You might have noticed that market gains have been extravagant of late. If you’re invested in a broad swath of the market, you’re likely happy. Happiness is perhaps an understatement when describing the emotional tenor of the stock market landscape. A better word, at least according to Robert Shiller, might be “Mania”.
Nobel Prize winner Robert Shiller is an expert on Market Volatility and the Economics of Behavior. He wrote a book called “Irrational Exuberance” just before the Dot-Com Bubble burst more than a decade ago, and he’s trotting out his particular brand of logical wet blanketism again in 2017. Shiller says many of the conditions which presaged the last market crashes are in full bloom today.
— Robert J Shiller (@RobertJShiller) February 18, 2017
Is he right? If so, what do we do about it?
Is Today’s Market Overpriced?
Most of the time when people describe a security as “overpriced”, their statement is somewhat subjected. Many investors are very sophisticated in the judgments they make about the inherent value of stocks. And many are not. Oftentimes, the investors buying because of emotional or cultural reasons drive up the cost of stocks well beyond their logical valuation. Glancing casually at the stock market today, this may or may not be true.
But there are ways to find out.
One of the simplest metrics that Robert Shiller offers up is the Trailing P/E Ratio. Normally, a trailing P/E will measure a stock’s current price relative its Earnings Per Share from the last 12 months. Shiller replaces that second variable with 10 years.
P/E Ratios tell investors how many dollars they would have to invest in order to get one dollar of return. When comparing current prices of the entire stock market to the last decade’s returns we get:
That’s the highest Shiller trailing P/E we’ve seen since the early 2000’s.
The Market Loves Excitement, but Hates Uncertainty
It’s important to note that much of the recent stock market boom has directly resulted from the election of Donald Trump. Trump has blared his pro-business, anti-regulatory message for months. He hasn’t actually done much of anything in this regard yet, but he symbolizes a healthy regulatory environment for big gains.
Shiller urges investors to think about the other side of a revolutionary President. When national budgets are massively altered, emotions run high, important policies are gutted and scrapped, it creates a vulnerable environment for a market achieving ever higher heights – especially if those heights (like Trump’s pro-business message) are mostly symbolic.
It’s also important to remember that we’re well into an 8-year bull market. Trump or no Trump, there will be a market correction one of these days.
So What Do We Do About It?
I agree with Robert Shiller’s sense of current market health. But it’s more difficult to decide what to do with that.
It’s almost never a good idea to try to time the market. The current bull run could last another two years for all we know.
The key to investing today is 1) Diversification, and 2) Risk Assessment/Caution.
If you’re invested in individual stocks, consider how the companies might handle a market correction, or even a crash of 30-40%. Would they survive? Consider increasing your bond position, or investing in index funds that give you mammoth diversification across continents.
If you want to ride this bull market out and see how high it goes, be more vigilant than ever about watching the international factors that determine the success of the companies you are invested in. Remember, Warren Buffett said “Be cautious when others are greedy”.
Nobody can predict the future, but I think Shiller’s on the money with this one.