But is the stock market really irrational now? One reason CAPE may be high is that corporate earnings over the past decade were depressed by the Great Recession. If the average unemployment rate over the next decade is lower than over the past decade, CAPE may return to its historical average because earnings increase, not because stock prices fall.
Another reason that CAPE is relatively high is that, as Shiller notes, yields on 10-year Treasury notes are less than 2.5 percent. Although the price-earning ratio P/E is more familiar than the earnings yield E/P, the positive relationship between interest rates and the earnings yield is easier to see than the negative relationship between interest rates and the price-earnings ratio. This figure shows that the cyclically adjusted earnings yield for the S&P 500 and the ten-year Treasury rate have tended to move up and down together:
Despite these limitations, the correlation between the earnings yield and bond yield in the above figure is striking. So, too, is the fact that since 2009, the earnings yield has gone up while the bond yield has gone down, suggesting that stocks are attractively priced relative to Treasury bonds.
Shiller also notes the argument made by Franco Modigliani and Richard Cohn in 1979 that investors in the 1970s mistakenly compared earnings yields to dollar interest rates when they should have been looking at real, inflation-adjusted interest rates. Modigliani and Cohn argue that, because of this market-wide mistake, stock prices were about half what they should have been, which made earnings yields twice what they should have been.
I calculated the real inflation-adjusted interest rate each year by using the change in the consumer price index over the next year. For example, I adjusted the dollar interest rate in January 2000 by using the change in the consumer price index between January 2000 and January 2001. This is an imperfect measure of investors’ inflation expectations, but maybe it is not systematically biased.
The next figure compares these real interest rates with Shiller’s cyclically adjusted earnings yield. What immediately leaps out is how close these were between 1981 and 2009, and how far apart they were in the 1970s. A comparison of the two figures confirms the Modigliani-Cohn argument. In the 1970s, investors evidently compared earnings yields with dollar interest rates, rather than real interest rates. If this was a mistake, stock prices were much too low in the 1970s.
As it turned out, the annual return on the S&P 500 between 1979 (when Modigliani and Cohn made their argument) and 1989 was an eye-popping 18 percent. Part of the reason was the drop in interest rates in the 1980s, but part of the reason may well have been that investors made a colossal mistake in the 1970s.
This is one of those occasions, like speculative bubbles and panics, where the assumption that markets know best is battered and bruised. It wasn’t a slight mispricing. It was an expensive car wreck that left truckloads of $100 bills on the sidewalk.