Brad DeLong has a post that is mildly critical of Shiller’s stock market model in almost precisely the same way that I am critical of Shiller’s stock market model. The only difference is that DeLong knows more finance than I do, and makes the case far more effectively than I can. I was intrigued by his conclusion:
That is a perspective very different from mine, which regards the failure of the CAPE to spend most of its time north of 25 as a mystery.
But given that it does not, it would be very rash for anybody who is not certain that they can wait out the market to invest more than they can afford to lose. And past performance is not only not a guarantee it may not be an indicator of future results. We have had one real Black Swan–World War I–in the past 130 years.
The first part refers to what DeLong and I think is the real mystery—not so much why stocks were so high in 1929, 2000, and now, but rather why they were so low 90% of the time.
I think WWI is a great black swan example, but without really disagreeing with DeLong I’d like to throw out another possible black swan—1968. And no, I’m not thinking of all the assassinations and political turmoil in the US (as well as many other countries.) It’s not clear that the political events of 1968 had much permanent effect; 1979 was the real turning point (see the PPS of this post.) Instead I’m going to argue the shift from gold to fiat money was a black swan.
First let me digress with a bit of history. It became illegal for Americans to redeem dollars for gold in 1933. I seem to recall that in 1968 the gold window was closed to foreign individuals, and in 1971 the window was closed to foreign central banks. (Someone correct me if I am wrong.) So the gold standard sort of faded away over a 40-year period. Then why pick 1968?
Even though Americans could not redeem dollars for gold in the 1960s, they could buy foreign currencies, and/or goods in foreign countries. And there was a free market in gold in some foreign countries. So up until 1968 gold continued to provide at least a weak anchor to the monetary system, at an international price of $35/oz.
My second point is that switching to a permanent fiat system was much more inconceivable to people in the old days than you might imagine. Yes there were brief experiments like the greenbacks of the Civil War and the German paper money of 1920-23. But even Keynes opposed a pure fiat regime, and viewed these historical examples as sort of pathological cases. If you had told someone in 1968 that by 1980 the price of gold would be over $800/oz. they would have thought you were a lunatic. It was $20.67/oz. in 1879. It was still $20.67 an ounce in 1932. It was $35/oz. in 1934. It was still $35/oz. in early 1968. I recall that when gold was around $150/oz. in the 1970s, one of my economic professors at Wisconsin predicted the price would soon fall back into the $40s, as it was far overvalued.
DeLong identifies three periods when stock investors did poorly over the following 10 years—right before WWI, the late 1960s and early 1970s, and the late 1990s. Even today I’m not sure exactly how much of the poor stock market performance of 1968-81 was due to the Great Inflation. Inflation did punish savers given that the IRS taxes nominal capital income. But does that explain the entire underperformance? Was there money illusion (confusing real and nominal interest rates) when discounting future profits? I’m not sure. I am confident, however, that moving to a fiat money regime was a black swan for the US 30-year Treasury bond market, and pretty much every other bond market as well.
PS. And take a look at this excellent post over at MarginalRevolution.