Category: Robert Shiller

The Times Cheers Up Stock Market Investors

Last weekend The New York Times, no doubt in response to criticism that the media reports nothing but grim news about the economy, did its best to cheer us up with an article about how a stock market debacle from 75 years ago wasn’t really all that bad after all.

NYSE floor Old - Crop It started out squarely addressing the problem.

Historical stock charts seem to show that it took more than 25 years for the market to recover from the 1929 crash — a dismal statistic that has been brought to investors’ attention many times in the current downturn.

I’m not that easily cheered up, partly because I understand the nature of the optical illusion that makes those charts “seem to show that it took more than 25 years” to recover from the ‘29 crash.  The charts tend to make the uninformed observer think it took 25 years to recover because it’s actually true.  It was not until 1954 that the Dow got back to its 1929 high.

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The Back to the (Stock Market) Future

It seems that when journalists can’t think of anything else to say about the latest slaughter on Wall Street they point out that the stock market is now back to where it was X years ago.  It’s not a meaningless comparison.

On Friday the S&P 500 closed at 683.38, up 0.12% over the close the day NYSE-Mod-Smallbefore.  Prior to Thursday, the last time the S&P closed at that level was September 20, 1996. Old guys like me think that was just yesterday, but it was actually rather a while ago.  Clinton (the husband) was running for reelection.  The internet stock craze was just beginning.  Steve Jobs hadn’t returned to Apple yet and Amazon and eBay were both still privately held.

Does it make sense that the 500 largest companies in America are now worth what they were 12 1/2 years ago?

Of course, simple price level is not the only way to judge what stocks cost.  Consider price earnings ratio (PE), what you pay per dollar of corporate profits.   What the S&P 500 companies will probably earn in 2009 turns out to be roughly comparable to what they earned in 1996.  But that’s not apples to apples, because in 1996 the economy was humming along in a boom and today the economy is in recession.  (We hope.)   To normalize the cyclicality out and get a handle on the gross earnings power of the S&P 500, Yale’s Robert Shiller has popularized PE10, which is the ratio of price to the average earnings over the previous ten years.  Plug in Friday’s close to his spreadsheet and you get a value of 11.8.  The last time we saw 11.8 was in January 1986.

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What Home Sales Numbers Mean to You

The AP has a story today about how January home sales were down 7.7%.  This from yesterday’s press release from the National Association of Realtors.  According to them, the number of existing house sale contracts signed in January, i.e. the number of agreements made to sell a house, was down 7.7% from December.   (That’s a seasonally adjusted number, something you’d have to read the footnotes to their release carefully to discover.  In raw terms January sales were up 18.1% from December.)

What does this mean to you?  That depends.  Are you a Realtor?  Then it is bad.  Business is really slow.  Are you an ordinary non-Realtor, perhaps a home owner concerned about the value of your largest asset or somebody interested in house prices as an important economic indicator?  Then this means nothing.

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House Prices: The Long View

There was an interesting post at Debit vs. Credit two days ago suggesting that now may not be the time to buy a house. The gist of the argument was that house prices still have a way to go before they return to normal. This was illustrated with a chart of median new home prices as a ratio to median income since 1963. That’s not the most ideal set of data to use, for reasons that I will spare you.

The most useful measure of house prices are the S&P/Case-Shiller Home Price Indices. They only go back to 1987, but one of the co-inventors of the index, Robert Shiller, has chained together other useful house indexes to patch up a composite going back to 1890. (This is the third post that has mentioned Prof. Shiller in the past month. Just coincidence, I swear.)

I downloaded the data from his site, updated and cleaned up a few things, and produced the following chart, showing the inflation-adjusted sale price index for existing homes since 1890.

If you’ve never seen something like this before, you may be experiencing some shock and confusion. This is normal. Just keep breathing deeply. You thought house prices went up over time, didn’t you? Well, they do, but mostly because of inflation. Recent experience excepted, house prices are generally flat over long periods of time once inflation is factored out.

A few other observations worth making:

1) The last index value in this chart (which is for November 2008) is 144.0, still 13% higher than the 1989 peak of 127.4. That does suggest that we have a little more to go, or at least did as of November. On the other hand, it’s already down 40% from the 2005 peak of 202.5, so the worst may be behind us.

2) The recent run-up in house prices actually began in 1996. (From 1996 to 2005 real prices went up 86%.) It may not have gotten weird enough to be noticed in the media until the last years of the boom, but the index began hitting all-time highs as early as 2000. I mention this because it’s currently fashionable to blame the low interest rates of 2003-04 for the housing bubble. They sure didn’t help, but the worst you can say is that they were gasoline thrown on an already blazing fire.

3) As impressive as the 1996-2005 run up is, it is not entirely out of the ordinary. From 1942 to 1947, real house prices went up 60%, which is the best five year run in history. Further, prices pretty much stabilized after that and did not give back very much of the gain. This needs to be pointed out to those who say, in hindsight, that of course house prices had to fall after 2005, because the rapid gains made in years before were just unsustainable.

So is this a good time to buy a house? That depends. Do you need one to live in? There are many factors to consider, including interest rates, tax breaks and other incentives from the government, and local market conditions. (It is worth stating the possibly obvious that the chart above is a national average. Specifics of a particular area may differ both in the short and long run.)

But if you are looking at a house as a possibly shrewd investment, something you can buy cheap now and sell dear later on, you are likely to be disappointed. Even if the crisis were over today, and house prices returned to their pre-bubble habits, the normal state of things is that they don’t go up very much.

What to Expect from the Stock Market

Just about all mainstream personal finance writers advise making stocks the centerpiece of your investment plan. Most will quote a reassuring average market return over a reassuringly long period and make the argument that for sober long-term investors such as yourself, stocks are the place to be. But few writers explain what that long term average return really means and what expectations you should draw from it.

The first thing to understand is that you cannot expect to actually get that average return in any given year. Get Rich Slowly has a guest post by Carl Richards that patiently makes this point with the use of an elaborate animated presentation. His data has an average return of 10% over eighty years and shows that only twice in that time did the actual market return for a year fall between 9% and 11%. I would hope that this is a nearly obvious point to all stock market investors, but I know better.

Moreover, I worry that by saying that the market has good years and bad ones, but that the long run average is high, people are led to believe that as long as they can stick it out through the ups and downs, after twenty years or so they will get the promised average return. This is not necessarily so. Those long run averages are not that much more predictable than individual years.

To illustrate, I will run some numbers of my own. Yale’s Robert Shiller has a website with the S&P 500 index returns annually back to 1871 as well as some other useful stuff such as inflation rates. It turns out that, sure enough, the average return for the US stock market, as measured by the S&P 500, was 10.08% per year over the 138 years from 1871 to 2008 inclusive.

What do we know from this? We know that funds invested in the market on December 31, 1870 and held through December 31, 2008 would have made an average of 10.08% a year. We do not know what the average returns for the next 138 years will be. 10.08% is a pretty solid guess, and in fact is almost certainly the best guess we’ve got, but it’s still just a guess. There is no “true” expected stock market return, even over long periods of time. Setting market return expectations is not science, just thoughtful estimation based on what has happened in the past.

To get a better feel for how volatile even long term averages can be, consider the 80 year period that Richards uses. The 80 year average return for the period ending in 2007 was 11.52%. But move it forward a year to end in 2008 and you get only 10.46%. That is a big difference considering those two periods are 98.75% identical.

And 80 years is a lot longer than the typical person will be invested in the stock market. For most, there is a critical twenty years or so from middle age to retirement when the nest egg does or doesn’t grow. And the returns for twenty year periods are all over the place.

As it happens, the best twenty year period in the stock market since 1871 was recent enough that a lot of us remember it well. From 1979 to 1998 the market averaged 17.32% a year. One dollar invested at the end of 1978 grew to $24.41 by the end of 1998. At the opposite extreme, 1929-1948 averaged only 3.00% a year. The $1 invested at the end of 1928 became only $1.80 by the end of 1948.

There aren’t a lot of people still around who remember the stock market in 1929-1948. But your parents or grandparents might be able to tell you about the period 1962-1981. The market went up an average of 6.57% per year, which doesn’t sound so bad until you find out that inflation averaged 5.50% over the same period, leaving stock investors with an average real return of only 1.07%.

If you are like me, in your mid-forties and heading into the intense period of investing for retirement, the big question is will the period 2009-2028 be more like 1979-1998 or 1962-1981? Nobody knows.

There were 118 twenty year periods ending from 1890 to 2008. The average twenty year period had an average annual return of 9.22%, but a forth of those periods had returns worse than 7% and a fourth beat 11.5%. And you only get to do this once. Consider the difference in circumstances of a person born in 1933, who turned 45 in 1979 and enjoyed fat returns on his way to retirement in 1998 at 65, with somebody born in 1916 whose nest egg went nowhere in the twenty years before his retirement.

What can you do about this? In the most direct sense, nothing. Diversification will help some, but not by as much as you might like. Bad decades for the stock market tend to be bad decades for bonds and real estate too. The truth is that this is one of the many things in life that are beyond your control.

But you can take it into account when doing your financial planning. If the difference between 8% and 10% returns over the next twenty years is the difference between a comfortable retirement and hoping your kids can support you, you need to reconsider your plans. Expecting 10% a year from the stock market over the long run is reasonable, but counting on it is foolish.

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