Shiller Did Not Say U.S. Stocks Are 30% Overvalued

by: Andrew Butter
The headline on The Business Insider says that “according to Professor Shiller’s” website…Stocks are 30% Overvalued” . That story is now being picked up here and there.

Read the small-print; notice they didn’t say that Professor Shiller “IS” saying that stocks are over-valued. There is a difference.

The evidence for this “alarming” state of affairs is the Good Professor’s website, where you can go and look up his analysis, on an Excel spreadsheet that is helpfully in the public domain and kept up-to date.

Shiller’s chart shows the ratio of what he calls the cyclically adjusted P/E ratio [CAPE] which is today’s price divided by the average of “Real” earnings (adjusted for inflation) over the past ten years.

TEN years!

The logic that says the Stock Market is 30% overvalued is that “CAPE” today is 22, whereas the historical average of CAPE is 16.

If you read his lips, what Professor Shiller does say is price should bear some relationship to earnings, which is a perfectly reasonable and logical thing to say.

What he does not say is that you can use CAPE as a sure-fire reliable tool to work out the “fundamental” value of the stock market. Neither does he come out on Prime-Time television, like for example Professor Roubini and periodically declare that the recent rally in the markets from the low in March 2009 was a “Dead-Cat-Bounce-Sucker-Rally”.

If you count Roubini’s calls on the stock market as part of his “record” for “getting it right”, he scores a hit rate of about 10% on his predictions, with about 30% proven to have been 100% wrong. Sure, he predicted the credit crunch, but with a track-record like that, the snide remarks that some people make (not me) of “A Broken Clock is right twice a day”, are not totally unfair.

If Professor Shiller did do something like that, I would be the first to stand up and declare that he was dead-wrong.

But (a) he did not and (b) he is a scientist, and like all scientists what he does is “Measure First” then “ Talk about it”, as opposed to what appears to increasingly pass for main-stream economics these days, which is “Talk about you big new theory first”, then “Measure”.

CAPE is an interesting measurement, but it is not a valuation, and Professor Shiller never said it was. There are about twenty logical disconnects between getting from CAPE to a valuation of the “fundamental” of the stock market, here are two:

1: Efficient Market Hypothesis

The so far unproven “assumption” there is that collectively markets can figure out the “fundamental” value, and that any changes in the circumstances of the market-place are magically and instantly “priced in”.

Apart from the fact that the body of evidence that markets are very often not efficient is, hugely, more than the evidence they generally are; that logic relies on the “assumption” that there is at least one person in the herd who knows what he is doing (and then the herd all follow him).

Well that may be true, but is it’s probably not Professor Shiller, and more to the point, he has never ever given any indication that it is him. Which begs the question…who is it? Who is the genius that invariably, and instantly knows what the correct price is, and that the herd all follow….by instinct?

2: Do you value a company based on the past ten year’s earnings?

In a word….no you don’t, and you don’t value five hundred companies that way either.

When you value a company, one way (there are others) is to try and figure out (or guess) what the earnings will be in the future, and then work out the Net Present Value of those anticipated earnings.

Then you discount those using a yield that is chosen (by you), that reflects [a] the cost of money (the 10-Year or 30-Year Treasury yield is a good place to start), plus [b] your idea of the risk premium the market add-on (not what you think, what the market thinks) to cover the fact that your crystal-ball soothsaying prediction might in fact be wrong.

Sure, the average, and / or the trend-line of the past ten years of earnings is, most certainly interesting, but it’s not the ONLY thing you think about, by no means.

And one thing you shouldn’t do (if you are smart) is just blindly draw out a trend-line, and say things like some geniuses were saying in 2006….“based on the current trend line which has a 99% correlation (against time), house-prices are going to go on going up forever”.

Is CAPE “Wrong”?

No it’s not, it is what it is.

But just because you come up with a “tool” and people use it to shoot themselves in the foot (most of the people who did not buy into the markets starting March 2009 were following some re-incarnation of the CAPE logic), should not mean you are liable.

Although there again, I wouldn’t rule out some creative lawyers coming up with a Class-Action against the Good Professor for causing them to miss the rally (plus triple damages for the emotional anguish).

Professor Shiller is one of the heroes of this great big mess, his house-price index (which he developed with Professor Case), is one line of data that everyone believes, and is rigorously scientific. His general observations on how markets get mispriced; are all spot-on; plus one thing that I really like about his style, is that he has a website, anyone can go there, anyone can download data, and anyone challenge or discuss what he is talking about. That’s what Martha Stewart calls “A Good Thing”.

But putting words into his mouth is simply disrespectful.

Is the market 30% over-priced?

In my (humble opinion), I don’t think so; my view is it’s still below the “fundamental”, although that doesn’t mean it’s not immune to a 20% reversal, particularly once the DOW gets to 12,000.

Why is a lot more complicated than just looking at CAPE.

Disclosure: "Neutral US Stock Market"