Robert Shiller, the Nobel Prize-winning economist, thinks this may be a “dangerous time” for the stock market.
In an interview Thursday on CNBC’s Squawk Box, he described how his cyclically adjusted price-to-earnings (CAPE) ratio is signaling a warning for stocks.
“The monthly CAPE ratio reached a peak of 44 in the year 2000 and that was followed by an important drop. It went down to 13, came back up to 27 in 2007 and [was] followed by another drop and then we were recently back up to 27 again,” the Yale University professor told CNBC. “It does seem to forecast somewhat – it’s not reliable – but it’s a warning signal.”
Right now the CAPE ratio is around 25. According to Shiller, “it’s high.”
If the CAPE index were to drop again – 17 has been the historical average – the DOW and S&P 500 would also fall “quite a bit lower,” Shiller says.
If this happened, Shiller predicts the Dow Jones industrial average would fall to “something like 11,000” and 1,300 on the S&P 500. On Thursday, the Dow was around 16,351, and the S&P 500 around 1,948.
That’s not to say that will happen or that stocks couldn’t also go higher from here, Shiller says.
“They could go a lot higher,” he told CNBC. “I just mentioned the CAPE got up to 44 – even higher on a daily basis. That was in 2000. Nobody can really forecast the market accurately, but I think this is a risky time. There is a risk of substantial declines, as well as [increases].”
Risky enough for Shiller to reduce his exposure to U.S. stocks. He confirmed to CNBC that he has taken money out of the stock market.
“But, I don’t take myself as a model for everyone else,” he told CNBC. “Everyone is different. People need to look at their own risk situation.”
While recent market volatility has had many urging investors not to panic, Shiller doesn’t necessarily agree.
“This advice that one should not react to a stock market drop like we’ve seen in the last 10 days or so is, I think, a little bit misleading,” he said on CNBC. “Maybe it’s someone’s goodwill effort to stabilize the market and tell people not to overreact – and one shouldn’t overreact – but the market is high now and people have to look carefully. Maybe this recent turmoil is making many people think that this is a time to look at their holdings and see whether their exposure to the market is right. Some people are surely overexposed and ought to reconsider.”
The CAPE ratio, which looks at price divided by 10-year average earnings, should be used as a standard of valuation for the whole stock market, Shiller says.
“The ordinary price-earnings ratio is misleading because earnings can drop precipitously in a recession, and they’re volatile from year to year, so we just take a long average. It’s not a new idea. You find beginnings of this in [Benjamin] Graham and [David] Dodd['s "Security Analysis"] in 1934. It’s been mentioned over the time, but it’s never become a standard. It should be a standard. It’s a standard of valuation for the whole stock market.”
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