolio?

ROBERT SHILLER: Okay. Well, I’m going to be provocative here and offer as a One Investment, the investment that by some account looks like the worst of them all, and that is, I’ve mentioned this before on this show, TIPS, Treasury Inflation-Protected Securities, the safest asset in the world. That’s what I want to mention, it’s the safest asset in the world.

CONSUELO MACK: So why do you think that treasury, U.S. Treasury Inflation-Protected Securities are the safest asset in the world, with the downgrade?

ROBERT SHILLER: Yeah, the downgrade doesn’t mean anything. The U.S. government will pay its debts, and…

CONSUELO MACK: Thank you, Bob, for saying that.

ROBERT SHILLER: Okay. And they’re promising a real payment, in other words it’s going to be corrected for inflation, and that’s what you care about, the real value of something. So long-term government bonds could be inflated away if the Fed were to be overly ambitious with its quantitative easing, and they might do that, so it makes bonds risky. Not TIPS. They have no risk. But I was going to add, there is a little bit of a negative, and that is that the yield on them recently has been negative. Even on ten-year TIPS, which are relatively long-term. And that sounds bad, right? In other words, they’re complete…

CONSUELO MACK: You said the yield is negative. You mean that…

ROBERT SHILLER: That means if you hold them for ten years, you will get back less than you put in.

CONSUELO MACK: Even with the inflation adjustment?

ROBERT SHILLER: That’s with it. You’ll get more in dollars, assuming there’s inflation. But in real terms, you will get back less than you put in.

CONSUELO MACK: Because of what the rate is on them now?

ROBERT SHILLER: It’s negative. It’s like a negative interest rate. And you might say, “How can it be a negative interest rate? Why would anyone go into something?” Because you’ve got to save, you’ve got to put your money somewhere, and you cannot find any investment that doesn’t have the risk of a negative return. This one, the negative return, actually it’s slightly positive yesterday. It bounces around zero. So you might actually get a positive return of 5/100ths of a percent or something like that. I’m trying to be a little provocative here, but it’s not being provocative, it’s the truth. Don’t be dissuaded by a negative return. As part of your portfolio, it’s a stabilizing thing. It doesn’t produce return.

CONSUELO MACK: Final question. When you were on WealthTrack before the financial crisis really hit, I remember talking to you about, you know, number one, that you were saying that people should, would lighten up on their home investments, if they had a second home or whatever, but the second thing is that you said you would talk to your wife, who is a child psychologist who said, you know, let’s get out of the market, the stock market, which happened to be a terrific call on her part, and you did. So what’s your advice now? I mean, you know, should we get back in the market?

ROBERT SHILLER: Yeah, well, I’m not a financial advisor, but…

CONSUELO MACK: I know you’re not.

ROBERT SHILLER: … and I recommend, actually, if you get this in- I have no connection to financial advisors, but I think people should get one, and talk it over. I mean, talk these things over with someone who has some better perspective. Because you can make mistakes if you’re not as familiar with these institutions. But in terms of just a general gut reaction to the stock market, I think that young people should own stocks, particularly, because they can handle the risk, and it has a lot of return. Older people have to be more careful. As the stock market goes down, I think we should generally rebalance and put more in. It’s not just rebalancing. As it goes down it becomes a better investment. And so that’s what’s been happening since April, and stock prices have been coming down. People should be going in a little bit more.
There’s a question of downward momentum. You know, you might think, “Well, it’s going down, it’s going to keep going down, so I’ll wait awhile.” There is some evidence for momentum in the stock market, but it’s weak. I think the overwhelming thing is rebalancing, so when the market goes down, start moving into it. Not aggressively. This is not a time to be aggressive in moving into it, but moving into the stock market.

CONSUELO MACK: Robert Shiller, it’s always a pleasure to have you on WealthTrack. Thank you so much for joining us.

ROBERT SHILLER: My pleasure, too.

CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point: think like a contrarian and selectively invest against the crowd. Robert Shiller just quoted financier Bernard Baruch who famously and successfully bet against the herd. The current Wall Street sentiment is against buying TIPS, or any long term U.S. treasury securities for that matter, because of their low yields. As Shiller says, they provide portfolio ballast against market swings.
This week Warren Buffett bet against the crowd by investing $5 billion in Bank of America stock. Financial stocks have been vilified; until now, they have been the worst performing S&P industry groups so far this year, down around 25% at one point. As Warren Buffett recognizes, there are selective bargains to be had in the financial services sector. Incidentally next month, I will have a rare interview with Morningstar’s Fund Manager of the Decade, the Fairholme Fund’s Bruce Berkowitz, who has created quite a stir by investing a large portion of his equity holdings in financial stocks.