I had the opportunity to attend a presentation by Robert Shiller, the esteemed economics professor at Yale. He released the book “Irrational Exuberance” darn near the top of the stock market in 2000, which earned him significant notoriety. The book was a serious-minded appraisal of the equity outlook in a time of near mania for large-cap growth stocks.
Shiller describes himself as a business economist, not an academic one. He differentiates the two by noting academia’s interest in abstract concepts backed up with a lot of equations. Shiller, on the other hand, focuses on the practical history of things and how they relate to the future. His talk primarily addressed housing and equities, with emphasis on their long-run cycles.
There has been some chatter about the housing market bottoming out, but Shiller urged caution. So far, there’s only been a barely perceptible change in the data series. Moreover, he noted that housing has been a pretty weak investment over time. There are immensely long stretches where the real returns have been zero. In fact, from 1890 to 1990 U.S. home prices were unchanged in real terms. Looking back, present day prices are not much different in real terms than they were in 1960. I bet your real estate agent didn’t bring that up.
Shiller was more optimistic about U.S. equities, where he has done important work over the years on his own and with collaborators. One of his big contributions built upon the framework of Ben Graham and David Dodd—who originated the idea of looking at company earnings on a 10-year basis. They didn’t want data mucked up by business cycles, so they adopted a time horizon that could smooth them. Shiller took it one step further by looking at real earnings and real prices over rolling 10-year periods. Over very, very long periods of study, this closed in on underlying business economics, and not simply inflationary effects. It’s now well accepted and known as the cyclically adjusted price to earnings ratio (CAPE).
So what now? Shiller’s model, which has more than 100 years of history, suggests that the present U.S. CAPE correlates with a 10-year real return of 3.6% annualized. Long-term real equity returns in the U.S. have been just below 7%, so this forecast is low in historical terms. However, looking around, it is hard to see how one can achieve a higher return in other core asset classes. It also implies that nominal returns can be around 7%, which is nothing to sneeze at (forecasts may not be achieved).
Though global research is not Shiller’s area of study, it is one of ours, so we’ll add that some of the major European markets have CAPEs today which fall in the high single digit/low double digits range. The U.S. last had similar CAPEs in 1982 and March of 2009. France, Germany, the UK and Spain all are in this range today. So while we hear more chatter about returning to investing in the U.S., and effectively de-globalizing, that may be the wrong idea. We do agree that things in Europe are quite awful. However, they are always awful at major secular lows: In 1921, 1932, 1982 and 2009 the fundamentals were bleak; the prices were not.