By Scott Sumner
MaynardGKeynes recently left this comment:
Simple fact is that Shiller correctly predicted 3 of the last 3 bubbles (2000, housing, 2007).
That’s a widely held view, but is it correct? This is from Eugene Fama’s Nobel Prize lecture (in the AER):
On the website for his book Irrational Exuberance, Shiller says that at a December 3, 1996, lunch, he warned Fed Chairman Allan Greenspan that the level
of stock prices was irrationally high. Greenspan’s famous “Irrational Exuberance”
speech followed two days later. How good was Shiller’s forecast? On December 3,
1996, the CRSP index of US stock market wealth stood at 1518. It more than doubled to 3191 on September 1, 2000, and then fell. This is the basis for the inference that the original bubble prediction was correct. At its low on March 11, 2003, however, the index, at 1739, was about 15% above 1518, its value on the initial “bubble” forecast date. These index numbers include reinvested dividends, which seem relevant for investor evaluations of “bubble” forecasts. If one ignores dividends and focuses on prices alone, the CRSP price index on March 11, 2003, was also above its December 3, 1996, value (648 versus 618). In short, there is not much evidence that prices were irrationally high at the time of the 1996 forecast, unless they have been irrationally high ever since.
The second “success” story is the forecast in the mid-2000s that real estate prices were irrationally high. Many academics and practitioners made the same forecast, but an easy one to date is Case and Shiller (2003), which was probably written in late 2002 were early 2003. To give their prediction a good shot, I choose July 2003 is the date of the first forecast of a real estate “bubble.” The S&P/Case Shiller 20-City Home Price Index is 142.99 in July 2003, its peak is 206.52 in July 2006, and its subsequent low is 134.07 in March 2012. Thus, the price decline from what I take to be the first forecast date is only 6.7 percent. The value to homeowners from housing services during those nine years from July 2003 to March 2012 surely exceeds 6.7% of July 2003 home values. Moreover, on the last sample date, October 2013, the real estate index, at 165.91, is 16% above its value on the initial “bubble” forecast date. Again there is not much evidence that prices were irrationally high at the time of the initial forecast.
I see this sort of thing all the time. In January 1987 John Kenneth Galbraith claimed stock prices were a bubble. They then proceeded to rise by nearly 1000 points and then fall by nearly 1000 points, all within 1987. After stocks fell sharply, some people assumed Galbraith had predicted the crash. Back in 2003, The Economist magazine predicted that housing prices would fall in a number of specified markets. After the housing bubble burst, they ran an advertisement bragging about their prescience, even though their specific predictions were almost all incorrect. Housing prices rose strongly after 2003 in most markets, and remained well above 2003 levels even after declining.
If Shiller had lived in the UK, Canada, Australia or New Zealand, his housing price forecast would not have been just a little bit wrong, but rather wildly off base. He’s lucky that he lives in a market that recently had a once in a century housing price drop, and yet as Fama shows his prediction was still somewhat off target. And of course his stock market model has done very poorly since 2010, when his model suggested the S&P500 was 20% overvalued. At the time it was at 1070!
We all make either implicit or explicit forecasts about the markets. If we later notice market movements that seem to align with our initial forecasts we tend the pat ourselves on the back and assume the forecasts were correct. This is just one of many cognitive biases that we human beings are prone to. My suggestion is to pay no attention to bubble forecasts. They are useless. Indeed the entire bubble concept is useless.