The Economist Who Predicted The Dotcom Crash Thinks Stocks Are… Actually Remarkably Cheap

The Economist Who Predicted The Dotcom Crash Thinks Stocks Are…  Actually Remarkably Cheap
Milou Beunk

about 3 years ago3 mins

Mentioned in story

What’s going on here?

With several major stock markets scoring fresh record highs, company share prices are by most measures looking expensive – very expensive. The corresponding risk of a valuation dip should normally send investors running a mile. Yet a new study from the rockstar economist who spotted two of the biggest bubbles of all time explains why, seen another way, stocks are actually really cheap right now – and may represent one of your best shots at making money.

What does this mean?

Robert Shiller has superstar status in the economic world, thanks to his famously accurate predictions around the bursting of both the dotcom bubble and the last US housing bubble. And the very valuation measure that he used to call those previous stock market drops currently shows that US shares in particular are more expensive than they’ve ever been before – higher even than right before the Great Crash of 1929. Given that we’re still in the middle of a pandemic, you might think it’s especially surprising that the S&P 500 index has risen 15% this year.

So why isn’t Shiller calling the next stock market crash? Thanks to one factor that’s significantly different this time around: while stocks are at record highs, interest rates are at record lows. Shiller and his colleagues took a fresh look at what this means for share prices – and came up with a new way to adjust stock valuations accordingly. The results might surprise you: correcting for current interest rate levels leaves stocks looking the cheapest they’ve been in almost 40 years.

Why should I care?

Investors have good cause to obsess over the justifications for stock prices: if they’re expensive, then you’re not likely to make much money in the coming years; if they’re cheap, then you are.

Applying Shiller’s updated measure to historical data suggests that it does a good job of predicting returns from stock investments over the following decade, as shown in the below graph. The blue line indicates that US stock investors should see respectable gains of around 5% a year over the next 10. Shiller’s conclusion is therefore that stocks look like an attractive option in spite of markets’ all-time highs.

Shiller's adjusted valuation measure (ECY) compared to subsequent 10 year returns
Shiller’s adjusted valuation measure (ECY) closely parallels subsequent returns (Source: Bloomberg)

Of course, theories always attract critics. In this case, they point out that interest rates are normally low when economic growth is weak – and weak growth is normally bad for stocks since companies struggle to increase earnings. With earnings growth the more important driver of stock prices, any changes to companies’ future profit outlook could cause stocks to crash regardless of whether rates remain low.

Even these critics, however, have to admit that economic growth expectations for 2021 look pretty rosy – and there’s no sign central banks will abandon rock-bottom target interest rates anytime soon. The reality is that the unprecedented nature of the present situation means no backward-looking model is foolproof.

What’s worth noting, though, is that the above debate largely centers on US stocks. Outside of America, markets appear even more reasonably priced given interest rates there. Shiller, indeed, points out that while stocks are near their cheapest in 40 years in the US, China, and across Europe, his model suggests that major share indexes in the UK and Japan are at their cheapest ever.

For my part, I agree with the idea that many of the world’s stock markets are headed for a perfect scenario of improving growth and low interest rates in 2021. But I’m planning to look outside the US for the best potential returns – checking out exchange-traded funds such as the iShares Core FTSE 100 UCITS ETF and the iShares MSCI Japan ETF to play Shiller’s suggestions regarding the UK and Japan.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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