ROBERT SHILLER: NOBEL PRIZE WINNING ECONOMIST – Transcript 2/21/2014 #1035

February 21, 2014

CONSUELO MACK:  This week on WealthTrack, financial thought leader and Yale professor Robert Shiller won the Nobel Prize for economics for his ground breaking work on market bubbles. Where does he see bubbles developing now?  Robert Shiller is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Over the years we have had the great privilege of interviewing Yale economics professor Robert Shiller on WealthTrack. And for many of those years the scuttlebutt was that Bob would one day win a Nobel Prize for his ground breaking work on market psychology and bubbles.  Well last year he did just that. He won the Nobel Memorial Prize in economic sciences. As the New York Times put it:

“the Nobel committee described professor Shiller as a founder of the field of behavioral finance, an innovator in incorporating psychology into economics and a pioneering analyst of speculative bubbles in the stock and real estate  markets”.

 

Shiller is the Sterling professor of economics at Yale University and Professor of Finance at the Yale School Of Management. He is the author of numerous books and articles including two editions of Irrational Exuberance which correctly identified the developing bubbles in the stock and housing markets. He is the co-creator of the widely cited measure of U.S. housing prices, the Case-Shiller Home Price Index and creator of the Cyclically Adjusted PE Ratio, known as the CAPE Ratio which is a price earnings ratio for the S&P 500 based on average inflation-adjusted earnings from the previous 10 years instead of just one year’s earnings. Because it includes ten years of earnings many consider it to be a more reliable gauge of market value. Bob is one of those extremely rare individuals who combines research and analytical brilliance, with creativity, entrepreneurship, investing skills and a love for teaching. Plus he is one of the nicest and most self-effacing people you will ever meet.

 

A classic example: this winner of the Nobel Prize in economic sciences laments that “economics is not an exact science!”

 

ROBERT SHILLER:  That term, “economics is not an exact science”, goes back over 100 years to Alfred Marshall who said that, and I’m trying to piece together what he meant, but it seems to me that economics is … the approximations in any theory are much greater, and they are theories about people, so economic forecasting is very different from, say, forecasting the weather or forecasting sunspots or whatever because people can just change their mind and defy you. People are smart and they have feelings. Economics is usually some kind of story that we tell that we think approximates reality, but we can get carried away with our stories.

 

CONSUELO MACK:  Which explains why bubbles happen, and we’ll get to that in a moment.. How much is market performance determined by psychology?

 

ROBERT SHILLER:  I think that if you look at the aggregate stock market, most of the fluctuations are due to psychology. If you look at individual stocks, it’s not quite that bad.  It’s still bad but not quite that bad because often there is information that people have that an individual stock is going to go down or it’s going to go up, and the market prices are reflecting new information.

CONSUELO MACK:  What are you basing that assertion on, that much of the broader market … I’m talking about what the Dow does or the S&P 500 does, what the broader market does … that much of that is attributable to human behavior, to psychology?

ROBERT SHILLER:  There’s a whole revolution in academic finance that has taken place over the last few decades.

CONSUELO MACK:  Right, and you’ve been leading it as a matter of fact.

 

ROBERT SHILLER:  Richard Thaler and I have regular workshops. We have hundreds of papers presented. It’s difficult to summarize all of this evidence. Some of the evidence is experimental where they put people in an economics laboratory, and they watch them trade. Some of it is based on extrapolation of results from psychology lab experiments. Some of it comes from neuroscience now. It’s discovering how the mind works, and some of it comes from statistical analysis of speculative prices that shows a forecastable element to them.

 

CONSUELO MACK:  The economic establishment in academia is very much wedded to the other theory which is the modern portfolio theory, the efficient market theory. Is there anything rational? Is there anything efficient in the markets from your point of view?

 

ROBERT SHILLER:  Definitely yes. I teach efficient market theory to my students, and I consider it a half truth. Let me put the true side of it. It almost becomes obvious maybe that if you’re going to be the average investor, you’re going to have the average performance. If you want to outsmart the market, you have to try harder. You have to maybe be smarter, and that’s not … you know, a lot of people are trying hard.

 

CONSUELO MACK:  Yes, they are.

 

ROBERT SHILLER:  And so don’t assume that it’s going to be easy. If that’s the efficient markets theory, I’m completely in agreement with it, but I think that much more has been read into it than that. What seems puzzling to me is that there is an assumption that comes up in a lot of academic discussion as if there aren’t any people who are just trying hard and smarter and more organized and look at the data and look for things that other people haven’t found.  That should work. There’s a lot of literature showing, for example, that mutual funds can’t beat the market. You must be aware of them.

 

CONSUELO MACK:  Yes, very.  You said that the efficient market theory, it’s a half truth. So part of it is true in that the average market performance, right, you will get an average market performance.

 

ROBERT SHILLER:  Well, I have to warn students, and this is something that Eugene Fama and I and others are in agreement on, that there’s a misconception that amateur investors fall into that they see the market going up, and they say, “Oh, that’s obviously a trend that’s going to continue,” but as Eugene Fama and other show that the day-to-day movements don’t really continue. I mean, it’s just random, mostly random on a day-to-day basis, so lots of people have to be told that, because when they look at a plot of stock prices, they think it looks obvious that there’s a trend there, but it’s not true for the stock market because there’s a lot of smart people playing that market.

 

CONSUELO MACK:  Why do you think that academia is so wedded to the efficient market theory?  Why is it treated as orthodoxy?

 

ROBERT SHILLER:  For several reasons. One of them is economic theory thrives on the assumption that people are rational, because there’s some core theory about scarcity of resources and technology and marginal costs. It all fits into a rational story. You start bringing in psychology, it’s just kind of messed up. When I first started teaching, someone said, “Present a nice elegant lecture, and don’t say ‘on the other hand’ too much. The students don’t like that and, by the way, the incentive in academia is to get good student evaluations, and that will even go into your tenure decision. So don’t confuse them.  Right? We’re the econ department, they came here, they didn’t come to hear psychology. Anyway, that’s part of the story in academia.  Another part of the story I suspect is sour grapes. We’re not making a lot of money, and so we conclude that it’s not possible to do that.

 

CONSUELO MACK:  How did you overcome that?

 

ROBERT SHILLER:  Well, I’ve just never been someone who fits in well with the crowd. I’ve always been skeptical. Maybe it’s because I took psychology and sociology courses. I married a psychologist, too. I hear other views, and I always thought that in any profession this is what psychologists called ethnocentricity. That goes back to William Graham Sumner, a 19th century sociologist/economist. They used to be the same thing in those days.  So you develop a connection with another group, say, a department in the university, and you develop a “we’re right and they’re wrong” attitude. It’s just human nature.

 

CONSUELO MACK:  So what if you’re looking at the economy, for instance, or the markets today. We’re an investment show, so let’s look at the markets. What are you particularly skeptical about?

 

ROBERT SHILLER:  Right now today?

 

CONSUELO MACK:  Yes.

 

ROBERT SHILLER:  Well, I think that valuations in the market are high, but I’m not extraordinarily skeptical. They’re not super high.

 

CONSUELO MACK:  I mean, you’re …

 

ROBERT SHILLER:  And also the housing market is zooming up, and I’m starting to worry about … the housing market, by the way, is much less efficient than the stock market. It shows strong momentum. It just goes up every month lately. According to the S&P/Case-Shiller home price indices that I developed with Karl Case and Standard & Poor’s, it went up over 13 percent in the last 12 months. That’s pretty fast. What’s going on?  Why would they be going up so much?

CONSUELO MACK:  You tell us.

 

ROBERT SHILLER:  Yeah, well, it’s complicated.  This is another reason why I think it’s not an exact science. There’s too many things going on at once. It’s not like in a lab you can set up your apparatus and you know exactly what’s happening.

 

CONSUELO MACK:  What home buyers are going to do and home sellers are going to do.

 

ROBERT SHILLER:  There’s no way to do lab work. I mean, you can try, but it’s hard to do lab work. So things are happening that the government in the United States is supporting in the housing market. Recently 90 percent of new mortgages were guaranteed by the government.

 

CONSUELO MACK:  Fannie and Freddie. Right.

 

ROBERT SHILLER:  So I have to predict that, and then institutional investors are getting into buying homes more. Foreign investors. I’m supposed to figure out what all these people are going to do?

 

CONSUELO MACK:  Yes.

 

ROBERT SHILLER:  See, this is why it’s not an exact science. Could there be an exact science of forecasting what you’re going to have for dinner tonight?  No, there can’t. You’re going to have whatever you feel like for dinner tonight, but I can’t have a science of forecasting that. It’s the same problem with forecasting the markets. They depend on people and they depend on changes in thinking and changes in attitudes.  There’s an intelligent part of it, but part of it is just whimsical. It’s animal spirits. When I think of what drives bubbles, and I talked about this in Sweden when I was arguing with Eugene Fama, but it’s like …

 

CONSUELO MACK:  Your fellow Nobel Prize winner.

 

ROBERT SHILLER:  What you have to appreciate is there are so many plausible stories you can tell about markets why we’re entering a new era. If you hire a writer, a finance or economics writer, at any point in history this is a creative writing project.  Write a story that says we’re entering a new era where stocks are going to do really well. They can do it.  They can write. They don’t do it all the time. It’s in a boom time when…

 

CONSUELO MACK:  That these stories come out.

 

ROBERT SHILLER:  Yeah, with the feedback between price increases and stories. People love these stories when prices are going up. I’m sounding a little bit more cynical than I should perhaps.  I think that we have a news media of dedicated people, and it’s maybe a little bit more subtle than I just made it, but what does happen is that after the stock market has been going up for a while, people remember that the stock market has always outperformed other investments. They have forgotten that when it was going down. It’s that kind of thinking that drives a lot of market fluctuations.

CONSUELO MACK:  We’ve had a phenomenal bull market after the 2009 low. Of course, we forget how we got to the 2009 low after a while. So what’s the story, the prevalent story do you think about the stock market right now?

 

ROBERT SHILLER:  Let’s go back to 2009.  I do questionnaires surveys of investing. You can see them on my website, the results, and I have something that’s called the Crash Confidence Index. I just ask people, “Do you think that something like the 1929 crash is possible?” and I have an index of how many people think that.  That index reached an all-time low in 2009 which means that I know that even though the market was low, people were telling me they were worried about a crash happening going into the future. Since then, it’s rebounded. They’ve given up on that, and so the market came back, and then … the next story is that the stock market leads the business cycle. Everyone says we’re having a disappointing recovery, but the stock market … you don’t want to wait until recovery is secure and established.  You want to buy early, so that’s what people have been doing, and then they’ve been propelling it up, and it starts attracting enthusiasm as it always does during a bull market.

 

CONSUELO MACK:  So isn’t that a healthy phenomenon, and isn’t that something that as investors that we can take advantage of if we see confidence increasing?  Isn’t that a reason to be invested in the stock market?

 

ROBERT SHILLER:  Well, I’m working on that I think it’s hard to predict in the short run. One thing, momentum, upward momentum has been identified in the stock market. There’s a nice long academic literature, but it’s weak. It’s not as strong as you’d think.

 

CONSUELO MACK:  You mean weak as a predictor of where stock prices are going to go?

 

ROBERT SHILLER:  Yeah.  I think there is some upward, but that will peak out and surprise you and go down.  So I don’t have a good science. I wish I did, but it’s easier for housing. Housing shows much more momentum. So right now home prices are going up rapidly. I kind of think they will for another year or more, maybe not as rapidly. So if you’re thinking of buying a house, and you don’t care between this year and next, maybe you should do it this year, but I don’t want to make too much of that, because even that market is unpredictable.  So this comes back to I teach …by the way, I have an online course which anyone can take.

 

CONSUELO MACK:  Coursera. Right?

 

ROBERT SHILLER:  That’s starting. Well, it’ll be running from mid February to mid March.

 

CONSUELO MACK:   So we’ll make sure we have it on our website so that the audience can …

ROBERT SHILLER:  But I’m maybe not the best teacher, because I keep saying “on the other hand” too much.

 

CONSUELO MACK:  But it is kind of Finance 101?  Is it a basic finance class?

 

ROBERT SHILLER:  It is. It’s basic finance.

CONSUELO MACK:  So Bob, are you invested in the stock market right now?

ROBERT SHILLER:  I am.

 

CONSUELO MACK:  How would you describe your attitude towards the stock market right now personally?

 

ROBERT SHILLER:  I have something like 50 percent exposure, you know, half of my assets in the stock market.  I’m looking at it from a value perspective. I have a value index which is a conventional value index, and then I have sector indexes that are low priced.

 

CONSUELO MACK:  And so what are the low-CAPE sectors right now, the lowest-CAPE sectors?

 

ROBERT SHILLER:  So right now the four sectors that my colleagues at Barclays and I have identified are health care, industrials, consumer staples and now technology again. Those are the sectors that I think are substantially better prospects in the aggregate market.

 

CONSUELO MACK:  Interesting that technology is now one of the best values in the market.

ROBERT SHILLER:  Well, things come and go. You know, I did a long study of sector performance in the United States, and what about railroads?  That was a sector that people wrote off like 80 years ago. They thought it’s a declining sector because we had automobiles and airplanes. So what about railroads?  They’re dying. But you know what? They come in and out. There are times when railroads are great investments and times when they’re not. It’s all price relative to some fundamental, and I’ll tell you a great time to invest in railroads was at the beginning of this century, right after the stock market crashed, right around that time. Railroads were cheap, and they did very well.

 

CONSUELO MACK:  And guess who bought them?  Warren Buffett bought some railroads.

 

ROBERT SHILLER:  Warren Buffett.

 

CONSUELO MACK:  Exactly

 

ROBERT SHILLER:  So when people approach investing with prejudices rather than just looking at value, looking at what company is well managed and has a proven record and just compare the price for that, that’s not always so easy to do, but there are approaches to doing that.

 

CONSUELO MACK:  So how actively do you trade?

 

ROBERT SHILLER:  Not very active. I don’t trade very often.

 

CONSUELO MACK:  You don’t.

 

ROBERT SHILLER:  Because it’s costly to trade, and that’s one lesson now I’ve learned from various advisors.  A lot of people eat up their profits with trading costs.

 

CONSUELO MACK:  What are the signs that you look for in the market that are going to tell you that the market is really over valued?

 

ROBERT SHILLER:  Well, it may not be extremely clear and extremely obvious.  I have this CAPE ratio, but I don’t think it’s extremely obvious right now. It’s somewhat high, but then look at the alternatives.  The interest rate is zero on the short rate at least, and long bond yields are low, so it’s not giving such clear signals right now. This is another reason why it’s difficult to beat the market. Sometimes you might have a way of judging the market that gives you a buy and sell signal once every 10, 20 years. You can’t make a career of that.  It doesn’t come along often enough.

 

CONSUELO MACK:  Right, but individuals can.

 

ROBERT SHILLER:  Well, yeah, so I do think that in 2000 the market looked really overpriced, the stock market, and then in 2005 the housing market looked really overpriced, and now it’s not as clear in either of those cases.

 

CONSUELO MACK:  So I think there’s one market that you said it’s pretty clear that it’s in a bubble and that’s the bitcoins market.

 

ROBERT SHILLER:  Yeah, right.

 

CONSUELO MACK:  So what’s going on? I mean, is this a fascinating phenomenon for you?

 

ROBERT SHILLER:  Well, bitcoin is fascinating, because it represents a new computer technology for transferring funds. That’s interesting. The actual bitcoin experiment has generated competitors, and I think that maybe something good will come from this. I wish that they could produce a medium of exchange that had more stable value, but I think that …

 

CONSUELO MACK:  More stable value that the dollar, the currency right now.

 

ROBERT SHILLER:  Well, more stable than the bitcoin. It’s wildly unstable.

 

CONSUELO MACK:  Oh, okay, right, right.

 

ROBERT SHILLER:  But I think what’s happening is that people are attracted to bitcoin partly out of envy for people who make a lot of money including the inventor of bitcoin who reputedly is a billionaire.

 

CONSUELO MACK:  I love it. Reputedly.

 

ROBERT SHILLER:  That’s the story anyway.

 

CONSUELO MACK:  That’s the story.

 

ROBERT SHILLER:  We don’t even know who he is.

 

CONSUELO MACK:  Exactly.

 

ROBERT SHILLER:  And the other thing is that it appeals to people who have a kind of feeling of friction with the government, and I have the same feeling every time it’s income tax time. I know what you mean, so somehow it would be nice if you could just cut the government out of your life.

 

CONSUELO MACK:  But the bitcoin, you know, this phenomenon of bitcoins, is this indicative of anything bigger going on in society or in the markets, or is it kind of a one-off speculative?

 

ROBERT SHILLER:  Well, big things are happening because of new technology, and they will change finance and change everything, but I actually admire people who experiment, and bitcoin was certainly a provocative experiment, but I don’t think that it’s the final product yet.  We’ll see what happens.

CONSUELO MACK:  One investment for a long-term diversified portfolio. We ask all of our guests at the end of every WealthTrack.

 

ROBERT SHILLER:  I’ll tell you what I did around the time I was last on your show in March.  Invest in Italy, and I’ll have to say first.  I’m not Italian. In fact, it’s a little bit of faint praise for Italy, but it is praise for Italy, but their …

 

CONSUELO MACK:  Why Italy?

 

ROBERT SHILLER:  Because their market is priced so low. Their CAPE as we calculate is among the lowest in Europe.  Now, it’s come up a little bit since I bought, but I think it has a ways to go.

 

CONSUELO MACK:  And there’s a particular ETF I know that you said that you bought. Right?

 

ROBERT SHILLER:  EWI.

 

CONSUELO MACK:  Right, the MSCI. Right, the iShares Italy Index.

 

ROBERT SHILLER:  So it all comes back to value investing, and I’ll put it like if I were an Italian American, but I’m not, so I can praise Italy all I want. Italy is a great country. It’s only 60 million people, so that’s like one percent of the world, but you hear about them all the time. We love their food. Maybe they have the best cooking in the world. Now, I like French cooking. It’s a little bit more pretentious. Italian cooking, it’s just we all love. They love it in China now and everywhere. If it’s not their cooking, it’s their whole civilization… they did the Renaissance. They did ancient Rome.  So let’s not write them off too fast. They’re going through a hard time right now, a definitely hard time. I just think they’ll be back, and that’s value investing.

 

CONSUELO MACK:  While Rome burns, Bob Shiller is in here buying the Italian index. Bob Shiller, Professor Shiller from Yale and Nobel Prize winner, thank you so much for being with us on WealthTrack, and congratulations, Bob, on winning the Nobel Prize. It is so well deserved.

CONSUELO MACK:  At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point:

Beware the signs of irrational exuberance and market bubbles wherever they occur. As Bob Shiller has pointed out they can occur in non-traditional market niches as small as bitcoins, or as we learned the hard way in stock sectors such as technology, or major segments of the economy such as the housing and credit markets. The signs are always the same: irrational exuberance driving prices far above the underlying fundamentals. If you want to see this interview again, past programs or our additional segments done exclusively for our website’s extra feature please go to wealthtrack.com. And for those of you on Facebook and Twitter we look forward to connecting with you. In the meantime have a great weekend and make the week ahead a profitable and a productive one.


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