Robert Shiller is a Yale economist who won the Nobel Prize in 2013 for his empirical work on asset pricing. He’s pioneered work in behavioral finance and narrative economics and is well renowned for correctly predicting the stock market crash of 2008.
The above chart is based on Shiller’s CAPE price earnings ratio. This ratio adjusts for inflation and business cycle variations. According to the CAPE ratio, the market is currently more highly valued than during Black Tuesday. The only time the market has been more highly valued was during the dot com boom. And we all know how that ended.
We can also see how stocks are overvalued by looking at total market cap divided by GDP which is known as the Buffet Indicator. According to Warren Buffet, this is “probably the best single measure of where valuations stand at any given moment.” Since GDP generally fluctuates much less than the stock market, this can be a good way of predicting future returns.
So it is perhaps puzzling that this recent Market Watch article “Sky High Stock Prices Make Sense” by Shiller argues that stocks are not currently overvalued due to certain narratives and low interest rates.
Indisputably, asset markets are substantially driven by psychology and narratives. As the Nobel laureate Daniel Kahneman wrote, “familiarity breeds liking,” and several familiar narratives have emerged in the world’s stock markets this year, following the initial COVID-19 shock in the first quarter.
For example, there is the V-shaped recovery narrative and the FOMO (fear of missing out) narrative; both might be helping to drive markets to new highs. There is also the work-from-home narrative, which has specifically benefited technology and communication stocks.
Shiller is correct to say that a V-shaped recovery narrative and FOMO may currently be contributing to high equity valuations, but it does not follow that stocks will remain elevated or that the V-shaped narrative is actually correct.
Arguing that FOMO justifies high asset prices seems dubious to say the least. Normally, FOMO is a key ingredient preceding the burst of a bubble.
For starters, many were arguing that we were already entering a recession before the pandemic hit. While those calls may have been premature, it seems doubtful that the economy can recover as quickly as the stock market suggests, especially given that we are nearing 400,000 dead Americans.
The market is basically pricing out the possibility of a double dip recession, which given rising Covid cases and new potential lockdowns on the horizon seems risky.
As economist Stephen Roach points out, the markets are only focusing on Fed policy of keeping interest rates at zero for the indefinite future. But interest rates were already extremely low back in February 2020 when markets were at all time highs preceding a massive crash.
Shiller argues that low interest rates justify higher valuations:
Thus, the level of interest rates is an increasingly important element to consider when valuing equities. To capture these effects and compare investments in stocks versus bonds, we developed the ECY, which considers both equity valuation and interest-rate levels. To calculate the ECY, we simply invert the CAPE ratio to get a yield and then subtract the 10-year real interest rate.
This measure is somewhat like the equity market premium and is a useful way to consider the interplay of long-term valuations and interest rates.
Essentially, Shiller is arguing that because stocks are cheap relative to bonds (due to low interest rates) valuations aren’t as absurd as they might be considered in isolation. But as Mark Hulbert points out, “In an econometric model that includes both the Buffett Indicator and real interest rates, lower rates are associated with lower subsequent 10-year returns — not higher.”
In fact, whether looking at price earnings ratio, CAPE, or the Buffet Indicator, Hulbert’s metrics paint a bearish picture of an overextended market. “Far from allowing us to wriggle out from underneath the bearish weight of that overvaluation, today’s low interest rates add fuel to the fire.”
Persistently low interest rates indicate that the markets expect future economic growth to be anemic at best.
— Mark Hulbert
Shiller mentions that the recent Covid vaccines could be reason for optimism. I am certainly optimistic, since anything that reduces the death toll from this pandemic should be greeted positively. But the market already priced in vaccines months ago. And much of the bear case for 2019 was that the market was already overvalued and due for a recession.
Politics are relevant for market valuations. Recent Democratic victories in Georgia are both positive and negative for markets. On the positive side, there are signs of increased stimulus, which can ameliorate decreased consumer spending in a recession. 2020 was one of the first recessions where consumer spending actually increased due to stimulus checks.
Nevertheless, there could be potential for much needed anti-trust regulation against the largest corporations in the US. This could be extremely bearish for markets, as the above chart shows. Almost all of the bullishness over the past year is from the top 5 tech companies in the S&P500. The S&P 495 is still in a bear market down trend as of late 2020.
Finally, Shiller is known for his work on narrative economics. The core idea here is that narratives drive economic activity, especially financial activity. But Shiller should know best of anyone how quickly narratives can change. A double dip recession narrative could overshadow a V-shape recovery narrative if economic data, especially employment data, turns south.
None of this is to predict doom and gloom. The bull market could continue for months or even years. Trying to predict an exact turn around for the market is fruitless. Nevertheless, Shiller should not abandon his own CAPE measure’s warning that this market is clearly overvalued in early 2021.
Disclaimer: This article is not intended as investment advice.