Cape Crusader – Robert Shiller

Robert James Shiller

Born March 1946 in Detroit, Michigan. Currently teaching at Yale

A proper mathematical logician

Yes, the Thinkers column is returning to hard logic again, after a couple of months of diversions into the realms of soft sciences and sociology. The joint 2013 Nobel Economics laureate won his prize, together with Eugene Fama and Lars Peter Hansen, “for their empirical analysis of asset prices”. You can’t get more grounded than that.

Or so you might suppose. But the famed creator of the Cyclically Adjusted Price/Earnings principle (CAPE) has had a hard time convincing the investing community recently. Shiller’s CAPE calcs suggest that today’s long-term share price perspectives are already running close to the top end of their historical averages, whereas all other measures point to further strong equity growth because of improving fundamentals.

Right now, CAPE stands alone. But is it wrong? Perhaps the new year will tell.


First blood

Shiller first came to the market’s attention in 1981 with an article in The American Economic Review, snappily entitled "Do stock prices move too much to be justified by subsequent changes in dividends?" His paper queried the dominant efficient market hypothesis, which said that markets automatically factored in all the relevant information available at the time.

If that were the case, asked Shiller, how could you account for the extreme fluctuations and surges seen in the 1970s, when markets had halved and then rebuilt themselves in the space of only a year?

Instead, Shiller argued, a properly rational stock market ought to base its stock prices on the expected level of future dividends, discounted down to a present valuation. That would give you a firm basis for assessing prices – but somehow it wasn’t happening. The trouble must be that human emotion, ‘sentiment’ and self-deception must be calling the shots instead.

The ensuing global stock market panic of 1987 concentrated the market’s mind quite wonderfully, and Shiller's theories inevitably started to attract more attention. How, he asked, did investors and stock traders feel motivated to make their trades? And he set about a long-term study of these behavioural factors.

Ben Graham’s heir

All of which was to lead, in good time, to the development of what we now know as the Shiller p/e calculation method. Essentially, Shiller built on a model originally devised by value investors Benjamin Graham and David Dodd, which had posited that a five to ten-year smoothed average of a company’s earnings would give a less volatile picture of where its business was really going.

After much experimentation, Shiller’s team decided on the ten year version which now predominates. And, when painstakingly worked up as a way to value an entire stock market, its value has been shown by events such as the 2000 stock market crisis, which Shiller’s CAPE had accurately forecast. His bestselling book Irrational Exuberance (March 2000) specifically warned that the stock market had become a bubble at the exact moment when it was all set to plunge.


A CASE in point

Powerful stuff, but he wasn’t finished yet. Since 1991 Shiller had been working on a way to measure relative overvaluations of the property market, via the so-called Case-Shiller index – which his company Case Shiller Weiss had first developed, and which is now run by Standard & Poor’s. In 2005 the Case-Shiller measure graphically predicted the 2007 house price bubble (at a time when Fed chairman Alan Greenspan famously did not), and these days it’s perhaps the most widely consulted index of US housing valuations.

Enemies and Detractors?

Thousands of them. Forget the long term averages, they say, because there are special economic fundamentals currently in play that make them irrelevant. This time it’s different. Trust us….


“This could end badly.” (November 2013)


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