Irrational Exuberance

Irrational Exuberance by Robert J. Shiller

The Stock Market Level in Historical Perspective

Shiller provides charts that show that the level of the stock market at that time (2000) was very high by historical standards. He shows a scatter graph that suggests that high P/E ratios are correlated with low returns over the next ten years. He concludes that the markets at the time were irrationally exuberant.

Precipitating Factors

These include the arrival of the internet, which both amazed everyone with its capabilities and provided the opportunity to trade stocks; confidence about capitalism and business; capital gains tax cut; the baby boom; extensive media coverage of the stock market; optimistic forecasts from analysts; expansion of defined contribution plans; the growth of mutual funds; the decline of inflation; the increased amount of gambling.

Amplification Mechanisms and Positive Feedback

These include high investor confidence and the following:

Feedback Models

The "price to feedback theory" postulates that rising prices attract attention and promote investor enthusiasm, promoting yet more buying, so success breeds success, until the bubble bursts. Smith et al (1988) were able to produce bubbles in experiments. Tversky and Kahneman show that people tend to extrapolate from past performance. Ponzi schemes are forms of natural experiments of these feedback mechanisms.

Smart Money

The efficient markets hypothesis asserts that smart money sells when irrational investors buy, and vice versa. But the smart money may not have the power to control the market. Further, some models show that the smart money may tend to amplify the mispricing by exploiting the irrational investors. Shorts may also face very high borrowing costs to secure stocks.

Other Factors

These include the news media (which has an incentive to amplify "news"), "new era" economic thinking (he shows that bubbles happen often around the world), psychological anchors, herd behavior through word-of-mouth "information cascades".

Efficient Markets and Random Walks

Shiller explains that the efficient markets hypothesis (EMH) implies that stocks follow a random walk, and that price changes are unpredictable, since they only respond to new information.

One of the basic arguments for the EMH is that the "smart money" will make money by buying underpriced assets and selling overpriced ones. The problem is that it is unclear when the mispricing might end, and so it is difficult for the smart money to profit. This argument is extended by Brunnemeier in his explanation of bubbles.

Shiller is weaker when challenging the argument that professional investors do not seem to be able to outperform the market as a whole. He says that is because it is difficult to measure the intelligence of investors, and says he has "no reason to doubt the thesis that smarter people will, in the long run, tend to do better at investing."

Shiller cites evidence of "obvious mispricing' in the time of the internet bubble. I agree that prices were obviously out of whack with what the business could earn.

There is evidence that firms that are overpriced tend to do poorly afterward. He cites Basu (1977) about firms with high P/E ratios, and Fama and French (1992) with high price to book value. This supports a value investing strategy.

Shiller points out that earnings and stock prices do not correspond well at all. He has a great chart on that.

Overall, Shiller is a skeptic, and with some justification, when it comes to the EMH. Yet he does admit that the theory is partly true.

Investor Learning

Shiller then tackles the idea that the market is higher because people have learned that the stock market always outperforms the bond market. In fact, says Shiller, this is not true, and stocks can stay low for long periods.

What to Do?

Shiller basically says that investors and authorities should prepare for a market downturn. Individuals should diversify, increase their savings rates and develop skills. Authorities should try to educate the public and consider safer investments for retirement planning.

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