Robert Shiller doesn’t live in a bubble. Last December the Yale University economics professor shared the 2013 Nobel Memorial Prize in Economic Sciences for his contributions to empirical analysis of asset prices. His two fellow laureates are from the University of Chicago: Eugene Fama and Lars Peter Hansen. Fama is father of the Efficient Market Hypothesis, which states that share prices always incorporate all relevant information, making it impossible to beat the market without taking on extra risk. In his 2000 book Irrational Exuberance, a classic of behavioral economics that appeared just as the tech bubble burst, Shiller showed how strongly he disagrees with Fama. The co-developer of the Standard & Poor’s Case-Shiller Home Price Indexes, which track the prices of U.S. single-family residences, also flagged the buildup to the 2007–’08 housing crash. Shiller, 67, weighed in on the wisdom of the market with Contributing Writer Robert Stowe England.
Institutional Investor: Do you see any signs that asset bubbles are forming?
Shiller: The first thought I have is to be clear on what is a bubble. There hasn’t been a really precise definition that has been agreed on. When I was at Nobel Week in Sweden in December, I had repeated arguments with Gene Fama, who refers to the word “bubble” as “that nefarious term.” He’s a smart guy. I’ve always admired him. I think he can’t be completely wrong. Fama thinks of the bubble as a term used by newspaper people — I’m not quoting him exactly — to hype the news. He thinks it means that asset prices will go up exponentially. They go up every day. Day after day they go up and up and up, and bang, it pops. Then it’s all over, and it’s for the history books, and people remember it 50 years later, like they remember 1929. Of course, 1929 wasn’t quite like that because it didn’t go up steadily. And it didn’t pop completely. It took two and a half years to reach its bottom, then it rallied again. Even 1929 doesn’t fit that story. And so Fama is right: That [kind of bubble] doesn’t happen.
What is the best way to think about asset bubbles?
I have a different definition of “bubble.” I thought I should define it myself. So in the second edition of my book Irrational Exuberance, in 2005, I wrote my definition. Paraphrasing it, a bubble is a social epidemic where there’s feedback from price increases to further price increases. The price increases attract investor attention, and then that’s spread by word of mouth and draws more people in. There’s a story behind every bubble. The human mind, psychologists tell us, is very influenced by stories. And so the prominence of certain stories heightens the intensity of the bubble. In the 1920s it was a story about prosperity, a very simple story, and about technological progress, with things like radio and automobiles and washing machines and all kinds of modern things. And there was also the story that the stock market has been the best long-term investment. Edgar Lawrence Smith published a book in 1924 called Common Stocks as Long Term Investments that became conventional wisdom.
Have markets become more vulnerable to bubbles?
Yes. You can see the tendency over time for more bubbles in the real estate market. I have a plot going back to 1890 of the rate of change of home prices, and you can see the volatility. There was a lot of short-run volatility in the first half of the 20th century, but I think that’s probably measurement error. But longer-term volatility has gone up for the last five or ten years. I think that it’s probably going to stay more volatile in the future.
Is the Efficient Market Hypothesis wrong?
The idea that markets are efficient has had a long history. It’s a half-truth. I think markets are efficient in the sense that it’s not easy to make money for the average person. However, it seems like those who support the Efficient Market Hypothesis don’t think there are differences in people’s intelligence and diligence. So the advice is, “Don’t try to beat the market because the market already knows anything you could possibly know.” What about people who work harder and do investigative work to pick investments, and suppose they’re smarter than the average person? Why shouldn’t they be able to outsmart the market? It just seems obvious that they can.
Academics will report that they’ve done studies of mutual funds and they don’t outperform the market. There are also academic studies that mutual funds that have performed well don’t continue to perform well. A lot of people have looked at this literature, which has impressive results, and concluded that it’s just not possible to outsmart the market. So they conclude the market must be brilliant. And I think it’s a mistake. I think the market is not so smart. I still believe that since the market is driven so much by psychology, there is room for smart investing that leans against and stays away from it.
Are there data that can alert investors that a market may be overvalued, such as the price-earnings ratio for stocks?
I have my own price-earnings ratio. It’s called the cyclically adjusted price earnings, or CAPE, ratio. It’s the real price divided by a ten-year average of real earnings. I published papers 25 years ago showing how that ratio predicts returns, and the subsequent data confirm that it still does. The CAPE ratio got up to 46 right before the burst of the [tech] bubble. That’s when I wrote Irrational Exuberance. I thought the market was quite plausibly headed for a crash, and I said so in that book. And when I wrote the second edition in 2005, I showed a plot of price and construction costs. I said I was worried about a crash in the housing market. Right now the CAPE ratio is a little high: It’s over 24. The historical average is something more like 15 or 18. So it’s high but not super high. I’m a little concerned about the market. The last time, the market didn’t turn until the ratio was almost 46. That’s twice as high as it is right now.
What is your advice to institutional investors about investing in a world where there may be more bubbles than in the past?
Someone who is responsible for a portfolio has to read widely and think about human nature and history. Read Irrational Exuberance. Also, read social psychology and sociology books. I recommend reading an old book [from the 1970s] by Irving Janis called Victims of Groupthink: Psychological Studies of Policy Decisions and Fiascoes. That’s a classic with actual case studies of colossal mistakes made by expert committees. They develop a set of criteria for decisions that is too formulaic and bureaucratic. People who belong to a group that makes decisions have a tendency to self-censor and not express ideas that don’t conform to the perceived professional standard. They’re too professional. They are not creative and imaginative in their approach.
