Consulting by RPM || Free Advice Blog

In Defense of Permabears

In his never-ending campaign to discredit those who warned of financial bubbles before the 2008 crash, Scott Sumner recently quoted with approval the following from Alan Reynolds’ 2010 analysis of Shiller’s thoughts on investing:

On the March 9 anniversary of the stock market implosion a year ago, a front-page story in the Wall Street Journal featured one of the same bears making the same bad argument he made a year ago.
The article, “Worries Rebound on Bull’s Birthday,” was almost entirely devoted to trying to explain a graph by Robert Shiller of Yale, titled “Stocks Still Expensive.” The New York Times ran the same graph on March 15, 2009, to warn us that the ratio of stock prices to earnings “hasn’t fallen as far as the market bottoms of 1932 and 1982.”

By then, reports from Barron’s, Bloomberg and the Wall Street Journal had already suggested that the Dow could fall to 5000 and the S&P 500 to 500. The Journal’s headline on March 9, 2009, was “Dow 5000? There’s a Case for It.”
. . .
Here’s the bottom line: Following Bob Shiller’s “over 20” rule would have kept you out of the stock market every single month from December 1992 to September 2008.

Sumner moves on in his blog post as if the above block quotation is a pretty damning indictment of Shiller. But is it really?

The St. Louis Fed conveniently posts the nominal daily value of the S&P 500. Now if I understand Alan Reynold’s critique, he is saying that Shiller’s rule would have told investors to get out of the market in December 1992, and it wouldn’t have told them to get back in until October 2008. So assuming somebody did that, what stock market appreciation would he have missed?

Well, if you let me pick the low point in October 2008 (which was not the overall market bottom, by the way), then I calculate the average annualized nominal return from December 1992 through October 2008 as 4.7%. Now it’s true, this doesn’t count dividends, so that understates the actual total return from being in the S&P 500 for that 190-month stretch. But still, that’s not an obviously amazing return that you would mock Shiller for having you avoid. Up through the fall of 1998, the yield on the 10-year Treasury was higher than 5%, and during the entire period there were only two brief periods where the yield dipped below 4%. So it’s not obvious to me that someone who was in 10-year Treasuries the entire period from December 1992 through October 2008 would have done worse than someone who was 100% in the S&P500 (especially if you get really specific about the fees for management and the fact that your holdings of Treasuries would have skyrocketed in market price in the winter of 2008), but even if the latter did moderately outperform, there is still the huge issue of the underlying volatility of the return. The S&P500 dropped more than 30% in the single year from September 2000 through September 2001, and it was down some 48% yr/yr in March 2009.

I guess it’s because Wall Street has become synonymous with “capitalism,” but there is an odd habit among mainstream free-market analysts to identify with equity markets. It is true that since Nixon finally took the dollar off of gold, the average investor has been increasingly forced into considering stocks as a way to protect himself from a debased currency. Yet we shouldn’t ignore the tremendous volatility that this monetary policy–and corresponding investment strategy–brings.