I wrote last week about an article recently published by Robert Shiller in which he observes that: “In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases and the price of the equity asset should appreciate, assuming all other model inputs stay constant. So, interest-rate cuts by central banks may be used to justify higher equity prices and CAPE ratios.” The article concludes that: “Despite the risks and the high CAPE ratios, stock-market valuations may not be as absurd as some people think…. With interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.”
Q3 2020 hedge fund letters, conferences and more
Low Interest Rates: A Cause For Greater Concern
I argued that today’s low interest rates should not be offering stock investors relief from concerns over today’s high stock prices. I see it just the other way. Today’s low interest rates are cause for greater concern. There is today pressure for stock prices to fall and for interest rates to rise. If stock prices start to fall, the Federal Reserve does not have the option available to them to lower interest rates to hold off a price collapse. The combination of high stock prices and low interest rates is the worst of all possible worlds.
Shiller’s argument comes as a surprise. He is of course known as the most prominent critic of high stock prices alive on the planet today. Yet in this article he is offering comfort to investors who are going with high stock allocations and who would like to tune out Shiller’s many warnings of the dangers of doing so at times of high stock prices. He writes that: “despite the risks and the high CAPE ratios, stock-market valuations may not be as absurd as some people think…. With interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.”
Shiller offered a tell when he used the phrase “in traditional financial theory” to make his case. Shiller’s research undermines traditional financial theory. His work challenges our fundamental understanding of not only how stock investing works but of how the broader economy works. In traditional financial theory, investors are rational. In the post-Shiller understanding, they are not. If traditional financial theory worked and investors were rational, we wouldn’t see a CAPE of 32 in the first place. So it is a little silly to employ traditional financial theory to make sense of a CAPE of 32.
Distinguishing Short-Term And Long-Term Timing
It is also odd that Shiller claims that interest rates are “low and likely to stay there.” Shiller’s breakthrough insight was the need to distinguish short-term timing and long-term timing. Market timing got a bad name because of Fama’s research showing that short-term timing doesn’t work. Analysts who failed to distinguish the two forms of timing rashly concluded that long-term timing doesn’t work either. But of course that is not so. Short-term timing doesn’t work because stock prices are determined by shifts in investor emotion and such shifts are highly predictable. Long-term timing works because the market must get prices right eventually and so knowing how far prices are off the mark at one point in time tells you how hard the pull will be bringing them back to fair-value levels in the long term.
We cannot predict the short-term direction of interest rates any better than we can predict the short-term direction of stock prices. But we can predict the long-term direction of both. When interest rates are a good bit lower than their norm, the odds are that they will be moving in the direction of their norm in the long run. Interest rates may remain low for some time. But they will not remain low indefinitely. And, when they rise, that will put downward pressure on stock prices. It’s the long run that matters. That should be Shiller’s focus.
Irrational Depression Will Replace Irrational Exuberance
If stock prices fall hard, there is a good chance that irrational exuberance will be replaced with irrational depression. There is a chance that we will be underpricing stocks and that that underpricing will be doing us economic harm. Reassuring today’s investors that sky-high CAPE levels are not absurd will make the job of dissipating that irrational depression all the harder because it makes it more likely that the price crash will come as a surprise.
It is my view that we should be doing nothing to reassure investors about today’s high stock prices. Investor concerns are appropriate. We should let those concerns be felt and hope that they serve their purpose of bringing stock prices down a good bit. Shiller seems to be twisting himself into a bit of a logical pretzel to justify stock prices that should not be justified. We don’t want a price crash. But the longer we keep prices up, the more likely it is that it will take a devastating price crash to eventually pull them down. Once prices reach these heights, a significant price drop is best for everyone.
My guess is that Shiller is trying to justify high stock prices today because he has been warning of their dangers for so long and has seen his earlier predictions of price crashes not come to fruition. I know the feeling. Still, it is not Shiller’s fault that the price crash has been so long in coming. His earlier warnings were appropriate. Sometimes dangers appropriately warned of do not come to pass for a long time. The thing to do is to continue with the warnings until they do, not to join in on the majority’s complacency re the dangerous circumstances that prompted the warnings.
Rob’s bio is here.
