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Home Publications Blogs Beat the Press Robert Shiller's Data Say the Last Two Times Have Been Different

Robert Shiller's Data Say the Last Two Times Have Been Different

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Tuesday, 06 May 2014 07:29

David Leonhardt presents a somewhat confused warning about stock valuations in his Upshot piece today. Looking at the recent run-up in stock prices the piece tells readers that it's "time to worry about stock bubbles." Actually, it's not. The stock market is high relative to its long-term trend, but there is little basis for fearing a plunge in prices as the piece suggests.

Leonhardt's basic story is that price to earnings ratios are substantially above their long-term average. He uses Robert Shiller's measure the ratio of stock prices to earnings (PE) lagged ten years. He notes that this ratio now stands at 25, which is well above its long term average. Leonhardt then tells readers:

"The average inflation-adjusted return since 1871 (the first year for which Mr. Shiller has data) in the five years after the ratio equals 25 or higher is negative 12 percent."

Leonhardt then warns against any assumptions that things might have changed and that this time is different. In other words, folks should expect some serious negative returns in the years ahead.

Of course folks who look at the data, including Shillers' data (available here), would know better. In the last two decades the stock market has twice hit the 25 PE ratio according to Shiller. The first time was in 1997, when Shiller puts the year-end ratio at 27.5. The average real return over the subsequent five years was -0.7 percent. That's not great, but not exactly a disaster either. Furthermore, the story would look considerably different if we started from the point where the ratio just crossed 25. Shiller puts the 10-year PE at 24.3 at the end of 1996. The average real rate of return for the subsequent five years from that point forward were 8.9 percent. Not much grounds for shedding tears.

The next time the PE crossed the 25 threshold was in 2004 when it hit 27.0. Shiller's data show the real rate of return in the subsequent five years was 1.1 percent. That's not fantastic, but it's probably better than you would have gotten in a money market fund and certainly a hell of a lot better than the negative 12 percent of which Leonhardt warns.

In other words, the last two times the market has crossed this magic 25 PE, investors would have been wrong if they expected a prolonged period of negative real returns. And, since these are the only two times it has crossed this threshold in the last 80 years, we might feel some comfort in using this experience as a basis for expectations of the future.

In fact, projecting stock returns really should not be a great mystery. If we assume that stock prices will on average grow at the same rate as the economy (i.e. we don't see permanently rising or falling PEs or profit shares), then the rate of return will be the rate of growth of the economy plus the portion of profit paid out to shareholders either as dividends or share buybacks. The latter has been in the range of 60- 70 percent in recent decades.

This means that if the ratio of stock prices to current year's earning is around 20 and the rate of growth is between 2.0-2.5 then we should expect real returns averaging between 5-6 percent going forward. (At the low end, we get payouts of 3.0 percent and 2.0 percent real growth. At the high end we get payouts of 3.5 percent and 2.5 percent real growth.) Note, this is a long-term average, not a prediction for next year.

This may take some of the mysticism out of stock returns, but hey, that is the way it is. Unfortunately this is far too simple for economists to understand. You can see a more elegant version of this here.

For those unfamiliar with my writings, I am not a crazy stock market enthusiast. I warned of both the stock bubble and the housing bubble.

Comments (22)Add Comment
double
written by medgeek, May 06, 2014 8:22
This note is so good, you should post it twice. Oh, wait...
:-)
Stock prices should not match economy
written by Ben Ross, May 06, 2014 8:36
Assuming a constant rate of profit, stock prices should grow slower than the economy. The aggregate value of the stock market is what should match the economy. New companies are constantly entering the stock market, so the trend in prices will be below the trend in aggregate value of the market.
Is this what the data shows?
written by keenan, May 06, 2014 8:47
Looking backward at the historical data, does it support this statement by Dean Baker? Anyone care to do the math?

"If we assume that stock prices will on average grow at the same rate as the economy (i.e. we don't see permanently rising or falling PEs or profit shares), then the rate of return will be the rate of growth of the economy plus the portion of profit paid out to shareholders either as dividends or share buybacks. The latter has been in the range of 60- 70 percent in recent decades."
Index Issues -price of existing stock will grow less than the economy
written by Dean, May 06, 2014 8:57
Ben is right on this. There should be some gap as new companies grow and take up some of the profit of existing companies. I'm waiting for someone to notice this issue in reference to a certain French economist's r>g.
Huh?
written by Larry Signor, May 06, 2014 9:55
...the trend in prices will be below the trend in aggregate value of the market.


If we determine the aggregate value of the market by price or some other price derivative, how can the determinant factor trend different than the aggregate value?
What is different?
written by ifthethunderdontgetya™³²®©, May 06, 2014 10:28
.
We are a consumer-driven economy now.

Our plutocrats are greedily destroying all the consumers...THAT is the difference. Six years of high unemployment, and most all of the government's efforts to combat it have been devoted to trickle-down economics. (That is, quantitative easing.)

Short run: more money for the plutocrats, less for everyone else.

Long run: we are all dead.

Seriously, how long do you think this can go on, Dean? Do you think our multinationals can just shift their profit sources to overseas consumers? The same thing is happening to them.

Of course, global warming and/or ocean acidification will probably get us all first, so there is that.
~
...
written by AlanInAZ, May 06, 2014 10:36
Why the emphasis on only the US economy when a very large percentage of S&P500 profits come from overseas sales. Its a global economy now - I think the long term stock market trend should viewed in the context of global economic growth prospects.
...
written by skeptonomist, May 06, 2014 10:57
Most discussion about stock prices, including this one, are about indexes like the S&P or DJIA, and new companies are constantly being added and declining ones removed, so why would the index price decline?
Citation for Ben's point
written by wkj, May 06, 2014 11:33
From William Bernstein's blog

http://www.efficientfrontier.com/ef/702/2percent.htm
By the way
written by Dave, May 06, 2014 1:03
Krugman misunderstands the source of shadow banking funds. It is true that shadow banking can capitalize on asset bubbles much easier than traditional banking, but traditional banking combined with the elimination of Glass-Steagall allowed the funds that would have normally been invested in business growth to be diverted to the asset bubble, which caused the bubble in the first place.

The financial mess built on top of this was not the cause of the misallocation of investment. Traditional banking was the cause.
...
written by rob urie, May 06, 2014 1:29
So the difference between investing in 1996 and 1997 is 9.6% (8.9% - -0.7%) per year for five years and it is of little consequence? The apparent premise is that P/E doesn't matter because inflated stock prices can always get more inflated? Look at rolling 20 years returns from Shiller's data to see how far off base this is.
Poor-cast
written by Squeezed Turnip, May 06, 2014 4:02
Sip the tea, don't worry about the shape the leaves take in the cup.

Trends are pretty meaningless. You can toss heads on a fair coin 5 million times in a row and it's still a 50-50 chance you get tails the next toss. The fact is that nobody here or elsewhere can predict the future that well, or they'd arbitrage that puppy to the bank (sorry for the mixed metaphors).
Profit payouts through stock buybacks are not the same as those through dividends
written by jm, May 06, 2014 10:13
If you receive a share of profits through dividends, you still own the stock and will continue to receive future profit payouts as dividends.

If you receive a share of profits by selling stock in a stock buyback, you no longer own the stock. Since the only way to receive future profit payouts through that mechanism would be to buy the stock again -- at the price inflated by the buyback -- that would make no sense.

The only way to get an income stream through a stock whose price is inflated by periodic buybacks is to steadily sell off you holdings. But since stock prices generally fluctuate much more than dividend payouts, the risk is much greater (especially since it's often the case that stock buybacks are mainly a means to reduce dilution when insiders cash out huge option grants at market tops and are financed with borrowed money, such that the company is borrowing money to "buy high", weakening the company financially).

If the tax code were changed to favor dividends rather than capital gains, we'd have a much more stable stock market.

lets test it-spoiler he's right price does grow at lower rate
written by jim, May 06, 2014 11:56
from 1937 to 2013 using shiller paper real return in stocks was 2.18 price versus GDP at 3.21. The shiller p/e was 21.8 then vs 21.18 in 2013 so fairly similar. cray cray

This means that if the ratio of stock prices to current year's earning is around 20 and the rate of growth is between 2.0-2.5 then we should expect real returns averaging between 5-6 percent going forward. (At the low end, we get payouts of 3.0 percent and 2.0 percent real growth. At the high end we get payouts of 3.5 percent and 2.5 percent real growth.) Note, this is a long-term average, not a prediction for next year.
Wishful Thinking
written by Fizo, May 07, 2014 9:14
Currently profit margins are at an all time high. This has ALWAYS been a mean reverting series. Good luck with your real returns averaging 5-6% over the next decade. Particularly starting out with a Shiller PE 10 of over 25. And if the real rate of growth is really "between 2-2.5" what do you think that will due to cheap financing that has been (in part) causing elevated profit margins?

I wonder if being wedded to our public pensions unrealistic return assumptions is influencing the analysis at CEPR?
...
written by ReturnFreeRisk, May 07, 2014 11:55
"The stock market is high relative to its long-term trend, but there is little basis for fearing a plunge in prices as the piece suggests."

Please explain why Twitter and other multi billion dollar companies are down 50% in price from highs. The stock bubble is bursting in front of our eyes and you are denying it. A folly, I think, in an otherwise pretty good track record of economic/financial calls by you.
The S&P 500 Has Been Virtually Flat in the Last Week
written by Dean, May 07, 2014 2:53
ReturnFreeRisk,

if the market is crashing, it's not showing up in the data. (The S&P is actually up slightly over the last month.)
I think the valuations of Twitter and many of the other social media companies are nuts. That doesn't mean the valuation for the market as a whole is crazy.
GDP per capita plus dividend yield = real stock return
written by Doug Rife, May 07, 2014 4:19
Historically, real US stock prices have not grown as fast as real GDP but only at the much lower rate of real GDP per capita or around 1% real. That means most of the real returns from US stocks has come from reinvested dividends and not from rising stock prices, which is commonly believed. When the dividend yield is low expect low future returns and vice versa.

See "What Risk Premium Is “Normal”? by Robert D. Arnott and Peter L. Bernstein 2002

http://www.researchaffiliates.com/Production content library/FAJ_Mar_Apr_2002_What_Risk_Premium_is_Normal.pdf

@FIZO
written by jim, May 07, 2014 6:34
tell that to profit margins. they have risen 2.7% compounded since 1982. mean reversion is bull. @dean twitter finally makes sense here. fair value around 30. intrinsic value has been rising for 3 quarters. while it was nuts at 70, and maybe momentum will push it to 20, it isn't a bad company. further biotech and internet make up about 8% of mkt cap of s and p. they are trading at a discount to historical norms on p/e basis. the most overvalued sector is utilities by far.
...
written by Mark Caplan, May 08, 2014 8:33
John Hussman has demonstrated several times on his website that stock buybacks are accounted for in the computation of the S&P500 Index itself. Total return of the S&P500 consists of only the level of the index plus cash dividends. If you also include stock buybacks in a total return estimate, you'll be double-counting.
john hussman is a moron
written by jim, May 08, 2014 12:24
hes produced negative absolute returns over 1 3 5 10 year time period. capital allocation strategies is how companies will generate excess returns in 2014-15.
A couple problems with the analysis here
written by Doug, May 18, 2014 7:46
The argument is basically that return equals dividends plus dividend growth, assuming a stable payout ratio. That's fine, but the S&P yield is around 2% and has been there for awhile, so the expected return would be lower than DB suggests - the error here is the assumption of a 70% payout ratio (the actual ratio is lower and likely to remain lower).

Further, if PE multiples are mean reverting and CAPE is 40% above average, tat suggests a very significant return headind over the period of reversion.

To really see an OK outlook for ten year returns I think you have to either believe that
1) multiples are not mean reverting, perhaps due to sustained low interest rates
2) margins are not mean reverting, which would mean Schillers CAPE is the wrong measure, and current PEs, which are less alarming, are more important.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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