Valuation-Informed Indexing #392 on why Shiller is unique among some who predicted the economic crisis of 2008 and how that applies to investing
By Rob Bennett
A Buy-and-Hold friend of mine (a severe critic of Valuation-Informed Indexing) recently posted a link to a paper that Robert Shiller published back in July of 1996. The title is “Price-Earnings Ratios as Forecasters of Returns: The Stock Market Outlook in 1996.” I found the discussion that followed intellectually stimulating because both of us were happy to look at the paper today, more than 20 years after its publication. My Buy-and-Hold friend felt vindicated that time had shown Shiller to be wrong in his core belief that it is possible to predict long-term stock returns. I feel that time has shown that Shiller got a lot more right than he got wrong and I was happy to see that Shiller was more willing to speak boldly about the far-reaching implications of his seminal research in those days than he generally is today.
The Bedford Park Opportunities Fund returned 13.5% net of all fees and expenses in the second quarter of 2021, bringing its year-to-date return to 27.6%. Q2 2021 hedge fund letters, conferences and more In the fund's second-quarter investor letter, which ValueWalk has been able to review, Jordan Zinberg, the President and CEO of Bedford Read More
Shiller states: “Looking at the diagram, it is hard to come away without a feeling that the market is quite likely to decline substantially in value over the succeeding ten years; it appears that long run investors should stay out of the market for the next decade. Is this conclusion right? How can we reconcile it with the widespread public impression that the random walk hypothesis is at least approximately true?”
I cannot imagine a more provocative statement. All people who work for a living depend on the stock market continuing to provide an annual return of something in the neighborhood of 6.5 percent real for their hopes of someday being able to retire to come true. And here is a Yale economics professor (later awarded a Nobel prize!) is telling them that those hopes are built on sand. It would be unsettling for him to say that the market return from 1996 forward would likely be only 5 percent or 4 percent. But he’s not saying that. He is predicting a return of less than zero! He is going against what pretty much all other experts of the time were saying. The vast majority of experts were recommending Buy-and-Hold strategies. They were telling investors just to put their money in stocks and to forget about it, that the only way to lose as a stock investor was to question the merit of always remaining one. Shiller, in stark contrast, was telling investors to “stay out of the market for the next decade.” These are shocking words.
You would think that we would all be able to agree today whether the conventional view of how stock investing works or Shiller’s radical departure from it is the right one. 22 years have passed. That’s enough time to tell whether a prediction that goes out 10 years has proven out or not, isn’t it?
For the ten years following, the market provided an annualized real return of 5.9 percent, and investors who stuck with their Buy-and-Hold strategy through today did even better — their return for 22 years was an annualized 6.5 percent real. In the eyes of my Buy-and-Hold friend, Shiller’s prediction clearly and simply failed and his ideas as to how the stock market works were discredited. Shiller’s ideas are wrongheaded. It’s that simple.
I don’t see it that way. In my view, Shiller got a lot more right than he got wrong. In 2008, we experienced the second worst economic crisis in U.S. history. Shiller predicted that crisis in a book he published in March 2000. An economist who can predict an economic crisis eight years before it happens, thereby giving policymakers time to avert the crisis, is doing us all a world of good. And of course the prediction that we would experience an economic crisis came from the same place as the prediction that returns would be negative for the ten years following July 1996 — Shiller’s belief that valuations affect long-term returns. Who really cares whether the price crash arrived in 2004 (two years within the 10-year window beginning in 1996) or in 2008 (outside the window by two years). The crash and the economic crisis that followed from it happened and it hurt all of us and Shiller warned us about it and told us what we needed to know to avert it. That’s heroic stuff. That’s what matters.
My Buy-and-Hold friend would not be impressed by that argument. The crash of 2008 didn’t hurt investors who stuck with stocks, in his view. Those who invested for the long run ended up with fine long-term returns, price crash or no price crash. I can certainly see why many find that argument persuasive.
But I find the fact that prices went back up following the 2008 crash more alarming than reassuring. If you believe that Shiller is right that stock prices are determined primarily by investor emotion, you don’t trust high prices no matter how long they remain in effect. The return from 2000 through today has been only 3.4 percent real, about half of the long-term return that has applied through the entire history of the U.S, market and that most investors are counting on to bring their portfolio balances to levels they need them to reach to finance their retirements. The 3.4 percent is a positive number. So in one sense it is not nearly as distressing as the negative return Shiller predicted for the 10 years following July 1996. In another sense, though, it could be argued that it is just as bad or perhaps a bit worse — the poor return period that we are living through today has lasted 18 years. Each year that we miss out on the compounding returns phenomenon to the extent that we expected to benefit from it sets us further back in our efforts to finance our retirements before we run out of time to do so.
And of course the killer is that stocks are today priced at more than two times fair value. If prices were to return to fair-value levels in the near future, we would all see our portfolio balanceds reduced by 50 percent. I doubt that there would be too many saying that Shiller has been wrong about the take that he has been offering on the dangers of stock overvaluation if we were all to live through the economic and political turmoil that would follow from a 50 percent price crash.
It should be possible to say today whether Shiller knows what he is talking about or not. He made public pronouncements that permit him to be held accountable. Events did not play out in the manner in which he predicted they would play out. That much is beyond dispute.
But things have not played out in the manner in which the Buy-and-Holders expected they would play out either. I don’t recall any Buy-and-Holders predicting the 2008 economic crisis, as Shiller did. I am confident that my Buy-and-Hold friend would have ridiculed anyone who predicted in January 2000 that the return for the next 18 years would be half of the normal return. I know because every prediction I have made in his presence that there will be a price to be paid for our collective irresponsibility in letting prices climb so high has been ridiculed.
The differences between Buy-and-Holders and Valuation-Informed Indexers are fundamental. One school of thought sees all price increases as the product of a strong economic growth engine. So they are always a good thing. And there is no end to the goodness of higher prices. If higher prices are good, even higher prices are even better. The other school of thought sees price increases beyond the ordinary annual price increase of 6.5 percent real as the product of investor emotion. Excess gains represent money stolen from the future to support greater spending in the present. To this way of thinking, big return years are years in which we all agreed to keep quiet about our collective irresponsibility because we didn’t want to miss out on the temporary fun ourselves.
Failed predictions or no failed predictions, the debate as to how the stock market really works continues.
Rob’s bio is here.