Editors Note: This is an interview conducted by Business Insider Editor in Chief Henry Blodget In Davos. Read the full transcription below.
BI: Where are we now in terms of the deflation of the housing bubble? I know the Case-Shiller numbers have started to turn down again; how much more of that is there to go?
RS: I wish I knew the answer to that. The housing market is behaving strangely. The peak in the market was around 2006; it went down for three years and if it behaved the same way it had in the last cycle, it would continue going down for years more. But then it had a sudden and sharp turn-around that we rarely see in this market, in the spring of 2009, and that seems to coincide with the American Recovery and Reinvestment Act, which created also the Homebuyer Tax Credit. And the recovery lasted about as long as the tax credit lasted.
And then it started turning down, a little bit, but I believe the Tax Credit was a good part of the story because the biggest price increases from 2009 – 2010 period was in the low priced homes. And remember the tax-credit was phased out for wealthy people, but even the high priced homes reversed, so it’s a little puzzling. UK home prices went up at the same time, so it’s not clear to me why this sudden shock … I think it’s also because of the panic over the Lehman crisis in September 2008 was beginning to wear off, because it wasn’t as bad as some people thought.
The question is will it resume the downward trend? I think it could, maybe not rapidly, but I think there could be further house price declines.
BI: You’re an expert in bubbles; you’ve studied them throughout history — what a lot of people will say, usually, is that after a bubble like this, is you don’t just return to the price trend you actually crash through the trend and spend a long time below the trend. Do you think that that’s possible? Because I think on your Case-Schiller index we’re still, even now, a little bit above the long-term trend.
RS: Right. It’s a question of how you define long-term trend. My company Macro Markets has a gap gauge which shows a picture, you can see it on our website. There are different ways to draw a trend, so it’s not so clear. If you do it in real terms and go back to 1890 there doesn’t appear to be any ? Well, we’re kinda close, but maybe not all the way back. It’s ambiguous; really unclear where we’re going, but could they go down more? Yeah, possibly.
BI: I know in the past you’ve called for more government stimulus. Do you think that would make sense here given that the price decline has resumed?
RS: I suspect so yeah. Right now, state and local governments are retrenching there’s this fear of their bankruptcy that is causing jobs to be cancelled. We just saw what happened with the austerity measures in the UK; they just had a negative GDP growth. I worry that’s going to happen. President Obama, in his State of the Union, promised five years freeze on discretionary spending. With state and local governments cutting back, that means negative growth. So I worry… I have my own definition for a double-dip recession. We already passed the time limit for a conventional double-dip, ’cause we’ve been growing for over five quarters now … it’s a recession that occurs before we have healed from the last one.
BI: Do you think that’s possible?
RS: I think that’s definitely possible because the unemployment rate is very high now and it’s not going down very fast, so I’m still calling for a double-dip. I mean I wish we didn’t have it, but that’s what I always meant. Nobody ever defined double-dip anyway, if you look at history the only example that looks credible for what people seem to be talking about was the 1980, 81 and 82 recessions, it was less than a year between them. But we’ve already made sure that we’re not going to have that because we’ve already passed the time limit.
BI: Going back to the stimulus. Have you ever seen a bubble bursting like this, where government stimulus has been able to forever stave off the price correction?
RS: The funny thing is housing was never a speculative asset until the 70’s and the bubbles tended to be local back then. Allen Greenspan was right in a sense when he said, “From bubbles, all we see are froth,” if he was talking about history that’s all we’ve seen, but now we’ve seen something different, now we’ve seen a bubble that extended across most of the country. This is the problem with economics; economists are good at predicting a stable environment where people don’t change their patterns of thinking, but something has changed, we’ve gotten more speculative in housing and that speculative attitude means that; I hate to say it, but we could have another bubble. We could even have it soon.
Another one of my themes and it may not be appealing for me to lay out all of these possibilities and then say, “I don’t know,” but this is the way I think, that it’s possible we could launch into another housing bubble if people think that the recovery is real and they want to get in early. We know one thing: according to the Michigan survey on consumer sentiment, people think that prices are low and that good buys are available. There is the beginning of bubble thinking, right there; all it takes is some sense that it’s going now. I’m sorry to be so weak as a forecaster. I think it could go either way.
BI: you’ve been focused a lot on behavioural finance over the years and Irrational Exuberance obviously talked about the fact that there were all these new explanations why the market was so high. I think you make the point that these explanations actually follow the market performance. They don’t come in advance of it. If you look at Wall Street now, stocks are back, they’re high and moving higher and if we look at your Case-Shiller P/E where you lag earnings, they’re probably 30 to 40 per cent overvalued. Do you think we’re in for a day of reckoning there too, or do you think it’s possible that we’re in a new paradigm again?
RS: I think day of reckoning is a bit strong. I think much more likely, is just flat, nothing happens, maybe goes down somewhat. Day of reckoning is very strong wording, umm, I don’t like to use that.
BI: But you do think P/Es will ultimately regress back to the mean?
RS: Possibly, yes. There’s two ways price-earning ratios can regress to the mean. One is, the price can go down (the numerator) and the other is the denominator should go up. Efficient Markets theory says that it’s going to be the latter — because you can never predict price. High price earning ratio is in itself a prediction. But in the study I did with John Campbell we looked at which one it has been historically and I’ll tell you, and hands down price does it. Price-earning ratio does not predict earnings growth. So, yeah, I think that the most likely scenario is that sometime over the next 10 years is we will see a big downward correction. I just don’t know exactly when.
BI: One thing that’s always amazed me about your argument and so forth, I’ve read Jeremy Seigel’s book Stocks For the Long Run. I gather, from an article at least, that you two are good friends. You remember when the S& P was trading for something like 850 in the middle of the crash, Jeremy came out and said, “the S&P is worth 1200 on my metrics”, and your metrics said it was worth about 900…Who’s right and how do two incredibly smart academics who have years of research come to such differences in terms of what the stock market’s worth?
RS: Well, I’ll quote Alfred Marshall the great late-19th early 20th-century economist: “Economics is not an exact science.” And there are reasons for that; I don’t think that the problem is we don’t have the mind of scientists. I think if you bring scientists in they act just like us. Because it’s something different about economics; we’re looking at phenomenon that are human and always changing qualitatively. That’s a problem and I can’t quote probabilities. And this what John Maynard Keynes made as an important part of his theory, which is often neglected; that economists like to build models of people as optimising decision theorists with decision trees and probabilities at each node, but the problem is we rarely have that. And so we are always in a situation of judgment, and it’s always in the situation in the judgment of the judgments of others and who is speaking the truth and who is dissembling? All this mixture just defies any … I still remark how much variation and opinion there really is. But, you know, I think on the whole it is not a bad thing. And I have debated Jeremy Siegel and I think our debate is productive. I think people probably come out ahead even though they don’t know who is right. At least they’re less likely to put their faith in some extreme view.
BI: But what does Jeremy say when he looks at your P/E ratio which has been you can just look at a chart 150 years, always regresses to the mean after maybe 15 to 20 years, but it gets there. What does Jeremy say when he looks at that? Can he explain why his theory is right? Even in the face of that?
RS: Well first of all I don’t think Jeremy is entirely unsympathetic to what I say. In fact he wrote in 2000, for the Wall Street Journal, about tech stocks being overpriced and he based it on a price-earnings index. He said some of them had P/Es over 100 and he said no stock with a P/E over 100 has ever succeeded. So, I think we’re sort of on the same wavelength. Maybe we appear to disagree more than we do.
BI: So, what are you doing with your own money now?
RS: Well I have it kind of diversified. It seems like everything is overpriced: stocks, bonds, and real estate. And index bonds were given a negative yield recently; maybe they’re coming back. Nothing looked attractive. There must be some people who can find attractive investments. But I’m really a professor, interested in broad issues. The question of whether you should put it in a hedge fund with an expensive manager. I think maybe you should, but only if you can judge managers right. I don’t think you should put it in a random one. Maybe this is my hubris, but I imagine I could make a lot of money investing — if I put my mind to it and stopped focusing on these big aggregates as I do. But I’m not, I’m an academic and I’ll let other people get rich. I don’t know what I would do with the money anyway.
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