Wall Street Journal

July 29, 2002

Prescient Professor Favors Market Timing

     By Craig Karmin and Michael R. Sesit

Before the bubble burst, Yale economics professor Robert Shiller warned investors early on that the bull market was doomed to end in tears in his prescient book, "Irrational Exuberance," published in March 2000.

Now he has another gloomy prediction: Though stocks are at a five-year low, they remain historically expensive and could end the decade where they began.

But investors still can make a profit, he suggests, by trying something derided by many others as irrational: market timing, or hopping in and out of the market, selling during the upswings and buying on down- swings.

"Market timing has gotten an excessively bad reputation," he says. "Conventional wisdom holds that it's a fool's errand. It's certainly not an exact science, but I think people will come back to it."

While Mr. Shiller doesn't say specifically when is the right time to jump back into stocks--and won't predict how much further stocks could fall--he suggests largely avoiding them until valuations, based in part on improved earnings, revert to their historical averages. He also advises watching for anecdotal signs that investor confidence has bottomed.

As it turns out, Mr. Shiller says he has been something of a market timer, albeit on a very long-term horizon. In 1982, at the start of the bull market, all his savings were in stocks. Even 14 years later, when he testified before the Federal Reserve board of directors that he felt the stock market was becoming dangerously high, he was still largely invested in stocks.

But shortly after Fed Chairman Alan Greenspan pronounced in December 1996 that the market had fallen victim to "irrational exuberance," Mr. Shiller began to sell down his positions until by 1999, he had only about 2% to 3% of his savings in stocks.

With his profits, he sought the safety of bonds and land: real-estate investment trusts, a real-estate investment fund, Treasury bonds and other fixed-income securities.

Although stocks have plummeted in the past two years, the time isn't right yet to jump back into the stock market, he thinks. First, he wants to see the questions about the trustworthiness of corporate earnings resolved and for valuations to revert closer to historic norms. By Mr. Shiller's calculations, the Standard & Poor's 500-stock Index is trading at a ratio of 21 times its 10-year trailing earnings, compared with an average of 15 between 1871 and 1990. Even if the market falls to the historical average, he says, the S&P 500 was below that level half the time.

But that valuation milestone alone would not be enough. "The market isn't just driven by profit expectations," he says. "It's also dependent on a public willingness to hold stocks."

Mr. Shiller thinks there are still too many investors who contend that stocks always go up in the long run. As the market ebbs and flows over the coming decade, he suggests, one by one people will abandon this belief and sell down their positions, keeping a lid on stock prices for years. The seeds of the next extended bull market, therefore, will be planted by disbanded investment clubs and a widespread feeling that it is passé to discuss where the Dow Jones Industrial Average closed.

"You want to go to a barbecue and hear someone say, ‘People used to think stocks always go up in the long run. I don't believe that anymore,’" explains Mr. Shiller, who says that would be a buy sign.

How long might an ensuing rally last before market-timing investors should again sell stocks? Again, he's reluctant to give a specific time period or price target, but notes that he is skeptical that any rally will last too long, since many weary individuals will be tempted to sell on the way up as they reach their break-even points.

In his book, published shortly before the S&P 500 hit an all-time high, Mr. Shiller argued that a speculative bubble was being fueled by investors who took it on faith that stocks represented the superior investment vehicle to be held under all conditions, even when the market was overpriced. This collective belief, he maintains, became a "self-fulfilling prophecy based on similar hunches held by a vast cross-section of large and small investors and rein- forced by news media."

It's the exact reverse of this that will keep stocks overall from surging, Prof. Shiller says. Public opinion has turned so dramatically against the once-burgeoning equity culture, he explains, that it is reminiscent of the dour mood of the 1930s bear market. "After the crash in 1929, it took a whole new generation to start buying stocks," he notes. Today, "the market is still overpriced and looks risky. It might be 10 years before people embrace stocks again."

The most egregious offenders of the 1990s, especially the technology stocks, could be out of favor for much longer than that, he reasons, since they are the ones that caused the most pain and suffering. Some new sector will eventually capture the public imagination, he thinks.

But until then, bonds and real estate will attract the crowds.

Another pessimist, across the Atlantic, agrees with Mr. Shiller's analysis. Mark Howdle, until recently a European market strategist for Citigroup Inc.'s Schroder Salomon Smith Barney unit and now in a graduate studies program at Cambridge University, suggests in that stocks will continue to face a strong headwind in both the U.S. and Europe.

During the extended bull market period of 1982 to 2000, when the Dow Jones Industrial Average soared eight-fold, investors found scant reward for looking beyond the stock market.

But in his report, "How Changing Fundamentals Reshaped the Investment Landscape," Mr. Howdle maintains that was a period uniquely favorable to share appreciation: Stricter monetary policy and lower oil prices kept inflation in check; corporate profitability rose in most every major market in the U.S. and Europe; and greater attention to corpo- rate governance and the end of the Cold War reduced the risks associated with share ownership.

"It was a pointless task to try to pick short periods when you had to be out of the market, because you had to scramble back into it," Mr. Howdle says.

But the market reversal has changed that. "Now market timing--and asset allocation--can make or break the performance for individuals or investing institutions," he argues. "It's a trader's market; the supreme skill is knowing when to be out and when to be back in." But he cautions that this is a strategy that could prove particularly challenging for individual investors who don't have access to the same data bases and number crunchers as professional fund managers.