- Dr. Shiller deserved the Nobel Prize.
- Shiller's CAPE ratio appears to have little predictive power and is usually bearish.
- CAPE ratio and other "predictive" measures of stock prices will be victims of their own success.
I was the biggest cheerleader for Yale Professor Robert Shiller to win the Nobel Prize in economic science. I think his first and revised editions of Irrational Exuberance were wonderfully written persuasive pieces about why the dot com and housing bubbles were bound to blow up. Yet, his repeated appearances on CNBC and his recent New York Times op-ed saying that his 25-year-old theory predicts an immanent crash of the U.S. stock market (NYSEARCA:SPY), (NYSEARCA:VOO), and (NYSEARCA:DIA) is running the risk of irreparably damaging his reputation.
By Dr. Shiller's own admission, his Cyclically Adjusted Price Earnings, CAPE, ratio has said the stock market was overvalued for the past 20 years. The only time this ratio dipped below its long-term average was during the stock market crash of 2007-2009. At best, it seems that this ratio might signal a once-in-a-generation buy signal. I won't provide a critique of this theory here. See another op-ed from the New York Times for a good discussion on the foibles of this ratio.
The whole idea that a decades-old study widely known and discussed has any predictive power seems foolhardy. If market participants are aware some data point has predictive power, then they have every incentive to incorporate that measure into market prices. There is almost no chance that people have not looked at the CAPE ratio by this point and are already incorporating it into prices. At my fund, Oxriver Capital, and other quantitative funds, portfolio managers are always looking for measures that are undiscovered or poorly understood predictors of the stock market in a reasonable time horizon. Yet in most cases, these "alpha factors" only work if very few market participants recognize them. Perhaps the CAPE ratio could have been considered predictive when he and his coauthor, Professor John Campbell, first unearthed it. Predictive factors work very poorly out of sample, especially if they are widely recognized. The size and book-to-market anomalies unearthed by Ken French and the man with whom Professor Shiller shared his Nobel Prize, Professor Eugene Fama, is a notable example of a theory that has not been as good out of sample.
Dr. Shiller is running the risk as painting himself as a "perma-bear." His bubble predictions look less prophetic if he always says a bubble is around the corner. Even the economist who has been tarred the most, possibly unfairly, by the "perma-bear" label, "Dr. Doom," Professor Nouriel Roubini has recently expressed his opinion that the U.S. economy is actually looking like it is in a robust recovery.
Dr. Shiller should worry about not having his reputation destroyed in the way that another Yale economist did with his public statements over eight decades ago. Ironically, Professor Shiller criticized former Yale professor Irving Fisher in the former's latest op-ed. The CAPE ratio talk for Robert Shiller may turn out to be as damaging to his reputation as Irving Fisher's statement on the eve of the great crash of 1929 that "stock prices have reached what looks like a permanently high plateau." Dr. Shiller should take care that his reputation is not diminished by his own over exuberant public statements.
Additional disclosure: I manage the hedge fund Oxriver Capital.