Stock Prices and the Titantic Theory

As I’ve written before, I’m not a fan of Robert Shiller’s “CAPE” valuation metric, which is the stock market’s P/E ratio based on the last ten years of earnings. I don’t see why we need to go back that far. Also, the CAPE has been above average almost consistently for the last 20 years. A good rule of thumb is that if some valuation metric reveals a big mispricing, the problem probably lies with the metric, not the price. In this weekend’s New York Times, Professor Shiller writes on stock market valuations:

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 in work 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.

I don’t accept the notion that stock prices are elevated. For one, the market’s dividend yield is near 2% as it’s been for the last decade (except for the worst of the financial crises). The stock market’s one-year P/E Ratio has been fairly stable over the last 15 months. That may come as a shock to many people, but it’s true.

Consider that the S&P 500 is up 6.65% so far this year and earnings are projected to grow 11.14%. The calendar year is 63% over which means valuations are basically the same now as they were at the start of the year.

Posted by on August 18th, 2014 at 1:37 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.