Valuation-Informed Indexing #217
by Rob Bennett
It’s one thing for the Buy-and-Holders to reveal an inability to make the critical distinction between short-term timing and long-term timing. It’s something else for the fellow responsible for revealing the importance of that distinction to fall into the same trap. But an article based on a recent interview with Shiller makes the case for the sad reality beyond any reasonable doubt — Robert Shiller believes in short-term timing.
Shiller says: “The market has gone up for five years now and is quite high, but I’m not selling yet.” The author of the article comments that: “Shiller, who is renowned for telling people when to get out of the market, advises investors to monitor not just the level of the market but ‘the stories that people tell’ about the market.”
The article goes on to point out that the P/E10 level is now at the fourth highest point it has ever reached in the history of the U.S. market and that the three higher peaks all produced stock crashes. But it reports that Shiller’s belief is that today’s P/E10 level “might be high relative to history but how do we know that history hasn’t changed?” Shiller believes that the long-term average for the valuation metric is “highly psychological.” He believes that “you can’t derive what it should be.” The article reports that: “The [P/E10 value] is most accurate in forecasting a market move when the ratio is at an extreme, but now it is only at 25.3, not far from the the 30-year average of 23.4.” He adds one of the things he is looking for to determine whether we are at a “turning point” is a showing that the economy is stuck in the muck.
This stuff is dangerous, in my assessment. I hardly know where to start in finding fault with Shiller’s understanding of the implications of his own research.
The one that gets my blood pressure up the most is the one where the reporter observes that Shiller has gained a reputation as someone with the ability to predict short-term market moves. He DOES have that reputation. But the reputation is unearned. Shiller gained this reputation by publishing his book Irrational Exuberance in March 2000, at the time of the crash in the prices of tech stocks. Shiller has been developing the ideas set forth in that book for two decades! The fact that the publication date coincided with the tech crash was pure coincidence. Shiller’s revolutionary research lends zero credence to efforts to engage in short-term timing (in no way did he discredit Fama’s critically important finding that short-term timing never works). For people to believe that Shiller has engaged in successful short-term timing is a mockery of his true contribution (showing the critical distinction between short-term timing and long-term timing).
Shiller’s statement that “I’m not selling yet” suggests that he WILL be selling but only when he comes to the conclusion that the time is right. In other words, he believes in short-term timing. Shiller is of course 100 percent free to engage in whatever investing strategies he chooses. But it does not help people understand the realities of stock investing when one of the most important figures in the field expresses confidence in a tactic (short-term timing) that was discredited by the academic research 50 years ago. Short-term timing doesn’t work. Why can’t we all accept that and move on? I view Shiller’s book as the most important book ever published in this field and it embarrasses me to see him cited in support of short-term timing strategies. Shiller does NOT make a case for short-term timing is his book or in his research.
I don’t believe that it is a good idea for people to monitor “the stories that people tell’ about the market, as Shiller advises in the interview. Shiller’s research shows that it is investor emotions that determine stock prices, not economic realities. So the idea of taking stories into account does make some sense. But we do not today possess good tools for analyzing stories in a scientific way. The risk of stock investing comes from the rationalizations we employ to persuade ourselves to ignore obvious danger signs (like that sky-high P/E10 level!). Examining stories is a subjective enterprise. People who want to believe that stocks are dangerous will find stories supporting that belief and people who want to believe that stocks are safe will find stories supporting that belief. To focus on the stories being told is to give up on the project of making stock investing more scientific and to return to pre-research strategizing.
The average P/E10 value over the 140 years of U.S. stock market history is nothing even remotely close to 23.4. It is the very purpose of the P/E10 metric to warn us when stocks are dangerously overpriced. If we adjust our understanding of what constitutes a normal P/E10 value to conform to the irrational exuberance that produces temporarily high P/E10 levels each time the metric signals danger, we undermine the entire Shiller project. When Shiller says that we can’t know what the P/E10 value should be, he is saying that we can’t know whether his life’s work has value. I agree that we cannot know with absolute precision what the P/E10 value should be. But, if Shiller is being quoted accurately (and these quotes are consistent with quotes that I have seen from Shiller in earlier interviews), he is saying a good bit more than that here.
I also think that Shiller is making a mistake in waiting for a showing that the economy is in trouble before acknowledging that stocks have become a high-risk asset class. The cause-and-effect relationship goes the other way. When stocks are insanely overpriced, we always see a crash (but we can never know with precision when it is coming). When stock prices crash, trillions of dollars of spending power leave the economy. That always causes an economic contraction. If Shiller is waiting for the economy to fail to pull out of stocks, he will reach a decision to sell his shares only after their value has plummeted.