Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
Uh oh. Once again, Robert Shiller says Rob Bennett is wrong.
First of all, Shiller is pointing out that the low interest rates (not buy and hold) are driving up stocks:
“ Market observers have noted the potential role of low interest rates in pushing up CAPE ratios. In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases and the price of the equity asset should appreciate, assuming all other model inputs stay constant. So, interest-rate cuts by central banks may be used to justify higher equity prices and CAPE ratios.
Thus, the level of interest rates is an increasingly important element to consider when valuing equities. To capture these effects and compare investments in stocks versus bonds, we developed the ECY, which considers both equity valuation and interest-rate levels. To calculate the ECY, we simply invert the CAPE ratio to get a yield and then subtract the ten-year real interest rate.”
Despite Rob telling us that Shiller thinks the market is about to crash, he actually says that the market looks attractive:
“ But, at this point, despite the risks and the high CAPE ratios, stock-market valuations may not be as absurd as some people think.”
And
“ But with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.”
Shiller already told you not to time the market with CAPE, but you wouldn’t listen and you paid the price. Here he is again, explaining how continue to be wrong. There goes your $500 million windfall.
That’s an important article, Anonymous. Thanks for bringing it to our attention.
I have been saying since the morning of May 13, 2002, that we need to open every discussion board and blog on the internet to honest posting re the last 39 years of peer-reviewed research in this field, without a single exception. This article is the sort of fruit that we see develop from permitting honest discussion. Shiller is offering views that we have not heard before, Everyone who works in this field should be taking the points he makes here into consideration and incorporating them into their own views as to how stock investing works. I will write a column for the Value Walk site offering observations on this article.
My initial reaction is not to be entirely persuaded by the points that Shiller makes here. It certainly makes sense that low interest rates make stocks look more appealing in relative terms. But I don’t agree that: “Despite the risks and the high CAPE ratios, stock-market valuations may not be as absurd as some people think.” Interest rates are today very low. It seems unlikely that they will remain that low for long. What happens when interest rates rise? Just as a lowering of interest rates brings stock prices up, an increase in interest rates brings stock prices down.
If stocks were priced low at a time when interest rates were low, the pressure on stock prices to fall when interest rates rose would not be so great — they would already be low. But it seems to me that we are in a doubly risky situation today, There is pressure on stock prices to fall because they are so high. And there is added pressure on stock prices to fall because interest rates are so low that they can only go up. How are stock prices going to rise if they are already at insanely high levels at a time when low interest rates are giving stock prices a big boost?
I think it would be fair to say that today’s low interest rates go a long ways to EXPLAINING today’s high stock prices. That I can buy. But the risk that those prices are going to fall hard in the not-too-distant future is still present. If anything, it is worse than it would be if interest rates were high today. If interest rates were high today, stock investors could hope that interest rates would drop and give stock prices another boost. That cannot happen with interest rates where they are today.
He says that the low interest rates are “likely to stay there.” He doesn’t say why he believes that. Economic conditions do not remain the same indefinitely. Every crash that we have seen was unexpected. If it had been expected, that expectation would have brought stock prices down and diminished the size of the crash. It is when investors stop worrying about a crash that the danger of a crash is the greatest. I see this as an article that will cause many investors not to worry so much about a crash. It is my view that people should be very worried.
Please remember that interest rates are “priced in” to the market price for stocks. But irrational exuberance is never priced in. It is the one factor that by definition cannot be priced in because the process by which factors are priced in is a rational process and irrational exuberance takes place outside of rationality (the rational thing would be for investors to price stocks properly).
I believe that Shiller has advanced the ball with this article. It gives everyone in the field something to think about. I look forward to seeing what lots of smart people have to say about it.
My sincere take.
Rob
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