Robert Shiller Transcript 3/29/2013 #940

March 29, 2013

CONSUELO MACK: This week on WEALTHTRACK, what does visionary Yale economist Robert Shiller who predicted the bursting of the tech and housing bubbles, think about stock and home prices now? And why does the author of Irrational Exuberance think bonds are dangerous? Answers from Robert Shiller are next on Consuelo Mack WEALTHTRACK.

 

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. Never look a gift horse in the mouth, or in this case don’t fight the Fed! It is a rare occasion in life that investors are given any degree of certainty for an extended period of time. But such has been the case since late 2008 when the Federal Reserve lowered its key short term interest rate, the federal funds rate, to a record low. Since then, the Fed has reiterated over and over again that it intends to keep short term interest rates “exceptionally low”, at zero to one quarter of a percent “at least as long as the unemployment rate remains above 6-1/2%” and inflation is projected to be “no more than a half percentage point above the Fed’s 2% longer- run goal.”

 

The Fed is also continuing its program of buying mortgage-backed securities, at a pace of $40 billion a month, and longer-term treasury securities at a pace of $45 billion a month to keep long term interest rates from rising. As top ranked economic research firm ISI Group told clients recently, “Fed policy is probably now the most stimulative it’s been in this cycle… and the stimulus is becoming more potent because it’s operating on a much improved economy…”

 

How much has the economy improved? Just look at what’s happening in the housing market. After plummeting from their recent peaks in 2005, housing starts and permits to build homes have taken off in recent months. The widely followed S&P/Case-Shiller U.S. National Home Price Index rose 7.3% percent last year. Then there’s the sluggish job market. While still high, the nation’s unemployment rate has fallen from 10% in October of 2009 to well below 8% now.

Meanwhile the stock market has more than doubled from its March 2009 lows, setting new records along the way.

 

Our guest this week is Financial Thought Leader Robert Shiller and few are more qualified to assess the values to be found, or not found in the stock and housing markets. Shiller is the Sterling Professor of Economics at Yale University and Professor of Finance at the Yale School of Management. His finance course is available on Open Yale courses and we will have a link to it on our website. But he is renowned on several other fronts. An expert on behavioral finance and market risk, he is author of numerous books, including his most recent, Finance and the Good Society, and two editions of Irrational Exuberance– the first published in 2000 warning of the tech bubble and the second published in 2005, raising the alarm about the housing bubble.

 

Shiller is a financial innovator. He is the co-creator of the widely followed S&P/Case-Shiller Home Price indices. He is the creator of the “cyclically adjusted price-earnings ratio, better known as CAPE. Many investment pros believe it is a far more accurate gauge of the stock market’s value than the traditional price-earnings ratio. Last year Shiller and Barclays joined forces and launched a family of CAPE indexes designed to offer investors stock market exposure with a value focus. I began the interview by asking Shiller to assess the stock market’s current value.

 

ROBERT SHILLER: A lot of people emphasize that it set new records lately, but if you correct for inflation, it isn’t even close to a new record because there’s so many different ways to describe the market. What I like to do is look at the price relative to some measure of fundamental value, and I have my own method of doing that. I’ve worked it out with Professor Campbell at Harvard years ago. It’s price divided by 10-year average earnings which I think, for various reasons, is a more sensible definition of value.

 

CONSUELO MACK: And why is that?

 

ROBERT SHILLER: Well, you want to look at it relative to fundamental value. I mean, if earnings have gone up a lot, then you naturally would think that the stock market should go up, too. But of course, if earnings go up very quickly, then maybe you don’t believe that. You want to take a longer average of earnings, and Campbell and I found that when price does get high relative to 10-year average earnings, the market tends to go down afterwards.

 

CONSUELO MACK: So is it high now relative to 10-year average earnings?

 

ROBERT SHILLER: It’s somewhat high, but it’s not super high, so the CAPE ratio- that stands for cyclically adjusted price earnings ratio, which I’ve just described- is at 23 now for the Standard & Poor 500, which puts it high.

 

CONSUELO MACK: Because the average is 15.

 

ROBERT SHILLER: Around 15, yeah, for the last century. That’s high, but it’s not super high. In March of 2000, it got up to 46. That’s twice as high as it is now, and then, of course, we know what happened after that. The stock market ever since has not produced any money in the 13 years since then. Right now, even on a total return basis, inflation corrected, it’s down below the peak of 2000. So it’s a bad sign when it gets really high. Well, it is somewhat high now, and so that’s a bit of a bad sign, but it’s not a horrible sign.

 

CONSUELO MACK: You just mentioned earnings growth, and you’re concerned that the earnings growth that we’ve seen in the last, what, five years has been pretty extraordinary historically and so, therefore, don’t expect earnings to continue to go at the pace they have. Right?

 

ROBERT SHILLER: In the aftermath of the financial crisis, there were a lot of changes. So 2009 was a horrible year for earnings, and then there was this amazing rebound. Now, it’s a complicated reason. One of them is that companies have gone on a cost-cutting vendetta. I mean, they were determined to get those profits back, and so that zooms profits up for a while, but cost-cutting can have long-term consequences that will bring it back down. So I’ve learned to mistrust any sudden surge in earnings, but the market seems to overreact, and that’s what we’ve just seen happen I believe.

 

CONSUELO MACK: So let’s talk about the market overreacting, because one of the things that you’ve written a tremendous amount about, you know, speculation and speculative bubbles, and you also study investor behavior. So talk to me about the fact that investors, who have been shunning the stock market, are suddenly rediscovering it after it’s doubled from its March 2009 lows.

 

ROBERT SHILLER: Well, I think they’re looking at earnings. Earnings are up a lot, and that substantially is driving the market. They’re just not thinking the kind of long-term thinking that I would advocate. They’re not thinking, well, when they shoot up suddenly like this, don’t trust it. That’s a thing that’s missing that people are taking kind of a short-term focus with these valuations. But once again, I have to say they’re not extremely high. It’s not like people are making a historic big mistake. It’s not like 1929, I hope. I hope not.

 

CONSUELO MACK: Or 2000 in the tech market.

 

ROBERT SHILLER: It’s not like 2000, in terms of valuations, but yeah, the market has come back somewhat, and people are… I think maybe they’re tired of worrying. They sense the recovery is underway, and so when they see earnings up, they’re starting to come back into the market, and…

 

CONSUELO MACK: So good idea? Bad idea? Neutral on it?

 

ROBERT SHILLER: It depends on where you were before. If you have all of your saving in the stock market, I think that’s a mistake, but some people had nothing in the stock market. So I think even today, if you have nothing in the stock market, it’s a no-brainer. You should put something into it even though it’s gotten somewhat high, because it can go a lot higher. That’s one thing we’ve learned historically. Historically, even though we’re in kind of an economic slump, that’s no reason why the stock market can’t keep going up. Now, I’m not saying that I know what it will do one way or the other, but I think it would make sense to have some exposure to the stock market. Exactly what depends on your personal circumstances.

 

CONSUELO MACK: You describe yourself as a lifelong value investor, and looking at the CAPE ratio that we just talked about, where are you seeing value now in the stock market? What sectors in particular?

 

ROBERT SHILLER: Well, the sectors that are most undervalued right now are financial. That is the bottom. The CAPE ratio there is only 14, so it’s below average by historical standards, and then you have health care, industrials and energy, which they’re all below average CAPEs right now.

 

CONSUELO MACK: So as a long-term value investor, you’ve actually identified some sectors and those among them that, if you have a low CAPE ratio, this low cyclically adjusted price earnings ratio, that in fact those sectors outperform over the long term?

 

ROBERT SHILLER: Yeah, you can’t say what they’ll do in the next six months, the next year, even the next… you can’t be sure about anything, but historically… I have a research study with my student that takes these ratios back to the 1880s.

 

CONSUELO MACK: That’s a long time.

 

ROBERT SHILLER: And we find that it seems to have worked. This is just value investing of a different form, and I think that looking at this value measure would augment other kinds of value investing.

 

CONSUELO MACK: So the low CAPE ratio sectors, and they’re the same as they have been traditionally, the four that you just mentioned, for instance?

 

ROBERT SHILLER: Oh, it moves around from year to year, but at this point…

 

CONSUELO MACK: Right, but right now the lowest CAPE sectors are what you just said… financials, health care…

 

ROBERT SHILLER: The lowest of them all is financials, and I think that that is kind of an overreaction to this crisis; that this was a financial crisis, and the financial companies did have problems. They still have problems. They’re laying people off, but those difficult moments are the time to go in as an investor.

 

CONSUELO MACK: As hard as that is to do.

 

ROBERT SHILLER: That’s right.

 

CONSUELO MACK: Housing market. You predicted the housing bubble. There has been some recovery in the housing market, you know, housing permits, housing starts. Prices are up. There’s a shortage of inventory in some markets, so what’s your take on the housing market right now?

 

ROBERT SHILLER: Well, this is a very interesting question. Where is it going? In some cities, it looks like we’re back to the races. Phoenix is the best example and some California- Los Angeles, San Francisco- and Las Vegas. There are booming areas. The bigger question, though, is, how long will it last? You know, bubbles do come to an end; and secondly, how pervasive is it? You know, if you’re living in Detroit or St. Louis, do you think is this relevant to me? So I’m careful about making any general remark, but I think that the general perception you get from reading newspaper or watching TV is a little bit too optimistic. I don’t think that we’re off to the races again in most places, and I think that there’s still a risk of declines.

 

CONSUELO MACK: So that’s interesting, because I know you wrote a New York Times editorial recently, and it was “A New Housing Boom: Don’t Count On It.” So what do you think we can count on, considering that’s still the biggest investment for most of us?

 

ROBERT SHILLER: That’s a nice question. In finance, you should never count on any newspaper account about new boom coming. They don’t mean much of anything. That’s one thing I’ve learned. Now, the housing market is a little different than the stock market because it has more momentum, and once it gets going, it goes for a while, maybe another year or more in the same direction, or it could even be longer, but don’t count on it. That’s absolutely the most important investment advice. Don’t get carried away by some sense that everybody knows the market is going to go up. If everybody knew it was going to go up, it would go up immediately.

 

It’s not so sure, not so secure, and at this point, I like to remember with regard to the housing market that something like 90% of our new mortgages are guaranteed by the government through Fannie Mae, Freddie Mac or FHA, and the government is also supporting housing with a mortgage interest deduction that’s under attack now and might get… so we don’t know how long these supports are going to continue. We have a budget crisis. The Congress can’t seem to agree on what to do. So this is another uncertainty.

 

From my mind, the uncertainties are very real, and I think it is not impossible that home prices five or ten years from now could be lower in real terms than they are now, entirely possible. It’s a risky investment like anyone else, but I don’t mean to scare people away from taking risk. This is America. This is a country of entrepreneurs, and I think that it’s okay to buy a house now. Mortgage rates are very low, but just don’t count on it. I didn’t write that. The copy editor wrote that at the newspaper, but I think it was very well chosen. Don’t count on it, and don’t worry if you don’t find it convenient to buy a house now. It’s not like there’s a bonanza that everyone sees and you better pile into it. I mean, take your time. Make sure that you get the right house. Make sure that you really want to settle down now, and if those things are okay, then go ahead and do it.

 

CONSUELO MACK: But otherwise, don’t feel compelled that you have to own your home.

 

ROBERT SHILLER: Don’t get caught into a gold rush mentality. The gold rush people were disappointed, too, if you remember, in 1849.

 

CONSUELO MACK: That could happen again. Bond market. You told me earlier it’s dangerous. You know, it looks really bad. What’s wrong with the bond market as far as you’re concerned?

 

ROBERT SHILLER: Well, right now we have negative real long rates. The inflation-protected securities…

 

CONSUELO MACK: The TIPS.

 

ROBERT SHILLER: …the TIPS, the 10-year TIPS are negative substantially, even now to 15 years we have negative interest rates, real interest rates.

 

CONSUELO MACK: Right, so their yield is lower than inflation.

 

ROBERT SHILLER: Which means you’ll get less back in real terms 15 years from now than you have today. You might say, well, why would anybody tie up their money for 15 years to get a guaranteed negative return? Well, it’s because we are living in a very unusual time and a very sick economy, and a lot of people think, I don’t know what else to do. Now, I can see if you’re very risk averse putting money into TIPS even at a negative rate, and there are some people who are very risk averse, but for most general investors, I think that… I’ve actually extolled TIPS on this show in the past.

 

CONSUELO MACK: Yes, you have. No, and actually they worked out well as an investment in prior years.

 

ROBERT SHILLER: But right now they’re yielding a negative return over the long run, and over the short run it might be even more negative if interest rates go up again.

 

CONSUELO MACK: Right, so now TIPS also have been looked upon as a diversifier and as basically a non-correlative asset. So TIPS do well when the stock market doesn’t do well, for instance. So do they have a place in your portfolio as a diversifier and a cushion against market declines?

 

ROBERT SHILLER: Yeah, they are the riskless rate. They are really riskless, and so I have had them in my portfolio. I might even have a little left at this point but not much, but it’s not going to give you any return, so I think, yes, if you’re really putting money away for 15 years, then the 2028 TIPS are the surest way to know what you will have in 15 years, but it’s not going to be much.

 

CONSUELO MACK: Which is not going to be much.

 

ROBERT SHILLER: I was an advocate for TIPS. I was writing papers on them back in ’97 before they launched them, so I’m happy that we’ve issued them and they are very useful, but we are at the most unusual time in history where they actually have a negative return.

 

CONSUELO MACK: Bond market bubble? Is that what we’re in?

 

ROBERT SHILLER: Yeah, maybe, but I tend to think of the bond market bubble as something that’s been going on for 30 years, because way back when Paul Volcker was Chairman of the Fed…

 

CONSUELO MACK: 1979. I just remember- ’80.

 

ROBERT SHILLER: …we had double-digit interest rates, and nominal interest rates have been just coming down steadily for 30 years, more than 30, and there’s one problem, though. They can’t pass zero. You’ll never have a negative nominal rate, and they’re getting awfully close to zero. I wonder what’s going to happen next. It’s a good question, and real long-term governments have been coming down, too, ex post real which is what you really get from them. They’ve been trending down for decades, and now we’ve hit this financial crisis that is causing a lot of revaluation, and now we have the Fed with QE1, QE2, QE3 supporting long-term bond price and keeping the yields down, and they say that’s temporary, so my guess is long term it’s not exactly a bubble, but it’s an unstable situation. It doesn’t make me enthusiastic about these investments at the moment.

 

CONSUELO MACK: So what do we do, Bob? You’re not a financial advisor, but you do invest personally. So what do we do with our bond portfolios, and it sounds like stocks are less riskier. So what’s your advice to individual investors? What do we do in our portfolios?

 

ROBERT SHILLER: Yeah, it’s an unusual time. In some sense it’s like the Great Depression in the 1930s when interest rates were very low. The long rates weren’t quite as low as they are now, but it was a low interest rate environment as well, and it was a very uncertain time. Everyone was saying uncertainty. So what was the best thing to do? Well, it depended on the time. You know, in 1933 when The Depression looked the worst, you should have gone whole hog into the stock market, because it had a huge boom despite The Depression. So you just don’t know, but my sense is that… you can’t predict the stock market, but I think that the historical evidence suggests that it looks like a better investment than the bond market. It hasn’t been for the last 30 years. The bond market has done wonderfully. That’s because of this bubble, but how long is it going to go on?

 

So I would be inclined to tilt actually more into stocks in my portfolio, which may sound like a contradiction, because I just got through saying that my CAPE ratio is high now, but the reason it’s high is because these interest rates are so low, and it’s not surprising. So I’m still thinking that a diversified portfolio that emphasizes stocks in the U.S. and in Europe, too, by the way, because they’re probably overreacting to their crisis, and then all over the world. A diversified stock portfolio makes sense to me.

 

CONSUELO MACK: You gave me a very provocative statement, I thought, and it was that, “Changes in the stock markets, housing market and the overall economy have relatively little to do with each other over years or decades.” I’m saying, okay, so what do we pay attention to if it’s not… ?

 

ROBERT SHILLER: That’s what you wouldn’t get by reading the newspaper. They talk about confidence is back, so everything is up- the stock market, the commodity market, the housing market- but I know that historically they haven’t been that correlated. The history is always surprising. So my thought is let’s go a little into all of those: stocks, even real estate and housing, even though I’ve expressed all these worries about these. Don’t let worry get away from you, and you know that one of these is likely to do well, so you want to be as fundamentally diversified. That means internationally and across major asset classes, and that’s all you can do and then not worry too much.

 

CONSUELO MACK: And I know that I’ve quoted Peter Bernstein to you before- the late, great Peter Bernstein- about “the only time you’re truly diversified is when you own something you are really uncomfortable with.” So is there an investment that you are really uncomfortable with that we should all own some of?

 

ROBERT SHILLER: Stay away from?

 

CONSUELO MACK: No, no, no. That in order to be truly diversified, that we’ve got to own something that we’re really terrified to own.

 

ROBERT SHILLER: Well, I’m thinking that the relatively high valuation of the stock market is not there in every sector of the stock market, so you can be reasonably diversified if you overemphasize certain sectors that are more value-oriented. So I would suggest buying some sector ETFs that have a low… well, I would measure it by CAPE.

 

CONSUELO MACK: Right, your low CAPE ratio.

 

ROBERT SHILLER: Yeah, that would have a low price.

 

CONSUELO MACK: So if you were to give us One Investment for a long-term diversified portfolio, then what would it be?

 

ROBERT SHILLER: Yeah, as part of a long portfolio…

 

CONSUELO MACK: Yes, diversified.

 

ROBERT SHILLER: One example would be the SPDR Select Sector Financials Index, ETF, and that has a ticker of XLF, and it just puts you into a broadly diversified portfolio of financial stocks, and it has a very low CAPE and a very low price relative to 10-year average earnings. Now, you might say I’m afraid to do that because, hey, we just hit them with the Dodd-Frank bill, and all these regulations are coming over. Dodd-Frank said we’re going to end “too big to fail”, and so are they pulling the rug out from under their government support? Well, they’ve already done that, though, and that’s two, three years ago, and I don’t think “too big to fail” is dead, either. I hope that it shouldn’t be a factor but still probably is.

 

So you know, I’m kind of betting on history repeating itself. Now, it’s been a big theme in my teaching at Yale and in books I’ve written that finance is a fundamental technology that drives our modern civilization, and it’s not about making money. I tell my students going into finance is about being a productive member of society, not about getting rich, and if you get rich, you should give it away. That’s what I tell them. I don’t know if they’ll do that, but I think finance is very important to our economy. It is beaten down right now. This is a time to go in.

 

CONSUELO MACK: So as a matter of fact, you’ve written your most recent book about that. It’s Finance and the Good Society, and in our WEALTHTRACK extra segment which we’re going to tape after this which will be on our website, we will talk about Finance and the Good Society as a matter of fact. So Robert Shiller, it’s so great to have you here. Yale economist and just economist and financial innovator extraordinaire, so thank you so much for being with us on WEALTHTRACK.

 

ROBERT SHILLER: My pleasure.

 

CONSUELO MACK: At the conclusion of every WEALTHTRACK, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: make sure you own some stocks. As Shiller and many of our other guests have told us, bonds have become risky after their big 30 year run-up. And this picture from Shiller adds another dimension. It compares the real total return, taking out the effects of inflation, of U.S. government bonds and U.S. stock prices. As far as inflation beating returns, preserving your purchasing power, stocks win hands down.

 

I hope you can join us next week. We are going to talk to award winning financial planner Harold Evensky about how to stay solvent in retirement. Think “simplify!” You will really appreciate his advice. In the meantime, thank you so much for taking the time to visit with us. Have a happy Easter weekend and make the week ahead a profitable and a productive one.

 


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