Shiller’s Research Doesn’t Permit Us to Predict the Future, It Permits Us to See the Present More Clearly

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Robert Shiller’s Nobel-prize-winning research permits us to predict future stock returns. There’s a strong correlation between the CAPE value that applies today and the annualized real return that we will see for stocks over the next 10 years. It is something that all stock investors should be taking into consideration when setting their stock allocation. When the CAPE value is 8 (as it was in 1982), the most likely annualized return is 15 percent real. When the CAPE value is 44 (as it was in 2000), the most likely annualized return is a negative 1 percent real. Investors clearly do not want to be going with the same stock allocation in both sorts of circumstances.

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Few Investors Take Advantage Of Shiller's Research

However, few investors take advantage of Shiller’s breakthrough research. I have discussed Shiller’s research with thousands of investors over the past 19 years and it is only about 10 percent of them who take valuations into consideration when setting their stock allocation. The other 90 percent believe that they would be engaging in market timing to do so (this is of course true) and believe that market timing is a bad idea (this is not). I believe that a big part of the resistance to the idea is skepticism that it is possible to predict the future.

What makes it hard to accept that market timing is a good idea is the reality that valuations cannot be used to know in advance how stocks will perform one year or two years or three years into the future. The strong correlation between CAPE values and returns applies only at the end of 10 years (returns are even more predictable 15 years out and 20 years out). The intuitive thought is that it would be harder to predict the return that will apply 10 years out than it would be to predict the return that will apply one year out. If the one-year return is not predictable, it seems a dubious proposition to engage in market timing based on a prediction of what returns will be 10 years out.

The reality is that Shiller’s research does not permit us to predict the future, it permits us to see the present more clearly. Shiller showed us the need to make a distinction between stock gains rooted in economic realities (such as increased productivity) and stock gains rooted in nothing more than irrational exuberance. Stock gains rooted in economic realities last forever and can be counted on when one is planning one’s financial future. Irrational exuberance gains are fake and temporary. They disappear into the mist when investor emotions swing in a new direction.

Two Consequences

There are two consequences that follow from this reality.

One, it is not necessary for the investor engaging in valuations-based market timing to make any guesses as to events that will take place in future days. Buy-and-Holders frequently assert that, for timing to work, an investor must guess right on when stock prices will fall and then guess right again as to when they will rise again. But this is not so. The reason why long-term timing always works is that the purpose is to keep one’s risk profile constant over time. Stocks become more risky at the moment that prices increase. The investor does not need to wait for prices to fall to benefit from making an allocation shift. He restores his proper risk profile at the moment he makes the allocation change. The CAPE level is not telling him what will happen in the future; it is merely telling him that his current stock allocation is no longer appropriate for an investor with his risk profile.

Two, it is not reasonable to think that timing would work over short time-periods. It is of course theoretically possible that timing could pay off within one or two or three years. But there is no way to know in advance that that will happen. The thing that will cause prices to fall is a shift in investor psychology. The fact that investors set prices too high for a time shows that they are irrational. It is not realistic to expect investors to regain their rationality according to any particular schedule. Rational price levels are always restored. So the market timer can have a high degree of confidence that his effort at market timing will work. But he cannot have hardly any confidence whatsoever that it will pay off in any specified time-period.

The reason why market timing is such a valuable strategy is that it is a virtual lock that prices will revert to the mean. It is the core purpose of a market to set prices properly. So, when an investor sees that the CAPE value has traveled far from its fair-market value of 17, he can have a high degree of confidence that it will be moving in the direction of 17 in coming days. What he cannot know is when that will happen. We would have to be able to see into investor minds to know when a shift in investor psychology will take place. We have to be satisfied to know that sooner or later it will take place and not concern ourselves with when it will happen.

We cannot see into the future. But the CAPE value tells us something of great importance about the present. It tells us when stock prices reflect reality and when they do not. It obviously makes sense to own more stocks when prices reflect reality than when they do not. So today’s CAPE value is knowledge of great practical value. We make a mistake, though, when we start thinking that the CAPE value permits us to see into the future. Give in to the temptation to think about market timing in that way and your efforts to engage in it will likely prove disappointing.

Rob’s bio is here.