Shiller’s ECY Makes Relative Sense, but the Market’s Absolute Return May Be Another Story

We cannot know how the COVID-19 pandemic will end, and it may well end soon with the advent of effective vaccines. But a key takeaway of the ECY indicator is that it confirms the relative attractiveness of equities, particularly given a potentially protracted period of low interest rates. It may justify the FOMO narrative and go some way toward explaining the strong investor preference for equities since March.

Eventually, down the line, bond yields may just rise, and equity valuations may also have to reset alongside yields. But, at this point, despite the risks and the high CAPE ratios, stock-market valuations may not be as absurd as some people think.

  • - Robert Shiller, Making Sense of Sky-High Stock Prices, November 2020

It often happens that associations which end up leaving an indelible mark on our collective memory of certain market events are the result of sheer happenstance. One instance of this is our association of the phrase irrational exuberance with the peak of the tech bubble twenty-one years ago. The phrase is most widely associated with Yale professor Robert Shiller, whose book titled Irrational Exuberance happened to be published in March 2000 — the very month that marked the peak of the tech bubble. If there was a single moment in the last few decades which defined irrational exuberance in the stock market more than any other, it was the frenzied buying in those last weeks leading up to the March 2000 peak. From that moment, irrational exuberance entered our cultural lexicon as the definition of the bubble experience, and it has been there ever since.

If the book Irrational Exuberance had been published a year earlier, or a year later, the phrase probably would not have the same legacy, as Shiller was not the first person to publicly cite irrational exuberance during that period. Fed Chairman Alan Greenspan used it in congressional testimony to describe the conundrum facing policy makers in judging the value of the stock market in 1996. In hindsight, 1996 happened to be the year which marked the beginning of the tech bubble’s speculative frenzy, and if not for Shiller’s book, irrational exuberance may have had a different legacy; perhaps a phrase marking the beginning of a bubble, not the end. As it happens, Greenspan’s use of irrational exuberance marked the moment of liftoff of the tech bubble, while Shiller’s book marked the moment it came to a crashing end. Those two uses of the same phrase neatly bookended the most speculative period in stock market history.

While the precise timing of the publication of Irrational Exuberance in March of 2000 may have been random chance, Shiller proved in subsequent years that his analysis was not the result of happenstance. The appearance of the first edition of Irrational Exuberance marked the peak of the tech bubble within a month, and the second edition of the book was published in 2005 — and it included a detailed discussion of the housing bubble. Within a year of the publication of the second edition, home prices in the U.S. reached their peak, and in the years that followed, investors endured the bursting of the second major market bubble within a decade.

It is not an extremely complicated task to look at a market’s valuation and assess whether it is likely overvalued, but it is nearly impossible to know just when an overvalued market will stop becoming even more overvalued, and begin to deflate. Yet with the first two editions of Irrational Exuberance, Robert Shiller managed to do the nearly impossible — twice. As a point of fact, however, Chairman Greenspan’s assessment of the market’s overvaluation in 1996 proved not entirely off the mark. While Shiller’s book marked the precise moment the bubble popped, Greenspan’s assessment happened to be made early in what turned out to be the largest market bubble since 1929. In the end, all the of gains made subsequent to his testimony proved to be temporary, which showed that his basic assessment was correct; the S&P 500 traded at the same level in 2003, and again 2009, as it did when he testified before Congress in December 1996. The ephemeral nature of gains is a hallmark of an overvalued market, as is the difficulty in precisely timing the deflation of those short-lived gains.