“In the Short Run, It’s Very Difficult to See When to Bail Out”

Wolf Richter wolfstreet.com, www.amazon.com/author/wolfrichter

Robert Shiller turns sour on “way overpriced” stock market.

The stock market is still flying high. OK, so the Russell 2000, the index of small-cap stocks, dipped into the negative for the year. The Nasdaq is still up 7.5%, the S&P 500 and the DOW about 5%. They’ve been edging down recently. But they’re still hovering near record highs. So why worry? Stocks can only go up. That’s what we’ve learned since 2009.

Robert Shiller, the Nobel Prize winner who correctly turned sour on the stock-market bubble of the late 1990s and the housing bubble a few years later, has turned sour on stocks again. He isn’t a perma-bear. On the contrary. But he is an interesting voice that folks ignored the last two times to their detriment.

“The market is way overpriced,” he told Bloomberg. “It’s not as intellectual as people would think, or as economists would have you believe.”

But that doesn’t mean the market has to go down right this minute. Irrationally priced financial markets, by definition, don’t have a rational limit anymore. Housing markets do have a rational limit: affordability. Affordability can be expanded with lower interest rates, higher leverage, and more government involvement. But in the end, enough people have to be able to live there, or else the market seizes. But no one has to live in irrationally priced stocks. So they can continue to surge way beyond any rational limit. Until they too flip.

So when is it time to bail out? Shiller, even as he sees the market as overpriced, sees a 4% upside. “I can’t speak authoritatively,” he cautions. “This is guessing human psychology.”

That’s his point. Financial markets are about human psychology. And now there’s a new element in the equation, as he calls it on Bloomberg TV: the “Trump effect.”

“My guess is that the Trump effect is really important,” he says. “Trump dominates our attention.” And the Trump effect is all over the world. “I think it should be stimulative in a psychological sense, beyond whatever is going on with tax rates.”

But he is worried. His own CAPE Ratio – “Cyclically Adjusted PE” Ratio, a price-earnings ratio that is based on average inflation-adjusted earnings from the previous 10 years (chart) – is at 29. The median historical CAPE Ratio is 16.

 

This is “very high, not quite as high as it was in 1929, but it’s getting close, so that’s a bad sign,” he says. “But on the other hand, the stock market has historically done so well, so many times, it seems to me this could be like 1997 again when the CAPE Ratio was also around 29. And you know if you held on for 10 years, which brings you to around 2007, you did just fine.”

But not if you held on another year or two. If you missed the exit point, you’d have to hold on to it for some more years. In the Nasdaq’s case, you’d have to hold on to it till July 2016, before it hit 5,000 again, after having hit it briefly in early 2000 before crashing, and re-crashing in 2008.

“That’s the uncertainty of the stock market,” Shiller says. “It has historically often done well when it shouldn’t have.”

“Given that, with just the CAPE ratio, it doesn’t look promising,” he says. But he cautions: usually we can’t forecast the stock market in the short run. We can forecast it better in the long run, over 10 years.

Markets have been fueled by promises of stimulus and tax cuts and the “Trump effect.” But what will happen if the hopes for fiscal stimulus and other things don’t come to pass? Not a rosy scenario, according to Shiller:

“Well, it will be a declining stock market,” he says. “It’s not just the fiscal stimulus. It’s the whole package of Trump. We’ve seen how much anxiety there has been generated in the first month of his presidency. It’s really an uncertain time.”

And yet… “The stock market could do very well,” he says, “it could go up 10%, 20%, 30%… if Trump does things well, if things work out.” Alas… “I’m talking about over 10 years.”

That’s a lot of IFs, over a 10-year time frame, which would boil down to annual gains in the best-case scenario of just above the current rate of inflation, and only “if Trump does things well, if things work out.”

So when is the time to get out of the market?

“This is called market timing,” he says. “And in the short run, it’s very difficult to see when to bail out.”

“If there is anything like a sign to bail out it would be the high CAPE Ratio,” he says. “To me that just gives me caution, don’t go overboard,” he says. And he added: “Don’t assume that Trump is going to work miracles.”

Because miracles might be required to sustain this market.

In normal times, stocks would have already come unglued. But these are not normal times. Read… How Will Stocks Come Unglued? Wolf Richter on the Keiser Report (video).

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