September 28, 1998

The Economists'Pinup Guy
Has Robert Shiller Finally Got It Right?

By Kim Clark

The stock market's recent swoon may have been a bitter pill for most investors, but it was sweet vindication for a boyish, self-deprecating academic in the boonies of New Haven who had been stubbornly predicting doom during the best three years in Wall Streets history.

Average investors may have ignored him, but Yale economist Robert Shiller has always had the ears of the nation’s most influential money managers and economists, from Alan Greenspan on down. (It may have just been a coincidence. but the Federal Reserve chairman called Shiller in to explain the irrationality of investors two days before his "irrational exuberance" speech.) He was the smartest guy who'd been most wrong about the stock market. Nobel Prize-winning economist Paul Samuelson says Shiller is "one of my pin-up guys." But now, as stocks flop around like (dying fish, Shiller’s obscurity may be ending. It may turn out that Shiller is smart and right.

Shiller has drawn attention in elite circles because of the reasoning behind his bearishness. Everybody knows by now that investors had bid price-to-earnings ratios far above their historical levels. But Shiller is one of the few people who applies rigorous economics and psychological research to come up with coherent, commonsense explanations as to why. One reason is that investors are irrationally overconfident (or had been, anyway). Another: People will go to great lengths to avoid the feeling of regret, so they tend to throw money into stocks to avoid feeling left out. He says that a prime contributing factor to market corrections is what he calls "magical thinking," the all-too-human practice of making fallacious causal links between what are really coincidences. That's why, for example, he thinks Octobers carry a heightened risk of crashes.

Putting it all together, Shiller is convinced that the market still has room to fall -- even after the big drop the Dow has suffered since its peak in July. If, as he expects, prices return to levels that fit historical rules of thumb, equity investors could lose 40%, in real terms, over the next decade. It also means that the Dow may settle into the 6000 range.

If his scary investment warnings don’t bring him fame, Shiller’s other work might. Shiller, it turns out, is one of the rare economists who could actually make people's lives better.

Eight years ago Shiller started a company that’s helping to invent new financial products that could cut your mortgage payments. Based in Boston, Case Shiller Weiss (the other names belong to Wellesley College economist Karl Case and Yale MBA Allan Weiss) has made a splash among investment professionals by creating the housing industry's equivalent of a Dow Jones index. The way it works is, the company gathers information ion on just about every house sale in the country to produce what have come to be regarded as the best housing indexes in the world. The company makes its money by selling investors estimates of the values underlying mortgage pools and homeowners' appraisals over the Internet.

Soon, however, Americans could watch a CSW index the way they do the Dow. The company is helping to launch revolutionary financial products that will allow homeowners to hedge real estate risk in much the same way investors hedge stock portfolios. Sam Masucci, executive director of global residential property markets for Warburg Dillon Read, for example, says his company is "extremely close" to marketing a "shared-appreciation mortgage," in which banks would cut about two points off a mortgage rate in return for half of a house’s price gain, as gauged by a CSW index. Warburg will pool the loans and issue derivatives so that investors can make bets on the direction of housing prices. This, Masucci says, "is completely new" and could revolutionize the nation’s $13 trillion housing market by making home ownership cheaper, safer and more liquid. Weiss who runs the company with the advice of Case and Shiller, says other investment products, such as house price insurance, should be available soon.

And that is only the beginning of Shiller's plans to improve the world. He's also been talking up proposals to create new inflation and GDP indexes that could be the basis of, for example, developing countries’ bonds. So far, however, investors have shaken their collective heads. Who'd want Thai bonds tied to its GDP when they could buy Thai bonds denominated d in dollars?

Practicalities and usefulness are often a problem, admits Shiller. For all the accuracy of his housing index, for example, his predictive models so far have missed badly. And Shiller can’t say whether investors are finally viewing stocks more rationally today, when they might do so, or even whether they ever will. But then, he's quite happy in his Ivy League office: He has his investments safely ensconced in Treasuries, and he doesn’t need to sell anybody any thing. He hopes that someday people will realize he was right. Also, he says, "I'd like it to happen in my lifetime."