Nobel laureate Robert Shiller thinks investors ought to ignore the recent burst in corporate profits and focus on longer-term valuation, which he says carries foreboding news for the stock market.
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At a time when earnings are rising 25 percent a quarter, Shilller said that’s not indicative of what longer-term results in the market will be. History has shown that in previous times, particularly around World War I, the late 1920s approaching the time of the Depression, and in the high-inflation 1980s, profits could be strong but equity results not as much.
In the present case, the recent surge in profits has been due to last year’s tax cuts, backed by President Donald Trump, that took the corporate rate from 35 percent to 21 percent.
“My own way of thinking is it looks like an overreaction,” Shiller said Friday at a conference in New York presented by the Wharton School. “We’re launching a trade war. Aren’t people thinking about that? Is that a good thing? I don’t know, but I’m thinking it’s likely to be bad times in the stock market.”
The Yale economist is known for a number of groundbreaking views and theories on the market, but perhaps most for a gauge he uses to measure stock market valuations. The Cyclically Adjusted Price to Earnings ratio — often referred to as the “Shiller CAPE” or “Shiller PE” — looks at valuations over a 10-year period to smooth for fluctuations in the business cycle.
Currently, the gauge is at 33.3, its highest level since June 2001. The index peaked near 45 in mid-2000, just as the dot-com bubble was about to burst. Testing the model over time, it saw the market crashes in 1929 and 1987 as well as the dot-com bubble.
Shiller cautioned that he is not predicting major calamity for the market but rather a much lower level of returns, in the 2.6 percent annual range, than investors have come to expect during the 9-year-old bull market. The longest rally in history has the S&P 500 up more than 335 percent since the March 2009 bottom.
“It’s not like I’m predicting a crash,” he said. “This is a 10-year forward return. This is not going to be great, because we’re just too high at the present value.”
Among other things, he said the current tax climate won’t last and corporate earnings will come back down, just as they have done in the past.
“Is Donald Trump permanent?” he asked to laughter. “I won’t get into that, a lot of discord about that.”
To be sure, the Shiller CAPE has been elevated for years and crossed 30 nearly a year ago. And not everyone agrees with his analysis — including his friend and sparring partner of 51 years and fellow speaker at the Friday event, Jeremy Siegel.
Siegel is the Russell E. Palmer professor of finance at the Wharton School and has long served as the bull to Shiller’s bear. He contested several of Shiller’s points, particularly about whether the market necessarily needs to revert to trend and what he sees as an oversight on the impact of low-cost passive investing on the market. On the latter point, thanks to low-fee ETFs it now costs investors less to have a balanced portfolio so they don’t require returns as high to beat the market.
Even if stocks are expensive, Siegel said, they remain a bargain compared with bonds when considering the risk premium, or the amount of return investors demand compared to risk.
“Stocks are overvalued on a longer-term basis, but bonds are enormously overvalued on a long-term basis,” he said. “Relative valuation of stocks vs. bonds is among the more favorable — not the most favorable but among the more favorable — in history.”