Bloomberg Personal Finance

May 2002

Jeremy Siegel and Robert Shiller

The Shiller & Siegel Show

     By Dan Rottenberg

Two brilliant professors, two lifelong friends -
and one giant disagreement about investing

In the fall of 1967, two graduate students newly arrived at the Massachusetts Institute of Technology found themselves waiting in line for MIT's then-mandatory tuberculosis X ray. Robert Shiller and Jeremy Siegel struck up a conversation and discovered that both had been raised in the Midwest, both were enrolled in MIT's economics department, and both shared a relentless intellectual curiosity that transcended the narrow limits of their academic majors. From that first meeting blossomed a 34-year friendship whose synergy has helped propel both men to distinguished careers on separate college campuses. Even after Shiller wound up teaching economics at Yale while Siegel found his niche in finance at the University of Pennsylvania's Wharton School, their families routinely vacationed together, and the two professors often roomed together at conferences. Along the way, each prodded the other to explore the connections between abstract academic theories and the real world. "I learned a distinctive approach to finance from him," says Shiller. "He's one of the greatest economists in the world," says Siegel.

Then two years ago, their relationship took an unexpected turn. After years of benign and private mutual nudging, Siegel and Shiller became embroiled in a public disagreement over where the stock market is heading and why, which continues even today in their views of what the next couple of years will hold for stock market investors.

The battle is engaged  The first hints of a schism occurred in 1994, when Siegel helped stoke the'90s bull market with his now-classic Stocks for the Long Run (McGraw-Hill). In that book, Siegel argues that stocks have been undervalued for two centuries, that stock markets in the computer age have become safer over the long term and more efficient as investors have grown more sophisticated, and that over the long haul, stocks have been no more risky on average (and possibly even less risky) than bonds. Shiller, by contrast, appeared before the Federal Reserve Board in December 1996 to testify that the market's high stock prices were "irrational," perhaps inspiring Fed chief Alan Greenspan to famously coin the term "irrational exuberance" a few days later. Shiller expanded his ideas in 2000 with a book that specifically attacked Siegel's thesis. Where Siegel perceives an efficient marketplace, Shiller's Irrational Exuberance (Princeton University Press) per- ceives only speculative bubbles. To Shiller, the only thing predictable about future market performance is the fallible nature of human behavior.

Both books benefited from uncanny (which is to say lucky) timing. Siegel's paean to stocks, published when the Dow Jones Industrial Average was below 4,000, seemed prescient indeed when the Dow nearly tripled over the next six years -- bolstered, some observers say, by Siegel's zealous promotion of his data. Shiller's timing seemed even better: Irrational Exuberance, researched over more than a decade, had the good for- tune to hit bookstores in March 2000. "Jeremy Siegel, in a phone call, urged me to write it," Shiller says of the timing. Bringing it to market just before the Dow peaked at 11,000 and then hurtled southward made him look downright prophetic.

Shiller claims the swoon vindicates his warnings; Siegel insists that primarily the technology sector swooned -- not the market as a whole -- and he notes that even after last year's drop, the Dow remains far higher than it was in 1996," when Shiller first called stock prices "irrational."

From his airy, cluttered, square modern second-floor office on the Penn campus, Siegel cuts to the heart of their argument: "I think investors are far more rational than Bob does." Shiller, from the spacious and high-ceilinged (albeit drafty) reaches of his Victorian office at Yale, agrees on that point, but not without adding a dig at his pal: "It does't look like people in the late'90s were geniuses at figuring out the value of stocks, despite all their sophistication."

"Do you know the last time a diversified portfolio of stocks underperformed a 30-year government bond?" Siegel jibes back. "From 1831 to 1861. I'm not saying it never happens and it never will, but those are pretty good odds." But not good enough for Shiller: "People think anything that's true for a hundred years has to be a law of nature," he counters. "That's just not what history tells us." And so their debate goes.

Regardless of who's right, one thing is certain: This friendly feud has transformed two deserving but previously obscure academics into media celebrities. TV shows invite them for joint appearances. The New York Times recently dubbed them "the yin and yang of Wall Street." Their debate last spring at the Wharton School attracted the sort of standing-room-only crowd that would have been the envy of the Penn and Yale football teams. Like Siskel and Ebert, Pavarotti and Domingo, Michael Kinsley and Pat Buchanan, and Mary Matalin and James Carville, not to mention John Maynard Keynes and Friedrich Hayek (who helped each other collect antique books even as they quarreled publicly about government's role in the economy), Siegel and Shiller have discovered the virtues of contention, even as they remain the best of friends.

"They're not deeply committed ideological opponents," argues Andrew Cassel, economics columnist for the Philadelphia Inquirer. "They're great buddies and co-conspirators -- academic entrepreneurs using their expertise to write books that become hot topics on the lecture circuit." Indeed, what stands out most about the pair is not their differences but their similarities: Both are engaging, seemingly guileless fellows whose youthful enthusiasm, even in their mid-50s, seems untainted by insecurity, greed, cynicism, or academic jealousy. "Our views on life and what we think is important are virtually the same," Siegel insists.

Who's right?   So how can two bright and otherwise simpatico scholars examine the same evidence and reach diametrically opposed conclusions? What are the implications of their dispute for investors and money managers (not to mention readers of this magazine)? Where do Siegel and Shiller invest their own money? Where do they see the market going from here? Most important, who's right?

The short answer is: Both men are right, because they're analyzing different questions. Where Siegel studies the long-term behavior of broadly diversified stock portfolios, Shiller examines the short-term behavior of human investors. The professors stumbled into the stock market by accident and from divergent scholarly disciplines. Siegel's introduction came late in the'80s when a fellow Wharton finance professor, Marshall Blume, enlisted his help for an in-depth internal study commissioned by the New York Stock Exchange. In the process of gathering data, which stretched back to 1802, Siegel found that "over the past 200 years, the compound annual real return on stocks is nearly 7 percent in the United States."

What's more, the return on stocks was similarly constant in other major countries. Siegel reached the stunning conclusion that a diversified basket of supposedly risky stocks, when held over long periods of time, actually produced better returns and was safer than ostensibly more secure investments like bonds or even bank savings accounts.

Siegel's Stocks for the Long Run appeared a year later and focused his thesis on the more recent past. He cites, for example, the "Nifty 50," a group of once-favored growth stocks (such as Coca-Cola, IBM, Polaroid, and Xerox) that commanded what seemed to be outrageously high price-to-earnings ratios (an average of 40) in the early '70s. Ultimately, some of the group didn't justify their high expectations -- but the Nifty 50 as a whole did: If you bought all 50 in December 1972 and held them through November 2001, Siegel points out, collectively they would have returned 11.76 percent -- almost equal to the 12.14 percent return of the S&P 500 Index during the same period. The lesson, Siegel suggests, is that over the long haul the market did indeed price that particular bundle of stocks almost precisely correctly. "I mean, sometimes Bob writes as if there's no knowledge" in the market, Siegel,says. "It's almost as if we should price all stocks the same because, you know, you can't predict anything. I disagree with that."

Shiller, meanwhile, had approached the market through his mathematical studies of "rational expectations" and "behavioral finance," which examined not stock returns but the psychology of investors. His studies of investment patterns and the disconnect between dividends and stock prices suggested the critical role of human wishful thinking in all decisions, investments included. Shiller focused on the propensity of most people to exaggerate the potential success of their own portfolio, company, team, or nation. From this perspective, the "efficient markets" hypothesis (that computers and academic research have transformed investing from a crapshoot into a science) itself persuaded many people that stocks were a safe bet -- which drove up stock prices without necessarily making them safer investments.

"In some sense, Jeremy's right that the markets can be very useful coordinators of information," Shiller allows. "But the fundamental question when it comes to the stock market is: Information about what?" Shiller cites John Maynard Keynes's analogy of the newspaper beauty contest in which readers must pick not the prettiest faces but the faces that other readers are likely to consider prettiest. In such a case, he notes, readers must actually deduce "the faces that most people think that other people think that other people think would be the prettiest. That kind of thing unravels, and it produces nonsense. The stock market is like that."

Shiller thought the market was overvalued in the late'90s. But by 1999, he says, "it was absurdly overpriced, you know, and this is the point when I dropped everything and wrote a book." Shiller's Irrational Exuberance savages Siegel's conclusions (for example, "There is actually little evidence in favor of efficient markets theory to be found in [his] analyses"), even while it generously credits Siegel as the book's "real instigator" and "a lifelong friend" from whom "I learned a distinctive approach to finance." Siegel, for his part, readily volunteers that Shiller is "a better economist than I am. But when we look at this little area, it's very interesting how the history [of our disagreement] has evolved."

What's in store for investors?   Siegel believes stocks will remain high for the next year or two and, consequently, deliver lower returns. Shiller expects prices to fall through this year -- at which point stocks will offer much more attractive opportunities for investors. So for now, you could say that Shiller sees more opportunity for investors than Siegel does. "I'm not a roaring bull for 2002," Siegel says, "because the market already expects it." He figures the market indexes are now fairly valued and should deliver returns of 5 to 7 percent after inflation over the next year or two. "If there are no further terrorist acts, we'll have a moderately good year, but not spectacularly so. Low interest rates will continue to feed the market. I think the Fed will increase interest rates as the market recovers."

Shiller expects some growth in the economy, but at a slower pace than in the'90s. "I'm saying that unemployment rates in the United States and some other countries will probably continue to rise -- above 6 percent, maybe above 7 per-cent, even -- and then come down," he says. "My expectation is that three years from now, people are going to be wondering, why is the Dow still at 10,000?" He hastens to add: "I'm not saying that will happen. That's a scenario."

Each man puts his money where his mouth is. The core of Siegel's investments is in indexed mutual funds -- that is, funds that reflect broad market sectors or the market as a whole. "The average investor will do best by diversifying among all classes of stocks," Siegel writes in the third edition of Stocks for the Long Run, due out this spring. "Trying to catch styles as they move in and out of favor is not only difficult, but also quite risky." Siegel has cooled off a bit on indexing the market as a whole, now preferring to tilt toward "small value" stocks.

Shiller, by contrast, has almost nothing in the market, aside from a few shares of Kmart inherited from his mother, which he obviously holds only for sentimental value. Much of his net worth is tied up in Case Shiller Weiss, a real estate firm that develops risk management products like home equity insur-ance and real estate indexes. (Siegel is on the firm's advisory board.) Like Siegel, Shiller believes in diversification, but his definition is different: He holds municipal bonds, real estate, investment trusts, and an international value fund that invests in low-priced stocks outside the United States. But perhaps his favorite vehicles of all are "index bonds" -- U.S. Treasury Inflation-Protected Securities (TIPS) that offer a guaranteed 3.5 percent return above inflation.

"If someone had to pick -- all my money in the stock market or all my money in index bonds," Shiller says, "TIPS would win hands down. But very few people are able to keep that perspective right now. There's just so much excitement around the stock market and so many varied games to play, and for many people it's a part of their lives -- you know, it's just fun to watch, and index bonds can't compete with that."

Both Siegel and Shiller agree that, in Siegel's words, "You've got to have a very broad view of diversification: what kind of employment you're in, your outside sources of income, a little bit even about your house." To Shiller, financial planners are more important than investment managers: "The financial planning aspect of your life is more important than the stock-picking aspect."

But would Shiller steer investors clear of the stock market altogether, depriving them of those long-run returns (not to mention all that fun)? "It's a little bit like alcohol," he replies. "They say a glass of wine a day is good for your heart. But then if someone says, 'I don't drink. Should I start drinking?' you'll say, 'Probably not,' right? I know some other investments that are very promising right now. So if you're not doing it, don't start drinking wine, and don't start investing in stocks." But if you must? "Put just a little in stocks, and try to spread it out over a lot of things, and do it around the world, not just in the United States."

From Shiller's perspective, his celebrated feud with Siegel is already history. "That was 2000, when my book came out, and September 11 seemed to change everyone's thinking. Whether I was right or wrong seems to matter less now. I think I've learned from him and he's learned from me, but I think it's more of a discourse, an expositional thing that we have rather than a particular point of view." Shiller's next book, due out this fall at the earliest (and not yet titled), will have nothing to do with stocks; it's about how technology can provide new tools to manage risk.

Still, it may be difficult for the dueling professors to discard their current mind-sets completely. Even in jest, Siegel assumes people are rational and Shiller assumes they're irrational. Siegel jokes, for example, that they both now have a vested interest in the market's success or failure: "When the market goes down, the demand for my speaking appearances will go down, too, whereas Bob's fees will probably go up." Shiller demurs. No matter what the market does, he replies, "I think Jeremy gets more speaking fees than I do, because there's much more interest in a bullish market person than a bearish one."