They called him “Mr. Bubble.”

Peter Yang

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How “The Chart” Works

Imagine that, in December 2007, Company X's stock was selling at a record $60 per share. Its earnings for the previous year had been better than ever before, at $4 per share. So its price-to-earnings ratio was 15. That's a comfortably low number on the price-to-earnings scale -- showing, apparently, that Company X's record stock price was reasonable. The price, said its CEO, simply demonstrated that investors appreciated Company X's increased profitability.

But 2007 was a boom year. What if Company X's big profits were only temporary? Then its good price-to-earnings ratio was illusory, and its stock might be seriously overvalued.

Shiller and Campbell account for the booms and busts by using earnings figures for the previous ten years. Company X's average earnings for the past decade had been $1 per share. By the ten-year calculation, its price-to-earnings ratio was alarmingly high at 60. Unless there were a concrete reason to think the recent high earnings should continue, many investors would see that number as a red flag signaling SELL.Shiller and Campbell applied their method to stock indices like the S&P 500, which tracks the share prices of 500 large U.S. companies. When they graphed a price-to-earnings ratio using average earnings of the S&P companies over ten years, they found that the highest numbers often predicted the steepest falls.

 

Mark Zurolo ’01MFA

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With the graph above, Shiller and his former student, Harvard professor John Campbell ’84PhD, created one of the signature pieces of economic research of the past generation. Wall Street had long used the ratio of a company's stock price to its earnings to judge whether the stock is fairly valued. But Shiller and Campbell used average earnings over ten years instead of current earnings. The resulting graph foretells stock market peaks and plunges with uncanny accuracy.

 

Sometime in the mid-1980s, Robert Shiller and John Campbell ’84PhD created The Chart. It wasn't especially complicated. It showed average stock prices, relative to corporate earnings, going all the way back to the late nineteenth century. Wall Street analysts produce charts along these lines all the time. The measure is called the price-earnings ratio, and it is the single most common analytical yardstick of the stock market.

The yardstick that Shiller and Campbell created, however, came with a twist -- a twist that transformed their little chart into The Chart. Today, The Chart stands as one of the signature pieces of economic research of the past generation. It is rigorous enough to have appeared in the Journal of Portfolio Management and simple enough to be understood by those of us who are behind on our Portfolio Management reading.

Anyone who heeded the central lesson of Shiller and Campbell's analysis -- as well as the lesson of a subsequent chart, created by Shiller, on the housing market -- could have avoided some of the worst pain of the financial crisis. If Alan Greenspan had taken The Chart seriously during the late 1990s, Greenspan's reputation might be in better shape today. So might the United States economy. Nouriel Roubini, the doomsday-prophesizing finance professor at New York University who has lately become a media darling, credits The Chart for much of his clairvoyance.

The Chart and its co-creator happen to have much in common. At first glance, they both seem simple enough. It is just a series of numbers, depicted on a piece of paper. He, as his old teacher, the Nobel Laureate and textbook author Paul Samuelson, has said, is “a long-jawed, serious fellow” -- “like a hayseed boy off a farm with a straw in his mouth.” The Arthur M. Okun Professor of Economics, who has taught at Yale since 1982, Shiller has a hesitant, almost shy, manner. But don't be fooled by that.