Bears Vs Bulls

**mlk_man** · 12-18-2005, 03:29 AM

Doesn't seem to be enough bear talk around here these days to even things out so thought I'd post this:

We're still too exuberant

The man who wrote the book on irrational investing says we haven't learned our lesson. I believe him
December 17, 2005: 9:00 AM EST
By Geoffrey Colvin, FORTUNE senior editor-at-large

NEW YORK (FORTUNE) - One of the most important lessons you can ever learn about markets is also one of the easiest to forget: Just because prices are more reasonable than they were doesn't mean they're reasonable. I'm sorry to report that it's absolutely the lesson to keep in mind now that the Dow has hit 42-year highs and crept back up near 11,000.

The preeminent teacher of that lesson is Robert Shiller, a Yale professor with a strong record of thinking independently and being right. His book "Irrational Exuberance," arguing that stock prices were insanely high, appeared almost precisely at their peak in March 2000. Now he has updated the book to reflect 2005 valuations and concludes that, believe it or not, the market is still irrationally exuberant.

How does he come to this conclusion? After all, stocks are generally lower than back in the bubble days, and we've had four years of economic growth to rehabilitate corporate profits. His answer is simple. As he told me the other day, all the competing theories boil down to one easy-to-understand calculation: "The trailing P/E ratio for the S&P composite is still around 25, vs. a long-term average of 15."

That's a huge difference, much greater than what you read about in the newspapers. The commonly cited figures -- a current market multiple of 17, vs. a historical average of 15.2 -- are based on the previous 12 months' earnings. But, as Shiller points out, that's foolish: "Twelve months is kind of short, only a fraction of one business cycle."

So he uses a ten-year earnings average, an approach advocated by Graham and Dodd in Security Analysis, the value investor's bible. And while prices are clearly above the long-term trend any way you cut it, by that measure they are still mountainously beyond normal.

For some people -- I don't want to mention any names, but cast a glance at "Nope -- We're Too Gloomy" -- that conclusion is impossible to accept. So they contort the numbers and cook up theories about why today's prices aren't really as high as they appear. The most significant theory, which surveys show is believed by vast armies of investors, is that stocks aren't as risky as we used to think they were, so they're actually worth more than investors have historically been willing to pay. In other words, we were simply wrong for the past several decades but at last have seen the light, and in that light today's overall market valuations make sense.

Shiller would hoot at that one if hooting were his style. Instead he just mentions that this is "the Dow 36,000 theory." That 1999 book by investing columnist James Glassman and former Fed economist Kevin Hassett, you'll recall, argued that prices would rocket as the populace realized that in the long run, stocks always beat other investments, so they're really safer than conventionally thought.

We must all thank Shiller for reminding us of this prediction from the book: "... a sensible target date for Dow 36,000 is early 2005, but it could be reached much earlier." Or not.

It's easy to make fun of Dow 36,000, but it's more important to recognize that the theory behind it is still at work, and it still doesn't add up. As Shiller points out with voluminous support, it just isn't true that stocks always outperform other investments over long-term periods, and, he says, "there is certainly no reason to think they must in the future." If that's true, then stocks would appear to be just as risky as ever. We are not in a "new era." Math still works the same way. And today's valuations are too high.

No one wants to hear that. It's almost irresistible to believe that after all we investors have endured -- the hellish bear market, the recession, the scandals -- we've emerged from the crucible sadder but wiser, finally willing to face the truth about stock values. But it isn't so. The amazing reality is that we haven't learned our lesson even yet.

**Mike** · 12-18-2005, 08:05 AM

So what would this guy's theory be going forward?

Crash?
Correction?
Consolidation?

Does he account for money flow into / out of the market?

Growing population + growing number of people entering peak earnings years = more $$$ moving into the market (which one would expect to translate into higher stock prices... right?).

**rokid** · 12-18-2005, 12:10 PM

Mike,

Dr. Shiller is stating, as he did in 2000, that we're paying too much for stocks (S&P 500). Stock prices should reflect the expected, discounted flow of income from stock ownership (dividends and capital appreciation). Apparently,Shiller doesn't believe potential, discountedincome flowsjustify current prices, i.e. P/Es at 25 using the 10 year earnings average.

More money moving into the market could drive prices higher. However, those prices would have to be based, not on fundamentals, i.e. earnings and growth, but being able to sell to the "greater fool". During the Internet bubble lots of "greater fools" were found until March 2000.

Shiller, and most academics, predictedbelow average market returns for all of this decade.Since the S&P 500 has averaged .5% a year through the first six years of the decade, their predictions, so far, are correct.

No crash, correction, or consolidation. More a slow reversion to the mean from the long bull market of the 1980s-90s.:?

**Birchtree** · 12-18-2005, 02:25 PM

Dr Shiller is a bear, was a bear and will always be a bear. But it certainly doesn't hurt to know his views - similar to EWP Robert Prechter. Love them bears.

Dave M · 12-18-2005, 04:14 PM

Is it not a fallacy to say the market is so perfectly predictable? The academic wants it to be so, and if it were he would be correct: we would own stocks in order to receive the earnings stocks provide. I own a few such stocks, or rather mutual fund shares, notably the Templeton Foreign Fund which has been a favorite of mine for many years because of its dividends.

But that is not why I own shares in the TSP. I'mlooking forvalue not income. For that reason I have mostly abandoned trading. Instead I have adopted an allocation strategy which ignores the unpredictable bumps and just steers the middle ground, with a little of this and a little of that andconstant course corrections.

Thanksfor this site, Tom.

Dave

**rokid** · 12-18-2005, 06:03 PM

Dave M,

Unpredictable market.

A person could wait a long time (and lose a lot of money) waiting forexpert predictions to come true. I'm hedging my bets byspreading my retirement money over all of the TSP asset classes -except the G Fund.

I like your approach, i.e. steer the middle course!:^

**Mike** · 12-19-2005, 06:40 AM

So, does his theory apply to all markets - i.e. commodities, real estate, precious metals, and bonds?

If that's the case, the bond market is probably undervalued.

**The_Technician** · 12-19-2005, 01:42 PM

I can't help but look at the Oil crises in the 70's to foresee what is coming.....a correction in the making.....this is one true fact here, if you're spending your money on fuel, you ain't got it to spend anywhere else....and that means flat profits....

But that doesn't mean you can't make a return on investment....you just have to be like a cat jumping from one hot tin roof to another....

:^

**rokid** · 12-19-2005, 01:57 PM

Mike wrote:

So, does his theory apply to all markets - i.e. commodities, real estate, precious metals, and bonds?

He addresses real estate in the latest edition of his book "Irrational Exuberance". Although I haven't read it, I'm under the impression that hebelieves we're experiencing a real estate bubble.

Dr. Shiller is an advocate of behavioral finance, i.e. he doesn't believe that the efficient markets theory and/or CAPM explain enough about how the markets actually work.

**Mike** · 12-20-2005, 07:24 AM

If he thinks there is a national real estate bubble, I would say he's wrong. Local ones? Yes - just like there's always a local "bubble" in some sector or industry. In order for there to be a national bubble, prices should have gone up in all areas - and they didn't. There are still places with cheap housing whose prices haven't gone up at all recently.

**rokid** · 12-20-2005, 12:13 PM

Mike wrote:

If he thinks there is a national real estate bubble, I would say he's wrong.

This is a quote from a review on Amazon.com by Izaak VanGaalen:

"With the publication of the second edition of his book, Shiller argues that many of these factors are at work in the real estate market boom. The prices of US homes have increased 52% from 1997 to 2004. Historically this is unprecedented. Today people are speculating in the real estate market like they did in stocks in the 1990's, and much like the stock market, the phenomenon is global. It is happening in London, Vancouver, Moscow, Shanghai, and elsewhere. All the indicators of a speculative bubble are present."

I was in London last year and couldn't figure out how peoplewere paying for houses on their salaries. The same is true in Washington, DC for anyone just starting out.

I read Dr. Shiller first edition - in 2004! I think I'll get the second edition to actually see what he says about housing. He sure wascorrectabout the2000 stock market, i.e. his book came out and the market crashed!