On the tenth anniversary of the financial crisis, Nobel Laureate Robert Shiller and Wharton’s Jeremy Siegel debated the question on every investor’s mind – is the market overpriced? According to Shiller, if the market’s reaction to Trump’s presidency and low-interest rates are just short-term fluctuations, then valuations are indeed precariously high.
The pair delivered a keynote presentation at the Wharton Jacobs Levy Center’s 2018 Conference in New York on September 14. You can view the keynote slides from Shiller’s presentation here and Siegel’s presentation here.
Shiller teaches at Yale, is the best-selling author of Irrational Exuberance and the winner of the 2013 Nobel Prize in Economic Sciences.
Siegel is the Russell E. Palmer professor of finance at the Wharton School of the University of Pennsylvania in Philadelphia and author of the classic book, Stocks for the Long Run, now in its sixth edition.
The two have had a long-running debate about U.S. stock market valuations, and they have faced off publicly several times since the Great Recession. You can read about the claims they made a year ago in this article.
The central issue upon which the two differ is the appropriate measure of stock market earnings. With the cyclically adjusted price-to-earnings (CAPE) ratio near historic highs and many analysts questioning equity valuations, it is unclear whether market conditions are being driven by short-term earnings spikes.
Siegel has been critical of the CAPE ratio’s methodology, which was popularized by Shiller and is widely used to assess whether the market is overvalued or undervalued.
Siegel has been unabashedly bullish on stocks during the post-crisis period, and vehemently disagrees with warnings by Shiller and other pundits that stocks are overvalued. He has provided some context for his bullish outlook based on the long-term performance of stocks versus other major asset classes. You can read about Siegel’s predictions for 2018 here.
Normally these two focus their debate on strategies for evaluating market levels. But this time, the pair made new claims about how investors should consider short-term fluctuations when analyzing U.S. stock market prices.
I will review the arguments made by Shiller and Siegel, but first let’s look at why they have shared the same basic economic perspective for a half-century.
Why Shiller and Siegel are celebrating a half-century long friendship
Long before these two established themselves as widely respected investment industry experts, they established a friendship as a pair of M.I.T. graduate students.
Shiller and Siegel became friends 51 years ago as of this month, when they met in a line of students on campus. “This is MIT for you, they sent us lined up in alphabetical order,” Shiller recalled, “we met because ‘Shiller’ and ‘Siegel’ are adjacent.”
Give that they have similar surnames, their publications tend to be next to each other in bookstores as well. Because Siegel’s books were next to his, Shiller joked, “I say Jeremy really got me started.”
The pair mourned their youthful good looks while recalling their college days fondly, and Shiller recalled their first conversation. He said that in their first exchange, Siegel taught him “that it's possible to do economics that’s really connected to the real world.”
Their families have remained friends for over half a century, and the pair recently traveled to the Poconos for summer vacation.
Though the two often face off as market pundits, but it’s a misconception that Shiller is a perennial bear and Siegel is a perennial bull, they said.
They both share a fundamental economic perspective, they explained, which is that history is important when taking a long-term prospective look at markets.
“Why is history important? Because big movements in these ratios don't happen that often and you want to understand what they mean,” Shiller said. “You'd better look at the longer period in history.”
Shiller: Markets are overvalued
Shiller is currently writing a new book, he said, which examines economic trends “driven by the story of time.”
According to Shiller, there is disagreement over market valuations because investors tend to forget historical lessons. “You think that stock prices shouldn't react to earnings too much because they've gone back down so many times.”
Shiller said the market is dominated by short-term market conditions that are driving high earnings levels that won’t be sustained. He compared it to other similar historical instances, and commented on what happened to equity prices at those times.
The first example Shiller pointed to was the spike in earnings that occurred in the early 1900s before the U.S. ended WWI. “But stock market prices didn’t go up very much,” he said.
“The newspapers called this ‘the flood of earnings’ and they attributed it to the war,” Shiller explained. Investors acknowledged that it was driven by Europeans buying ammunitions and supplies from the U.S., he said.
But the market didn’t go up because investors understood that the war wasn’t permanent, and earnings were going to go back down after the war ended. According to Shiller, the market did the right thing, “which was not to overreact to the sudden burst in earnings.”
He pointed to a second historical lesson, when earnings went up again between 1921 and 1929. This time, he said, the market went up all the way. “The kind of irrationality that I think peaked in 1929, was the overreaction.”
“They didn't have the skepticism that they had in 1916,” Shiller said. “Why didn't they? It was a different atmosphere, it was the roaring twenties.”
According to Shiller, the market has overreacted to earnings jumps in recent years. Both in the 1990s and in the years leading up to the 2008 financial crisis, earnings shot up and prices went up as well.
“The market is filled with real people and they have their own stories they're telling, and ideas that change from time-to-time,” Shiller said. “Right now, we are in this big boom period, in terms of earnings.”
“Part of the reason earnings are up is because they've cut corporate profit taxes and Donald Trump is president, but is Donald Trump permanent?” Shiller said. “I won't get into that, there’s a lot of discord about that,” he said, “we just don't know.”
“This looks like an overreaction,” he said. With a potential trade war looming, he said, “I'm thinking it's likely to be a bad time for the stock market.”
“You just don't want to overreact to these short run fluctuations,” Shiller advised. “We call it ‘cyclically adjusted’ because it smooths over the business cycle, or smooths over wars, for that matter.” He added, “And 10 years is a long time.”
Shiller looked at the CAPE ratio over time showing that has periodically signaled mispricing, and reiterated that the ordinary price to earnings ratio is very noisy right now.
“That's where we are now; it's not like I'm predicting a crash,” he clarified. “I'm saying this is a 10-year forward return, this is not going to be great.”
Siegel: Stocks are overvalued, but not as overvalued as bonds
Siegel maintained his bullish stance on stock market valuations.
According to Siegel, over past 140 years, P/E ratio averaged about 15, which corresponds to U.S. stocks having had real (inflation-adjusted) returns of 6.7% . This is far more than bonds (3.5%), he said.
“The earnings yield is a very good predictor of long-term returns,” he said, arguing that earnings measures are more important than prices.
Siegel has previously contended that the CAPE ratio does not provide a valid forecast of future prices because it uses earnings measures that are overly bearish and it is biased downwards as a result of particularly bad economic years.
Siegel said that when people ask him where he thinks today's stock market is forecasting forward, he says "5.5% real, right now.” He added, “That's lower by a point or so from the long run, nominal if you have a 2% inflation is 7.5%.”
With S&P at 2871 (as of September 7), stocks are selling for about 18-times 2018 and 16.1-times 2019 estimated operating earnings. Siegel looked at S&P 500 prices from a historical perspective, arguing that “really, we're not that high.”
“Yes, stocks are ‘overvalued’ on a long-term basis,” Siegel said, “but bonds are enormously overvalued on a long-term basis.”
According to Siegel, “the valuation of stocks relative to bonds is actually among the more favorable – not the most favorable, but among the more favorable in history.”
Siegel argued that prices are higher than they have been historically for a few reasons, including reduced trading costs due to the rise of indexing, allowing investors to access far superior risk-return trade-offs.
Siegel also said that real rates are likely to stay low, which will lower stock prices and push up the S&P 500. “Record low real interest rates could push equilibrium P/E ratio even higher,” he added.
We’ve followed the Shiller-Siegel debate in this publication for many years as an example of a friendly exchange between expert analysts who disagree over a crucially important question. This installment moved no closer to providing a clear answer as to whether stocks are under- or over-valued.
The only reliable way to answer that question would be to take every stock in the index and evaluate its discounted prospective cash flows relative to its current price. That requires a significant commitment of analytical resources – every company must be evaluated, based on its competitive positioning, to determine the prospect for its business model.
Unless someone is willing to undertake such an effort, which is unlikely, we will continue to rely on shortcuts, such as the CAPE ratio, to understand how stock prices compare to their intrinsic values. Shiller and Siegel provide good insights with their approach, but not definitive answers.
Marianne Brunet is a financial markets analyst at Advisor Perspectives.
Read more articles by Marianne Brunet