Thursday, January 3, 2008

Shiller's 1996 Prediction

The Famous Robert Shiller Stock-Market Prediction

By | 3 January 2008

Will Robert Shiller be proved wrong about the famous stock-market prediction he made in 1996? Or will be be proved right?

There was a recent thread at the FIRE discussion board ( in which a poster brought up the famous stock-market prediction made by Robert Shiller (Yale Professor and author of "Irrational Exuberance") in 1996.

Irrational Exuberance (Paperback, 2006, 2nd ed.) "
by Robert J. Shiller

He said that, based on his review of the historical stock-return data available to him in January 1996, "it appears that long run investors should stay out of the market for the next decade."

The poster suggested that Shiller's views on the long-term predictability of stock prices have been discredited as a result of the failure of his prediction to come true. I maintain the opposite, that subsequent events back up Robert Shiller's understanding of what the historical stock-return data tells us more than they discredit it.

The poster is making a fair enough observation in pointing out that the events that Robert Shiller said were coming to pass within 10 years have not come to pass within that time-period. In that sense, Robert Shiller has indeed been proved "wrong" in his prediction.

However, the 10-year time-frame he put forward was a relatively insignificant aspect of the groundsbreaking message being delivered by Shiller at the time; and he wouldn't be the only one to have missed the 2003— 2007 bull market, especially from a viewpoint 7 years in advance. Lots of evidence has accumulated in the past 10 years (including evidence gathered as part of our community’s Great Safe Withdrawal Rate Debate) that backs up those early claims made by Robert Shiller.

Robert Shiller Was More Right Than Wrong

It probably will turn out that Shiller got the 10-year thing wrong. But look at what he got right! Robert Shiller was telling us nearly ten years ago important stuff about what the historical data says WRT long-term stock performance that the vast majority of investors still do not yet understand. And the evidence backing up his arguments just keeps getting stronger and more compelling all the time. I don’t think Robert Shiller has anything to apologize for in guessing wrong just a wee bit as to when the things that the historical data says are going to happen actually do take place.

Robert Shiller’s mistake was in giving too precise a date by which he expected to see stock prices at a bottom. Giving time limited stock predictions is generally a fool’s game. Shiller is no fool, of course. My guess as to what happened is that he was trying to give a sufficiently long-term stock prediction (where the odds of being proved right are good) and missed— one could argue he was either too late or too early in his guess.

Is 10 years a long enough time-period for purposes of measuring definitive stock performance? It’s rather a twilight zone time-period, too long to be considered short and too short to be considered truly long. Stock valuations were very high in 1996. Looking at the historical data that existed at the time Shiller made his prediction, I can see why he was led to conclude that it was likely that we would see a big downturn in prices sometime within the next decade [[and we certainly got our downturn in 2000— 2002: normxxx]].

What caused Shiller's prediction to end up wrong is that we entered uncharted waters in recent years. He underestimated AG's propensity to "give money away"— resulting in an unprecedented world-wide housing boom that buoyed all economies and stock markets with $Trillions in printing press paper. There is no earlier time-period in the history of the U.S. in which anything similar occurred. Robert Shiller was fooled. But he was fooled for the best of reasons. He was fooled because he read the historical data so well that he discounted the possibility of the Fed going wild (guess AG wanted desperately to go out with a bang!)

What Matters And What Doesn’t

Robert Shiller will be proved wrong on the small point of timing (and exact timing is a small point). The important practical point for investors seeking financial freedom early in life, however, is that his groundbreaking research has been vindicated on the big points. What difference does it really make if it takes 10 years for those who bet too heavily on stocks to regret doing so, or 11 years, or 12 years, or even 15 years?

The true 'buy-and-hold' investor is not concerned with whether something happens in Year 10, Year 11, Year 12, or Year 15. He is invested in stocks for the long run. And, in the long run, Shiller is going to be proved right, if stocks perform in the future anything at all in the way in which they always have performed in the past. That’s what matters.

Stock prices are going to head downward in years to come because they must. The speculative component of the return on stocks has grown too large to be sustainable for the long term. Stock prices are going to move to more moderate levels sometime in the not-too-distant future (either by declining for a few years or by languishing for many years).

I’m not going to pull a Shiller. I’m not going to say when this is going to happen. But I am confident based on what I know of the message of the historical stock-return data that it is indeed going to happen. I am also confident that Robert Shiller will be recognized in days to come as a pioneer in development of the Valuation-Informed Indexing approach to stock investing (e.g., as William Bernstein, Rob Arnott, Andrew Smithers, Peter Bernstein, Scott Burns, and John Walter Russell).

I doubt whether the investors who listened to Robert Shiller’s words of warning in 1996 are going to regret doing so because those words did not come true until 2008 or 2009. My guess is that some of those who ignored Robert Shiller’s warnings may come to see that they are overlooking the forest for the trees in taking comfort from the fact that Robert Shiller was proved wrong on the small point of timing, while being proved right on the main aspects that matter most.

Irrational Exuberance: Second Edition— New Predictions: Housing

By Peter Han

Sequels often disappoint when compared to their predecessors, but author Robert Shiller has proved the exception to the rule with his second edition of Irrational Exuberance. When the original book released in 2000, Shiller's prescient analysis of bubble-like market behavior provided perspective on the painful meltdown of stock-price valuations that subsequently occurred. Five years later, the Yale professor's bearish predictions about real-estate valuations are enough to give any savvy investor or homebuyer pause.

Shiller is one of several well-known economists and pundits who've begun a running dialogue in the last few years around the drawbacks of unchecked free markets. Few writers, though, dissect the phenomenon of bubble behavior as clearly and thoroughly as Shiller does. As with the first edition of his book, Shiller begins this one with reams of quantitative data around the late 1990s stock-market runup. This new edition adds data on real-estate price trends in the early 2000s, and points out the striking parallels between the earlier stock-market boom and bust, and current trends with housing prices in the United States. Shiller actually believes the two phenomena are related; as investors lost confidence in the stock market and moved their money into real estate, one asset class fell while the other rose. According to Shiller's analysis, the pattern is destined to repeat itself.

Aside from the initial data, the real strength of Irrational Exuberance is the straightforward, almost clinical way in which it explains why things happen as they do. The book walks readers through structural reasons for market bubbles, then ventures into "softer" analyses which professional economists less confident than Shiller would be scared to touch. It examines cultural factors behind market bubbles, such as hype-mongering news media, and psychological factors, such as herd ('crowd') behavior.

In the end, Shiller closes his book with an intriguing set of policy proposals. He argues for a revamping of the U.S. social security system, a new system of house-price insurance for homeowners, and risk reduction through portfolio diversification. Fans of the brainy academic will note with approval that Shiller practices what he preaches: he has begun trying to implement some of his ideas in the real world through two private consulting firms he has founded, Macro Securities Research and Macro Financial. The hope is if Shiller's as correct with this second edition of his book as he was with his first, readers will all learn something from these pages. It's not too late!

See Project Syndicate: Finance in the 21st Century

Imagining Recession

by Robert J. Shiller

The world’s housing, oil, and stock markets have been plunged into turmoil in recent months. Yet consumer confidence, capital expenditure, and hiring have yet to take a sharp hit. Why?

Ultimately, consumer and business confidence are mostly irrational. The psychology of the markets is dominated by the public images that we have in mind from day to day, and that form the basis of our imaginations and of the stories we tell each other. Popular images of past disasters are part of our folklore, often buried in the dim reaches of our memory, but re-emerging to trouble us from time to time. Like traditional myths, such graphic, shared images embody fears that are deeply entrenched in our psyche. The images that have accompanied past episodes of market turmoil are largely absent today.

Consider the oil crisis that began in November 1973, resulting in a world stock market crash and a sharp world recession. Vivid images have stuck in people’s minds from that episode: long lines of cars at gas stations, people riding bicycles to work, gasless Sundays and other rationing schemes. Today, the real price of oil is nearly twice as high as it was at the peak of that crisis, but we have seen nothing like the images from 1973-5. Mostly we are not even reminded of them. So our confidence is not shaken— yet.

Just before the October 19, 1987, stock market crash, the biggest one-day drop in history, the image on people’s minds was the crash of 1929 [[the market had been acting horribly all the preceding week: normxxx]]. Indeed, the Wall Street Journal ran a story about it on the morning of the 1987 crash. I know that those images contributed to the severity of the 1987 crash by encouraging people to sell, because I ran a survey of individual and institutional investors the following week.

Images of 1929— of financiers leaping from buildings, unemployed men sleeping on park benches, long lines at soup kitchens, and impoverished boys selling apples on the street— are not on our minds now. The 1929 crash just does not seem relevant to most people today, probably because we survived the 1987 and 2000 crashes with few ill effects, while 1929 seems not only the distant past, but another world.

But some images of the 1987 crash, driven by computers in tall modern steel-and-glass office buildings, do seem to be on people’s minds today. The stock market suffered one of its biggest one-day drops this year on the 20th anniversary of the 1987 crash, with the S&P 500 falling 2.56%. No previous anniversary of the 1987 crash showed any such drop.

The image of a bank run, of long lines of angry people lining up outside a failed bank, was briefly on our minds after the Northern Rock failure in Britain. But the Bank of England’s direct intervention prevented these images from gaining a foothold on our collective psychology. The images that are uppermost in our minds are of the housing crisis. We imagine residential streets with one "for sale" sign after another. Worse, there are images of foreclosures, of families being evicted from their homes, their furniture and belongings on the street.

If home prices continue to decline in the United States and possibly elsewhere, there could be many more such vivid images. You may yet be presented with the image of your child’s playmate moving away because his parents were thrown out in a foreclosure. You may yet see a house down the street trashed by an angry owner who was foreclosed. Such images become part of your sense of reality, and could disturb your sense of confidence and reduce your willingness to spend and support the economy.

Could such changes in psychology be big enough to tip us into a world recession? While it is far from clear that they will, it is a possibility. Psychology need only change enough to bring about a drop in consumption or investment growth of a percentage point or so of world GDP, and imploding market repercussions can do the rest.



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