Financial Update
They Called Him "Mr. Bubble"
excerpted from the Yale Alumni Bulletin
September/October 2009 by David Leonhardt '94,
an economics columnist for the New York Times.
BackgroundSometime in the mid-1980s, Robert Shiller and John Campbell (Yale '84 PhD) created The Chart. It wasn't especially complicated. It showed average stock prices, relative to corporate earnings, going all the way back to the late nineteenth century. Wall Street analysts produce charts along these lines all the time. The measure is called the price/earnings ratio, and it is the single most common analytical yardstick of the stock market.
The yardstick that Shiller and Campbell created, however, came with a twist -- a twist that transformed their little chart into The Chart. Today, The Chart stands as one of the signature pieces of economic research of the past generation. It is rigorous enough to have appeared in the Journal of Portfolio Management and simple enough to be understood by those of us who are behind on our Portfolio Management reading.
If Alan Greenspan had taken The Chart seriously during the late 1990s, Greenspan's reputation might be in better shape today. So might the United States economy...
Anyone who heeded the central lesson of Shiller and Campbell's analysis -- as well as the lesson of a subsequent chart, created by Shiller, on the housing market -- could have avoided some of the worst pain of both financial crises. If Alan Greenspan had taken The Chart seriously during the late 1990s, Greenspan's reputation might be in better shape today. So might the United States economy. Nouriel Roubini, the doomsday-prophesizing finance professor at New York University who has lately become a media darling, credits The Chart for much of his clairvoyance.
When Wall Street analysts talk about the price-earnings ratio -- the P/E ratio -- they generally base their analysis on a very short-term measure of corporate earnings. They typically look at earnings over the past year or at forecasts of earnings over the coming year. They then divide the price of a company's stock by this measure of earnings, to judge whether the stock is fairly valued. The same can be done for the market as a whole: the Standard & Poor 500 index, for instance, divided by the average earnings of the companies in the index.
How "The Chart" Works
Shiller and John Campbell, a former Shiller student and longtime Harvard professor who now runs Arrowstreet Capital, had come to believe that such measures were fatally flawed. Earnings over any given 12 months can fluctuate wildly, depending on whether the economy is booming or busting. Forecasts of earnings are even more problematic, given Wall Street's unimpressive forecasting record. No P/E ratio based on only 12 months of earnings will tell you much about the long-term prospects of American companies, which is precisely what stock prices are meant to capture.
Imagine that, in December 2007, Company X's stock was selling at a record $60 per share. Its earnings for the previous year had been better than ever before, at $4 per share. So its price-to-earnings ratio was 15. That's a comfortably low number on the price-to-earningsscale -- showing, apparently, that Company X's record stock price was reasonable. The price, said its CEO, simply demonstrated that investors appreciated Company X's increased profitability. But 2007 was a boom year. What if Company X's big profits were only temporary? Then its good price-to-earnings ratio was illusory, and its stock might be seriously overvalued.
Shiller and Campbell account for the booms and busts by using earnings figures for the previous ten years. Company X's average earnings for the past decade had been $1 per share. By the ten-year calculation, its price-to-earnings ratio was alarmingly high at 60, unless there were a concrete reason to think the recent high earnings would continue. They were right — and the market crash, followed by the housing crash are proof of their theories.
What does Robert Shiller predict now?
Read (much) more at: Dr. Bubble Continued
For a fascinating discussion by Robert Shiller on NPR's Charlie Rose, click here: Dr. Shiller Meets Charlie Rose
