Robert Shiller surprised me with comments he made in a recent interview with Yahoo Finance. He pointed out that “we’re overdue for another recession” and characterized a recent moderation in house price gains as a “sign of weakness.” However, he added that “I wouldn’t expect something as severe as the Great Financial Crisis coming on right now.” According to Shiller, “There could be a significant correction or bear market, but I’m waiting and seeing now.”
These words confuse me. The focus is on the housing market. In fact, the article reporting on Shiller’s views did not contain any discussion of today’s high stock prices and the role that they might play in making the next recession a moderate one or a severe one. My view, which has been greatly influenced by Shiller’s work, is that it is impossible to assess the likelihood and severity of possible recessions without taking into consideration stock valuations.
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In the old days (before Shiller’s 1981 research discrediting the Efficient Market Theory), the stock market was not viewed as a driver of the economy. If stocks are always priced properly, the risk of a big price drop is the same at all times and there is never a time to be particularly concerned that stock prices will fall hard and remove trillions of dollars of consumer buying power from the economy. But Shiller showed that that old understanding of how things work needs to be updated. He observed in his book Irrational Exuberance, published in March 2000, that: “"If, over some interval in the first decade or so of the twenty-first Century, the U.S. stock market is going to follow an uneven course down, as well it might - back, let us say, to its levels in the mid-1990s or even lower - then individuals, foundations, college endowments and other beneficiaries of the market are going to find themselves poorer, in the aggregate by trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country."
The suggestion here is that, if excessive stock prices are the product of irrational exuberance rather than of economic realities, they can change suddenly and dramatically and for no good economic reason. If it is investor psychology that causes stock prices to rise to very high levels, a shift in investor psychology can cause trillions of dollars of wealth to evaporate. That of course leaves millions of consumers with less money to spend on goods and services, forcing an economic contraction.
That’s what happened in 2008, isn’t it? Weren’t we just seeing the prediction in Shiller’s book quoted above play out in the real world? I understand that several non-stock-related explanations were given for the economic crisis and that these focused on real-estate-related developments. But it has always been my thought that the primary driver was the high stock prices that applied at the time. Money is fungible. High stock prices made millions of people feel artificially rich for a time, causing them to bid up real estate prices to an extent that they otherwise would not be able to. And the loss of the stock market wealth made those same people feel uneasy with their level of commitment to real estate investments.
I have been concerned that today’s stock prices, which are nearly as high as those that caused Shiller to write the words quoted above, will cause a repeat of the 2008 crisis. At some point, stock prices will return to fair-value levels. When they do, trillions of dollars in spending power will disappear into thin air and the economy will contract.
Shiller seems to be discounting that possibility in the words of his recent interview. I of course hope that he is right to do so. Another economic contraction of the magnitude of the one we saw in 2008 would come as a serious blow so soon after we recovered from what Shiller refers to as “the Great FInancial Crisis.” However, I have a hard time understanding why he did not even give consideration to today’s high stock prices in his (admittedly brief) examination of the question.
High stock prices represent a threat to economic stability. Is that not so? It certainly seems to be so to me. I consider it one of the most important implications of Shiller’s work that he showed how stock gains that are built on passing investor emotion rather than hard economic realities hurt us all when the emotion shifts. Shiller is not saying different in the words of his recent interview. But his failure to even mention the stock valuations aspect of the question makes me wonder a bit whether he views the role of stock valuations in causing economic contractions in the way that I have long believed he does. Perhaps Shiller will provide greater clarity re his views in a future interview.
I am a tiny bit reassured to hear his words, in any event. A soft recession would be a lot easier for us to take than a repeat of what we saw in 2008. I am not personally persuaded that a repeat of 2008 is off the table, But I would like to believe it is. And, if there is anyone who possesses a strong understanding of both the stock market and real estate aspects of the question, it is Shiller.
Rob’s bio is here.