Valuation-Informed Indexing #116
by Rob Bennett
Yale Economics Professor Robert Shiller does not fully appreciate the most far-reaching implications of his own investing theory.
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I know it sounds arrogant of me to say that. Shiller is the man who showed with research that valuations affect long-term stock returns. I am some guy who posts stuff on the internet. If you want to dismiss anything I say about Shiller’s theory that conflicts with what Shiller says about it, please know that you do so with my blessing.
Still, I think Shiller’s theory (I call it “Valuation-Informed Indexing”) is the future of investing analysis. Thus, I think it is important that there be discussions of every implication of his ideas. And I don’t think it is always the case that the guy who goes first ends up being able to see all the implications clearly. It is sometimes the case that future generations of analysts bring a new perspective to things. I feel obligated to at times put forward my take as to where Shiller is getting things wrong as well as to more frequently make the case for the many ways in which I believe he got things precisely right.
The words I advance below are in reaction to a recent video interview with Shiller that is available here.
Shiller says in the interview that the recent uptick in housing prices is more encouraging than the one we saw in 2010 because the earlier uptick was in reaction to a government-financed stimulus. The suggestion here is that the earlier uptick was artificial and that this one is more real and thus should inspire more confidence.
He expresses a belief that some may in days to come be “kicking themselves” for not having confidence that today’s recovery in housing prices will prove to be a long-running one. He adds, however. that “I can’t be sure.”
Shiller notes, however, that consumer confidence remains weak and that most professional forecasters share the pessimistic outlook. He describes this pessimism as a “drag” on the housing recovery.
He tells the interviewer that the flirting with non-extension of the debt limit of a year or so ago represented “a big hit to confidence” and adds that the “fiscal cliff” coming up soon might provide another such hit.
Finally, he observes that “home prices are not a random walk, they have momentum, so it’s tempting to go into the housing market now.”
I approach this question from a very different starting point. I think it would be fair to say that Shiller is looking at the various economic indicators and making an effort to sort through them and come to some reasonable conclusions. All of his comments sound perfectly reasonable and perfectly conventional. This is what alarms me.
Shiller’s views on how stock investing works are NOT conventional; they are “revolutionary,” according to the subtitle of his book. And, full truth be told, Shiller’s views on how stock investing works are not entirely reasonable either. They are counter-intuitive. They are in many respects UNreasonable. This is why they are so exciting and potentially powerful, in my assessment.
The conventional view is that stock price changes are caused by economic developments. This is why most believe that future stock prices cannot be predicted. Tomorrow’s economic developments are not known. It follows that, if stock prices are determined by tomorrow’s economic developments, then tomorrow’s stock prices cannot be known either.
Shiller says “no” to all that. He says that today’s valuation levels predict tomorrow’s stock prices. How do they do this, if tomorrow’s economic developments are not known? Shiller says that tomorrow’s stock prices are not determined by tomorrow’s economic developments. They are determined by today’s valuation levels. Today’s valuation levels are the product of the investor emotions of recent years. Shiller fixes the cause of tomorrow’s stock prices in the past, not the future.
That’s why it becomes possible to predict tomorrow’s stock prices under the Shiller model. Predicting future events really is impossible. The Buy-and-Holders are of course right about that. But if Shiller is right (there is now 30 years of academic research showing that he is), it is not necessary to know the future to predict tomorrow’s stock prices effectively. It is only necessary to know the past (as revealed in today’s P/E10 value). That’s easy!
Whether housing prices will continue to increase or not is indeed determined by consumer psychology. On that much everyone agrees. But the biggest factor (in my view!) is what happens to stock prices. Stocks have not crashed since early 2009. People are beginning to develop a tentative confidence that they may not lose most of their retirement money in this bear market. So they are venturing out and buying houses. But another stock price crash would smash those hopes and the housing recovery with it.
Shiller’s book reports that there has never been a secular bear market that ended with a P/E10 value above 8. We are nowhere close to 8 today. A drop to 8 would represent a drop in stock prices of about 60 percent. That sort of loss would be devastating for millions of middle-class people. Millions would lose interest in buying houses if we saw that sort of price drop. If Shiller’s model for understanding how stock investing works is on the mark, we WILL see that sort of price drop. The housing recovery is doomed, according to Shiller’s theory.
We always experience upturns during bear markets. The trick is not being fooled by them. We need an objective tool to tell us which upturns are real and which are phony. Shiller’s P/E10 valuation metric is that tool. The stock market cannot experience a sustained recovery until investor psychology has turned (it must get worse before it can get permanently better). And the housing market cannot experience a sustained recovery until the stock market is on its way to a sustained recovery.
Rob Bennett has written extensively about the effect of valuations on long-term returns. His bio is here.