The U.S. stock market is trading at a very high level today. The data show where the market stands, but don’t tell us how it got there. For an explanation of that, we need to take into account a factor that sound very unscientific: “animal spirits,” sometimes called “gut feelings.”
First, let’s look at some of the numbers. More than 30 years ago, economist John Campbell and I developed what we have called the Cyclically Adjusted Price Earnings (CAPE) ratio, a measure that enables the comparison of stock market valuations from different eras by averaging the earnings over 10 years, thus reducing some of the short-term fluctuations of each market cycle. CAPE reached 33 in January, 2018, and is almost as high now, at 31. That number might seem meaningless in itself, but it is significant when you consider that it has been as high or higher on only two occasions: 1929, just before the 85-per-cent stock market crash ending in 1932, and in 1999, just before the 50-per-cent drop at the beginning of the new millennium.
People will point this year to low interest rates to justify the high CAPE ratio. But interest rate levels historically have not correlated well at all with the CAPE. For example, low long-term rates did not explain the high CAPE ratios in 1929 and 1999, nor did rising long-term interest rates explain subsequent market crashes.
That brings us to another factor, which John Maynard Keynes called “animal spirits.” It is a sense of optimism and ready energy to be entrepreneurial and take risks, and it has been adjudged to contribute to high stock market levels. Animal spirits are not adequately measured by business consumer confidence indexes, because the surveyors do not probe for such deep feelings.
High animal spirits in the stock market are often associated with the disparagement of traditional authority and expert opinion. This popular narrative often advocates relying on your “gut feelings” to try what experts say is doomed to failure.
U.S. President Donald Trump uses this kind of language. Recently, for example, he said, “I have a gut, and my gut tells me more sometimes than anybody else’s brain can ever tell me.”
Make America Great Again, Mr. Trump’s election slogan, remains on his supporters’ lips. The question for the market outlook hinges partly on how the Trump narrative – the notion that he and his followers are on the road to a triumphant future – will evolve.
Belief in the MAGA narrative would probably encourage people to buy into the stock market, even at elevated levels, thinking it will go up. It is more complicated to anticipate the actions of those who do not believe in Mr. Trump’s supposedly intelligent gut.
While skeptical themselves, they may well believe that enough other people believe, so the markets will thrive, at least in the short term. Investing for the short term – “speculating” is another word for this – tends to be influenced by thoughts that investors have about the thoughts of other investors.
The rise of an explicit belief in irrationality like this one is troubling on many levels. An essential element of a modern democracy is the wide dispersal of knowledge among a multitudes of experts. But there is reason to think that respect for science has been diminishing over the past decades. References to the “scientific method” peaked in news and newspapers in the 1940s, and are lower today. Instead, we have the phrases “gut feeling,” “visceral feeling,” and “trust your gut,” which are proliferating. None of these phrases had any currency before 1960, and they have been rising, going viral ever since.
This “gut feeling” narrative is not conterminous with the current bull market in its entirety, but seems to be an important factor permitting the U.S. economy and markets to move ahead amid widely reported fears of a coming global recession.
Long before the Trump presidency, we saw milestones in public awareness of thinking that comes “from the gut.” For example, there is the 2001 bestseller by Jack Welch, Jack: Straight From the Gut (written with John A. Byrne), about his successes as chief executive of General Electric from 1981 to 2001. Mr. Welch described his management style as intuitive, and not relying on experts, whose analyses he viewed as often phoney. Mr. Welch says, for example: “I crossed out the payback analysis on his last chart. I drew an 'X' over the transparency and scrawled the word Infinite to make the point that the returns on our investment would last forever. I meant it.” Whether Mr. Welch’s supposed genius has been called into question by the sharp drop in share value of GE after he left the company is a matter of debate.
The 1997 book Rich Dad Poor Dad, written by Robert Kiyosaki, with Sharon Lechter, described two fathers (one his own, the other a friend’s). The book’s publisher, Plata Publishing, reported that the book sold nearly 40 million copies as of 2017. His own, poor dad had college degrees, deferred to authority and told his son that many things were impossible. The uneducated but rich dad told him he should think about how he can make his dreams a reality. Mr. Trump comes across to many people rather like the rich dad. (Mr. Kiyosaki and Mr. Trump have co-authored two books, in 2006 and 2011.)
Then there is the 2011 book Steve Jobs, by Walter Isaacson, which described the co-founder of Apple this way: “Jobs was more intuitive and romantic and had a greater instinct for making technology usable, design delightful, and interfaces friendly.”
We are being saturated with these kinds of narratives today: describing inspired young people, some of whom drop out of college, who surpass overly polite conformists pursuing dull, bureaucratic work lives. For people who buy into this dream, one simple step is to avoid the mistake of missing out, by acting like a rich person and buying stocks.
This is obviously not an explanation for the level of the entire market, but it is surely part of it. We have a stock market today that is less sensible and orderly than usual, because of the disconnect between dreams and expertise.
Robert J. Shiller is a Nobel-prize winning economist and Sterling Professor of Economics at Yale University.