Yale University market scholar Robert Shiller entered the bubble debate last week as noted in the Financial Times article Fears Grow Over US Stock Market Bubble. 

 The Nobel economics laureate told the Financial Times that his valuation confidence indices, based on investor surveys, showed greater fear that the market was overvalued than at any time since the peak of the dotcom bubble in 2000.

It looks to me a bit like a bubble again with essentially a tripling of stock prices since 2009 in just six years and at the same time people losing confidence in the valuation of the market,” he said.

Prof Shiller added there was no historical evidence for a link between interest rates and share prices. “You would think that when interest rates are higher people would sell stocks, but the financial world just isn’t that simple.

He defended his now famous measure of valuation, often referred to as the Cape (for cyclically adjusted price/earnings multiple), which compares share prices to average earnings over the previous 10 years. This adjusts for the cyclicality of earnings.

Mr Shiller pointed out the fall in earnings in 2008 came as part of a severe recession. “Companies like to take write-offs right away during a recession. Then their earnings can recover from there. If I average over 10 years I don’t see that as a problem. The average includes the actual losses that companies have made.”

He said changing accounting standards could create difficulties for his model but added: “I think we’re better off with changed accounting standards than if we ignored all the changes that happened since 1871.”

Equity Allocations vs. Shiller PE

Michael Green at Ice Farm Capital emailed the above chart as well as the reference to the Financial Times article.

The chart shows equity allocations on the left axis vs. the Case-Shiller smoothed PE ratio on the right.

It is based on Ice Farm analysis using Shiller’s and Fed Flow of Funds data. 

Simple World

I had seen the Shiller piece before, but something caught my eye when I read it a second time.

You would think that when interest rates are higher people would sell stocks, but the financial world just isn’t that simple,” said Shiller.

I am a big fan of Shiller’s model. However, the above statement makes no sense because quite frankly, what Shiller suggests is impossible!

Simple Math

Here’s a simple economic truism: Someone must hold every equity share and every bond 100% of the time.

In aggregate, it’s impossible for people to sell stocks to buy bonds when interest rates are high (or vice versa). For every buyer of common stock there is a seller. Likewise, for every buyer of bonds there is a seller.

Sentiment can change (and pricing with it), but because of simple math, if there was an aggressive sentiment shift towards getting out of stocks in favor of high-yielding bonds, then bond yields would plunge. 

At an individual level one can make changes, but at an aggregate level it is impossible.

Thus, the financial math is indeed simple. It’s the timing of sentiment changes that makes it difficult for the individual and impossible for the aggregate investor. 

Stocks vs. Bonds

Individually, one can sell stocks to buy bonds or vice versa. But what about the possibility that neither is the place to be?

Seven-Year Asset Class Real Return Projections

As of 2015-08-31 (posted on September 15), GMO sees things like this:

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