Robert Shiller, Market Valuations and Irrational Exuberance (By Nikhil K. Majithia, CFA, CFP ®)

Yale University Professor Robert Shiller, a well-respected economist, and the co-creator of the Case-Shiller Home price Index, won this year’s Noble Prize (along with Mr. Fama & Mr. Hansen), for his contributions in the area  of Economic Research (long-term asset price spotting).

 As this Bloomberg story, aptly puts it – this year’s winners’ circle is a contradicting mix:

…The winners represent a "very interesting collection because Fama is the founder of the efficient-market theory and Shiller at least is one of the critics of it,” said Robert Solow, winner of the Nobel economics prize in 1987 and professor emeritus at the Massachusetts Institute of Technology in Cambridge.

"It’s like giving a prize to the Yankees and the Red Sox,” he said, comparing the competing theories to the rivalry between the New York and Boston baseball teams. “What it suggests is there really isn’t a settled doctrine in finance.”

Shiller, who correctly predicted the dot-com bubble and the housing bubble in advance, was acknowledged for his work in the area of trend-spotting asset prices over a longer time-frame.  (If you have not noticed, we are seeing somewhat similar behavior in a lot of the cloud services companies and in social media stocks lately.)

His work in the areas of dividend payouts and stock prices, and price-to-earnings ratio (Shiller P/E) is widely followed by the investment community. And his book, Irrational Exuberance, is a mandatory read for business school graduates (finance major), and is also a part of the curriculum for the CFA charter exams. 

Source: multpl.com

This chart of the Shiller P/E  can be used to illustrate what longer-term valuation metrics suggest about the current valuation of the S&P 500 index[1].

Source: greenbackd.com; aqr.com

This table provides additional insights about likely future returns with different levels of starting Shiller P/Es.  

With the current Shiller P/E ratio [2] above 24, the prospect of long-run positive real returns from stocks is likely going to be mediocre. We understand that this is just one valuation measure. 

However, other valuation metrics  -- such as price-to-sales (chart below) price-to-GDP, price-to-book value and Q ratio -- also suggest that we are bumping at the higher-end of the valuation range for US stocks (notice the price-to-sales ratio at the bottoms in 2002 and 2008).  

 

Source: factset; zerohedge.com

Of course a recurring-liquidity-dose from the fed (and other central bankers) can make a huge difference when it comes to driving stock prices higher (chart below).  

Source: forbes.com; Bianco Research

Obviously, it did not help if you were a rational allocator of capital (basing  your decisions on long-term valuations or some of the earnings/economic data points or the fiscal tightening that was on the horizon this year) and hence, missed some of the strong up move this year and last. 

But over the longer-term, stock prices do follow fundamentals, and valuations are mean-reverting. Extreme optimism (in stock prices in the face of relatively weaker economic data) can turn and move the other way very fast. 

Some of  the smartest money managers and asset allocators are expressing more concerns about the fed's QE program:

Speaking this week at a panel discussion in Chicago, world's largest asset management firm, Blackrock's CEO, Larry Fink, said "It is imperative that the fed begins to taper," referring to the central bank's $85 Billion in monthly bond purchases. "We have seen real bubble-like markets again. We have had a huge increase in equity market. We have seen corporate-debt spreads narrow dramatically."

Additional Reads/Links:

 Richard Koo: QE Trap 

Hedge Fund Manager: Distorted Market

[1] S&P 500 Index: The S&P 500, or the Standard & Poor's 500, is a stock market index based on the market capitalization of 500 large companies whose common stock is publicly traded on the NYSE and NASDAQ Market. 

[2] P/E Ratio is a key valuation used in the investment world; is a ratio of current market price of the security  divided by its earnings (on a per share basis)

The above links are provided for your information only. As they are provided by third parties, NFP Securities, Inc. (NFPSI) does not endorse, nor accept any responsibility for the content. NFPSI does not independently verify this information, nor do we guarantee its accuracy or completeness. The opinions expressed in this commentary are those of the authors and may not necessarily reflect those held by NFP Securities, Inc.  This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results.