There is a risky and dangerous novelty in the financial markets: “the prices of stocks, bonds and real estate, the three most important asset classes in the United States, are all extremely high”.
That is the warning from Robert Shiller, the 2013 Nobel Prize-winning economist and scientist, in an opinion piece in the New York Times. “Never have the three been so overvalued at the same time in modern history.”
Shares
Stock prices in the US market, despite the September dip, continue to rise. The CAPE (Cyclically Adjusted Price Income Ratio) stands at 37.1, the second highest level since 1881. On average it has been 17.2 since then. In December 1999 it reached 44.2, after which prices collapsed worldwide at the beginning of the 21st century. On the eve of this crisis, Shiller published the book Irrational Exuberance, which also held out the prospect of this crisis.
The so-called CAPE ratio, coined by Shiller, is defined as the real share price divided by the 10-year average of real earnings per share.
Bonds
For bonds, 10-year Treasury bond yields have been on a downward trend for 40 years, Shiller told the New York Times. It reached a low of 0.52 per cent in August 2020. But as bond prices and yields move in opposite directions, bond markets have also hit a record.
Real estate
Finally, he referred to the S&P/CoreLogic/Case-Shiller National Home Price Index. This rose by 17.7 per cent, adjusted for inflation, in the year ending in July. That is the highest 12-month increase since this data began in 1975. According to this measure, real house prices across the country have risen 71 per cent since February 2012.
Such high prices are a strong incentive to build more houses - which is expected to eventually bring prices down. The ratio of price to construction cost (using the Engineering News Record Building Cost Index) is only slightly below the peak reached at the height of the housing bubble, just before the Great Recession of 2007-2009.
Is the Fed the culprit?
Shiller said he shared only a limited part of the widely held view that high prices are the result of the Federal Reserve’s monetary policy. This explanation is too simple, as the Fed has been following a simple stabilisation rule for years when setting short-term interest rates.
According to Shiller, the cause of the unprecedented market rises lies in the fact that most investors are not guided by complex mathematical models, but by “catchy stories that stir the imagination”. He refers to economist John Maynard Keynes, who said that speculative prices are determined by intuitive guesses. But the great British economist warned that sooner or later the basis for these prices was likely to change “violently as a result of a sudden fluctuation of opinion”.
Shiller argued that there is a ubiquity of imaginative stories about investing, such as “self-improvement videos; and books that encourage people to believe in themselves and distrust so-called experts”. He refers to a book by real estate tycoon and ex-president Donald Trump, among others, in which he claimed that “billionaires don’t care about the odds. We do not listen to common sense and do not do what is conventional or expected. We follow our vision, no matter how crazy or idiotic others think it is.”
Vision and advice
Shiller concluded in his opinion piece for the New York Times that these and other theories, models and manias are affecting the pricing of major asset classes in bewildering ways. His view: there is an increased risk of declines over periods of a decade or more. His advice: in these circumstances, it is wise as an investor to ensure that their holdings are thoroughly diversified and focus on less highly valued sectors within broad asset classes that are already highly priced.