Taking a look at the well-explained yet a bit too long for the average millenial post published on thenytimes.com by the Nobel laureat Dr. Robert J. Shiller, Nobel prize winner and author of Irrational Exuberance, a GREAT book about what you can find out more below!
The second edition, 2005, added an analysis of the real estate bubble as similar to the stock market bubble that preceded it, and warned that “Significant further rises in these markets could lead, eventually, to even more significant declines. The bad outcome could be that eventual declines would result in a substantial increase in the rate of personal bankruptcies, which could lead to a secondary string of bankruptcies of financial institutions as well. Another long-run consequence could be a decline in consumer and business confidence, and another, possibly worldwide, recession.” Thus, the second edition of this book was among the first to warn of the global financial crisis that began with the subprime mortgage debacle in 2007.
The global financial crisis has made it painfully clear that powerful psychological forces are imperiling the wealth of nations today. From blind faith in ever-rising housing prices to plummeting confidence in capital markets, “animal spirits” are driving financial events worldwide. In this book, acclaimed economists George Akerlof and Robert Shiller challenge the economic wisdom that got us into this mess, and put forward a bold new vision that will transform economics and restore prosperity.
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.
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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 percent 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.
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 (C.A.P.E.) 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 percent stock market drop, when it was 44.
Now, the C.A.P.E. 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 C.A.P.E. 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 emphasize 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.