(MONEY Magazine) -- The bursting bubbles of the 1990s and 2000s caught most of the experts by surprise. Not Robert Shiller.
The Yale economist isn't so much a forecaster as a historian of financial data. His work on the history of stocks led him to advocate a market valuation tool now popularly known as the "Shiller P/E."
Traditional price/earnings ratios compare today's share prices with often overly bullish estimates of future profits and can sometimes make stocks look more reasonably priced than they really are. Shiller looked instead at the averaged 10-year history of earnings, which captures both the ups and the downs of the business cycle. This P/E flashed red warning lights as it reached new highs during the tech boom.
Next, Shiller's research into home values led him to conclude in 2005 that real estate looked bubble-like. Today he still isn't much of a stock market optimist. But in his new book, "Finance and the Good Society," he argues that Wall Street can be a force for progress; his conversation with editor-at-large Penelope Wang has been edited.
You have become famous for your cyclically adjusted 10-year price/earnings ratio. What do the latest numbers say about future stock market returns?
When my former student and I did the original analysis -- I was working with John Campbell, now economics department chairman at Harvard -- we found a correlation between that ratio and the next 10 years' return.
If you plug in today's P/E of about 22, it would be predicting something like an annualized 4% return after inflation. Not so bad when you look at the 20-year Treasury bond yield of 2.8% and the likely capital losses if interest rates go up.
A real 4% return seems like a worthwhile investment.
Then again, I don't know that I trust that number. It goes back to this whole academic literature on the outperformance of equities.
My old friend Jeremy Siegel [Wharton professor and author of "Stocks for the Long Run"] makes the strongest claim about this. He has data going back 200 years showing that the market has had a real 7% return over that period.
But there's no solid reason it should do so well. Things can go for 200 years and then change. I even worry about the 10-year P/E -- even that relationship could break down. But I believe I'm on better ground thinking that the P/E forecasts returns than thinking one asset just always outperforms.
Are you saying that there's no reason stocks should outperform bonds at all?
Oh, no. If you go back to textbook finance and make some assumptions about investors' risk aversion and that assets should be priced to pay investors for added risk, you would get some outperformance for stocks. But not as much as it's been; it looks as if past high returns were a historical anomaly.
So when I said the 10-year P/E predicts a 4% return, that's conditional on past returns being a guide to future returns, and the truth is, we don't know. Maybe it will be only 2%.
The S&P Case-Shiller housing index, which you helped create, recently showed another drop. Are you surprised the housing decline has gone on this long?
I'm not surprised, no. There have been long periods when home prices declined, including the first half of the 20th century.
The National Association of Home Builders housing market index is sharply up. It's a sign of a possible turning point. But there's another side of me that says that the housing market decline hasn't overshot yet, really. It could do that.
You've argued for changing the home mortgage deduction. Why?
There are good reasons to promote home ownership -- it's a way to stake people in citizenship. But I think it makes sense to phase out the home mortgage deduction and instead offer a tax credit [which would be worth the same amount to low- and high-income taxpayers].
Many low-income people don't itemize and claim the mortgage deduction, even after they buy a home, because the standard deduction looks better to them. Even if they do use it, the benefit is smaller because they're in a lower tax bracket.
So we're giving a big incentive to high-income people and not much to lower-income people. Why do we give a tax incentive for people to build McMansions?
Your new book is called "Finance and the Good Society." What's one got to do with the other?
Finance has become unpopular today -- a little like being on campus teaching ROTC a generation ago. I wanted to clarify what finance does and remind people it does have a social purpose.
The thing about stock markets, and why they have been so successful, is that they create a serious, playable game. It's like gambling, but it's not. Having a stock market provides excitement and lets people think about real things. It was a wonderful invention, behaviorally.
So how do you turn that invention to broader social ends?
One problem with philanthropy is that it's unrewarding: You give away the money, and that's it.
So as an example of ways to humanize finance, I have a notion of a different form of philanthropy that would have shareholders. You're still basically giving away the money, but the shares you bought through your donation would pay dividends. And at your discretion you can reinvest them in that company or in another nonprofit.
You're just back from an economic conference in Europe, where policymakers are pushing budget austerity. Any lessons we can take from that?
There's a debate about the merits of austerity among economists. It's like a medical judgment: We have to deal with the debt eventually. Do we let the patient rest before we do the surgery?
I think probably austerity is bad at this time. Confidence and market psychology are important in promoting consumer spending and growth. The only way we can collectively decide, "Okay, we need to spend," is to tax and spend. The problem is, those words are loaded ideologically -- and they raise fears that once spending goes up, it won't come down. And that's a legitimate fear.
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