Valuation-Informed Indexing #230
by Rob Bennett
It sounds crazy. Yale Economics Professor Robert Shiller is the loudest growling bear out there. The back cover of his book describes him as a “perma-bear.” If there is one fellow who no reasonable person can characterize as a bull, it’s Robert Shiller.
But I really do think Shiller is a bull. I don’t think that the terms “bull” and “bear” are terribly helpful signifiers anymore. But if those terms continue to carry any meaning, I think it would be fair to say that Shiller is more a bull than he is a bear. The fact that at least 90 percent of the investing population thinks of Shiller as a bear tells us something important about the state of our understanding of how stock investing works in the real world.
Shiller published research in 1981 showing that valuations affect long-term returns. That research changed the history of investing analysis. Not in a practical sense. Not in the real world. Not yet. But I believe that in time we will all come to see that that is indeed the case. Shiller stood all of the old beliefs on how stock investing works, which generally remain popular to this day, on their heads.
We used to think that stock investing risk was stable. That’s why we came to think that the neutral course of action was to rebalance, to remain at the same stock allocation at all times.
If valuations affect long-term returns, risk is VARIABLE. The amount of risk that goes with owning stocks CHANGES with changes in valuations. To rebalance is to permit your risk profile to jump all over the place. Rebalancing is a dangerous practice. Prudent investors should be adjusting their stock allocations in response to valuation shifts.
Shiller also showed that long-term returns are predictable. Look at the P/E10 value that applies today and you can have a good sense of where stock prices will be 10 years from now.
But even Shiller’s breakthrough findings don’t let us predict stock returns precisely. We can identify a range of possible long-term returns. And we can assign rough probabilities to each point along the range. But we cannot know in advance what the return will be at any particular point in time. The return pattern by which high valuations will be pulled down to fair-value levels remains unknown.
Today’s P/E10 level is 27. A regression analysis of the historical return data shows that the most likely annualized return starting from that P/E10 level is 1 percent real. But there’s a 20 percent chance that we will see a return of 4 percent real or better and a 20 percent chance that we will see a return of a negative 2 percent real or worse.
To be a bull is to have optimistic expectations of how stocks will perform in coming days. To be a bear is to have pessimistic expectations.
The point of the seemingly outrageous claim that I make in the headline of this column entry is that Shiller’s 1981 research (and all of the research that followed from it over the past 34 years) dramatically changed our understanding of what it means to be optimistic or pessimistic re future stock returns. In the old days, all we knew was that the average long-term return was 6.5 percent real. An expectation of a return greater than that was optimistic (bullish) and an expectation of a return less than that was pessimistic (bearish). Given what the last 34 years of peer-reviewed research has added to our understanding of how stock investing works, it is an expectation of a return of greater than 1 percent real that is bullish and an expectation of a return of less than 1 percent real that is bearish.
Given that context (that is, given what Shiller’s “revolutionary” [his word] research adds to our knowledge base, Shiller is a bull.
If Shiller believed that the long-term return on stocks was going to be less than 1 percent real, he would not be advocating a high stock allocation today. Shiller has said publicly that he expects a stock crash soon (in fact he predicted a stock crash for the year 2014 that did not come). So, relative to most other investing experts, he is very much the bear that he is perceived to be. But Shiller has also said that he believes that a stock allocation of 50 percent makes perfect sense today. He has even said that he could see how young investors with a willingness to take on more risk than most might go with stock allocations of more than 50 percent. These statements show that Shiller foresees a return of more than 1 percent real, perhaps a return as high as 4 percent real. Given the spectrum of long-term return possibilities revealed by his research and the research that followed from it, Shiller’s current expectation is bullish indeed.
Shiller is a bull!
You didn’t know that, did you?
I’ll tell you something even more amazing.
Shiller doesn’t appreciate how bullish he is.
My argument that Shiller is a bull is a numbers-based argument. It’s not a complicated argument. It’s simple. You just run the regression analysis and you look at the numbers generated and that’s that. Given the possibilities, Shiller is optimistic. Shiller is a bull.
In future days, I think it really will be that simple. But today it is not.
We’ve known what Shiller’s research shows for 34 years now. But as a society we have not yet processed it into our understanding of how stock investing works. Shiller published the research. So you would think that he would be the first to process it. He probably will indeed be one of the first. But Shiller lives in the same society as all the rest of us. There is a Social Taboo in place today that keeps us all from going too far in our thinking about how Shiller’s breakthrough findings changed things. Shiller holds back (as we all do) from exploring the implications of his findings in too much depth.
He knows that today’s valuations suggest lower returns on a going-forward basis. But he is reluctant to go through the math exercise that I put forward above. Rob Arnott once observed that a lot of investment analysis is simple math but that most of us remain wary of performing the simple acts of addition and subtraction that would help us so much if we dared to break the taboo. Shiller has gone farther than most of us. But he has not yet worked up the courage to take his ideas as far as someday he and the rest of us will take them.
Shiller is a bear compared to most investment experts of today, who ignore the import of the last 34 years of peer-reviewed research.
Shiller is a bull compared to most investment experts of tomorrow, who will employ the simple math that we need to have the courage to apply to achieve the potential advances in our understanding to which Shiller’s 1981 research pointed.
Rob Bennett recorded a podcast titled At First Valuations Don’t Matter At All, Then They Matter Big Bunches, Then They Don’t Matter At All Again. His bio is here.