I spoke with Yale professor Robert Shiller in Davos earlier this week.
Shiller has correctly identified (in advance) two major price bubbles in recent decades—the stock market bubble of the late 1990s and the housing bubble of the late 2000s.
One of the key attributes of most bubbles is that, when they finally burst, prices tend to “overshoot” on the downside, crashing well below fair value until all the exuberance is wrung out of the system.
So is that what’s going to happen to house prices this time? Or, as many people think, are house prices finally “bottoming” and getting ready to blast higher again?
BLODGET: A lot of people have just called the bottom in the housing market in the United States, and there’s been some OK data recently. Is that your take? That finally housing prices are bottoming?
SHILLER: When people phrase is that way, they say ‘we’ve reached the bottom.’ That suggests that we have the expectation of a major turning point right now. But I don’t see that. I don’t see any reason to think that prices are going to start heading up dramatically now. We do have some good news. Permits are up. Notably, the National Association of Homebuilders Housing Market Index is up and that’s a forward-looking index. But it’s not up very much. If you look at the rate of change it looks dramatic but it’s still at a low level.
BLODGET: One thing that people are saying is that we have finally absorbed the excess inventory, and with just the general growth of the population and families in the United States, we’re getting close to where we are meeting supply and demand. Is that true?
SHILLER: Well, one simple model of home prices is the construction-cost model. Traditionally, home value was about 15 per cent land and 85 per cent construction costs. The land component has gotten bigger with the bubble. That might be kind of a long run equilibrium. If you believe that, that’s an oversimplified model, then it probably suggests we’ll just stay where we are.
BLODGET: And where are house prices relative to long-term historical trends? I’ve tracked at a lot of measures and it looks to me like we’re finally starting to close in on fair value. But it’s not as though we’ve crashed way below fair value.
SHILLER: It depends what you mean by fair value. If you take account of the very low interest rates, you might think that housing prices should be higher than historically. But then on the other hand, that model hasn’t worked very well historically. That would be like the Fed model applied to housing. But it doesn’t seem to fit. But I think the construction costs model says that housing should track the costs of construction. It doesn’t depend on interest rates, doesn’t depend on the economy. That’s a model, I’m not saying it’s the only model.
BLODGET: And what about price-to-income and price-to-rent?
SHILLER: Those things have come down a lot. I don’t know exactly where the middle is but it’s not like we’re overpriced anymore. Now the question is whether we’ll overshoot, which is a common thing that happens after bubble burst.
BLODGET: And you’re an expert in bubbles and I’ve looked at some on your work going back several hundreds of years on housing. Have you ever seen a bubble where there wasn’t a major overshoot?
SHILLER: Well, the problem is we’ve never had, in the United States, a bubble like this, of this magnitude before. That’s the problem. That’s the fundamental problem of economics. We’d like to be statisticians but in fact the world is always changing on us. So we end up having to use judgment. We’re not very good at that.
BLODGET: Going back to the point about interest rates… People make a huge to-do about the affordability of houses. In your research on house prices, do interest rates actually matter? Or is mortgage finance such a new concept in the history of home ownership that you just don’t have enough data?
SHILLER: I think historically, if you look at it, interest rates don’t seem to matter very much in determining home prices. In terms of forecasting, which you’re asking me to do, to forecast the change, the big thing in forecasting home prices is momentum. It’s different than the stock market. So if it’s been going up it will continue going up and if it’s been going down it will continue going down. By that model, which is the most successful forecasting model for home prices, prices will keep going down.
BLODGET: That’s encouraging! And what about stocks? You pioneered, or at least have really popularised, the “cyclically adjusted price-earnings ratio,” which looks at prices relative to smoothed earnings over 10 years. Recently, over the last few years, a lot of people have come back and said, oh no, it should be sixteen years or it should be five years. Your friend Jeremy Siegel says no, you shouldn’t normalize them at all and so forth. Are you still comfortable with the CAPE as a good measure of base value?
SHILLER: It’s a powerful predictor of the market. John Campbell and I, my former student who is now the chair of the econ department at Harvard…
BLODGET: Congratulations, you taught him well!
SHILLER: That’s why I am proud of my former students! We found that price divided by 10 year average earnings predicts price changes. It really does. Over a long time. It may not say what will happen next year. Right now that ratio is kind of high in the United States and that is a suggestion that its not the greatest, but it’s not super high. So if you look at what our model predicts, it would still predicts positive, good substantial returns, better than the 2 per cent on 10-year Treasuries.
BLODGET: A lot of people argue to me that the CAPE includes 2009 which was a terrible year and includes other aberrational years and that’s skewing the average somehow. Is that not the case?
SHILLER: The analysis Campbell and I did, didn’t include that year because we did it in 1996. But you have to look at the anomalous years. They have to be part of the analysis. Sometimes you have very big movements in one year.
BLODGET: And that’s the whole point of the analysis—to smooth it out.
SHILLER: Right. I don’t know why people keep using one year earnings. That is the time it takes the earth to go around the sun. I don’t see any other significance.
BLODGET: Part of your argument there is that profit margins tend to regress to means and right now we’re at an all-time high profit margin or very close. Do you think that profit margins can continue going up for U.S. companies?
SHILLER: Profits have been very volatile over the last 10 years. They look much more strongly mean-reverting than in the past. So that suggests that the current strong profits might turn out to be misleading.
BLODGET: When you think about smoothed earnings as a way of predicting prices, do you think about it as a predictor of what the price is going to do or is it better to think about it as the likely 10 year return for the market is ‘x’ at this particular price?
SHILLER: You could go either way… I think that the returns that we could see going forward are not lousy, they’re low…
Thanks to BI’s Ben Walsh for transcribing this interview.
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