Legends Of Indexing: Robert Shiller

December 22, 2014

This is the fifth in a series of interviews with some of the most influential people in the field of indexing and index-based investment. The interviews are also published in the November/December 2014 issue of the Journal of Indexes.

In 2013, Yale professor Robert Shiller was awarded the Nobel Memorial Prize in Economics alongside Eugene Fama and Lars Peter Hansen. Before that, Shiller was perhaps best known in the wider financial media for recognizing the housing bubble before it collapsed in 2006-07 and for his numerous books. However, in indexing circles, Shiller's name is well-known from the S&P Case-Shiller Home Price indexes, which he developed with Wellesley College's Karl Case.

This is probably a question you're getting a lot lately: Are we in a period of irrational exuberance right now?
I'm actually working on the third edition of my book, "Irrational Exuberance." Anyway, it's a matter of degree—it's a matter of percentages. The market has been going up rapidly and there is some exuberance behind that, I suppose. But it's not something that is uniform. There is a story at any time, and the story has multiple dimensions.

One thing that our story now is starting to share in common with the year 2000, which was the peak of the market in real terms—the 2007 peak didn't make it back up to that level, so I think of 2000 as a major turning point—is at that time, people were very concerned that the market was overpriced. We have been seeing increased concerns that that would happen; that is a sign of a bubble. If you're buying and holding the market but think it's overpriced, that might be a sign of irrational exuberance.

What is irrational exuberance? I think it's often a sense that the market always goes up in the long run, and it's hard to predict when it might go down, but it will surely come back up. So one question I have been asking in surveys is, "Do you agree with the following statement: The stock market is the best investment for long-term holders who can just buy and hold through the ups and downs of the market." Our agreement with that is going up, but it's not as high as it was in 2000. We're not quite in a 2000-like irrational exuberance, but we're moving in that direction.

In a recent interview, you basically said, "Don't pull out of the market." When would you exit the market?
Predicting turning points is an art, not a science, unfortunately, and not many people have much experience doing it, because major turning points are rare events. I'm thinking of past turning points—they seem in my mind to occur when there is a changing story.

There is always a story that drives markets, and that story changes. For example, in the 1920s, there was Coolidge prosperity and a sense that we are so much smarter and more sophisticated now. Industry was reorganizing itself in very productive directions. People were enthralled by the fact that they now had electricity and a radio and a car, and that was a new era. Then the story changed, so much that a significant number of Americans started to become communist. In the next decade, there was an era of communism in the United States. It was still never a majority, but we had a lot more of them then. A different story indeed!

I'm looking for changes in stories like that. We haven't had the most inspirational story lately, because there is still this nagging fear that the economy hasn't completely recovered and that there are still problems. It's not exactly the same kind of bubble at 1929. First of all, the market isn't as high, and secondly, it doesn't have the same fervor yet. It could keep going up. But the kind of thing that would change would be some new focus in the story.

There is worry now that is increasing about just long-term funks—what Bill Gross called "the new normal"—and that kind of story is gaining in people's imaginations, which could provide a sell signal. If you just read any article about the stock market, it tends to mention that it is five years after the crisis and we're still not really caught up. Things are disappointing all over the world. That is a story suggesting a turning point, and it might be amplified.

My theory is that stock price movement amplifies stories that explain that movement.

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Do you think housing will continue its recovery? It looks like it has been slowing.
The last three months have been slow in our S&P/Case-Shiller Indexes, and in fact, negative on a seasonally adjusted basis, although I don't completely trust the seasonal adjustments—they might be a little bit too strong. The housing market has been growing ever since 2012. It is up almost 20 percent from the broad housing bottom in 2012, and in some cities, it's up more. In San Francisco, it's up two-thirds since its bottom in 2009. Those are big increases.

I have done another survey with questions about home buyer attitudes, and according to my research with Karl Case and Anne Thompson, our survey is showing that the tendency towards declining long-term expectations has been reversed. Ever since around 2005, people have been getting less and less optimistic about long-term home price growth, and it reached its lowest last year in 2013. But in a 2014 survey, it started to turn up again, although it's not a dramatic change.

It could be that the stock market will go up to even higher levels and the housing market will be carried along with that. On the other hand, the developing pessimistic stories might have the reverse effect.

What are your biggest concerns for investors right now?
Right now, everything looks a little overpriced. The stock market looks overpriced, the bond market looks overpriced. Housing is not clearly overpriced, and I'm especially unsure what it is going to do. It doesn't seem to me the best time to be an investor. Maybe my biggest concern right now is that many investors are not saving enough. They are blithely assuming the market will carry them forward. And this applies not only to individual investors but to managers of defined benefit pension plans—they might not be putting enough away for the future. The market may have a serious correction, so we could have a problem.

You always have an interesting take on indexing and where to take indexes next—home prices, health care prices. What other uses do you see for indexes in the current kind of environment?
I wrote a book on this 20 years ago called "Macro Markets," and that was the time when I was developing the home price indexes for trading. There is a futures market at the Chicago Mercantile Exchange for home prices based on those indexes. I also around that time started to work on labor income indexes, and I thought those should be traded too, so people could hedge their occupational risk. We had to create new indexes because the existing labor occupational income indexes are not really designed for trading.

I have been arguing now for 20 years that people should think seriously about indexes for trading. Another example is GDP, gross domestic product. That is published by the government, but it's not published with a mind for trading. They make revisions very slowly—they can do it five years later. There could be a better effort there. I also think we might want to develop trading in components of GDP, because different components mean different things. There could be a consumption-based market, for example.

And then there's also commercial real estate. There is already some over-the-counter trading of commercial real estate derivatives based on the International Property Databank indices. There are others who are working on developing alternative commercial property indexes—the Costar Commercial Real Estate indexes or the pure-play REIT commercial property indices developed by NAREIT and the MIT Center for Real Estate are some interesting examples. I haven't studied them in detail, but I can imagine they are useful and that could maybe still be improved further.

Anything that matters to people should be an index, should be traded. There is talk about national economic welfare, something that takes into account environmental costs—we could have a socially responsible GDP contract, something like that.

What do you see as the biggest positive or negative developments in the indexing space in the past 20 years or so?
Off the cuff, the thing is that it hasn't been developing as well as I had hoped. For example, we launched home price futures, and it hasn't taken off. CBOE launched a real estate contract too and then shut it down. They launched Consumer Price Index futures, and they shut those down. We do still have inflation-based index funds, so there is effectively a market for the Consumer Price Index, but not all the markets that we thought.

We have seen ETFs take off in the last 20 years, and that is encouraging. We have seen REITs take off, but even so, I wish the REITs indexes were more focused on kinds of real estate and geographical regions so that they could serve a hedging purpose. It seems like indexes are very important for hedging opportunities, but I think they should be developed much more.

What is the CAPE ratio telling you these days?
It's been quite high—it has been up to 26—but not anywhere close to record highs. The other side of it though is that the bond market—which is the natural alternative—and the money market are both yielding very low. They are very highly priced. It doesn't have the same exit signal that it would normally give. I don't see the need to pull completely out of the market right now. I am a little worried about the volatility we have seen recently, but you don't want to overreact to these things.

The story of slow global growth, as indicated by the IMF, is just not compelling enough. I don't see it at the present moment as the major worry.




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