Robert Shiller's Bubble Vision
By this point one mainly reads Robert Shiller’s “Irrational Exuberance” for the prefaces. In the preface to the first edition, published in March 2000, the Yale economics professor argued that “the present stock market displays the classic features of a speculative bubble.” In the second, published in March 2005, he warned about “the enormous home price boom that many countries have been experiencing since the late 1990s.”
The third edition is out this month. This time Shiller expresses surprise that even “the bursting of the speculative bubbles that led to the 2007-9 world financial crisis” hasn’t really sobered us up.
[E]vidence of bubbles has accelerated since the crisis. Valuations in the stock and bond markets have reached high levels in the United States and some other countries, and valuations in the housing market have been increasing rapidly in many countries.
Never fear, though. Things are “not yet generally as extreme” as in 2000 or 2005. So we’re safe for a few years, right?
Well, not necessarily. Shiller has been making the TV rounds lately to promote the book, and the conversations always seem to turn to investment tips (buy European stocks -- even Greek ones -- and sell U.S. equities). Calling market turning points has never been the man’s strength, though. Yes, the first edition of his book did come out the same month that the dot-com bubble began to deflate, but that had more to do with the slow-moving ways of the book-publishing business than any magical prescience on his part. He had been warning about overpriced equities since 1996, and as Brad DeLong and Konstantin Magin of the University of California at Berkeley, pointed out in 2006, the subsequent decade was, on balance, pretty good for buy-and-hold investors.
In the new “Irrational Exuberance” preface, Shiller notes the objections that the University of Chicago’s Eugene Fama -- with whom he shared the Nobel prize in economics in 2013 -- has long raised to those who speak of market bubbles. If a bubble is defined as “an irrational strong price increase that implies a predictable strong decline,” Fama said in his Nobel lecture, then there’s not much evidence that such things exist. Replies Shiller:
If that is what bubble means, and predictable means that we can specify the date when a bubble bursts, then I agree with him that there may be little solid evidence that bubbles exist. But that is not my definition of a bubble, for speculative markets are just not so predictable.
Shiller’s big contribution to academic finance was to point out that speculative markets, while perhaps not “so predictable,” are at least a little bit predictable. Stock prices move around a lot more than such corporate fundamentals as dividends, earnings or book value. This means that when prices are markedly higher or lower than normal relative to those fundamentals, they will eventually revert to the mean.
This may seem to you like something of a “no duh” finding, but when Shiller started publishing his stock market research in the early 1980s, it went directly against the then-reigning academic consensus. Here’s University of Chicago finance professor John Cochrane (who also is Fama’s son-in-law, for whatever that is or isn’t worth) in his 2011 presidential address to the American Finance Association:
In the 1970s, we would have guessed exactly the opposite pattern. Based on the idea that returns are not predictable, we would have supposed that high prices relative to current dividends reflect expectations that dividends will rise in the future, and so forecast higher dividend growth. That pattern is completely absent. Instead, high prices relative to current dividends entirely forecast low returns.
The “low returns” Cochrane was talking about are over a 15-year time horizon. During shorter periods there’s actually lots of positive momentum in stock prices, and I would guess that any professional money manager trying to make his or her decisions over a 15-year time horizon wouldn't remain a professional money manager for long.
These predictabilities that Shiller has documented, then, really aren’t all that useful in figuring out what the market will do next week, next year, or even during the next five years. What they are useful for is understanding that financial markets inevitably overshoot, and that for all their brilliance in ferreting out and processing information, they’re just as stumped as anybody by the great information vacuum that is the future.
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