By Robert J. Shiller
Despite an eight-day losing streak that ended on Tuesday, the stock market has generally been buoyant in the opening weeks of the Trump administration. The bullish mood could be a self-fulfilling prophecy and lead to continuing gains for a while.
Yet important measurements — some of which I developed — tell us that the market is quite expensive and that investor optimism is tinged with plenty of worry. None of this tells us where the market is going tomorrow, but it suggests that some caution is advisable, and that returns over the next decade or so are likely to be constrained.
Consider first the evidence from what is often called the Shiller CAPE ratio.
What is CAPE, or the cyclically adjusted price-earnings ratio, exactly? Bear with me. This is a bit technical: It is real, or inflation-adjusted, stock price divided by a 10-year average of real earnings. It is usually measured using the price and earnings of the Standard & Poor’s 500-stock index, adjusted for inflation with the Consumer Price Index. In 1988, John Y. Campbell (now at Harvard) and I showed in a joint article that such a ratio has, since 1881, forecast returns somewhat well in the stock market. That “somewhat” is important because the ratio has its limits as a forecasting tool.
Combining value investing with Austrian economics? Read this.