Many of you have been sprinkling the term
“animal spirits” into your blogs and articles lately and referencing the Shiller
CAPE ratio. Good stuff. That’s why we’re sharing Robert Shiller’s piece from
yesterday’s NY Times with you: Consumer
Confidence Is Lifting the Economy. But for How Much Longer?
Shiller, originator of the eponymous Cyclically Adjusted Price to Earnings (CAPE) ratio, argued that consumer confidence is a critically important advance indicator of economic booms and busts. That said, he admitted we don’t really understand how and why consumer confidence behaves the way it does.
That’s a dangerous notion. We can talk all we
want about a very low (perceived) jobless rate, GDP approaching the magic 3%
target, inflation in check and a record-high stock market with earnings (sort
of) keeping pace with ever-rising share prices, but Shiller argues that doesn’t
fully explain the buoyant mood from Wall Street to Main Street.
Our Take: It reminds of us of the balloonist who doesn’t understand the concept of helium—and that he doesn’t have an infinite supply of it. The view’s great now, but you better be ready when the fuel that’s keeping you aloft eventually runs out.
Our Take: It reminds of us of the balloonist who doesn’t understand the concept of helium—and that he doesn’t have an infinite supply of it. The view’s great now, but you better be ready when the fuel that’s keeping you aloft eventually runs out.
Shiller argues “animal spirits” are at work,
referring to the term popularized by economist John Maynard Keynes in the 1930s
referring to a “psychological state in which people get a consumerist and
entrepreneurial bug that allows them to forget their worries and let their
optimism guide their economic decision-making.”
Is the exuberance
irrational?
According to Shiller, exuberance like this is fueling the lofty stock market, in which “prices have far exceeded fundamental valuations.” He observed that real (inflation-corrected) corporate earnings per share for the S&P 500 in Q3 were only 6-percent higher than they were in Q2 of 2007, just before the financial crisis. In contrast, real stock market prices were 39 percent higher. “That disproportionate increase is based much more on how earnings are being valued than on how the level of earnings has increased.”
According to Shiller, exuberance like this is fueling the lofty stock market, in which “prices have far exceeded fundamental valuations.” He observed that real (inflation-corrected) corporate earnings per share for the S&P 500 in Q3 were only 6-percent higher than they were in Q2 of 2007, just before the financial crisis. In contrast, real stock market prices were 39 percent higher. “That disproportionate increase is based much more on how earnings are being valued than on how the level of earnings has increased.”
Our own Wealth
Advisor Confidence Survey last fall found that nearly 80 percent of
advisors expected a double-digit market correction in 2018, but less than one
third (31%) expected a recession.
Obviously, this disconnect has happened before and
will likely happen again. According to Shiller, “The four major confidence
indexes took a long ride up between 1990 and 2000, again after a recession.
From the bottom of the Michigan index in October 1990 to a peak in February
2000, real S&P 500 price per share rose 256 percent while real
earnings per share rose only 78 percent.”
What gives? Shiller said a traditional explanation is that investors had a rational expectation of future earnings increases, “but, it is clear that they were grossly mistaken. The S&P 500 lost just over half of its real value from its peak on March 24, 2000, to its trough on Oct. 9, 2002. No concrete event caused this plunge, though we can point to the bursting of the dot-com bubble and a recession. Both were plausibly caused by a drop in overinflated confidence.”
What gives? Shiller said a traditional explanation is that investors had a rational expectation of future earnings increases, “but, it is clear that they were grossly mistaken. The S&P 500 lost just over half of its real value from its peak on March 24, 2000, to its trough on Oct. 9, 2002. No concrete event caused this plunge, though we can point to the bursting of the dot-com bubble and a recession. Both were plausibly caused by a drop in overinflated confidence.”
Shiller
said that while Trump’s presidency may have exerted “some impact on animal
spirits in the last year,” it doesn’t explain the preceding eight years of gradually
rising confidence. “I am skeptical that the upward swing can be entirely
explained by standard factors like government and central bank stabilization
policy or technological innovation,” added Shiller.
Our Take: If we
don’t know what’s keeping the balloon aloft, then we’ll never know what’s going
to cause it to plummet--or when. Don’t trust the gauge just because it says
there’s gas left in the tank.
Conclusion
Said Shiller: “History indicates that a long uptrend like this one will eventually shift downward, even if we can’t say when it will happen. While the timing will be a surprise, we can expect a sharp change in direction that is likely to have serious consequences for the economy in the United States and around the world.”
Said Shiller: “History indicates that a long uptrend like this one will eventually shift downward, even if we can’t say when it will happen. While the timing will be a surprise, we can expect a sharp change in direction that is likely to have serious consequences for the economy in the United States and around the world.”
Fasten your seatbelt and always make sure your parachute is working. Think we’re full of crap? We’d love to know what you think and why.
TAGS: Robert Shiller, CAPE ratio, consumer confidence, market overvalued, animal spirits, irrational exuberance
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