I wrote with some concern about the high ratio in this space a little over a year ago, when it stood at around 23, far above its 20th-century average of 15.21. (CAPE stands for cyclically adjusted price-earnings.) Now it is above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.
Pointer from Mark Thoma. Here is my take:
1. I think investors look at the zero interest rate on short-term money-market instruments and say, “I can’t possibly settle for that.” As they reach for yield, long-term interest rates fall.
2. At low interest rates, long-term bonds become very speculative investments. A small decline in market interest rates, and the market value of your bonds shoots up. Conversely, it takes only a small increase in market interest rates to create a negative return on a bond mutual fund (holding the actual bond rather than a bond fund avoids marking your losses to market, but on an opportunity-cost basis, an actual bond still gives you a negative return in a rising-rate environment.)
3. If Shiller is right and stocks are over-priced, your best strategy may be to sit on those low-yielding short-term instruments and wait for prices to come down. This is hard to do. It is my strategy in fantasy baseball auctions–watch the first 50 players get chosen at prices that I think are too high, and then wait for prices to come down. If prices are too high early, this has to work, because the fixed budgets given to owners mean that prices have to come down eventually. I am not saying you win a fantasy league that way, because luck tends to dominate any advantage you might appear to gain in the auction. But if you wait, you can get good value cheap. I think that we are in that type of stock market.
4. Having said that, we know that for every credible theory that stocks are over-priced there must be an equal and opposite theory that they are under-priced. (See Brad DeLong’s response to Shiller. See also this comment that Tyler Cowen found on his blog) Otherwise, prices would not be as high as they are. The thing is, most of the movement in stock returns is due to changes in the taste/toleranace for risk, and there is no guarantee that this parameter will head toward one particular value.
Related: James Hamilton on the San Diego public employee pension fund reaching for yield.
Arnold, I have to agree with you. The converse of “I can’t possibly settle for that.” is “I am not getting anything for all that extra risk”.
Hussman found that the market cap to GDP ratio is an excellent predictor of 10-year returns (he looked at a bunch of possible predictors, and found that was one of the best). See the graph, right-hand scale:
http://www.hussmanfunds.com/wmc/wmc140728.htm
Hussman has the most sanity inducing take on the market I have seen byfocusing on expected mid term return rather than short term fluctuations. Sure stocks could be content to return a stable zero for a decade. It could happen without any dramatic crash. But why would they be content to do that?
A lot of the commentary is on how the CAPE could plateau at a new mean, thus no reversion to the old mean. That is fine, this time is different aspersions aside, but it also doesn’t argue for p/e expansion that typically underlies bull markets (Arnold’s point about cycles of risk appetite). Stocks don’t seem to like sitting serenely atop plateaus.