Shiller Should Return to Making Long-Term Return Predictions

Shiller Should Return to Making Long-Term Return Predictions

Valuation-Informed Indexing #400

By Rob Bennett

I wrote here recently about how Robert Shiller made a prediction in July 1996 that did not come close to proving out. He said in a paper titled “Price-Earnings Ratios as Forecasters of Returns: The Stock Market Outlook in 1996.”  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.” Shiller couldn’t have been more wrong. The annualized real return for the ten years following the day that Shiller made that prediction was 5.9 percent. From the time that he made the prediction through today, the return has been 6.5 percent.

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Shiller has been reluctant to offer such predictions in recent years even though valuation levels are now higher than the ones that caused his alarm back in 1996. In several interviews, he has disdained market timing. He indicated in one interview that, while he once believed that some forms of return predictions were possible, he no longer does. He did not say what caused the change in heart but I think that the most likely explanation is that seeing his own prediction fail so spectacularly convinced him that it would be a mistake to try again.

I think that Shiller did a good thing to advance the return prediction he made in 1996. I think he made a mistake when he decided to refrain from making further predictions.

I have personally partaken in the humbling experience of seeing a public prediction fail in spectacular fashion. I wrote a column at this site a number of years back saying that I thought we would see another price crash prior to the end of President Obama’s second term. Things obviously did not turn out that way.. There are a number of critics of my investing work who to this day appear on the comments section of my blog to taunt me about the failed prediction. There have been moments when I wondered whether I should have held back from committing the words of that column to the permanent record of my words that follows me everywhere I go on Planet Internet. So I think I am well positioned to feeling some sympathy for Shiller’s reasons for wanting to get out of the return prediction game.

There’s another side to the story.

I believe that it is possible to make long-term return predictions. I believe that because of the research that Shiller published in 1981 showing that valuations affect long-term returns. If valuations affect long-term returns, the market is not efficient and price changes are not determined by economic realities but by shifts in investor emotions. Those shifts have always caused overpricing to disappear in the long term. So the risk of owning stocks is not static but variable. Stocks are more risky when priced higher and investors need to know how much more risky. Return predictions quantify the added risk. They provide investors who believe that valuations matter guidance on what sort of stock allocation they should be going with at times when prices are temporarily out of control.

Shiller is wrong to suggest that timing doesn’t work. His entire life’s work shows that it must work (at least that’s my opinion). I certainly do not believe that short-term predictions work and I of course fully understand why Shiller would not want to advance predictions for how stocks will perform over the next year or two or three. But, if even long-term predictions don’t work, I don’t see how his work (which caused him to be awarded a Nobel prize in Economics) has value. If valuation levels do not provide guidance as to how much we should change our stock allocations at times of high prices, I don’t see how there is any practical significance to our new-found knowledge that valuations affect long-term returns. Making even long-term predictions is clearly a risky business. But if even long-term predictions do not work at all, the only alternative is to join our Buy-and-Hold friends in sticking with the same stock allocation at all valuation levels.

There are two reasons why it is important for those of us who believe in valuation-informed strategies to offer predictions for how the market is going to perform over the next 10 years or so.

One, it is the fair thing to do. Our Buy-and-Hold friends do not believe that predictions work. Shiller’s research suggests that they should. The Buy-and-Holders are right to seek accountability from those of us speaking from the other side of the table. If we truly believe that Valuation-Informed Indexing is a better strategy, we should demonstrate the courage of our convictions needed to put our names on publicly voiced return predictions. When those predictions fail, it helps the Buy-and-Hold case. And it should. If effective predictions cannot be made, Buy-and-Hold is the best strategy and investors need to know that.

Two, the humbling experience of seeing a prediction fail forces those of us who believe that at least long-term return predictions should be possible back to the drawing board. Shiller got it wrong back in 1996. I got it wrong when I made my prediction after the price recovery of March 2009. As painful as it is to make public mistakes, doing so can bring on a learning experience if we dig deep to discover why we got it wrong. None of us today knows all there is to know about how stock investing works. We all need to be digging deeper all the time. We possess a human inclination to become complacent in our beliefs. Seeing those beliefs fail a public test shakes us out of our complacency.

Rob’s bio is here.

Updated on

Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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  1. I don’t need a link, Sammy. I remember what I said. You can link for the benefit of others if you think that that’s a plus, so far as I am concerned.

    The reason why I changed the data is that we do not know the date. Shiller’s research shows is that it is irrational exuberance, not economic gains, that causes overvaluation. Irrational exuberance is not rooted in anything real, it is just the product of investor emotion. So it never lasts. It always disappears into the mist in time. So it is a terrible mistake to engage in financial planning in which you count stock gains that are the product of irrational exuberance as if they are real money. If you retire based on overvaluation in your portfolio, you are going to pay a terrible price down the line.

    All of that is 100 percent solid, 100 percent of the evidence available to us supports what I said in the paragraph above and 0 percent cuts against it. But what most people want to know is WHEN is this going to happen. That we do not know. All of evidence available to us ALSO shows that short-term timing never works. So we always know which direction prices are headed in the long run and we never know when the price change is going to take place.

    This is why Shiller went 10 years out in the prediction that he made in 1996. He knew what the evidence says and he was trying to be careful. He felt that by going that far out he could get it right. What he said was totally in line with what has always happened before. So I would say that it was a safe prediction at the time he made it. But it STILL did not work out. If prices go down tomorrow, people who followed his advice will be ahead as a result. So his words possessed great value. But the prediction he made failed all the same. It’s easy to get the long-term price direction right, it is very hard to get the precise timing right.

    I do think that my failed prediction is grounds to question VII. The entire purpose of me giving the prediction was to hold myself accountable and the prediction failed. Doesn’t that have to count as credibility taking points away from the strategy that I am promoting? I think that it does. The failed prediction is grounds for taking points away.

    But it’s not like the Buy-and-Holders have been doing at all well with that they are saying. The Buy-and-Holders got the retirement numbers used by millions wildly wrong. They said that a 4 percent withdrawal was “100 percent safe” for those retiring at the top of the bubble. When you do the calculations accurately (presuming that valuations affect long-term returns), the safe withdrawal rate you get is 1.6 percent. Huh? What the f? Those Buy-and-Hold retirement numbers were cited in thousands of newspaper articles. We are likely to see millions of failed retirements in days to come as a result of that little mistake.

    I don’t say that Valuation-Informed Indexing is perfect in every last detail. But we have to invest out money somehow. We can;’t just say “well, I will not invest one penny of my money until there is a model that gets every single prediction right, not one exception!” we are not there and we have to make a choice out of two options. VII got a few predictions wrong in circumstances in which it’s not likely that it will make much difference in the long run. Buy-and-Hold likely caused millions of failed retirements and an economic crisis that has caused serious political frictions in recent years. I choose Valuation-Informed Indexing 500 times over.

    Can I understand how somebody who was right on the line between the two strategies might get pushed to the Buy-and-Hold side of the line because of my failed prediction? I can. If you are right on the line, it would make sense that the failed prediction would push you the other way. That’s why I offered the prediction in the first place. I wanted to provide some accountability. The failed prediction counts against VII, there’s no question about that much.

    Does that help at all?


  2. You predicted a crash much earlier than 2016. You just kept changing the date. After changing the date a few times you then gave a revised timeframe and said that if we didn’t see a crash by the end of 2015, that would be grounds for people to question VII. Would you like a link to those comments?

  3. I was wrong in the prediction that I made. I said that we would see a crash by the end of 2016. I wouldn’t describe it as a “small miss.” I made the prediction for the purpose of being held accountable and the prediction failed. I think that people need to know that. I think it is significant.

    I don’t quite go along with the idea that it blows a big hole in VII. It diminishes the case for it a bit. I think that much is fair to say. But that’s as far as I can go.

    The big issue that divides Buy-and-Hold and Valuation-Informed Indexing is that Buy-and-Holders believe that stock market gains represent something real, they are produced by economic developments, while Valuation-Informed Indexers believes that in circumstances in which valuations are super high they represent only irrational exuberance, they are produced by extremes in investor psychology and cannot be counted on to last. If the Valuation-Informed Indexers are right re that one, that is a very, very big deal. It has implications that affect the continued viability of our economic system. Shiller predicted the economic crisis of 2008. He was able to do that because of what he learned about how stock investing works as a result of his Nobel-prize-winning research. Knowing what causes economic crises and what we need to do to stop them is a very big deal.

    Shiller got a prediction wrong too. So it would be fair to say that the prediction-making aspect of the Valuation-Informed Indexing project has not been working out so hot. The trouble is that we cannot stop making predictions. Shiller was able to foresee the economic crisis because an implicit prediction he made that trillions in consumer spending would disappear when the crazy valuation levels of the mid-2000s dropped to more reasonable levels. Had we all paid attention to what he said in his book, we could have avoided that economic crisis and all the political turmoil that followed in its wake. We need to continue to make predictions about how permitting stock prices to rise too high ends up hurting us all in very big ways. The only way to stop the crazy price jumps is to explain to people how much harm they do to all of us.

    So I strongly believe that we need to continue to make predictions. But I do agree that it’s a dangerous business. I had a prediction that failed. So did Shiller. We need to be very careful when making predictions. We don’t know it all and it is easy to get the predictions wrong. Shiller was careful when he made his prediction and I was careful when I made mine. So even being careful is not enough. We need to be super careful. We need to be humble. We need to realize that we don’t know it all. We need to keep digging into this stuff so that over time we know more and we can be confident that we are able to make predictions that won’t fail.

    I do think you taunt in your comments, Sammy. Not in this particular comments. But you have done it often both in comments you have made here and in comments that you have made at my site. You are helping people when you point out that my prediction failed. That’s a pure positive.But, yes, there have been times when you have pointed it out not in a spirit of trying to learn more about the subject matter but in a spirit of trying to silence me. That’s different. And the reality is that I have been proven right in the story that I have been telling for 16 years 20 times for every time that I have been proven right. I was the person who first posted about the errors in the Buy-and-Hold retirement studies. That was on May 13, 2002. I helped a lot of people doing that. That post was based on a sort of prediction too, one that has checked out. None of us bat 1000. I get a lot more right than I get wrong and I have helped a lot of people by getting the ones right that I got right and I couldn’t make those contributions if I were not willing to take the risk of getting one wrong every now and again.

    That’s my sincere take re this one in any event, my dear friend. I naturally wish you all the best that this life has to offer a person regardless of our differing views on how stock investing works.

    Sometimes Wrong (but Sometimes Right Too!) Rob

  4. Rob,

    I don’t post here to taunt. I post to correct factual errors. As you have pointed out, you have been WRONG about your predictions on the market. That blows a big wide hole in your whole story around VII. It is not just a small missing there is no minimizing how bad this is for the story you have been telling us for the past 2 decades. Instead, it just provides further support for those that have stuck with buy, hold and rebalance.

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