How does one invest wisely? According to Yale School of Management Economics Professor Robert Shiller, it’s all about avoiding economic and market bubbles. Shiller received the 2013 Nobel Prize in Economics for his research into how financial markets price the things they sell, and he wrote a book on speculative manias tilted Irrational Exuberance. And recently, he sat down with Quartz to discuss the new speculative bubble market: Bitcoin.
According to Shiller, Bitcoin is the best current example of a speculative bubble, which refers to an item priced above its value due to herd behavior driving up its valuation. “I think that has to do with the motivating quality of the Bitcoin story,” says Shiller. “And I’ve seen it in my students at Yale. You start talking about Bitcoin, and they’re excited! And I think, what’s so exciting? You have to think like humanities people. What is this Bitcoin story?”
Shiller points out that one reason people love Bitcoin so much is because it is shrouded in mystery. Satoshi Nakamoto, who may or may not be a real person, is credited with creating Bitcoin. Little is known about him or how Bitcoin got started, but that’s what makes it exciting. Shiller points out that people like stories that are larger than life, and Bitcoin fits the bill.
The interest in Bitcoin, according to Shiller, is also driven by a deep anxiety about digitization, computers, and what the world will be like in a few decades. “Somehow Bitcoin fits into that, and it gives a sense of empowerment: I understand what’s happening! I can speculate, and I can be rich from understanding this! That kind of is a solution to the fundamental angst,” explains Shiller.
Shiller commented that bubbles were made possible by the invention of the printing press in the 1400s, though it didn’t gain true success until the 1600s. At that point, suddenly, news could quickly travel from town to town, spreading like wildfire. The Internet and social media are two modern-day equivalents that take economic bubbles to the next dimension.
According to Shiller, “Reputations don’t seem to matter as much at this point in history.” This means that various forms of media, from news media to mainstream media to conspiracy theories, all have a chance to flourish. “These are the stories that drive the bubble,” says Shiller.
So, the question becomes, how do you protect yourself from falling for a market bubble? According to Shiller, his C.A.P.E. Ratio—the cyclically adjusted price-to-earnings ratio, which is a valuation measure based on average inflation-adjusted earnings—is one useful tool for assessing something’s value.
According to a recent article written by Shiller for the New York Times, the C.A.P.E. Ratio is currently very high, which is troubling. “The C.A.P.E. Ratio is above 30 today, compared with an average of 16.8 since 1881,” he writes. “It has been above 30 in only two other periods: in 1929, when it reached 33, and between 1997 and 2002, when it soared as high as 44.”
Another tool that investors can use is the Valuation Confidence Index, which was established in 1984 based on questionnaire survey data about the behavior of U.S. investors. Though the tool isn’t completely up to date, Shiller says that, “valuation confidence is at the lowest it’s been since around 2000. In other words, people think the market is highly valued. They don’t have to look at C.A.P.E. People think it. I know that. Both individual and institutional investors. We are in a time of mistrust of the market.”
Shiller writes that mistrust of the market is currently similar to levels around the time of the dot-com boom, when tech companies were seen as incredibly exciting, and everything was a “must do immediately.” He argues that many investors are most likely getting ahead of themselves and they need a more realistic view of FAANGs (Facebook, Amazon, Apple, Netflix, and Google).
As for Bitcoin, while it is a bubble, for Shiller its total market value is too low to be of much concern. As he wrote in the New York Times, “There may well be a Bitcoin bubble, but with a total market value for bitcoin that is still less than $100 billion dollars, potential problems within that world don’t seem to provide investors with sufficient reason to consider bailing out of the vastly larger stock market. And articles about the outlook for the stock market on New Year’s Day in 2017 contained barely a hint of the concerns about speculative mania that were so evident in 1929.”
If there is a danger, it’s that people’s attention is capricious. Right now, the media is heavily covering President Trump and the aftermath of Hurricanes Harvey and Irma. Until the attention shifts toward the stock market—its low volatility, the low interest rates, and other alarming factors—not much will change for the worse.
About Robert Shiller
Robert Shiller is an economics professor at Yale SOM teaching financial markets as well as behavioral and institutional economics. He is also considered to be one of the leading experts on market valuation. He helped create indexes for measuring real estate prices, and his C.A.P.E. Ratio is considered one of the best forecasting models for stock returns. He writes a regular column, “Finance in the 21st Century,” for Project Syndicate and “Economic View” for the New York Times.