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Interview With a "Grizzly Bear"

TMF: Getting back to some valuation issues, you mentioned in a Wall Street Journal column a few weeks ago that the historical price-to-earnings ratio (P/E) for the S&P 500, up through 1995, was 14. Are you ready to say that the market will return to that valuation?

Shiller: There's a lot of questions about that. It's a question of what aspect of history is likely to continue. Some people think that the average returns are something that we should expect to continue. Other people think it's ratios.

There are factors that might push the ratio up somewhat. Jeremy Siegel [author of Stocks for the Long Run] has been pointing these out. He points out that the inflation rate is lower, capital gains taxes [are lower], and he also points out that people have the ability to be more diversified now, with the growth of mutual funds, so maybe they're not as exposed to risk. These are all reasons to think that maybe the P/E should be up somewhat higher.

But I tend to think that it's not much higher.... I'm reminded of Irving Fisher, who wrote a book in 1929 -- this was published in 1930, but he wrote it in '29 -- he has a whole chapter on reasons why the price-to-earnings ratio should be higher from now on. So, I'm very wary of people who come up with theories about why it should be higher.

TMF: You mentioned the lower interest rate environment. That's one of several factors that many commentators have cited to justify higher P/Es. Another such factor is the recent increase in economic productivity. What's your take on that?

Shiller: Well, if you look at productivity... there was a very strong period in the 1960s, which looks stronger than what we've just been going through. So it's not such an enormous revolution. In fact, we seem to be coming out of a doldrums in productivity growth.... Also, part of the productivity growth... has to do not so much with the new technology but with the bubble itself. We've had this long expansion and it's been driven by strong consumer demand, and also strong investment demand, and that's because of the bubble, I think. And everyone's so optimistic, it's natural to suppose that productivity will go up for a while. I don't think that there's any evidence that the long-run productivity growth should be higher.

TMF: What about corporate profits? Glassman and Hassett noted in the Journal that from 1996 to 2000, corporate profits grew at a pace about double their historical average. Is that a legitimate cause of the market's increase during that time?

Shiller: I think that's again part of the bubble. This is the longest economic expansion in U.S. history, the one from 1991 to the present. Let's look back at the second-longest, that was 1961 to '69, and S&P earnings, in real terms, inflation-corrected, rose 45% in that period.... So it was a similar period of spectacular growth, maybe not quite as spectacular as recently, but then they stopped growing.... When you get up to 1994, 25 years later, [corporate profits] were at the same level in real, inflation-corrected terms. And that was also a bubble, a euphoric period.

There, it was connected more to the moon shot, and a lot of the fantasies about technology revolved around that.... People were spending, and the economy boomed for a while, and earnings grew a lot, but then once the euphoria faded, they stopped growing.

TMF: What about the "reduced risk premium" argument, the idea that if investors see investing in stocks as less risky, than, say, generations that grew up in the Great Depression or the recession of the early '70s, then they will pay a higher P/E for stocks?

Shiller: I think that was one of the arguments. I mentioned this book by Irving Fisher in 1929 -- that was one of his arguments. It's really remarkable how history repeats itself. In 1924, there was a book by Edgar Lawrence Smith which argued that stocks have always outperformed other investments, and that book got a lot of attention in the '20s, and it seemed to help propel the market up. And Irving Fisher, then in '29, said that people have learned, investors are much more sophisticated now, and they know that there's really no risk to stocks -- amazingly, he said that.

TMF:  Well, that is interesting, although surely there are many differences between now and the 1920s. How do you respond to those who argue that we've learned how to prevent Great Depressions, or severe recessions similar to what we experienced in the early '70s?

Shiller: First of all, I should dissociate myself from those who think history repeats itself in exact detail. The only reason for singling out '29 is that is the other biggest bubble. There was a speculative bubble going on in the '20s, and so it's the other example, for what it's worth. But you're right, I think the Fed is more enlightened now. After the crash in '29, the Fed tightened interest rates, and that's a big factor in the Depression that followed. We won't make that mistake, so I think that we shouldn't assume that anything terrible is going to happen to the economy just because of these drops in the stock market.

TMF: Your book focuses a lot on the S&P 500 and the overvaluation of the market generally. Yet there are those who argue that if you take out the largest 70 or 80 companies in the S&P, the price-to-earnings ratio of the rest of the index is not very high.

Shiller: I think there are still low-P/E stocks, and there must be some good investments. That's one thing I changed in my afterword. I found it [the book] so completely negative on stocks, I have to recognize that they're not all expensive, and there are certain things that are traded in the stock market that are very different from others, like real estate investment trusts [REITs], for example.... There's not any simple advice. There must be stocks that are good investments.

TMF: On that note, thanks a bunch for your time.

Back to Part 1 »


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