I recently re-read an article I cut out of The Wall Street Journal on July 29, 2002, titled “Prescient Professor Favors Market-Timing.” The prescient professor referred to was Yale economist Robert Shiller. You’ve certainly heard of Prof. Shiller, and you may have read his bestselling book Irrational Exuberance, published at the peak of the market bubble in March 2000.

I’ve followed the writings of Prof. Shiller for several years, and I often wonder how he is invested at any given time. Unlike most professional and private investors, and certainly unlike most economists, Prof. Shiller is able to think against the crowd, even when it’s virtually impossible for the rest of us to do that.

For example, at the height of the stock market’s bubble, he predicted it would “end in tears.” He was dead on, of course. His prediction was somewhat premature because he warned of the coming gloom in his 1996 testimony before the Federal Reserve’s board of directors. But for those who heeded his advice and were patient, their fortunes are still intact.

The Journal article quoting Shiller back in July 2002 happened to have coincided with the end of that long bear market. Ironically, the market turned up almost immediately, corrected again, and then moved higher in earnest just before the outbreak of war last year.

When the Journal article appeared, the Dow Jones Industrial Average was down about 30% from its prior peak of 11,722 and the S&P 500 was off about 44% from its all-time closing high of 1527. In the article, Prof. Shiller said he still wasn’t interested in buying stocks at those levels, but he would return to stocks when people started questioning whether stocks “always go up in the long run.” He was also looking for stocks to trade closer to, or below, their long-term 10-year trailing average price-to-earnings ratio of 15.

Quite an Investor

According to the Journal, Shiller had sold off almost all of his stock holdings by 1999. (He had been in the market since 1982.) With the proceeds, he loaded up on real estate investment trusts, Treasury bonds and other fixed-income investments. That call was beautiful.

Think back for a moment. At that time, no one wanted bonds and REITs were still out of favor and little-known by the investing public. All anyone wanted was growth stocks. Shiller was attracted to out-of-favor income-producing investments: real estate and bonds. He not only predicted the stock market bubble based on the obvious “irrational exuberance” he saw, but was able to capitalize on it. Remember, pretty much the entire investing world was sucked into that bubble and couldn’t see straight. Shiller was able to see it for what it was at the time, and I would imagine his strategy paid off handsomely.

Prof. Shiller has admitted he’s a fan of long-term market-timing and thinks the public will come back to trying to time the market. He predicts the market will “ebb and flow” during this decade as investors sell down their positions and abandon the belief that stocks always rise over the long haul. A “lid will be kept on stock prices for years,” but this will also clear the way for a longer-term bull market. If he’s right, market-timing may be the only way to make any money, and your asset allocation decisions during the ups and downs this decade will make or break your performance.

Real Estate Bubble

In April 2004, Prof. Shiller published his second paper in less than a year on the real estate bubble in certain regions of our country and the dangers that lie ahead. He cited Los Angeles and Boston in his study, but his findings can certainly be applied to other large cities that have experienced rapid real estate price appreciation in recent years.

He says this real estate bubble has the potential to be worse than the real estate bubble in 1990, which led to a recession and “had negative effects on the economy for years.” The reason he cites is that the loan-to-value ratio on homes is much higher now, and the effects of defaults would be much greater. He also says financial institutions like Fannie Mae (FNM:NYSE), mortgage insurers and even regional municipal governments are at risk.

What would he do with his money now?

My best guess is that Prof. Shiller has probably already sold off his real estate holdings and his bonds. He apparently missed the turn in stocks back in the summer of 2002 (judging by his bearish comments in the July 2002 Journal article), and I doubt he’d be interested in owning them now. Again, my best guess says that Shiller probably doesn’t think stocks are particularly attractive right now based on P/Es, so he’s probably waiting patiently on the sidelines.

I also imagine he finds it curious that in this stock rally beginning in March 2003, stocks of lesser quality (trading in single digits with scant earnings) have been the best performers. It’s as if we’ve had a mini bubble in these stocks in the past year. This is also probably a sign to Prof. Shiller that the “exuberance” he wrote about in 1996 is still not washed out of the system, and indeed everyone still believes “stocks go up in the long term.” Until we believe otherwise, and stocks trade at very low valuations, or both, Shiller will probably avoid heavy exposure to stocks.

So if I’m right and Shiller has sold down his real estate holdings and taken profits in many of his bonds, he must be in a bit of a bind. If he doesn’t think stocks are attractive yet and he has sold off his real estate investment trusts and many of his bonds, he’s probably stuck with a lot of cash. If history is any guide, he’ll get his opportunity to load up on stocks again over the coming years as the public sells down its positions. Investment clubs will disband and stocks and real estate will no longer be considered investments that always go up.