What CAPE Value Justifies Alarm?
Robert Shiller was recently quoted as saying that he is not alarmed over today’s CAPE value even though “It kind of puts us where we were in other times in history that were relatively extreme.”
According to Shiller, the author of the book Irrational Exuberance, “the stock market has performed very well over the last 100 years. I like to look at long-term time horizons. And so when it’s highly priced, it doesn’t necessarily make it a horrible investment.”
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I do not agree. I am alarmed by today’s high CAPE value.
Shiller is of course correct that the stock market has performed very well over the last 100 years. I also believe that he is smart to focus on long-term time horizons. And it follows that even at today’s prices stocks do not constitute a horrible investment option.
So we agree on a lot. But I am very much in disagreement with his thought that today’s stock prices are anything less than alarming.
Alarming CAPE Value
I would characterize any CAPE value above 25 as “alarming.” I believe that, once the CAPE value begins to drift above 20, we should pull together as a society to encourage investors to lower their stock allocation and thereby to bring the CAPE value back down its fair-value mark of 17.
Irrational exuberance is a highly destructive force in our society. We should have a limited tolerance for it. For Shiller to say that he does not find today’s insane price levels alarming just encourages the widespread complacency over high stock prices that made today’s dangerous CAPE level a possibility in the first place.
Shiller’s claim that stocks possess some appeal as an asset class even when selling at today’s prices is technically correct but misleading. If you look 60 years out, stocks offer a strong value proposition starting from any possible price level.
That’s because prices head steadily upward (with some temporary price drops mixed in, to be sure) for many years and then head steadily downward (with some temporary price increases mixed in) for many years, always ending up somewhere in the neighborhood of the fair-value CAPE level of 17.
The 10-year or 20-year value proposition is off-the-charts amazing when the price level is super low and highly dubious when the price level is super high. When you look at a time-period long enough to include both super high prices and super low prices and all the in-between price levels, you see a value proposition that is very appealing indeed. Stocks are a great asset class.
But the appeal of stocks is certainly not anything even remotely close to being stable. The price at which stocks are selling affects their long-term value proposition in a profound way. Most investors have little idea of how much valuations affect stock returns and this is something that they very much need to know.
When investors are surprised by sudden price crashes, it causes them to become highly emotional, which of course causes even greater price drops. The great price drops take spending power out of the economy, causing severe economic contractions.
It is a critically important public policy concern that investors become better informed re how dangerous stocks become when selling at today’s prices.
Keeping Risk Profile Constant
I am describing a bit of a paradox. I said that I agree with Shiller that even when selling at high prices stocks do not represent a “horrible” investment choice. I also said that the valuation levels that apply today make stocks a far less appealing option than they would be if prices were at moderate levels. Both things are so.
The obvious strategic implication is that investors should not sell all of their stocks when prices reach dangerously high levels but should be sure to lower their stock allocation enough to keep their risk profile roughly constant over time.
Stocks are not a horrible choice today. But they are less appealing than they would be if prices were at reasonable levels. Perhaps an investor who at times of moderate prices goes with a stock allocation of 60 percent should be going with a stock allocation of 30 percent today.
What Shiller is saying is very much in tune with the Buy-and-Hold rationalization that investors do not need to engage in market timing because stock prices always eventually recover. It is certainly true that prices always recover.
That’s no reason for investors not to make an effort to maintain a constant risk profile by lowering their stock allocation at times of high prices and high investor risk. To fail to engage in market timing would be to practice price indifference.
If investors never succumbed to price indifference, stock prices would be self-regulating. High stock prices would make stocks less appealing and so investors would lower their allocations and the lower allocations would pull prices back to reasonable levels.
It is price indifference that is the cause of irrational exuberance. Shiller’s most important contribution was to discourage the creation of irrational exuberance and in these recent comments he is encouraging the behavior that causes it to get out of hand!
I have seen Shiller characterized as a “perma bear.” I believe that he is probably weary of being characterized as such and is attempting to play against type by focusing on the limited appeal that stocks offer even at times of insanely high prices.
If we all made more of an effort to speak frankly about today;s alarming prices, I believe that Shiller would feel less of a need to at times play it the other way a bit. My personal guess is that Shiller is more alarmed than he lets on and that he would be helping us all if he gave voice to that alarm in clear and bold statements.
It makes me sad to think that he may feel a need to understate his concerns. That’s what bull markets do to even the best of us!
Rob’s bio is here.