Monday, August 31, 2015

My Response to Shiller on Stock Prices and Historical P-E's

What is the better alternative to the "high" P-E's?

Bonds with near-zero real interest?

Real estate?

Let's consider real estate. A very serious bad future state [1], with a very substantial probability for most people, is artificial intelligence/robot revolution decimating jobs and wages [2]. What will happen to real estate in that state? The 80%+ have had their employment, and employment security, decimated, and wages have plummeted. How is that going to affect their ability to bid on homes and apartments?

And simultaneously, these robots will be able to build new homes and apartments at a fraction of the cost it takes today – Heard of massive 3-D printers on rails printing an entire track of homes' frames [3]? You will. When in the not too far future new homes, apartments, and offices can be built for half the cost, or a quarter of the cost, today, and be much higher quality, with incredible energy efficiency, solar built right into the structure, the walls even, and incredible computer control of the home or office built in seamlessly and beautifully, with amazing new materials for soundproofing, durability, and beauty, how is that going to affect the price of the real estate you're buying today?

So, real estate will plummet in this AI/robot revolution state, while in this same state the tech explosion may be very good for the owners of the robots – the owners of stocks. An asset that plummets in a majorly important bad state? Very risky. One which does well in that state, important insurance. The discount rate for the former is very high, all other things equal (and the former's expected return is also, I think, far lower than almost everybody thinks, because almost no one is considering this AI/robot revolution scenario with regard to real estate investing). The discount rate for the latter is very low, all other things equal.

Yes, there's also the possibility of the winner-take-all explosion getting the bulk of the tech revolution's bounty, but still, the 80% won't be winner-take-all's (WTA's), so at least they can own still needed robots, and raw materials, and patents, and have some negotiating power with the WTA's through the corporations they own, so they get some substantial percentage of the bounty; the WTA's don't get it all.

Because of the great future technological danger to the 80%+, stocks are becoming more and more insurance-like long run, and so meriting a lower and lower discount rate (even though very few people will think about this). And at the same time, bonds are currently paying nothing, and real estate is looking very risky long run.

So, what is better than stocks for long run savings? I ask seriously.

And, especially since Shiller wants to use historical comparisons for P-E ratio, we should also consider historical comparisons for other things too. Shiller writes, "… and within a year or two restore CAPE ratios to historical averages. This would put the S&P closer to 1,300 from around 1,900 on Wednesday."

Ok, so if we're invested in the S&P 500 now (a broader market index is better, like the Vanguard Total Stock Market Index Fund, or one of the many similar offerings available elsewhere) at 1,900, and it drops to 1,300 in 1.5 years, how long until it's back up to 1,900 (adjusting for inflation too, so in today dollars)?

Well, we're going with historical averages, like Shiller, right? So what's the historical average real return on the stock market? Wharton's Jeremey Siegel has possibly the best long run data base. In his seminal book Stocks for the Long Run, 5th edition, he finds that from 1802 until 2012, the geometric average return was 6.6% real, inflation adjusted. And it was about the same for three major sub-periods in this 210 year span (see chapter 5).

So, at 6.6%, how long until the 1,300 gets back to 1,900? Taking out my trusty Hewlett Packard 10bII, 5.93 years. So, in about 7.5 years we're back where we started, inflation adjusted. And that's better than government bonds, which have a somewhat negative real expected return, and about equal to high grade corporates which are at about the expected inflation rate.

But what about after 20 years pass? We keep up with that historical 6.6% average, and after 20 years, 12.5 years will pass since break-even. Those 12.5 years take us to 4,361. So, investing today, with these historical averages, 1,900 goes to 4,224 in 20 years. That gives us a 4.08% real return.

What's going to beat that today? And with a risk level that provides insurance against future inflation (stocks are ownership of real assets which go up with inflation) [4], and crucially, robot/AI revolution causing devastation to employment income and security for the 80%+.

Even if Shiller's right with his historical averages, what's going to beat stocks for long run investment? And yes, if you knew stocks would drop to 1,300 first, then you'd leave until it happened, and then go back. But that's risky to try. It's far from certain they will drop to 1,300. What if things start going really well in the economy? What if the robot/AI revolution starts to really take off within just the next few years? P-E's could start dropping fast not because prices drop fast, but because earnings rise fast.

I still can't see a better vehicle for long run savings than a well-diversified stock portfolio. If you know of one please let me know.

A final point: It is possible that investors are a lot more savvy than in the past, and so less unduly afraid of the risk of stocks. Therefore, they discount their future expected earnings less, resulting in a new era of higher P-E ratios.

So this would argue for stocks not being overpriced at their current CAPE's. INSEAD economist Antonio Fatas just made this point:
The other justification for high CAPE ratios is that the risk aversion of investors has gone down relative to previous decades. While talking about low risk perception this week might not sound right, the reality is that the years while the stock market had CAPE ratios of around 17 where also the years where academics wondered about why risk aversion was so high among investors (what we called the equity risk premium).
So, here we get to the famous equity premium puzzle in financial economics. I've talked about this a lot in previous posts because for years I've had an explanation that I haven't seen in the literature, and I've studied this literature very thoroughly as a finance PhD student, you can't help but. So, please bear with me, and let's talk about this; I really think there are important points to think about.

The equity premium puzzle is that going back a century or two in the US (and this has also been observed in almost every developed market) stocks appear to have had a very high real return relative to their risk. So the question, or "puzzle", is how can this have persisted for as long as two centuries. With people being oh so efficient, oh so smart, expert, and savvy; or, with the expert minority being willing and able to buy as much of assets as it takes to push them to efficient pricing, or so they say, why wasn't the return on stocks bidded down?

Or at least, why have most people put so relatively little of their savings into stocks when the expected return relative to the risk seems so good?

And the explanations that have gotten published in the top journals basically come down to maybe for some reason stocks are riskier than they appear to be, and the general public understands this better than finance professors with massive statistical, mathematical, theoretical, and empirical knowledge. Or, people are a lot more risk averse than they appear to be.

So there's this thought that if people discovered what a good deal stocks are, they would start investing in them a lot more, and that increased demand would push up the price of stocks, and thus down their expected return from that point on.

So, it's always a thought about demand. Once people wake up and see that stocks aren't that dangerous for getting so much higher a return on average, then they will start bidding down the expected returns permanently, until they are no longer such an abnormally good deal.

But, what I ask is if this were any other good, would we think that once consumers change their attitudes and greatly increase their demand, the price of the good must go up, not just over the short run, but over the long run too?

And the answer, from long established and well proven economics, is not necessarily at all.

It comes down to the production technology, the supply side. Is it constant returns to scale, the old CRTS, or increasing returns to scale, IRTS, or decreasing returns to scale DRTS, or is the supply fixed, perhaps like gold (although, while the supply of gold on the planet is fixed, the supply available to the market is much less fixed; it depends on surveying and mining technology).

And whether production is CRTS or IRTS or DRTS can depend on the quantity and time horizon. For a large range of quantities production may be IRTS, then it may go to CRTS after that, and finally if you keep producing more it will eventually go to DRTS.

Well, with stocks, what are you purchasing? Ultimately, the money put into stocks goes into corporate investment projects. And those investment projects ultimately produce goods. Now, what I argue in my explanation of the equity premium puzzle is that investment projects financed with equity, rather than debt, are intrinsically more productive. It's like a technology that produces more output. If you produce with technology X, for every $100 you invest in that kind of production you will permanently get $3/year of goods out. But if you invested that $100 instead with the more efficient technology Y, then you would produce more, $7/year.

And why might equity-financed investments be more efficient and higher productivity than debt-financed? Because equity financing gives managers the option much more to take much longer term projects whose exact fruition and cash flow is harder to predict with certainty, but have nonetheless a very high risk-adjusted expected return. If the financing is in debt, often these projects will be forgone, because the debt provides an often very substantial risk to managers from taking on these projects. If the cash flows don't come in in time, the company can be put under severe financial distress, really costing the manager who took on that project in his career, in just keeping his job. Equity is flexible, there are no fixed interest payments which must be made on precise schedule to avoid very bad consequences. So, basically we can expect, given this, that equity-financing will persistently provide a higher risk-adjusted return than debt. 

Now, what if suddenly people recognize this much more, and start investing much more in equity to take advantage of this, say twice as much. Will they bid down the risk-adjusted expected returns on equity? Well, not if there exist twice as many good equity projects. So, in other words, if the good equity type projects are CRTS over this range, then the increase in demand won't move the price. The long run supply curve is flat over this range, and so an increase in demand does not change the price. In fact, if the potential equity based projects are IRTS an increase in their demand would even push up the risk-adjusted expected return, allowing for excellent large scale projects that otherwise wouldn't have been possible.

So, this is my supply side explanation for the equity premium puzzle. For more, I have a brief write up here.  And so when Fatas writes, "But I wished that he [Shiller] would have considered as well the third possible scenario where current CAPE levels are fine and investors should get used to lower-than-historical returns but returns that are consistent with what is going on in other asset classes.", he's saying that maybe now investors are more savvy, and so are willing to invest a lot more in stocks and so will push down the risk-adjusted expected return, but be fine with that. What I'd reply is that even if what he hypothesizes about the demand side is true, it will not necessarily mean lower future risk-adjusted expected returns for stocks due to my supply side explanation, where higher demand will just mean more of these high risk-adjusted expected return equity-type projects get financed. And less will be financed through less efficient debt. Which may be a very good thing.

[1] The state of nature framework is standard in academic financial economics. You say in the future there are a number of possible states, where various things happen, or various levels of good or bad economic factors occur. And each state has a certain probability of occurring.
[2] To learn about this I recommend, The Second Machine Age (2014), by MIT Economist Erik Brynjolfsson and MIT information technology expert Andrew McAfee, and Rise of the Robots (2015), by software expert and entrepreneur Martin Ford. Ford's not an economist, and the economics is often off, or quite wrong, but the technological information is amazing, and often surprising.
[3] See Rise of the Robots above in endnote 2
[4] I'm not talking about Zimbabwe inflation, but over the next decade or two it is possible we'll start intelligently considering the dangers of lowflation, the ZLB, and lost decades, and raise the target to 3 or 4 percent, even 5, or at least make the current 2% a target, not a ceiling.


Unknown said...

Very nice piece.

There are some issues with the 'Stocks are best' belief.
Things to consider in no particular order;
The sequence of returns
The life span of Homo Sapiens
The duration of equities
The volatility (which you got into to some degree)
The effect of living standard transitions on expected returns
The Possible versus the Probable (given the above issues)
The stress of what is quite possibly for the average investor 'too much' risk

Richard H. Serlin said...

The historical record of American stocks I don't think shows that much risk over the long run. As Wharton Finance professor Jeremy Siegel notes in "Stocks for the Long Run", 5th ed., going back to 1802, there has never been any 20 year period where real stock returns were negative (page 85). And the worst 30 year period for stocks ever recorded was a positive 2.6% real return (page 94), so even the worst 30 year period ever for stocks was as about as good as an average period for long term government bonds, and long-term government bonds, in contrast to stocks, have had negative real returns, sometimes very negative (page 85).

With regard to time horizon and human lifespan, the horizon only has to get to 20 years before stocks start looking pretty safe, but if you have children, the horizon for money saved for their benefit can easily be 50 years, or much longer.

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