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Robert Shiller warns us to prepare for a bear market

Robert Shiller warns us to prepare for a bear market

We make no claim to be accurate forecasters of market booms and crashes.  That’s because, in the very long run, successful value investing does not require an ability to predict markets or economies.  But when respected people like Nobel Laureate economist, Professor Robert J. Shiller, put pen to paper about a looming bear market, we find it pays to listen up.

Despite the above truth, there is no diminution in the world’s fascination with short-term forecasts. Those articles that predict an imminent crash, for example, are widely disseminated, despite their very poor performance record.  Perhaps this is because, as Will Rogers observed: “The fellow who can only see a week ahead is always the popular fellow, for he is looking with the crowd. But the one who can see years ahead, has a telescope but he can’t make anybody believe he has it.”

Shiller recently drafted an essay for the Project Syndicate titled The Coming Bear Market? In the essay, Shiller asks: “The US stock market today is characterized by a seemingly unusual combination of very high valuations, following a period of strong earnings growth, and very low volatility. What do these ostensibly conflicting messages imply about the likelihood that the United States is headed toward a bear market?”

Shiller begins his answer by critiquing the media’s adopted definition of a bear market – being a decline of 20 per cent – as having no prior recorded history in either academia nor industry. Attributing the commonly-accepted definition to the 1987 ‘experience’, followed by plagiarism among editors and journalists, he then proceeds to adopt and refine the definition with the necessary addition of a timeframe, and the required prior peak being within 12 months.

Thus defined, Shiller observes there have been 13 bear markets “in the US since 1871. The peak months before the bear markets occurred in 1892, 1895, 1902, 1906, 1916, 1929, 1934, 1937, 1946, 1961, 1987, 2000, and 2007. A couple of notorious stock market collapses – in 1968-70 and in 1973-74 – are not on the list, because they were more protracted and gradual.”

Shiller then proceeds to examine stock valuations prior to each bear market, using the (CAPE) indicator that he and his Harvard colleague John Y. Campbell developed in 1988 to predict long-term stock market returns.

The cyclically adjusted price-to-earnings CAPE ratio is found by dividing the real (inflation-adjusted) stock index by the average of 10 years of earnings, with higher-than-average ratios implying lower-than-average returns.

Shiller’s work on the CAPE ratio revealed that it is somewhat effective at predicting real returns over a 10-year period.  But Shiller also notes “we did not report how well that ratio predicts bear markets.”

Shiller than turns to present conditions.

“This month, the CAPE ratio in the US is just above 30. That is a high ratio. Indeed, between 1881 and today, the average CAPE ratio has stood at just 16.8. Moreover, it has exceeded 30 only twice during that period: in 1929 and in 1997-2002.

“But that does not mean that high CAPE ratios aren’t associated with bear markets. On the contrary, in the peak months before past bear markets, the average CAPE ratio was higher than average, at 22.1, suggesting that the CAPE does tend to rise before a bear market.”

Importantly Shiller adds that bear markets did occur in the past despite the fact that the CAPE ratio was below average.  In other words, there were periods – after 1916 (during World War I), 1934 (during the Great Depression), and 1946 (during the post-World War II recession) – when the CAPE ratio failed to predict bear markets.

Nevertheless, for investors today, with the CAPE ratio well above average, it is valuable to note that each of the 10 bear markets since 1871 was preceded by an above average CAPE ratio.

Shiller does not comment on the false positives – those occasions when a high CAPE ratio was not followed by a bear market.

Supporting current market valuations, Shiller points to very strong real earnings growth being registered from the second quarter of 2016 to the second quarter of 2017, of 13.2 per cent, which is well above the historical annual rate of 1.8 per cent since 1881.

Any comfort gleaned from this strong earnings growth, however, is quickly dispelled by Shiller’s observation that “peak months before past bear markets also tended to show high real earnings growth: 13.3 per cent, per year, on average, for all 13 episodes”. He adds that “the market peak just before the biggest ever stock market drop, in 1929-32, [recorded] 12-month real earnings growth [of] 18.3 per cent”

Those who point to near record low levels of volatility as protection against a bear market should heed Shiller’s observation that “stock-price volatility was lower than average in the year leading up to the peak month preceding the 13 previous US bear markets”.  And, he adds, at “the peak month for the stock market before the 1929 crash, volatility was only 2.8 per cent.”

Shiller concludes his essay thus:

“In short, the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets. This is not to say that a bear market is guaranteed: such episodes are difficult to anticipate, and the next one may still be a long way off. And even if a bear market does arrive, for anyone who does not buy at the market’s peak and sell at the trough, losses tend to be less than 20 per cent.

“But my analysis should serve as a warning against complacency. Investors who allow faulty impressions of history to lead them to assume too much stock-market risk today may be inviting considerable losses.”

Shiller’s essay can be read in its entirety here.


Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. I had a long time friend tell me last week that he was doing alright trading index ETF’s and that it’s safe because it’s the whole market and not just any share, and although he is not a taxi driver, it was kind of like my doctor telling me my car needed a tune up, Just another red flag waving in my face is what went through my mind as he spoke. I sent him a link of Jim Rodgers explaining the dangers involving ETF’s currently, But who knows he could be right, and if Yellen and co have his back as has been the case for so long, this casino could be around for a long time yet.

  2. Brett Edgerton

    Long time fan of Shiller – all versions of Irrational Exuberance are on the book shelf and occasionally re-read in part or full…

    So today I am milking the conformational bias for all it’s worth – yesterday I put in the sell order on my Berkshire Hathaway shares after 3 years of ownership – only disappointment the higher AUD (but proceeds will go into USD ETF to continue that exposure, as I did in my initial two-stepped purchase strategy)… 

    The thing that people need to realise is that timing for individuals is very different than for Fundies… the question I ask myself is what is the probability that I will be able to buy this same asset at a lower price some time in the future… if my answer is high then I will very strongly consider going to cash or choosing another asset which is likely to outperform in the intervening period…

    I am unsure whether I will ever buy BRK again… I think that BRK has a massive advantage in that their credibility is so high that they have earned the right to genuinely invest with a long term view in mind – they are impervious to wall street shenanigans and pressure.. thus they are rare in the current environment (low yield) where many capital allocators are feeling pressure to maximise payments to owners rather than investing for future growth… And I am a major fan of Buffett and Munger… But that is not a basis to allocate capital, and the major nagging in my mind is that – while what these guys have done over the last few decades, every bit including up until today, will ensure that the company will perform well when they are gone, there will be inevitable turbulence when they do pass… And sadly, with Munger well into his 90s and Buffett only half a decade behind, well even their cash can not have them beating the odds for much longer – though they are a wonderful example of the benefits of their oft mentioned “healthy” diets :)

    Back to timing, from late 2004 I was sceptical on the stockmarket and so, even though quite young (and theoretically able to withstand a significant drop in invested capital), I clamped down allocation to stocks to 50% (so didn’t get the full value of the market run up) and by 2007 liquidated and went to cash… didn’t really matter how long I had to wait, I was confident I would have the opportunity to buy those assets cheaper in the future…

    Through 2008 I bought and bought equities, and by complete luck finished my buying (reached 100% equity allocation) a week or two before the trough… In 2013, after having traded in and out with some range trading, I figured that the hammered Gold Coast apartment market was significantly undervalued and invested (which again by some luck turned out to be pretty much the trough)…

    Fung managers can’t behave in this way for obvious reasons… a 30% cash position, that Roger and others of the more cerebral and contrarian fundies, places pressure on them to explain this relative to the title of their fund, especially by investors who are employing their own capital allocation nouse. (Though in my letter of “suggestions” to my loved ones if I should pass unexpectedly I suggest placing most capital with such managers so at least some of it will be protected if the market should be irrationally exuberant at the time)…

    But I think employing blind dollar cost averaging or the like for an individual investor is crazy, would suggest that taking a strong interest in markets and understanding that timing markets – whether broad markets or in individuals issues such as stocks (in other words buy low sell high) – is the way towards superior returns is the way to go… And as any of these generous finance thinkers who regularly publish their thoughts will tell you, if you think by timing you need to be accurate within a day, week or even a month, that might be the case for fund managers (who come under increasing pressure the longer market prevailing behaviour continues), you don’t need to be anywhere near that accurate in your timing to profit handsomely…

    All that matters is what are the chances that I can buy this at a later date for a lower price if I should so choose (and yes, taking into account relative yields in the intervening period)…

  3. Roger,
    I am a regular viewer of US based financial news tv stations and the optimism displayed by these journalists is in stark contrast to this article. Every stock that these commentators review seem to be undervalued by 20% or more (regardless of industry). Usually these valuations seem to be anchored in the belief that they present good value when compared to the valuations of the high profile tech stocks. Do you think that the lofty valuations of the tech stocks are distorting the expectations of investors and the metrics they use to assess value?

    • Hi ANdrew, Of course comparing something expensive to something more expensive does not make the former cheap. This is the relative value investing approach I crtiqued here “On the subject of low interest rates, it is worth noting that stocks only appear cheap because interest rates are low. The US 10-year Treasury bond is trading on a yield of 2.27 per cent as I write this column. That’s equivalent to a PE ratio of 44.1 times earnings and the earnings don’t grow. Therefore, if you can find a stock with a lower PE than 44 times and offering a little growth, the stock must be cheap.”

  4. Hi Roger,
    i would appreciate your thoughts on the fact that Shiller is referring to the Dow Jones ratios and not to other stock markets around the world. I am aware that most markets follow the lead of the Dow but, could it mean the All Ords will follow to the same magnitude given that the Dow is up more than 60% in ten years and our market is down about 15% over the same period. Also with prices perceived to be high, should one bail out of long term investments that are showing excellent paper profits (not to mention bright future prospects) in this current environment? I’m thinking no, ……your thoughts??

  5. Hi Roger,

    The article summarises the key points from the essay quite well. Thanks for that.

    However, I have a couple of questions that are probably more from an educational perspective. Reading George’s article he notes that you deal with probabilities of certain events happening or circumstances that are, or are not reflected in a shares price. So:
    1. How do you determine a probability of a bear market occurring in the near to medium, given in the long term it is definitely going to happen at some stage?
    2. What are some considerations that individual investors should be thinking about in terms of broad portfolio positions and individual stock positions given the current environment?

    Your book is wonderful at helping to identify great businesses and how to value them. But stops short of how to invest when the environment is more uncertain. I think most of the people that follow your blog have come to terms with nature of the current investing environment.

    But how can investors be best prepared for it. Maybe another book, if you have some spare time??



    • Thanks for your encouraging words Pascal.

      1) When thinking probablistically we are referring to company/business/transaction events rather than probabilities of market direction.
      2) The current environment is no different to any other. There are always uncertainties and we are rewarded for investing amid those uncertainties. One way of reducing risk is to provide in our mandate the flexibility to hold cash. Wealthy investor certainy value the preservation of their capital. We have developed a portfolio construction process for each of our funds where the cash balance is the remainder of a process of investing in companies that are both high quality and offering value.
      3) When you say the books stops short and doesn’t address how to invest in more uncertain climates, I wonder whether you have taken in the point of the book. The first two chapters explain that uncertainty is a constant and no time is more or less uncertain than any other. The great thing aboyt a value-oreinted approach, particularly aboslute value – rather than relative value – is that you are able to see market conditions for what they are. You’ll inevitably be out of step with the majority but that is what is required for long term capital growth and preservation.

  6. As an SMSF investor in your Global Fund I trust the funds cash holdings are also at record levels then??

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