Robert Shiller - A Cautious Outlook For Stocks
July 9, 2010 - Robert Shiller, Arthur M. Okun Professor of Economics, Yale University, is interviewed by Dan Richards, ClientInsights.ca.
Highlights/Transcript
Robert Shiller: Valuations are on the cautious side.
Its hard to predict the market.
A) His work comes from long-term historical studies on price-to-earnings ratios,
B) The iffy situation in the world economy right now.
First, P/E ratios - on his website, Shiller has his P/E ratio plotted, which is Price divided by 10-year earnings, going back to 1881.
RS: Its [Shiller P/E] had many ups and downs, and it is a little bit on the high side, today.
Dan Richards: The normal thing to do is to compare the price to the last 12 months of earnings, or forecast earnings. Why does Shiller focus on 10-year of past earnings, adjusted for inflation?
RS: Twelve-month earnings are too volatile, and tied up with recessions - suppose we went a little further and went to quarterly earnings - as the denominator, then we would have blown up in many cases; recently they've been negative. We've never had a year of negative earnings on the S&P, but we sure could some time and then the isn't even defined.
I think a ten year average is a sensible, conservative benchmark for what the fundamental value of earnings power of companies is.
DR: It takes up the short term fluctuations.
RS: In my work with John Campbell, we found that in going back to 1881, that ratio seems to predict future ten year returns; its not just predicting the next day or next month, it's long term.
When the ratio has been very high like it was in 1929, or 2000, it did badly. And when it was low, like it was in 1920, or 1933, or 1980, 1982, those were times when the market did very well.
Its simple. What goes up, comes down.
DR: What's the long term average price-to-earnings multiple based on ten years earnings?
RS: It's about 15 times, depending on which period you're looking at. If you raise your sample period up to [the year] 2000 it would be higher than that.
The ratio got up to 46 [times 10-yr. earnings] in 2000. That's when he wrote his book, "Irrational Exuberance."
I [Shiller] thought that something was amiss then; turns out, [he doesn't like to make forecasts like this all the time], when it gets so wild and crazy, its time to write a book.
The long-term average is about 15 times.
Our [Shiller's] measure currently points to 22 times 10-yr. earnings. It's high, but its not super high.
DR: Wharton's Jeremy Siegel contends that the earnings of the market have been dramatically altered by the financial crisis, in companies like AIG and other financial firms (i.e. banks). To what extent does that skew the results of the "Shiller P/E"?
RS: It's certainly true that the market's earnings have been exceptionally volatile recently, as he said, we just had a quarter of negative earnings, but he thinks it would be difficult to be systematic in correcting for that because going back a hundred years, its happened before; they've had write-offs, they've done funny things.
I don't know that anyone can be authoritative, making judgements like that.
DR: The second point that Siegel made is in relation to the interest rate environment. His comment was that, based on his research, that periods that have high interest rates, the [market] P/E multiple, historically, has been much lower, and in periods of low interest rates, such as we have today, that multiples, the normal multiples, that is, would be significantly higher, and that we should be adjusting for that in terms of what a fair value is. What's Shiller's view on that?
RS: This is a complicated point. One thing is whether we look at nominal or real interest rates. He assumes that Jeremy Siegel is looking at real, like the TIPS in the US or the inflation index. But we don't have a history of that before 1997.
Look at nominal rates. If you look at nominal long-term rates and you compare them with the P/E ratio back to 1881, there were periods where it looked Jeremy was right, but it hasn't been consistently right. I think that's a half truth.
The other thought is, okay, long term interest rates are very low now, so that would seem to say, the stock market is very high, and also commodities and everything else should be high. There's some truth to that, but the other question is, how reliably are those long term rates going to stay low?
The real question that people really want to know the answer to is how do we forecast the market?
I don't think that anyone has found that long term rates offer a significant way of forecasting the market.
DR: Last question. You mentioned that the long-term average multiple is 15 times 10-year earnings, currently its about 22 times, which you said, is a bit on the high side, not egregiously... Based on that, what kind of returns could investors expect over a 10 year period, coming from an environment like the one we're in today?
RS: Based on our forecasting regressions, its a tough call, whether stocks or bonds will pay more over that period. Its not an inspired time.
The Campbell-Shiller forecasting regression suggests positive returns, but not teriffic.
