“I’m not predicting that the market is going to fall 12 percent or 50 percent. (And if I did, you should stop reading this column.) As (Nobel Laureate) Mr. Shiller says, ‘There is no way to predict the future.’”, David Leonhart, New York Times
“Tell that to the FDIC, who thought I alone should have been able to foresee the unprecedented housing, mortgage and financial crisis in mid-2007!!!”, Mike Perry, former Chairman and CEO, IndyMac Bank
Time to Worry About Stock Market Bubbles
MAY 6, 2014
With relatively little fanfare, the stock market has become expensive again.
While the rest of economy has been growing frustratingly slowly for almost five years, stocks have been rising at a boomlike clip. An investment in the Standard & Poor 500-stock index would have doubled from early 2009 through early 2013 and then gained an additional 18 percent over the last year.
Relative to long-term corporate earnings – and more in a minute on why that measure is important – stocks have been more expensive only three times over the past century than they are today, according to data from Robert Shiller, a Nobel laureate in economics. Those other three periods are not exactly reassuring, either: the 1920s, the late 1990s and in the prelude to the 2007 financial crisis.
Wall Street, of course, can always come up with justifications for high stock prices. Remember: The Internet changes everything. Or:The business cycle has been repealed. Some of the current justifications even have a ring of reality to them.
Robert Shiller, seen here in 2009, says people are too quick to believe that the present differs from the past. Credit Peter Yang
Today’s economy seems almost perfectly built to raise stock prices. Economic growth is weak enough to keep interest rates low, which both reduces corporate costs and makes stocks seem more appealing than safe, low-return investments. And despite the mediocre economy, corporate profits are fairly strong, because companies have the upper hand on workers today and wage growth is modest.Inequality, in other words, tends to be good for stocks.
It’s possible that a world of rising inequality and low interest rates is here to stay – and that stocks have reached a permanently high plateau. In that case, whatever our other economic worries, the stock market’s valuation doesn’t need to be high among them.
An Expensive Stock MarketRelative to corporate earnings over the previous 10 years, the Standard & Poor’s 500-stock index is still less expensive than over much of the last 15 years. But it’s more expensive than at any other time over the last century, save the 1920s.
S.&P. 500-stock index, divided by average earnings over previous 10 years, inflation adjusted
Source: Robert Shiller, Yale University
Yet any argument that depends on the notion of a new paradigm is one you should treat with a healthy amount of skepticism. Those arguments are usually wrong. They were wrong in the 1920s, when the economist Irving Fisher coined the phrase “permanently high plateau” to describe stocks. They were wrong in 1999, when the book“Dow 36,000” appeared. They were wrong in 2007, on the eve of the financial crisis.
“You can always think of reasons of why now is different,” Mr. Shiller told me, when I called him recently to ask his view of today’s stock prices. “But maybe the mind is too creative in thinking of how it’s different.” As John Campbell, a Harvard economist who has collaborated with Mr. Shiller, puts it, “One should be skeptical of ‘This time is different’ arguments.”
We obviously can’t know which way stock prices are headed. But the evidence, as I read it, suggests that stock prices are now high. The best assumption – for retirees, future retirees, other investors, pension-plan managers, federal budget analysts and anyone else whose life depends on stock prices – is that returns in coming years will be modest at best.
If the historical comparisons here surprise you, it may be because you are used to a different yardstick for the market’s valuation. The most commonly cited measure is a price-earnings ratio that compares the current price of stocks to the earnings of the underlying companies over the past year.
The problem with this measure (which also shows that stocks are expensive, but less severely) is that a year isn’t a very long time. Judging a company’s long-term future based on the last 12 months puts too much weight on fleeting factors, like the current state of the economy or a company’s latest product.
That’s why the classic 1934 textbook “Security Analysis” – by Benjamin Graham, a mentor to Warren Buffett, and David Dodd –urged investors to compare stock prices to earnings over “not less than five years, preferably seven or ten years.” Ten years is enough time for the economy to go in and out of recession. It’s enough time for faddish theories about new paradigms to come and go.
Mr. Shiller picked up the Graham-Dodd thread and has long published on his web site a version of the price-earnings ratio that compares current stock prices to average annual earnings over the last decade. He shared the Nobel Prize in economics last year for “empirical analysis of asset prices.”
The 10-year price/earnings ratio has as good a record of any stock-market measure in warning about excess. More broadly, when the ratio reaches 25, roughly where it is now, disappointment tends to follow. The average inflation-adjusted return since 1871 (the first year for which Mr. Shiller has data) in the five years after the ratio equals 25 or higher is negative 12 percent. After stocks get expensive, a correction typically follows.
I’m not predicting that the market is going to fall 12 percent or 50 percent. (And if I did, you should stop reading this column.) As Mr. Shiller says, “There is no way to predict the future.”
Sometimes, the economy really can change in important ways. Maybe stock prices will be somewhat higher in the 21st century than in the 20th. Mr. Campbell, for example, notes a couple of plausible explanations for higher stock prices: the lack of recent world wars, for example, and the spread of stock ownership to a larger group of investors, which distributes risk more broadly.
But none of these changes are likely to rewrite the rules of economics in a fundamental way. Based on history, stocks look either very expensive or somewhat expensive right now. Mr. Shiller suggests that the most likely outcome may be worse returns in coming years than the market has delivered over recent decades – but still better than the returns of any other investment class.
So don’t be tempted (or terrified) by the siren song of a rising market. For most people, the sensible path is still to find a low-cost way to save for retirement, typically through diversified index funds. And given where the market now is, you should err on the side of conservatism.
The fact that the last three decades have witnessed one bull market after another shouldn’t fool you into thinking that the next three decades will.The Upshot provides news, analysis and graphics about politics, policy and everyday life. Follow us on Facebook and Twitter. A version of this article appears in print on May 6, 2014, on page A3 of the New York edition with the headline: Maybe It’s Time to Worry About Stock Market Bubbles.