Is the Miraculous Economic/Market Balloon Coming Back to Earth?

Many of you have been sprinkling the term “animal spirits” into your blogs and articles lately and referencing the Shiller CAPE ratio. Good stuff. That’s why we’re sharing Robert Shiller’s piece from yesterday’s NY Times with you: Consumer Confidence Is Lifting the Economy. But for How Much Longer?

Shiller, originator of the eponymous Cyclically Adjusted Price to Earnings (CAPE) ratio, argued that
consumer confidence is a critically important advance indicator of economic booms and busts. That said, he admitted we don’t really understand how and why consumer confidence behaves the way it does.

That’s a dangerous notion. We can talk all we want about a very low (perceived) jobless rate, GDP approaching the magic 3% target, inflation in check and a record-high stock market with earnings (sort of) keeping pace with ever-rising share prices, but Shiller argues that doesn’t fully explain the buoyant mood from Wall Street to Main Street.

Our Take: It reminds of us of the balloonist who doesn’t understand the concept of helium—and that he doesn’t have an infinite supply of it. The view’s great now, but you better be ready when the fuel that’s keeping you aloft eventually runs out.

Shiller argues “animal spirits” are at work, referring to the term popularized by economist John Maynard Keynes in the 1930s referring to a “psychological state in which people get a consumerist and entrepreneurial bug that allows them to forget their worries and let their optimism guide their economic decision-making.”

Is the exuberance irrational?

According to Shiller, exuberance like this is fueling the lofty stock market, in which “prices have far exceeded fundamental valuations.” He observed that real (inflation-corrected) corporate earnings per share for the S&P 500 in Q3 were only 6-percent higher than they were in Q2 of 2007, just before the financial crisis. In contrast, real stock market prices were 39 percent higher. “That disproportionate increase is based much more on how earnings are being valued than on how the level of earnings has increased.”

Our own Wealth Advisor Confidence Survey last fall found that nearly 80 percent of advisors expected a double-digit market correction in 2018, but less than one third (31%) expected a recession.

Obviously, this disconnect has happened before and will likely happen again. According to Shiller, “The four major confidence indexes took a long ride up between 1990 and 2000, again after a recession. From the bottom of the Michigan index in October 1990 to a peak in February 2000, real S&P 500 price per share rose 256 percent while real earnings per share rose only 78 percent.”

What gives? Shiller said a traditional explanation is that investors had a rational expectation of future earnings increases, “but, it is clear that they were grossly mistaken. The S&P 500 lost just over half of its real value from its peak on March 24, 2000, to its trough on Oct. 9, 2002. No concrete event caused this plunge, though we can point to the bursting of the dot-com bubble and a recession. Both were plausibly caused by a drop in overinflated confidence.”

Shiller said that while Trump’s presidency may have exerted “some impact on animal spirits in the last year,” it doesn’t explain the preceding eight years of gradually rising confidence. “I am skeptical that the upward swing can be entirely explained by standard factors like government and central bank stabilization policy or technological innovation,” added Shiller.

Our Take: If we don’t know what’s keeping the balloon aloft, then we’ll never know what’s going to cause it to plummet–or when. Don’t trust the gauge just because it says there’s gas left in the tank.

Conclusion

Said Shiller: “History indicates that a long uptrend like this one will eventually shift downward, even if we can’t say when it will happen. While the timing will be a surprise, we can expect a sharp change in direction that is likely to have serious consequences for the economy in the United States and around the world.”

Fasten your seatbelt and always make sure your parachute is working. Think we’re full of crap? We’d love to know what you think and why.

*** Take our Insta-Poll and see how you stack up to your peers.

TAGS: Robert Shiller, CAPE ratio, consumer confidence, market overvalued, animal spirits, irrational exuberance




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