BOOK REVIEW

Irrational Exuberance
by
Robert J. Shiller

FUTURECASTS online magazine
www.futurecasts.com
Vol. 3, No. 12, 12/1/01.

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Imperfect markets:

   In this prescient and well timed book - first published early in 2000 as the 1990s bull market reached its peak - Yale economics professor Robert J. Shiller does an excellent job in debunking "new economic era" myths. These help propel vastly wasteful stock market bubbles that periodically arise and burst with damaging impact on the nation's economy.
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  Inevitably, this book is also a critique of the "efficient market theory" that is so obviously at odds with the observable facts of market history.

  "The high recent valuations in the stock market have come about for no good reasons. The market level does not, as so many imagine, represent the consensus judgment of experts who have carefully weighed the long-term evidence. The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom."

  Of the econometric models that purport to support the efficient market theory, he perceptively points out that "these models deal only with problems that can be answered with scientific precision. If one tries too hard to be precise, one runs the risk of being so narrow as to be irrelevant."

  Well said - and applicable to ALL macro econometric models. They simply fail "to grapple with [the] messier aspects" of macro economic reality.

  However, like so many useful debunking books, Irrational Exuberance occasionally does tend to overstate its case - and in one instance - with respect to its analysis of the financial news items that provided the information context for the bursting of previous stock market bubbles - it demonstrates a deplorable ignorance of the relevant facts of economic history.

During bubble market periods, prices respond - and over respond - more to immediate movements in earnings than to any rational evaluation of prospective earnings.

  The book begins with a review of historic stock price movements relative to price/earnings ("p/e") ratios running back to January, 1881. The review is based on the S&P stock price index and real (inflation adjusted) S&P composite earnings. Then it presents the p/e ratios using a 10 year moving average of real earnings for the denominator.
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  The use of 10 year moving averages of real earnings serves to highlight the poor performance of p/e ratios as a forecasting tool during periodic periods of over optimism - of market bubbles. (During these periods, prices respond - and over respond - more to immediate movements in earnings than to any rational evaluation of prospective earnings.)
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  The resulting charts are quite dramatic. There have been previous periodic sharp rises in stock prices and p/e ratios - in 1901, 1929, and 1966 - but nothing like the surge that culminated in the first quarter of 2000. In this latest bull market, both stock prices and p/e ratios took off like rockets, reaching heights that tower over previous high points.
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20 year returns were always less than 2% after previous stock market "new era" spikes.

  Then, Shiller presents the real returns - including both dividends and stock price movements - on stock investments over 5 year, 10 year, and 20 year periods following the earlier spikes. These 20 year returns were always less than 2%.
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  Shiller thus confirms the old market wisdom that - if you would buy low and sell high - you must buy when everyone else has been selling long enough to collapse p/e ratios, and sell when everyone else is buying so exuberantly as to cause p/e ratios to soar. Shiller demonstrates that p/e ratios are generally poor economic predictors and thus good contrarian investor indicators. With a few exceptions, 10 year returns have been low following periods of high p/e ratios - and high following periods of low p/e ratios.
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  Low dividends are also viewed as a negative indicator. He points out:  "The reliable return attributable to dividends, not the less predictable portion arising from capital gains, is the main reason why stocks have on average been such good investments historically. - - - [T]imes of low dividends relative to stock prices - - - tend to be followed by price decreases (or smaller than usual increases) over long horizons."
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When expansion efforts fail, they waste vast sums - but the powerful noxious tax incentives will undoubtedly continue to propel such efforts, somewhat disconnecting dividend yields from stock performance for most public companies.

  There has, in fact, been a key change in the factors relevant to this analysis that Shiller fails to take fully into account. He does recognize that, since WW II, persistently high taxes, high marginal tax rates, and various other noxious tax incentives, have induced corporations to shift some of their managerial compensation packages away from fixed salaries. Instead, they offer participation as investors in the firm. Stock options have become especially popular, giving managers a powerful incentive to boost share prices.

  However, Shiller fails to mention that shareholders - even more than managers - have been driven to value capital gains over dividends. Noxious tax incentives have greatly reduced the desirability of dividend income relative to capital gains.
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  Increasingly, over time, this has induced managers to retain and invest earnings rather than distribute them as dividends. Sometimes, they use earnings to buy back the corporation's shares. However, they most frequently strive for expansion, even when the risks outweigh the possible gains. When such efforts fail, they waste vast sums - but the powerful noxious tax incentives will undoubtedly continue to propel such efforts, somewhat disconnecting dividend yields from stock performance for most public companies.

Precipitating factors of market booms:

 The "irrational" factors - over and above such "rational" stimulants as rising earnings and declining interest rates - that led to the recent stock market boom are analyzed.

  Shiller provides a generally realistic discussion of the strengths and weaknesses of arguments that attribute positive market impacts to these factors. However, on a few points he is not convincing.

 

 

 

 

Existing companies don't have a monopoly on information technology and other technologies - globalization brings many foreign problems and competitors as well as opportunities and new markets - expansion to serve the baby boomers doesn't explain why stocks should move so far ahead of earnings, especially when the baby boom was followed by the baby bust.

  Some of the psychological factors reviewed are: The information technology revolution, the worldwide victory of capitalism, the increasing social emphasis on business success, political shifts in favor of business (especially, reduced capital gains taxes), the baby boom generation, the decline in inflation, the growing acceptance of a culture of gambling, increased media coverage of business, overoptimistic stock analysts, 401(k) plans, rapid growth of mutual funds, and increased stock trading.
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  Shiller recognizes that many of these factors will have a positive effect on business, but questions whether they justify significantly higher stock valuations. After all, existing companies don't have a monopoly on information technology and other technologies - globalization brings many foreign problems and competitors as well as opportunities and new markets - expansion to serve the baby boomers doesn't explain why stocks should move so far ahead of earnings, especially when the baby boom was followed by the baby bust.

  Yes, these positive factors can be helpful to all competitors, but they inevitably will help some more than others. Some of these factors increase access to equity capital, or reduce risks, or open up opportunities that the best managed businesses can take disproportionate advantage of - especially if they are headquartered in the United States or similar economic system that is reasonably flexible and enjoys governance that facilitates commerce. Thus, U.S. markets and similarly affected stock markets should rationally enjoy higher valuations as a result of the opportunities arising from such factors.

Fear of being cut off from access to corporate management, and fear of loss of underwriting business for an investment banking department, greatly undermine objectivity of stock analysts.

  Professional stock analysts are hammered - appropriately - by Shiller. In late 1999, only 1% of their recommendations were "sell" recommendations. Almost 70% were "buys" and 30% "holds." Fear of being cut off from access to corporate management - and fear of loss of underwriting business for an investment banking department - greatly undermine objectivity. There is also a tendency for analysts to remain among the long term optimists who  dominate their profession.
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  Earnings estimates, too, have been inflated. Between 1979 and 1996, a Federal Reserve Board study indicated that analyst expectations of earnings exceeded actual earnings in 16 of the 18 years. "The average difference between the projected and actual growth rate of earnings was 9 percentage points." During the 1980-82 and 1990-92 recessions, earnings growth forecasts averaged about 10%.
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  Quarterly forecasts have been much better, and indeed tend to underestimate earnings, apparently because corporations like to "beat the street" when reporting actual earnings - and because it would become immediately embarrassing to be too far off on quarterly earnings.
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Inflation's adverse impacts are far more than merely its affect on nominal and real interest rates.

 

 Monetary stability is not in itself a sufficient cause of prosperity - but it is nevertheless a prerequisite.

 

Substantial rates of inflation inevitably mean instability, high risks, and the ultimate absolute need to confront a 1980-82 style austerity depression to regain stability in the monetary unit.

 

The stock market boom that began in 1982 - when inflation was brought under control - proceeded despite the highest real interest rates since well before 1970.

 

As inflation rates increased between 1966 and 1980 - stock market prices performed miserably despite low real interest rates that fluctuated near zero for several years.

 

 Keynesian macroeconomic policies cannot defeat the business cycle as promised, and any effort to do so must ultimately result in rising rates of inflation.

  The impact of declining inflation rates and "money illusion" impacts are analyzed. Unfortunately, Shiller relies on simplistic acceptance of the 1979 Franco Modigliani and Richard Cohn analysis. Citing their work, Shiller views as irrational much of the adverse public reaction to inflation. He points out that, although inflation pushes up nominal interest rates, real (inflation adjusted) interest rates may be quite low. (This, in fact, occurred from the mid 1960s almost to the end of the 1970s - a period of very poor stock market performance.)

  This type of simplistic view of inflation should have been discarded long ago with the death of Keynesian assumptions. Inflation's adverse impacts are far more than merely its affect on nominal and real interest rates. Economic history clearly demonstrates that efforts to accommodate inflation enough to keep real interest rates low - to "maintain liquidity balances" - invariably result in unmanageable and ruinous rates of inflation that must ultimately be reigned in by drastic austerity measures.
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   Monetary stability is not in itself a sufficient cause of prosperity - as Argentina currently is learning - but it is nevertheless a prerequisite. It is no accident that many poor nations suffer chronic or repetitive bouts of inflation - but prosperous nations don't.
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  Keynesian assertions of the manageability of inflation should have died during the stagflation and double digit miseries of the 1970s. When facts fail to conform to theory - it is the theory that is wrong, not the facts.
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  Thus, the much maligned public is far more perceptive than the Nobel Laureate Modigliani - or Cohn - or Shiller, too - in the realization that substantial rates of inflation inevitably mean instability, high risks, and the ultimate absolute need to confront a 1980-82 style austerity depression to regain stability in the monetary unit. These factors are - justifiably - murder on stock valuations. They materially increase risks and the cost of raising equity capital, adversely impact long term planning, and substantially reduce economic efficiency.
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  Declining inflation reduces risks and, because of accounting phenomena, increases the "quality" or reality of reported earnings. Shiller points out that inflation helps businesses "pay off" their debts, and that reported earnings should be adjusted upwards to reflect this benefit of inflation. However, he neglects to mention the degree to which inflation renders depreciation allowances inadequate. Inflation adds to equipment maintenance and replacement costs. Even with LIFO accounting methods, inventory replacement costs outrun inventory costs allowed.
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  Invariably, debtors don't pay off debts during inflationary times - they become even more heavily indebted and unstable - increasing risks for equity investors. Higher risks increase the difficulty and expense of raising equity capital. Inevitably, the credit mechanism contracts or collapses, as inflation cuts purchasing power faster than the printing presses can provide it. Inevitably, stagflation happens - and if inflation continues to be accommodated - so does inflationary depression.
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  Declining inflation is thus a fundamental factor justifying higher p/e ratios. Indeed, the stock market boom that began in 1982 - when inflation was brought under control - proceeded despite the highest real interest rates since well before 1970. In comparison - as inflation rates increased between 1966 and 1980 - stock market prices performed miserably despite low real interest rates that fluctuated near zero for several years.
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  Keynesian macroeconomic policies cannot defeat the business cycle as promised, and any effort to do so must ultimately result in rising rates of inflation. Thus, Keynesians remain determinedly ignorant about the full scope of the noxious impacts of inflation. Unfortunately, economic history perversely refuses to conform to their ideological needs.

Investors were undaunted by the high market levels of the late 1990s, because of the firm belief that the inevitable periodic downturns would be quickly reversed and followed by renewed market increases. This makes market timing foolhardy and supports "dollar averaging" strategies.

  Shiller covers the bias towards optimism of most investors and, thus, of the stock market itself. (Pessimists do not risk what they have already earned in the hope of future investment earnings. A modest degree of optimism is thus a rational market expectation.)

  Investors were undaunted by the high market levels of the late 1990s, because of the firm belief that the inevitable periodic downturns would be quickly reversed and followed by renewed market increases. This makes market timing foolhardy and supports "dollar averaging" strategies. (Despite the tragedy of 9/11/01, FUTURECASTS still firmly predicts that the major market indexes - the DOW Industrials and the S&P 500 - will hit new record highs before the end of next year - absent additional major acts of terrorism.)
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  A variety of other psychological drives and speculative bubbles are discussed. These are loosed as part of the "irrational exuberance" that drives markets considerably higher than good times justify.
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The market itself in its initial movements may alert enough investors to the importance of recent events to fuel major market moves.

  The role of media coverage is also assessed. Shiller's contention is that major market moves are frequently not related to major news events. Although recognizing that some such moves - like the decline in Japanese shares after the Kobe earthquake - clearly were impacted by a major news event, his examination of several U.S. market reversals indicates that nothing extraordinarily ominous occurred in the week prior to the collapse.
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  Shiller discusses the impact of "attention cascades" on both rational market responses and irrational "negative bubbles." He correctly points out that investors sometimes take awhile to realize the full impact of important events. Thus, it is the market itself in its initial movements that may alert enough of them to the importance of recent events to fuel major market moves. The Kobe earthquake, with its related major market decline six days later, is cited as an example of an attention cascade amplifying a logical response to a news event of real economic consequence.

The Crash of '29 was an irrational "negative bubble," operating through feedback effects of price changes, and an "attention cascade," with a series of heightened public fixations on the markets.

  However, Shiller finds no news events in the days and week prior to the Crash of '29 or the Crash of 1987 that could justify such dramatic declines. The debate over the Smoot-Hawley tariff is frequently cited as contributing to the '29 Crash, but the debate was ongoing over a long period and was not peculiar to those days or that week. The market had shown great volatility and weakness the previous week, but had been successfully supported by financial leaders. Indeed, the financial press was full of "confidence game" assertions by the political and business leaders of the day. (That, alone, is enough to alert you to make sure the storm cellar is well provisioned.)

    "There is no way that the events of the stock market crash of 1929 can be considered a response to any real news stories. We see instead a negative bubble, operating through feedback effects of price changes, and an attention cascade, with a series of heightened public fixations on the market. This sequence of events appears to be fundamentally no different from those of other market debacles - including the notorious crash of 1987, - - -."

Reading the financial news of those two months, it is remarkable that the market could hold up at those heights as well as it did until the collapse on October 28 and 29.

 

When railroad car loadings joined commodity prices, autos and steel production in decline in October, this was evidence of actual broad scale economic decline that no market professional could ignore.

  But, of course, Shiller is only an economist - not a market professional. His evaluation of the facts is clearly wrong.
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  The stock market was being hit by bad news of a fundamental nature at least since the first week in September, 1929 - and was being repeatedly hammered from the first week in October. Indeed, reading the financial news of those two months, it is remarkable that the market could hold up at those heights as well as it did until the collapse on October 28 and 29.
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  Somehow, Shiller's account misses all of the following news items from the week before the Crash of '29.

  1. Record numbers of margin calls were being sent out because of the cumulative decline since the September 19, 1929, high. For the first time, a large number of them couldn't be answered, forcing sale of the securities. Stop loss orders were also being hit in large numbers.
  2. Margin requirements had been tightened with each successive market break and in some instances brokers were now demanding 75% of market value on certain leading speculative stocks.
  3. The stubborn failure of margin loans - already for months at worrying levels - to decline anywhere near as much as the already substantial declines in market values had brought them to about 10% of total NYSE value.
  4. Roger Babson, an influential and accurate prophet of the market crash, predicted a further market fall.
  5. Railroad car loadings - a HUGELY important economic indicator in those days before interstate highways - joined commodity prices, autos and steel production - another HUGELY important economic indicator in those days - in substantial decline.

  Even with record profits and dividends, the long bull market had reduced dividend yield averages to and below 3%. This could only be justified if further stock appreciation was likely. After all, you could get 4 1/2% interest on a savings account.
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  Although it was not fully reported until November, European investment companies had been selling out since September - at the first indications of weakness in steel production - and the general withdrawal of European money from the market was already well known. The financial press had been agonizing over the growing weakness in steel since mid August - weeks before the initial actual decline in production was reported.
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  When railroad car loadings joined commodity prices, autos and steel production in decline in October, this was evidence of actual broad scale economic decline that no market professional could ignore. In those days before air conditioning and effective snow removal, business was seasonal. Business - and railroad car loadings - were expected to rise in the fall and spring business seasons. The stop loss orders and margin calls - and Shiller's "attention cascade" - did the rest.

Corporate insiders would have seen the poor results in their order books by mid October - just before the major market break. Insiders at railroads and other shippers were already seeing even sharper drops in shipments that wouldn't be reported until after the Crash.

 

Insider trading allows the stock market to react BEFORE the news comes out.

  The impact of insider trading is also ignored by Shiller. He fails to take into account news that breaks after a substantial market move about conditions just before the move.
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  Many businessmen had been reviewing their inventories in light of the market turmoil in early October, 1929, and revising downwards their purchasing programs for the months ahead. While this didn't make the news until later, corporate insiders would have seen the results in their order books by mid October - just before the major market break. Insiders at railroads and other shippers were already seeing even sharper drops in shipments that wouldn't be reported until just after the Crash.
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  Insider trading was legal in 1929 - and is still very important today despite regulatory curbs. Insider trading is, of course, rapidly amplified by sharp floor traders who watch out for early signs of such transactions. It allows the stock market to react BEFORE the news comes out. Nor would it show up in the otherwise excellent and informative investor surveys that Shiller has been conducting during these last two decades.
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  The commodity price index hit its lowest levels in two years in the week before the '29 Crash. Wheat, which had been as high as $1.62 per bushel that August, hit $1.14 on October 24. At that time, agriculture was still the biggest single industry and employer.

By October 24, the N.Y. Times was citing an observable business slowdown as a factor in the market decline. It also reported on the continuing sharp drop in commodity prices - and the decline in U.S. Steel production to 80% of capacity. Production had been running flat out at 100% just that summer.

  Indeed, even the media was already well aware of the causes of the stock market's weakness and the dangers threatening it. On October 22, 1929, a page one New York Times article stated:

  "Amid scenes of wild confusion and drastically lower prices, the stock market continued yesterday to pay the piper for its long dance with advancing and inflated prices."

    The article listed five major factors for the decline.

  1. Price readjustment downwards to levels commensurate with current earnings.
  2. Unanswered margin calls and stop loss orders sold "at the market."
  3. Large scale foreign liquidation - hitting railroad shares especially hard.
  4. Hammering of vulnerable stocks by short sellers.
  5. Loss of confidence by stockholders - many of whom still had substantial profits to protect.

  The October 22 N.Y. Times also contained an analysis of the substantial withdrawals of European capital, accelerated by a recent 1% increase in the London discount rate at a time when N.Y. rates had already fallen 2%. The N.Y. Times also reported a substantial drop in automobile production in September. By October 24, the N.Y. Times was citing an observable business slowdown as a factor in the market decline. It also reported on the continuing sharp drop in commodity prices - and the decline in U.S. Steel production to 80% of capacity. Production had been running flat out at 100% just that summer.
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  On October 25, the N.Y. Times reported that GM profits for the first 9 months had declined 7% from 1928 levels. It also reported that a great number of brokerage accounts had already gone off the books, and estimated that it would take at least six months to a year to interest enough new investors to replace them.

Even after October 29, 1929 - dividend yields of less than 4 1/2% indicated that the  market was still optimistic - still looking beyond the now evident economic decline to an expected quick economic and market recovery - such as had occurred during previous setbacks during the previous decade.

  While the market may grossly overshoot the mark and create irrational positive or negative bubbles as Shiller amply proves, he fails to prove that the general direction of its cyclical movements and dramatic collapses lack rational justification.
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  Indeed, even at the October 29, 1929 lows, dividend yields on the NYSE still averaged less than 4 1/2% - which could be earned on savings accounts. Dividend yields in those days before high marginal tax rates were -as Shiller correctly notes - a very important part of shareholders' return on investment. What this means is that - even after October 29, 1929 - the market was still optimistic - still looking beyond the now evident economic decline to an expected quick economic and market recovery - such as had occurred during previous setbacks during the previous decade.

When the full extent of the economic decline during the fall business season became evident, the stock market moved considerably lower in November than the lows of the October 29 Crash.

Shiller fails to distinguish functional and rational feedback effects from moments of irrational pessimism.

  The irrational bubble had indeed existed on the upside - however there was as yet NO evidence of a "negative bubble" from undue pessimism. Indeed, there would be no evidence of any pessimism - undue or justified - for at least another year. In fact, when the full extent of the economic decline during the fall business season became evident, the stock market moved considerably lower in November than the lows of the October 29 Crash.
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  All of this does not, of course, undermine Shiller's obvious "feedback loop" point that major market fluctuations, themselves, are often part of the cause of accelerated  market movements. However, they often do this simply by breaking human inertia - by alerting over confident investors that there may really be something to worry about that they were missing. Shiller here fails to distinguish this functional and rational impact from moments of irrational pessimism.

  For the October 19, 1987 Crash, Shiller has more than news stories to analyze. He has his own investor surveys and the results of a federal government study of the causes of the crash. Not surprisingly, they indicate a variety of causes - none of which appear dominant - amplified by the "feedback loop" of the market decline itself - which had been accelerating for some weeks prior to the crash. The rapid recovery from this crash tends to affirm Shiller's conclusion that this was an example of an irrational "negative bubble."

There is a difference between a momentary market spike - up or down - in rational response to sudden uncertainty - and irrational* exuberance or pessimism that drives markets substantially above or below rational levels for months or years at a time.

 

As with the Crash of 1929, it is futile to look for a single cause. However, taken together, there were ample reasons for extreme concern that the tide of economic activit*y was ebbing.

 

There is a difference between a momentary market spike - up or down - in rational response to sudden uncertainty - and irrational exuberance or pessimism that drives markets substantially above or below rational levels for months or years at a time.

  However, even this conclusion appears dubious - the result at least in part of 20/20 hindsight. There were, in fact, good reasons in the six weeks before the crash to suspect real economic trouble justifying stock market weakness. The rationality of "bargain hunting" and the subsequent ability of the economy to overcome the evident threats also justified the quick market recovery. This reduces the "irrational" aspect of the events to the common tendency of any rapidly moving market - like storm tossed waves on the ocean surface - to temporarily overshoot its rational equilibrium levels.
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  The market - after a 3 year bull market advance - had for weeks been battered by rapidly rising interest rates, rising inflation, weakness in the dollar, and surging gold prices. The trade deficit was a continuing worry. Indeed, Japanese investors were net sellers of U.S. treasuries in September, and foreign buying had been weak all year. All of this was in the financial news in the week before the crash, and much of this was considered by Shiller in his surveys. While the economy remained fairly good, a substantially greater than expected drop in automobile sales for early October had been reported the Thursday before the crash.
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  On the morning of the crash, the N.Y. Times had a page one article stating: "Recent indications by Treas. Sec. James A. Baker 3d that the U.S. would tolerate a lower dollar against the W. German mark confirmed the market's apprehension that a breakdown of international cooperation could fuel inflation, raise interest rates and further depress the stock market."
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  As with the Crash of 1929, it is futile to look for a single cause. However, taken together, there were ample reasons for extreme concern that the tide of economic activity was ebbing and that the still vulnerably high market would head for substantially lower levels. The market itself would become a part of the "feedback loop" described by Shiller. Market professionals would see the impacts on the tape - and react - even without consciously emphasizing any one of the reasons for the weakness. If they also had some insider information, they would not be telling Shiller or the government investigators about it.
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  There is a difference between a momentary market spike - up or down - in rational response to sudden uncertainty - and irrational exuberance or pessimism that drives markets substantially above or below rational levels for months or years at a time.

Existing levels of optimism and pessimism - of confidence and fear - are real economic factors that rational markets must reflect.

  "New era" thinking and speculative bubbles - both in the U.S. and world wide - are informatively reviewed and analyzed by Shiller. That markets are not precisely efficient - that they tend to overshoot during periods of great optimism or pessimism - should not be in question.  

  Shiller's overall argument about the weaknesses in simplistic "rational stock market" theory are clearly correct. The irrational has at times been evident in market moves. However, existing levels of optimism and pessimism - of confidence and fear - are real economic factors that rational markets must reflect.

  Several "bubble" markets in the U.S. are covered, including 1901, 1929, the approach to DOW 1000 in the 1960s, and the 1990s. Each of the first three bull markets was followed by lengthy periods in excess of a decade of poor or negative market returns. Sometimes - but not always - these were initiated by abrupt market crashes. Shiller provides lists of 25 of the largest one year and five year market increases and declines from around the world - ranging back to the 1960s - none of which occurred in the U.S. Even at its worst, U.S. markets have not been as volatile as those in other nations.

  "Often the ends of bull markets appear to be caused by concrete events unrelated to any irrational exuberance in the stock market. Notable among these are financial crises, such as banking or exchange rate crises."

  These technical reasons then submerge consideration of the extent to which the market reversal was due to psychological factors.
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Psychological factors:

  The conventional view that broad levels of "euphoria" or "frenzy" influence market rises or falls is debunked by Shiller. The vast majority of investors are busy going about their ordinary business without concern for the day-to-day movements of the markets. Given the normal degree of ambiguity in economic fundamentals at any moment, investors seek psychological "anchors" on which to base immediate judgments. Shiller categorizes them as either "quantitative" or "moral."
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  Quantitative anchors are provided by the market itself, which is relied upon to provide information about its own prospects. The current price is always an important anchor, as is recent highs and lows. Past percentage increases and falls are also viewed as important. A little more dubious are prominent index milestones. For individual stocks, price movements and p/e ratios for similar stocks are always influential.
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  Shiller questions why stocks of companies in the same industry but headquartered in different countries tend to have less similar price movements than stocks of companies in different industries headquartered in the same country. Also, he questions why real estate investment trusts ("REITs") rise and fall like ordinary stocks, rather than being tied to the appraised value of underlying real estate.

  These two arguments are weak. Changes in the economic environment within nations (political, economic, monetary, budgetary) can be far more volatile than economic conditions worldwide for a particular industry. Also, REIT stock prices reflect expectations of future earnings of commercial real estate rather than mere current appraised value. Furthermore, that expectation is constantly adjusted according to other relevant expectations such as for inflation and interest rate movements. Appraised values are lagging indicators and very inadequate guides for actual value.

  There are a variety of psychological "moral anchors" cited by Shiller.

  • Studies show that investors often respond more to "stories" about stocks than to quantitative evidence concerning fundamentals like earnings or dividends. (This factor undoubtedly waxes and wanes depending on how ambiguous quantitative expectations concerning fundamentals may be. Startups and periods of rapid economic expansion or contraction or rapid shifts in the economic environment all increase ambiguity and strengthen the impact of intuitive factors.)
  • There are tendencies to buy the stock of one's employer even though it would appear rational to diversify away from the company on which employment already depends. (However, employees generally have the advantage of being "insiders" only with respect to their employers - thus decreasing the risk factor for these investments. Also, especially for small companies, being a shareholder may enhance career opportunities.)
  • Investors may adopt simplistic reasons by which they can justify an investment to themselves or others. (This tendency may be just another way of saying that investors put their money in investments they think they understand -- even if other investment strategies look more logical to others.)
  • The tendency towards overconfidence in one's own beliefs encourages risk taking on the basis of  those beliefs - even though most people have no idea how much they don't know. Shiller found overconfidence especially strong in investors he interviewed for his surveys, and duly noted that overconfidence plays a significant role - especially in speculative markets. (Again, pessimists don't invest in risk capital.)
  • Investors look for familiar patterns in market behavior - without really understanding the forces behind those patterns. (This is especially influential with many investors.) Many traders, and even some investors, think they can at times predict what the market is about to do. This is especially influential with "bargain hunters" during rapid declines and short sellers during speculative bubbles. It frequently provides at least a temporary break in rapid rises or falls. 
  • The nation's increasing gambling tendencies are another psychological factor affecting stock investments.
  • Adoption of various behaviors on ethical grounds, such as frugality and saving, also influence investment tendencies.
  • Shiller has also found evidence of "magical thinking" - the superstitious belief that certain actions will make the investor lucky.
  • Then there is human inertia - investors are slow to change their mode of thinking once established.

In the U.S. and similar capitalist nations, investors have justifiable confidence in their country - and know that economics is not a zero sum game.

 

All who engage in the stock market can make money - although inevitably there are some who don't, and many whose returns are below average.

  Shiller is dealing with slippery stuff, here. It is not difficult to come up with qualifications to many of his contentions. But this is generally relevant to the strength of these psychological investment influences rather than to their existence.
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  However, stock investments are - after all - risk capital. Stocks are supposed to respond flexibly to all the myriad influences, uncertainties, and shifts in economic and psychological factors, because equity capital is flexible enough to recover as fast as it retreats. Equity capital sufficient enough to absorb the winds of change and the surges of uncertainty allows calm to prevail in the vast depths of debt and human capital. When equity capital is insufficient to protect debt capital, that's when the real trouble occurs.

  Unlike the decisions of an experienced chess player, Shiller points out, "real-world decisions are clouded by emotions and a lack of clearly defined objectives, and people do not generally behave as if they have thought things through well in advance."

  More to the point, investment decisions are real time decisions made on very incomplete information - like trying to play chess when your opponent has some invisible pieces. However, in the U.S., investors have justifiable confidence in their country - and know that economics is not a zero sum game. At least in the U.S., as David Landes has pointed out: "In the long run, only optimism pays." All who engage in the stock market can make money - although inevitably there are some who don't, and many whose returns are below average.

Herd behavior:

  Psychological tendencies are amplified by herd behavior into substantial market impacts. Shiller explains several analytical techniques that have been used to explain many of the factors involved in the propagation of herd behavior through the trading and investing community.
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Efficient markets, random walks, and bubbles:

  Poking holes in efficient market assumptions and the theory that stock price movements resemble an unpredictable "random walk," Shiller does an excellent job of undermining the theory that market prices are always rational.
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Not knowing when a market will correct mispricing prevents even "smart money" from profiting from knowledge of the error.

  Markets can remain substantially mispriced for extended times - even for weeks or years - or decades, even though always subject to forces tending to drive them towards rational price levels. Not knowing when a market will correct mispricing prevents even "smart money" from profiting from knowledge of the error, Shiller notes. Thus, "smart money" investors cannot by their actions efficiently correct these durable mispricing tendencies. However, this has permitted certain "value" investors to do remarkably well simply by finding, buying and holding "under priced" securities..
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  The rational market theorists point out that few market professionals beat the market averages. Shiller's efforts to counter this argument are admittedly modest. There is little evidence as to the actual intelligence and comprehension of market professionals, he points out. However, his conclusion that "smarter people will, in the long run, tend to do better at investing," does have some support.
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  Shiller then cites the absurd market valuations achieved by the "dot com" startups at the time he was writing his book. He also reviews the "nifty fifty" of the early 1970s and, of course, the 17th century "tulip mania" in Holland. He also cites studies that show poor performance for stocks that were most bid up during a preceding five year period, and above average performance for those that fell the most.
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  He argues that bull market increases have frequently been clearly disproportionate to earnings increases. Similarly, he points out that shifts in dividend rates only very weakly correspond to stock price movements.

  This is not strange, since other factors also apply - like reductions in interest rates, inflation, and a variety of other risk factors - like prospects for war or peace. Here, again, Shiller is not wrong - he just overstates his case.

The tendency of speculative bubbles to eventually lead to sharp reversals - and of substantially under priced markets to eventually lead to superior investment returns - is substantially predictable.

  Studies that show that stocks outperform other investments are recognized by Shiller. However, he correctly points out that this is no guarantee of future performance. There have been decade long intervals when stocks did not outperform bonds. These risks increase greatly as bull markets surge increasingly ahead of current earnings. He also questions the wisdom of investing in stock mutual funds, given their high fees and frequently high investment turnover rates.
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  While the short term market is not predictable, the tendency of speculative bubbles to eventually lead to sharp reversals - and of substantially under priced markets to eventually lead to superior investment returns - is substantially predictable.
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  Public figures have a responsibility  to speak out about the risks of markets that surge to apparently irrational levels. Economic and market developments are of obvious importance. Shiller asserts that this chore cannot be left to market professionals who have many conflicting interests that may inhibit critical evaluations.

  Lest it be forgotten, all of these things were, in fact, being actively debated for months and years before the recent  market peak - not just in financial pages, but in ordinary news and editorial columns and in a wide variety of talk shows and other venues. Nevertheless, this did not prevent the bull market from climbing this wall of worry to its dizzying heights. 

  Writing just before the market peak, Shiller reviews many of the constructive developments of the 1990s that led to the market upsurge. He logically - presciently - calculates that at least some of them may not persist or may be reversed. He provides a long admittedly very incomplete list of the many things that can go wrong. Indeed, war, terrorist attacks, and depression abroad are among the risks in his list.

  Low inflation, low interest rates, and low energy prices were already being reversed in 1999 - but have already been restored by the recession. The competitive superiority of the U.S. economy is being visibly enhanced even further by business responses to recession. If the war on terrorism continues to go well, a flexible and responsive U.S. economy will again quickly restore the bases for another surge in its prosperity.

  Shiller also raises the possibility that various forms of popular resentment will undermine globalization or that environmental problems - such as global warming - could impose massive economic costs - undermining stock prices.

  Shiller is usefully reminding us that stocks are indeed "risk capital" - and it must never be forgotten that they are designed to - and will - bear the brunt of risks that become manifest.

Policy advice:

  The advice offered as a result of his analysis is pretty standard stuff. DIVERSIFY!
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The stock market will do well if the economy is managed well. If the economy is managed in an irresponsible fashion, then the stock market will perform poorly - and Social Security benefits will be in trouble, too.

 

 

  He noted that it was already too late for the major funds and investors to duck, because any effort by them to sell would precipitate the market break. They can only prepare to live off of slimmer rations by reducing payouts. As an academic, he is especially concerned about university endowment funds, and criticizes recent advice advocating higher payouts.

  Here, Shiller exposes an underlying streak of irrational pessimism. Is he actually suggesting that the current market reversal is more than temporary? Does he actually believe that the U.S. economy - and its stock markets - will fail to recover and will perform poorly in the decade ahead?

  Defined contribution pension plans of middle and working class retirees are especially at risk. Shiller advises investment in U.S. government inflation-indexed bonds - especially for those dependent on meager pension funds. He notes with disapproval that, as of 1966, one study found more than two thirds of 401(k) balances invested in stocks. Even participants in their 60s were mostly in stocks.

  Then, these people are still doing very well, indeed. Except for the speculative issues mainly on the NASDAQ - the market hasn't even come close to declining to 1966 levels, and in 2002 it will move sharply upwards from its 2001 lows.

  Shiller points out that Social Security would be substantially reduced as a national risk sharing institution if a portion of the trust fund were invested in stocks. He is especially critical of instituting such a change when the stock market is already at an historic high.

  Unfortunately, however, the opportunity is now being missed to start such investments during this cyclical low. The stock market will do well if the economy is managed well. If the economy is managed in an irresponsible fashion, then the stock market will perform poorly - and Social Security benefits will be in trouble, too.

  Monetary policy in the face of a speculative bubble is very tricky. Shiller correctly asserts that tight money in the summer of 1929 played a major role in the ultimate Crash of '29. However, he incorrectly asserts that money remained tight thereafter and played a role in the economic Depression that developed thereafter.

  In fact, all interest rates - including those of the Federal Reserve Bank - declined sharply from the beginning of October, 1929, right through 1930. Business did not contract after 1929 because of a fall in monetary aggregates - the monetary aggregates contracted because business had no profitable uses for the funds. Rapidly declining private interest rates clearly demonstrated that - from the beginning of October, 1929 - there was never any shortage of funds.
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  The causes of the economic decline and failure to recover after the Crash of '29 lay elsewhere - as set forth and explained in FUTURECASTS' "Depression Chronology" series, especially "The Crash of '29," "Rebound from Crash of '29," and "The Collapse of Agriculture." An overview is provided in Depression mythology.

  Shiller also cites the bursting of the Japanese stock market bubble in 1990, from which point Japan has been unable to recover. (Here, again, the failure to recover is clearly due to causes other than Japan's monetary policy. See, Porter, "Can Japan Compete?") He notes that modest interest rate increases accompanied by cautionary statements may be useful in limiting such bubbles, but "authorities should not generally try to burst a bubble through aggressive tightening of monetary policy," because it is a blunt instrument that affects the entire economy.

  Cautionary statements by  cognizant public officials - such as the Federal Reserve Board chairman - have been made before each of the three extreme market peaks since establishment of the Federal Reserve system. However, these efforts had little observable impact due to the cacophony of conflicting opinions always present about the market. Shiller views skeptically the utility of securities transaction ("Tobin") taxes in damping market volatility, and is clearly opposed to market interference policies that may inhibit the "critical resource allocation functions" of speculative markets.
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  Ultimately, the bursting of speculative bubbles is not just inevitable, it is beneficial. It prevents further enlargement and even more devastating collapse later on, and often leads to beneficial reforms in securities regulation. Shiller recommends various methods for broadening markets and the establishment of various risk-hedging markets that could better focus attention on fundamental risks, and offer investors practical hedging opportunities for the risks they face.
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For economic freedom, we must rely on the ultimate good sense of the people in investing their funds and correcting their errors.

  Shiller closes with good common sense. For political freedom, we must rely on the ultimate good sense of the people in choosing their leaders and using subsequent elections to correct. inevitable misjudgments. For economic freedom, we must rely on the ultimate good sense of the people in investing their funds and subsequently correcting their errors.

  "Ultimately, in a free society, we cannot protect people from all the consequences of their own errors. We cannot protect people completely without denying them the possibility of achieving their own fulfillment. We cannot completely protect society from the effects of waves of irrational exuberance or irrational pessimism."

Afterword - written after the market peak:

  After the initial market declines in early 2000, Shiller's surveys showed little loss of confidence in stock markets - confirming his view that it takes years of poor market performance to undermine confidence gained from a long bull market - or vice versa.
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Productivity growth has no clear relationship to profitability and stock prices, since competition may force prices down and transfer all the benefits to consumers - as has been so clearly happening in the personal computer industry.

  "New era" and formulistic arguments for  continued exuberant bullish assertions by various "experts" and "new economy" advocates are again - perceptively - criticized. He accepts the possibility that an acceleration of technological development and productivity might indeed lead to superior stock market performance in subsequent years, but notes that nobody has come up with an objective way of proving or disproving that assertion. Technological progress today is not all that different. The internet has about the same impacts on productivity as the interstate highway system built in the two decades after 1955. During that time, Shiller points out, corporate profits rose only 1.6% per year - slightly below average.

  Economic analysis is not a laboratory science. You can't test any one thing, keeping other variables constant. Interpretation of economic events is dependent on professional skill. Shiller's two decade example ends misleadingly during a fairly severe recession.
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  That was the time when Keynesian economic policies were rendering "obsolete"  the business cycle. As a result, the nation's finances deteriorated, inflation accelerated, the dollar was devalued, energy prices soared, and a series of recessions began modestly in 1967 and continued with increasing severity until the depression of 1980-1982.

  Shiller is obviously correct in pointing out that technological progress is a constant process that proceeds in large matters and small at all times - not just during the construction of interstates or internets. Moreover, productivity growth has no clear relationship to profitability and stock prices, since competition may force prices down and transfer all the benefits to consumers - as has been so clearly happening in the personal computer industry.

  However, lower prices should increase demand and thus offer opportunities for larger and more valuable productive entities. Because of the tax laws, corporations will strive to pass these profits on to their shareholders as much as possible in the form of capital gains - by expanding where possible and by using earnings to buy in their own shares.
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  These factors, alone, should lead to persistently higher stock prices - as long as the economy remains relatively flexible and healthy. Add in the impact on share prices of lower interest rates during this recession, the elimination of weaker competitors by bankruptcy or withdrawal from markets, reduced costs due to recession induced cost cutting measures and reductions in commodity prices,  and the drawing down of inventories, and the basis for the next surge in prosperity and stock prices becomes clear.

  Again, Shiller closes with eminently good common sense. The business cycle is certainly alive and well in the age of the internet, and there remains the need for caution, discipline, and management that carefully retains the ability to weather periodic economic reversals.

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Copyright 2001 Dan Blatt