The United States stock market looks very expensive right now. The CAPE ratio, a stock-price measure I helped develop — is hovering at a worrisome level.
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.
The CAPE was never intended to indicate exactly when to buy and to sell. The market could remain at these valuations for years. But we should recognize that we are in an unusual period, and that it's time to ask some serious questions about it.
My colleague John Y. Campbell, now at Harvard, and I created the ratio more than 25 years ago. It works like this: Using inflation-adjusted figures, we divide stock prices by corporate earnings averaged over the preceding 10 years. Our ratio differs from a conventional price-to-earnings ratio in that it uses 10 years, rather than one year, in the denominator. It does so to help minimize effects of business-cycle fluctuations, and it's helpful in comparing valuations over long horizons.
In the last century, the CAPE has fluctuated greatly, yet it has consistently reverted to its historical mean — sometimes taking a while to do so. Periods of high valuation have tended to be followed eventually by stock-price declines.
Still, the ratio has been a very imprecise timing indicator: It's been relatively high — above 20 — for almost all the last 20 years, with the exception of 20 months, mostly in the recession of 2007-9, when prices tumbled and it fell as low as 13.32.
In other words, the ratio is saying the stock market has been relatively expensive for years. And that raises a question: Are there legitimate factors behind high stock prices that might keep them elevated for decades more?
Such a question has been addressed before. In 1930, just after the 1929 crash, Prof. Irving Fisher of Yale published "The Stock Market Crash — and After." The book explained why there were "sound reasons" for the high valuations of 1929. He couldn't have been more wrong.
To understand valuations, I have conductedquestionnaire surveys of individual and institutional investors since 1989, recently under the auspices of the Yale School of Management. One question, asking if stocks are overvalued, undervalued or valued about right, is used to create a valuation confidence index. When the CAPE ratio reached its record high of 44 in 2000, the confidence index hit a record low.
But as the market fell from its 2000 peak, the confidence index rose to high levels again, where it remained until recently. This year, the index took a dive for individual investors, and now is at the lowest level since 2000. The confidence of professional investors has fallen, too, but not as sharply. In short, people are beginning to worry.
Yet valuations remain high, and it would be comforting if they made sense. So I've been trying to come up with a theory to explain today's elevated stock prices — and maybe convince myself that they could remain lofty for some time. One factor to consider is that bond prices are high, too.
Inflation is running at only around 2 percent, and 10-year Treasury notes yield less than 2.5 percent, a very low level. Bond prices move in the opposite direction as interest rates, and high bond prices may account for the high valuations in stocks.
The inverse was certainly true in the late 1970s and early '80s, when inflation and Treasury yields were in the double digits. Back in 1979, Franco Modigliani of M.I.T. and Richard A. Cohn of the University of Hartford argued that investors were then undervaluing the stock market, because they failed to perceive that despite high inflation, real interest rates were relatively modest. The two men rightly predicted that there would be a stock market boom if inflation fell significantly — as we now know it began to do within a year after they made their case.
It's possible that bond prices account for today's stock market valuations. But that raises another question: Why are bond prices so high? There are short-term explanations: the role of central banks, for example. But is there a compelling reason for prices of stocks and bonds (and maybe houses, too) to remain high indefinitely?
I've looked for untraditional answers. Perhaps today's prices have something to do with anxiety about the future. I suspect that after the financial crisis, working people are much more worried about their future pay. Many are concerned that they might lose their jobs to cost-cutting, or that they might eventually be replaced by a computer or robot or website. Such anxiety might push them to try to make up for these potential shortfalls by investing in stocks and bonds — even if they worry that these assets are overvalued.
Extrapolating from a theory of Robert E. Lucas Jr. of the University of Chicago, one might well expect lofty stock prices amid such worries: When there aren't enough good investing opportunities, people wishing to save more for the future may succeed only in bidding up existing assets even if they think they're overpriced. Call it the "life preserver on the Titanic" theory.
This explanation, though, is probably not the whole story. The problem, as shown in my work with Sanford Grossman, founder of QFS Asset Management, and inwork by Lars Peter Hansen of the University of Chicago and Kenneth Singleton of Stanford, is that the market just moves up and down more than Professor Lucas's theory would suggest.
So nothing I've come up with is a slam-dunk explanation for the continuing high level of valuations. I suspect that the real answers lie largely in the realm of sociology and social psychology — in phenomena like irrational exuberance, which, eventually, has always faded before. If the mood changes again, stock market investments may disappoint us.
Sent from my iPad
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