Robert Shiller tells a story in his book about a woman who warned him prior to a television interview with him to be careful what he said because his words could cause stock prices to fall hard.
The Wealth Held By Stock Investors Is Imaginary
Shiller's book is titled “Irrational Exuberance.” He was awarded a Nobel prize for showing with peer-reviewed research that much of the wealth held by stock investors is imaginary. Stock prices do not reflect the economic realities, as the Buy-and-Holders believe. To the extent that stocks are priced above their fair-value price (the price that would put the CAPE value at 16), they reflect only passing investor emotions, nothing real and permanent.
What would happen if Shiller were to give a speech so powerful as to persuade all of the investors of the world of his case. U.S. stock prices would fall overnight by 50 percent. That would certainly be a show of the power of his ideas. But would it be a good thing? The millions of people who saw their retirement plans fail probably would not think so. The owners of the hundreds of thousands of businesses that went under probably wouldn’t think so. The millions of workers who would be thrown out of their jobs probably wouldn’t think so. The policymakers who would be left with the task of picking up the pieces of a broken country probably wouldn’t think so.
This Shiller fellow did something very important. But did he do something good?
I think he did something good. But not obviously good. You need to think about the matter a bit to see the good that lies beneath the surface.
When I read the passage about the woman interviewer and her warning to Shiler (I have reread the book several times), I wonder whether Buy-and-Holders are ever given similar warnings. Was there ever a television interviewer who warned Jeremy Siegal not to make too convincing a case for his “Stocks for the Long Run” thesis or else he might cause stock prices to rise even higher? Somehow I don’t think that that ever happened.
Fall in Stock Prices Is A Good Thing
We think of increasing stock prices as a good thing and of falling stock prices as a bad thing. But it is not so. The subtitle of Shiller's book describes his ideas as “revolutionary.” I believe that the most radical idea that he brings to the table is the idea that a lowering of stock prices is on many occasions a good thing. We all are better off knowing the true value of our stock portfolio. The best stock price is the fair-value stock price. That’s the stock price we would see after a 50 percent drop from today’s stock price. Yikes!
Could a 50 percent price drop be a good thing? In a theoretical sense, it would absolutely be a good thing. No one can plan her financial affairs without knowing the true and lasting value of her holdings. So our entire economy would operate more smoothly if we could bring the CAPE value down to 16. But it is not reasonable to ignore the ocean of pain we would experience as a result of that happening. Financial gains that are the product of irrational exuberance are not real. But the pain that is felt in the process of doing away with irrational exuberance is very real indeed.
If only we had known about irrational exuberance before this bull market got off the ground!
Shiller's Research Findings
I look forward to the day when all investors are familiar with Shiller's research findings and have spent some time thinking though their far-reaching implications. Once that happens, I don’t see how we could ever again experience a runaway bull market. The long-term return on stocks drops as stock prices increase. So investors knowledgeable enough to act in their self-interest would find high-priced stocks less appealing and would lower their stock allocations as prices increased. Stock prices would be self-regulating in a world in which Shiller's research findings were widely appreciated.
That’s obviously not the world we live in today. So today those of us who have spent some time coming to grips with what Shiller's work signifies are forced to hope for two opposite things. We are hyper-aware of the risk that we will soon experience another economic crisis and pray that we can be spared it for another week, another month, another year. At the same time, we understand that the only true safety lies in getting that darn CAPE value down, which would require bringing that price crash and the economic crisis that would follow from it on.
Is Shiller a success? He is a wild success according to the usual understanding of the concept. But there is one sense in which Shiller has been an abject failure. The point of Shiller's book was not to teach us to celebrate irrational exuberance but to teach us how to contain it. That we have not done. Stock prices have never stayed so high so long as they have in the years since Shiller showed so compellingly the danger of high stock prices.
Part of the problem is that those making Shiller's case always feel a need to pull their punches. No one wants to be the person who goes on a television interview and speaks with such power as to cause millions of retirement accounts to be wiped out.
Rob’s bio is here.