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During the palmy days of the tech bubble, countless gurus assured us that “it’s different this time.” All we had to do was load up on tech stocks or day-trade the latest dot-com and we'd be set for life. Then amidst all the ruckus stepped Yale professor Robert Shiller. His book “Irrational Exuberance” was a bold warning—stock prices were too high and bound to crash. He was right and we all should have listened to him.

The basic outline of this story has been written a few other places. There’s just one problem.

It’s wrong.

Few people have gotten further on inaccurate market predictions than Robert Shiller. But still, the media keeps repeating the same urban myth. For the record, Dr. Shiller never called the top. He had been a bear for years (since at least 1996). And he’s never said to go back in the market—he’s still a bear today. That’s been his call and it’s been terribly wrong. Since no one else is saying it, I'll say it. If investors had followed his advice, they would have missed out on a great profit opportunity.

If you’re always screaming that the market is too high, you’re bound to be right one day. I’m sorry, that doesn’t impress me. I need more. You also have to tell me when to get back in again. Over the last 10 years, the S&P 500 with reinvested dividends is up over 140%.
If you bought at almost any point before the market’s peak, and held on to today, you would have made money. The danger period was very brief—from November 1999 to November 2000. And we may soon top those numbers.

By the way, that’s only counting the S&P 500. The S&P Mid-Cap and S&P Small-Cap Indexes have both hit all-time highs recently.

Also, if someone continued to buy as the market fell, their returns would have been even greater. The market is up about 60% in the last three years.

Here’s Fortune’s recent article on Shiller:

One of the most important lessons you can ever learn about markets is also one of the easiest to forget: Just because prices are more reasonable than they were doesn't mean they're reasonable. I'm sorry to report that it's absolutely the lesson to keep in mind now that the Dow has hit 42-year highs and crept back up near 11,000.

The preeminent teacher of that lesson is Robert Shiller, a Yale professor with a strong record of thinking independently and being right. His book "Irrational Exuberance," arguing that stock prices were insanely high, appeared almost precisely at their peak in March 2000. Now he has updated the book to reflect 2005 valuations and concludes that, believe it or not, the market is still irrationally exuberant.

Forty-two year highs! I hope that’s just a misprint. The Dow is at a 4-1/2 year high.

How does he come to this conclusion? After all, stocks are generally lower than back in the bubble days, and we've had four years of economic growth to rehabilitate corporate profits. His answer is simple. As he told me the other day, all the competing theories boil down to one easy-to-understand calculation: "The trailing P/E ratio for the S&P composite is still around 25, vs. a long-term average of 15."

That's a huge difference, much greater than what you read about in the newspapers. The commonly cited figures -- a current market multiple of 17, vs. a historical average of 15.2 -- are based on the previous 12 months' earnings. But, as Shiller points out, that's foolish: "Twelve months is kind of short, only a fraction of one business cycle."

So he uses a ten-year earnings average, an approach advocated by Graham and Dodd in Security Analysis, the value investor's bible. And while prices are clearly above the long-term trend any way you cut it, by that measure they are still mountainously beyond normal.

By using 10-year data, we’re going to have the earnings bust of 2001 and 2002 stuck in our readings for years to come. According to data at Dr. Shiller’s Web site, the 10-year trailing P/E ratio was also over 25 in 1992. If we used that time the market, we would have missed another great bull market.

Worst of all, the 10-year trailing P/E ratio soared over 25 in 1933. That was one of the best times to buy in history. The truth is that this analysis has not been an accurate predictor of market behavior. Are we the ones being told that it's different this time?

Update: Brad DeLong has more.

Posted by edelfenbein at December 20, 2005 1:25 PM