A Nobel laureate is cautiously positive about the market for the long run but worries about how long that will need to be.
One prediction seems solid: The coronavirus epidemic will get much worse in the United States in coming weeks. But where the stock market is heading is much less certain.
It is too simple to assume that with its steep decline, the market has already discounted epidemiologists' forecasts for Covid-19. By this logic, the stock market would fall further only if the virus turns out to be worse than forecast.
But the world has never seen an event quite like this before — a new pandemic that is being aggressively throttled by draconian shutdowns of whole industries, and by confining millions of people to their homes. The tools of statistical analysis and machine learning, powerful as they are, can't adequately assess what the world is experiencing. There isn't any stock market experience that is entirely analogous.
I believe the pandemic's effect on stock prices today is better understood as a series of emotional responses to unique events. People are trading stocks with their cellphones on their living room couches with the television news blaring about the pandemic. There is widespread foreboding, not just about the economy but about the possibility of grave illness or death in the weeks ahead.
People are seeking reassurance from homespun investment advice, like the old nostrum that the percentage of stocks in your portfolio should be equal to 100 minus your age, come what may. If you are 60, for example, you should hold 40 per cent stocks, under this rule.
But this advice isn't grounded in any scientific truth about financial markets.
I don't object to it, however. For psychological reasons, it may be a good idea to follow some rule as long as it doesn't defy common sense. And the 100 minus your age stock market rule has some virtues: It impels older people to take fewer risks, yet encourages them to take limited action in market downturns, buying just enough to restore the stock balance after market declines. Taking some action may make people feel better.
This recipe for a healthy portfolio reminds me of a rule for insomniacs: Try to go to bed at the same time every night. Make that a routine and stop worrying. If it works for you, why not? If it doesn't, no matter. Try something else.
The truth, though, is that there is no purely scientific way to forecast turning points in the stock market in light of the kind of changes we have seen recently. Unfortunately, we just have to accept it.
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That said, we ask, is the market cheap today? Is it expensive?
Here's my equivocal answer: It's not as highly priced as it was just months ago.
Consider the cyclically adjusted price-to-earnings (CAPE) ratio (real stock price divided by a 10-year average of real earnings, sometimes called the Shiller P/E) that I have been advocating for decades. It was 31 in January 2020. That was high, surpassed only in two previous periods: the 1929 peak just before the crash, when it was 33, and in 2000, just before the 50% stock market drop, when it was 44.
Now, the CAPE is 23, compared with the historical average since 1881 of 17. From this perspective, the market looks on the expensive side, but not inordinately so.
When the CAPE has been at such a level, it has tended to show moderate positive, not disastrous, returns over the next 10 years.
If we stopped here, we could be sanguine about the market's prospects for the next decade. After all, epidemiologists conservatively forecast that the present pandemic will be over in a couple of years, at the most, though there may later be resurgences. We may well have a vaccine and effective treatments for the disease by then.
Unfortunately, though, we can't stop there.
I worry that the present anxious situation may stay in the collective memory for decades, much as the stock market crash of 1929 did. That could make people more risk-averse, possibly portending lower valuations on the stock market.
Consider that the 1929 crash and the Great Depression have remained vivid in the collective memory for over 90 years.
The stock market record from that period is sobering. I've calculated the real total return (including dividends and inflation) of the S&P Composite Stock Price Index. Using that metric, after the 1929 market peak, stock prices lost three-quarters of their value by 1932. They didn't rise above their 1929 peak until November 1936, seven years later.
That's not the end of the story. The market fell again in 1937, and oscillated above and below the 1929 level for many years. In fact, it was not until 1949, 20 years after the 1929 crash, that the real total return index finally surpassed its 1929 level on a sustainable basis.
Let's hope that the current pandemic does not reach proportions so tragic that will similarly blossom into a narrative that is remembered for decades, with the power of depressing stock prices for a long time. I think there is a risk that could happen but I don't expect that it will.
On balance, I'd emphasise that the stock market is not as expensive as it was just a month ago. Based on history we would expect to see it to be a reasonable long-term investment, attractive at a time when interest rates are low.
As a practical matter, my advice is to look at your portfolio to make sure that it is not so heavily weighted to stocks that further losses would be unbearable. Otherwise, I'd try not to worry too much about the stock market. Most likely, it will do moderately well in the coming years, even if there is a risk that you will need to be very patient.
I would worry more about keeping one's family safe from the coronavirus.
Written by: Robert J. Shiller
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