Yale’s Shiller: Stocks Are Expensive, So Stay Diversified

January 25, 2018

Robert Shiller, the Yale economics professor who won a Nobel prize in 2013, said stocks are expensive by historical norms and that’s a reason to stay diversified – basically, spread investments among a mix of equities, bonds, cash, commodities and real estate.

“The truth is that it is impossible to pin down the full cause of the high price of the U.S. stock market,” Shiller writes in an op-ed for the Guardian website. “The overall U.S. stock market should not be given too much weight in a portfolio.”

The S&P 500 stock index’s total return is more than 24 percent in the past 12 months, outpacing the 15-year average of 8.3 percent. But company profits didn’t grow nearly as fast, meaning investors paid a higher-than-average price for those earnings.

Shiller explains how he measures the market’s value in relation to the historical profitability of companies. The cyclically adjusted price-earnings ratio that he and economist John Campbell developed 30 years ago includes adjustments for inflation and 10 years of profit data.

The idea was to smooth out short-term fluctuations in company earnings as the broader economy went through cycles of recovery and recession.

The Shiller price-to-earnings ratio for the S&P 500 currently is 34 times, compared with the median level of about 16 times. As of last month, the U.S. market had the highest CAPE ratio among the 26 countries that Barclays Bank in London monitors. Shiller helped the bank develop its CAPE measurements.

While President Donald Trump touts the market’s rise to record highs as a sign that his policies of cutting taxes and regulations are juicing the economy, Shiller says the historical data don’t support that idea.

“It’s not the ‘Trump effect,’ or the effect of the recent cut in the U.S. corporate tax rate. After all, the US has pretty much had the world’s highest CAPE ratio ever since President Barack Obama’s second term began in 2013,” Shiller says. “Nor is extrapolation of rapid earnings growth a significant factor, given that the latest real earnings per share for the S&P index are only 6 percent above their peak about 10 years earlier, before the 2008 financial crisis erupted.”

Shiller says the U.S. market’s expensive valuation may be the result of record share buybacks and the psychology of Americans who are worried about job security amid technological change.

The Federal Reserve’s cuts to interest rates amid the financial crisis gave companies a big incentive to borrow money at a low cost. Many companies used their borrowings to buy back stock without considering how expensive the shares were.

“Part of the reason for America’s world-beating CAPE ratio may be its higher rate of share repurchases, though share repurchases have become a global phenomenon,” Shiller says. “Higher CAPE ratios in the U.S. may also reflect a stronger psychology of fear about the replacement of jobs by machines.”

That worry coincides with a “stronger desire to own capital in a free-market country with an association with computers,” Shiller says.

Timing the Market

The difficulty with historical valuation measurements is that they don’t provide investors with a reliable indication of when to buy or sell stocks, as Albert Edwards, the top-rated strategist at Societe Generale, said in a report last month.

“Clients are forced, as Chuck Prince of Citigroup famously said, to keep dancing while the liquidity mood music is playing,” Edwards said. “Clients are no longer concerned with overvaluation; they are more concerned about timing and triggers.”

Edwards said corporate profits aren’t as strong as they appear in data such as National Income Accounts, which showed a 10 percent gain in the third quarter from a year earlier. That rate matches growth estimates of the S&P 500’s 12-month forward earnings per share.

“Yet scratch the surface and all is not well,” Edwards said. “Looking at only domestic, non-financial companies (i.e., companies selling in the U.S.), profits have barely rebounded on an economic basis (i.e., adjusting for inventory gains and putting depreciation on an economic, rather than tax basis).”

He said much of the earnings rebound can be attributed to the recovery in oil prices, which have bounced back in the past two years to boost the profitability of energy companies.

“Much of the rebound is driven by the recovery in the oil price. Excluding energy, the post-2015 profits surge is already decelerating,” he said. “And in an over-valued, over-bullish and overbought market, this profits deceleration might yet prove to be highly significant.”