What's pushing the US stock market so high?

Robert J. Shiller
Economic theory offers ample reason to expect that long-term investment opportunities will never be eliminated from markets, even when there are a lot of very smart people trading.
Robert J. Shiller

THE level of stock markets differs widely across countries. And right now, the United States is leading the world. What everyone wants to know is why — and whether its stock market’s current level is justified.

We can get a simple intuitive measure of the differences between countries by looking at price-earnings ratios. I have long advocated the cyclically adjusted price-earnings (CAPE) ratio that John Campbell (now at Harvard University) and I developed 30 years ago.

The CAPE ratio is the real (inflation-adjusted) price of a share divided by a ten-year average of real earnings per share. As of December 29, the CAPE ratio is highest for the US.

Let’s consider what these ratios mean. Ownership of stock represents a long-term claim on a company’s earnings, which the company can pay to the owners of shares as dividends or reinvest to provide the shareholders more dividends in the future.

So, to arrive at a valuation for a country’s stock market, we need to forecast the growth rate of earnings and dividends for an interval considerably longer than a year. We really want to know what the earnings will do over the next ten or 20 years.

In pricing stock markets, people don’t seem to be relying on any good forecast of the next ten years’ earnings.

They just seem to look at the past ten years, which are already done and gone, but also known and tangible.

But when Campbell and I studied earnings growth in the US with long historical data, we found that it has not been very amenable to extrapolation. Since 1881, the correlation of the past decade’s real earnings growth with the price-earnings ratio is a positive 0.32. But there is zero correlation between the CAPE ratio and the next ten years’ real earnings growth. And real earnings growth per share for the S&P Composite Stock Price Index over the previous ten years was negatively correlated with real earnings growth over the subsequent ten years. That’s the opposite of momentum. It means that good news about earnings growth in the past decade is (slightly) bad news about earnings growth in the future.

Essentially the same sort of thing happens with US inflation and the bond market. One might think that long-term interest rates tend to be high when there is evidence that there will be higher inflation over the life of the bond, to compensate investors for the expected decline in the dollar’s purchasing power. Using data since 1913, when the consumer price index computed by the US Bureau of Labor Statistics starts, we find that there is almost no correlation between long-term interest rates and ten-year inflation rates over succeeding decades. But bond markets act as if they think inflation can be extrapolated.

How can we square investors’ behavior with the famous assertion that it is hard to beat the market?

Economic theory offers ample reason to expect that long-term investment opportunities will never be eliminated from markets, even when there are a lot of very smart people trading.

This brings us back to the mystery of what’s driving the US stock market so high. It’s not the “Trump effect,” or the effect of the recent cut in the US corporate tax rate.

Part of the reason for America’s world-beating CAPE ratio may be its higher rate of share repurchases, though share repurchases have become a global phenomenon. Higher CAPE ratios in the US may also reflect a stronger psychology of fear about the replacement of jobs by machines. The flip side of that fear is a stronger desire to own capital in a free-market country with an association with computers.

The truth is that it is impossible to pin down the full cause of the high price of the US stock market. The lack of any clear justification for its high CAPE ratio should remind all investors of the importance of diversification, and that the overall US stock market should not be given too much weight in a portfolio.

Robert J. Shiller is Professor of Economics at Yale University. Copyright: Project Syndicate. www.project-syndicate.org


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