The problem is that Western central banks have undertaken the largest financial experiment in history. Their policy has been to boost financial markets, particularly the US S&P 500 – the world’s most important equity market index.
This policy has failed twice before in 2000 and 2007, and Shiller fears we will now see a further collapse. This is a major risk as today’s Great Unwinding of policymaker stimulus gets underway.
US STOCK MARKET VALUATIONS ARE AT DANGEROUS LEVELS
Shiller’s original insight was that it was possible to recognise when investors had become over-enthusiastic:
- Traditional values for the P/E ratio simply divide the daily market price by current earnings
- But Shiller’s CAPE version instead uses average earnings across the 10-year business cycle*
Using a 10-year average for earnings enables his CAPE Index to highlight peaks and troughs in investor enthusiasm.
The ratio shot to fame in 2000, when published in Shiller’s book Irrational Exuberance, where Shiller correctly argued that markets were about to collapse:
- 1929 had been the only previous example when markets had traded above a CAPE ratio of 25 (red line)
- But in 2000, the ratio surged to nearly 45, as central banks allowed the dot-com mania to develop
- Until then, they had seen their role as being “to take away the punch-bowl as the party develops“
- Instead, under Fed Chairman Alan Greenspan, they came to believe their role was to support the stock market
Over the past 15 years, stock markets have become more and more dependent on central bank support. As we noted in chapter 2 of Boom, Gloom and the New Normal, Bank of England Governor Eddie George explained the policy to the UK Parliament in 2007 as follows:
“When we were in an environment of global economic weakness at the beginning of the decade it meant that external demand was declining… we knew that we had to stimulate consumer spending. We knew that we had pushed it up to levels that could not possibly be sustained in the medium and longer term…That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
But central banks have since refused to remove this ‘life-support’ and have instead increased it to all-time record levels, whilst taking interest rates to all-time record lows. As then US Fed chairman Ben Bernanke boasted in January 2011:
“Policies have contributed to a stronger stock market just as they did in March 2009, when we did the last iteration of this. The S&P 500 is up 20%-plus and the Russell 2000, which is about small cap stocks, is up 30%-plus.”
Shiller, like Warren Buffett and the blog, is a follower of Ben Graham’s work. Known as the ‘Father of Security Analysis’, Graham developed a simple formula to explain the importance of the Price/Earnings ratio:
- He showed that a P/E ratio of 8.5 meant markets were expecting zero earnings growth over the next 10 years
- Each 2 point change, up or down, meant they expected earnings to rise or fall by 1% a year for the next 10 years
Thus today’s CAPE ratio of 26.5 means investors are expecting S&P 500 earnings to rise by 9%/year till 2024. Yet earnings are already at near-record levels, so this is clearly impossible. Hence Shiller’s concern that the market is heading for a collapse.
For a fuller analysis by the Harvard Business Review of Graham’s pioneering work, and its triumphant confirmation during the 1987 stock market crash, please click here.
CENTRAL BANK STIMULUS HAS FAILED TO SUSTAIN CONSUMER SPENDING
Despite all their efforts, it is clear today that the central banks’ policy has failed. The main US Consumer Confidence Index remains well below Boomer-led SuperCycle peaks. Instead, we are moving into the Boomer-led New Normal, where spending will be much lower due to the impact of globally ageing populations.
Sensible central banks would have celebrated the fact that life expectancy has increased by 50% since 1950 across the world. They would have accepted that demand must slow as a result – particularly as fertility rates had fallen by 50% over the same period. After all, only people can create demand.
Instead of increasing debt levels, they would have ensured that the budget surpluses of the late-1990s were maintained, in order to pay the bills for pensions and healthcare spending.
But they chose to deny the impact of this demographic change, and so have instead created a ‘debt-fuelled ring of fire’. China’s reversal of its stimulus policy is the initial earthquake that is now opening up the fault-lines they have created.
Thus it seems that the Great Unwinding of these failed policies is now underway. We can have no idea how it will end.
As Shiller’s chart shows, the modern world has never seen such an experiment in monetary policy carried out on such a scale, and for so long. It highlights how policy has become entirely focused on the progress of the S&P 500:
- Policymakers believe that as long as it continues to climb, everything must be going well in the wider economy
- Thus they are ignoring China’s reverse-course, just as they ignored early signs of collapse in sub-prime housing
- Fed Chairman Bernanke at first said in July 2007 that losses would be no more than $100bn
They are also completely ignoring even the major changes now underway in oil, currency and interest rate markets.
Yet any impartial observer would see these as a clear warning sign that market direction was changing.
And when an informed observer such as Shiller, with a proven track record, gives the following warning, the blog feels we need to listen very carefully:
“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. … We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. …
“One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking that way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”
*The detailed calculation for the CAPE 10 year ratio is as follows: (1) calculate annual Earnings Per Share for the S&P 500 over the past 10 years. Adjust these earnings for inflation using the Consumer Price Index and average these adjusted figures over the 10-year period. Then divide the current level of the S&P 500 by this 10-year average number to get the P/E 10 ratio, or CAPE ratio.