Narratives, not reason, drive our investment decisions, says Robert Shiller.
Regular readers will know that at MoneyWeek we have heroes – people we think have advanced the cause of private investors everywhere. There aren’t many of them, but one standout has long been Yale professor and Nobel laureate Robert Shiller.
In 1981 he, with John Campbell, introduced the idea of the cyclically adjusted p/e ratio (Cape) as a valuation tool for equity markets. We love Cape, first because it works (when it’s low the next ten years tend to be good, when it’s high they tend to be bad) and second because it gives private investors something of an advantage over professional ones. They can’t afford to wait five to ten years for a value investment to come good. We can.
So I was pleased to get the chance to meet Shiller last week. He was in London to discuss a new ETF he’s helped Barclays and boutique fund manager Ossiam to produce – more on that later. We met in a smart room at one of Barclays’ buildings in Canary Wharf and began by talking about his thoughts on stories and how they drive economies.
Economists feel that “psychological talk is undignified”, says Shiller, that economics should have more of a “crisp sound” to it. But the human brain is “organised around narratives”. We act “based on stories that ignite emotions”, investing not because we know it makes sense perhaps, but because we “envy” someone who has done well.
A story that does the rounds can create a “collective consciousness” that then makes groups behave in the same, not entirely rational way. “Ideas have contagion.” They spread from person to person as “thought viruses” or memes, creating social epidemics along the way, which in financial markets eventually gives us bubbles.
I ask if there is a story doing the rounds at the moment that he sees as distorting markets. “There are a number of them.” There’s Greece. Look at the size of its population and its importance in the eurozone and you think “it’s tiny, so it can’t matter”, but it “turns out it can matter because of the story it generates”.
Greece, as the “ancient origin of our philosophy and science”, sounds “awfully important” so people assume that it is and the European debt crisis then becomes “an amplification of the Greek story… it wouldn’t have all these repercussions if it weren’t for the power of the story”.
We move on to talk about markets. If things in Europe aren’t as bad as the worries about Greek default suggest, then does it make sense that the Cape for Europe is currently half that of the US? Shiller doesn’t think so: “I think Europe is a good investment now and the US is not so good… I can’t imagine that American stock should have twice the valuation of European stocks.”
Would he buy Europe now? Would he perhaps buy the four lowest Cape countries in the region (Greece, Russia, Portugal and Hungary) and be reasonably confident he’d be richer in ten years than he is now as a result? He isn’t quite confident enough, he says, but he holds Italy and Spain “all as part of a diversified portfolio”.
I assume he will also be holding the new ETF* mentioned above when it lists on 16 February. It uses Cape to value sectors across Europe. The five cheapest are selected. The one with the worst momentum is rejected and the remaining four held. The result is a nice mix of momentum and value (both of which we approve).
We move on to the bond market. Shiller’s book, Irrational Exuberance, is into its third edition. The latest version has a new section on the risks in the bond market. Given that the last two dealt with the stockmarket and the housing market just before collapses in both, that might make the bullish worry a little. It should, says Shiller: the “bond market is strangely high in value right now… people are willing to lock up their money for 20 years at a guaranteed negative return”.
He is bemused by this – but also by governments’ reaction to the anomaly. If countries can borrow at a very low or negative interest rate, it’s hard to understand why they aren’t doing so: “wouldn’t you think that the UK government could find more to invest in that would have some positive return?”
It is, he says, “a puzzle of our time”.
I note that the UK government hasn’t a great record in producing infrastructure projects that produce a positive return after you’ve factored their cost overruns in. “Put me in charge of a public work reserve for the UK; I can find projects.”I can’t let him go without asking for his views on the UK housing market. The remarkable thing, he says, is the similarity between the UK and the US housing markets. If you take a plot of London home prices and those in Boston, it looks pretty much the same.
Prices in Boston have gone “way up” and while it is not in an “intense bubble phase right now”, the latest data are showing “slight declines”. So he isn’t buying houses in Boston at the moment? Actually, he is: he just helped his newly wed son buy a house in Boston – “that’s more important” than value.
* Ossiam Shiller Barclays Cape® Europe Sector Value TR UCITS ETF.