By Robert J. Shiller, Sterling Professor of Economics at Yale
The prices of stocks, bonds and real estate, the three major asset classes in the United States, are all extremely high. In fact, the three have never been this overpriced simultaneously in modern history.
What we are experiencing isn’t caused by any single objective factor. It may be best explained as a result of a confluence of popular narratives that have together led to higher prices. Whether these markets will continue to rise over the short run is impossible to say.
Clearly, this is a time for investors to be cautious. Beyond that, it is largely beyond our powers to predict.
Consider this trifecta of high prices:
— Stocks. Prices in the American market have been elevated for years, yet despite periodic interruptions, they have kept rising. A valuation measure that I helped create — the cyclically adjusted price earnings (CAPE) ratio — today is 37.1, the second highest it has been since my data begin in 1881. The average CAPE since 1881 is only 17.2. The ratio (defined as the real share price divided by the 10-year average of real earnings per share) peaked at 44.2 in December 1999, just before the collapse of the millennium stock market boom.
— Bonds. The 10-year Treasury yield has been on a downtrend for 40 years, hitting a low of 0.52% in August 2020. Because bond prices and yields move in opposite directions, that implies a record high for bond prices as well. The yield is still low, and prices, on a historical basis, remain quite high.
— Real estate. The S&P/CoreLogic/Case-Shiller National Home Price Index, which I helped develop, rose 17.7%, after correcting for inflation, in the year that ended in July. That’s the highest 12-month increase since these data begin in 1975. By this measure, real home prices nationally have gone up 71% since February 2012. Prices this high provide a strong incentive to build more houses — which could be expected eventually to bring prices down. The price-to-construction cost ratio (using the Engineering News Record Building Cost Index) is only slightly below the high reached at the peak of the housing bubble, just before the Great Recession of 2007-09.
There are many popular explanations for these prices, but none, in itself, is adequate.
One widely discussed model blames the high pricing on the actions of the Federal Reserve, which set the federal funds rate near zero for years and has engaged in innovative policies to push down the yield on long-term debt. This central-bank-at-the-center model says that when the Fed lowers interest rates, all long-term asset prices rise.
There is an element of truth to this model. But it is oversimplified.
After all, the Fed over the years has largely followed a simple stabilization rule in setting short-term interest rates. John Taylor, a professor at Stanford University, has created so-called Taylor rules that fit fairly well in describing Fed actions over decades, despite interruptions and innovations after financial crises. If there is a major decline in asset prices one of these days, it is unlikely to be a simple reaction to the Fed, which has, for the most part, behaved predictably.
In reality, most investors think in terms of contagious narratives that excite the imagination, not complex mathematical models. Economist John Maynard Keynes wrote that speculative prices are determined by intuitive guesses. He said that most people arrive at a “conventional basis for valuation” for asset prices such as stocks or homes, and that they accept it without much thought because everyone else seems to be accepting it. But Keynes warned that sooner or later, the basis for these prices is likely to “change violently as a result of a sudden fluctuation of opinion.”
Exactly when such changes will occur is the big question for investors. Unfortunately, economics provides few answers.
One problem is that popular, superficially plausible theories are hard to stamp out, even if they are misguided. They keep coming back, purporting to predict the path of the stock or housing market.
For example, there is a popular tendency to think that any apparent uptrend in speculative prices, even a short one, is a sign of economic strength or even renewed national greatness and that it can be extrapolated indefinitely. This is an illusion built around a tendency to see more momentum than there really is. Try looking at a plot of the U.S. stock market or the U.S. housing market since the COVID-19 recession and see if you are intuitively tempted to assume that you have discovered a powerful upward trend that will continue for years to come.
Stories about the futility of trying to beat the markets are worth paying close attention to, but they are generally not as lively as tales of an acquaintance’s making a killing on Robinhood or through flipping houses, and so are not usually as contagious.
To see how investor opinion about popular models has fared over time, at the Yale School of Management I have been directing stock market confidence surveys of institutional and high-income individual investors.
Consider this survey question: “If the Dow dropped 3% tomorrow, I would guess that the day after tomorrow the Dow would: 1. Increase, 2. Decrease, 3. Stay the same, or 4. No opinion.” The answer “1. Increase” usually dominates. There have been a few exceptions, as in the years leading up to the bursting of the millennium bubble in the stock market in 2000 and during the Great Recession. But we are not in one of those negative periods. The Buy-on-Dips Confidence index that I compute from these answers has been consistently robust for the past few years.
The pervasiveness of fanciful narratives in investing can be found in the genre of “self-improvement” videos and books that encourage people to believe in themselves and distrust so-called experts. This supports a popular culture where people are more inclined to take risks in investing.
Since 1997, in his “Rich Dad Poor Dad” books, Robert Kiyosaki has favorably compared his boyhood friend’s rich father, who was uneducated but had a strong business sense and drive, with his own poor dad, who was educated, politically correct and lacking in self-confidence. The reader is encouraged to identify with the rich dad. According to Publishers Weekly, the books have sold tens of millions of copies worldwide.
Former President Donald Trump has contributed to the risk-taking speculative culture. With Meredith McIver, he published “Trump: Think Like a Billionaire: Everything You Need to Know About Success, Real Estate and Life” in 2004. This book asserts: “Billionaires don’t care what the odds are. We don’t listen to common sense or do what’s conventional or expected. We follow our vision, no matter how crazy or idiotic other people think it is.” More generally, such claims encourage a celebration of one’s own unrecognized — and, in many cases, nonexistent — genius.
These various theories, models and manias are impacting the pricing of important asset classes in perplexing ways. It is difficult to predict when corrections downward might come in the three big markets, but the data suggests that there is an increased risk of declines over periods of a decade or more.
Timing is important, yet it’s impossible to time the markets reliably. It would be prudent, under these circumstances, for investors to make sure their holdings are thoroughly diversified and to focus on less highly valued sectors within broad asset classes that are already highly priced.