Remember this guy?
He is Robert Shiller, Yale economist, author of the bestseller, Irrational Exuberance and co-winner of the 2013 Economics Nobel Prize (see blog 27). Shiller has spent a big part of career studying episodes of insanity in the stock market, especially periods when stock prices went into orbit, reaching levels that were way above its long-term price-to-earnings (PE ratio).
Take a look at the following chart and you will see what he means.
This chart is downloaded from Shiller’s website just this week. The jagged line is the PE ratio of the S&P 500 index from Jan 1871 to Jan 2018. The S&P 500 is the barometer of the overall US stock market which comprises thousands of firms, many too small for institutional investors to bother.
Shiller calculates this PE ratio is a special way. He divides each month’s P by an average of the previous 10 year’s earnings of the 500 firms in the S&P 500 index. This is to account for the fact that earnings are cyclical. The 10-year average is smoother and arguably more accurate measure of ‘normal’ earnings than earnings in any particular year. Because earnings 10 years ago are not the same as current year earnings due to inflation, he also adjusts for that. The result is P/E10 shown on the vertical axis.
The historical average P/E10 ratio is about 15 (the moving average version of this mean moves around over time, but not much relative to stock prices). The consensus among market observers is that 15 is the market’s fundamental value, like an anchor that stock prices eventually return to if they go astray.
What catches your eye when you look at Shiller’s chart? If you take 15 has the ‘rational’ PE ratio of the stock market, then clearly, there are many periods of insanity in the stock market. Shiller himself identifies 1901, 1929, 1966, 1981, 2000 as key periods when stocks were grossly overpriced. But what goes up must come down. Big crashes following exuberant periods are evident from the chart. The opposite is also true: the market always rebound after periods when stocks were oversold.
Being a behavioral economists, Shiller argues that these big swings largely reflect’animal spirits’ – investor emotions gone overdrive, leading to extreme overoptimism and pessimism. You can tap further into Shiller’s thinking in his popular book, Animal Spirits: How Human Psychology Drives the Economy and Why it Matters, (2009, with fellow Nobel laureate George Akerlof).
Shiller’s chart also leads to a tantalizing thought: can one profit by selling stocks when the market’s PE ratio is above 15 and buy when the PE ratio below 15? Let’s call this the PE15 trading rule. This question brings me back to my recent theme, which is that many investors think there are profitable trading rules for predicting stock prices. Is PE15 a trading rule that investors should follow to avoid market excesses or hunt for bargains?
I will deal with this practical question in my next blog 🙂