Irrational Exuberance

by Robert J. Shiller, 2000, Princeton University Press, 296 p., hardcover, hardcover, ISBN 0-691-05062-7.

This book is an antidote for Dow 36,000, another recent and popular title (reviewed in the prior "Tip"). In fact, Shiller's data appear prominently Dow 36,000. Here we have a case of different people looking at the same data and arriving at dramatically different conclusions. Perhaps we'll know in a few years—or maybe much sooner—who is "right."

Alan Greenspan, chairman of the U.S. Federal Reserve Bank (our closest thing to a central bank), has been called "the most powerful man in the world." Most listen, yet few seem to react. "Irrational exuberance" is the phrase he is most famous for.

The author, Robert Shiller, is a Yale University economics professor. He was among experts testifying before the "Fed"—warning about the stock price "bubble"—two days before Greenspan's famous "irrational exuberance" pronouncement on December 5, 1996. The Dow Jones Industrial Average (the "Dow") has increased about 65% in the four years since.

Shiller's main evidence for caution: Three times in the 20th century we've had Price/Earnings peaks, followed by 20 years each of poor returns:

1901-1921, real returns averaged 0.2%/year
1929-1949, real returns averaged 0.4%/year
1966-1986, real returns averaged 1.9%/year

Shiller uses these data to show that, contrary to popular myth, there are examples of long periods where stocks have underperformed bonds. His main graph, page 6, shows P/E from 1881 to January 2000. We're now at a new high, P/E approaching 45. This far exceeds the ratios before prior crashes in 1901(P/E about 25), 1929 (about 33), and 1966 (about 24). What are we thinking?

He emphasizes that the P/E data are corrected for inflation. Normally this wouldn't matter, but the denominator he used is the average over the prior 10 years. This would not recognize recent strong productivity improvements.

Shiller would be more convincing for me if he had recognized that the world is somewhat changed. Here are two of my concerns:

Companies are paying less in dividends and repurchasing more of their stock. At least in the U.S., this avoids double taxation of gains distributed as dividends. Thus, price/yield curves don't mean much.
Companies are investing in ways that the accounting profession doesn't recognize. Investing in building brand names, human capital, software and research. These directly reduce "earnings" and, thus, increasing the P/E ratios. Of course, long-term, the successful investment must ultimately increase earnings and cashflow to investors.

The book was a bit long for me. Fortunately, it is well organized and I found myself comfortably skimming sections where the subjects were familiar. It is an easy read. I would have preferred more graphs, numbers and quantitative analysis.

           Contents
   Preface (substantial, overview)
   The Stock Market Level in Historical Perspective
        Structural Factors
   Precipitating Factors: The Internet, the Baby Boom, and Other Events
   Amplification Mechanisms: Naturally Occurring Ponzi Processes
        Cultural Factors
   The News Media
   New Era Economic Thinking
   New Eras and Bubbles around the World
        Psychological Factors
   Psychological Anchors for the Market
   Herd Behavior and Epidemics
        Attempts to Rationalize Exuberance
   Efficient Markets, Random Walks, and Bubbles
   Investor Learning—and Unlearning
        A Call to Action
   Speculative Volatility in a Free Society
   Notes, References (substantial), and Index

This book delves into an emerging field, "behavioral finance," where economic theory succumbs to fantasy and delusion. This is apparently Shiller's passion. He has been surveying investors since the mid-1980's to capture and understand their beliefs. He sees the stock price buildup as an unintentional Ponzi (pyramid) scheme, caused primarily by:

Experts promoting stocks as safe investments over time.
Inflation in analysts' ratings. Stocks that formerly would have been rated "sells" are now called "holds."
The media popularizing investments. It's almost like sports, where the companies are like teams or individual players. However, with rising prices, everyone is a winner; success is everyone's friend.
The many wonderful things happening in the world: rise of capitalism and demise of communism; Internet; apparent great wealth amassed by Baby Boomers.
Widespread belief in the resilience of the market: if it crashes, it will come back up within a few years.

The attitudes of investors is the subject of Shiller's research and the most interesting parts of the book. People are overconfident about the correctness of their beliefs. In particular, he is concerned about the "bandwagon effect." Stories in the media about upward price movements lead more people to invest. This (positive) feedback causes bubbles, and we're in one now. Shiller won't be surprised if stock prices halve. The feedback effect works both ways, and a falling market may happen in a panic selling frenzy. Shiller draws analogy to the amplification mechanism in propagating epidemics.

Business is working well, these days. Buried in the last section is a half-page paragraph listing some of the things that might go wrong, such as wars, regulation, and global warming. While Shiller was unable identify news events causing 20th century market crashes, much of what we enjoy today is built upon our perception of well being. I recommend reading this book for increasing your awareness of the possible future states of the world and potential causes for a changed economy.

—John Schuyler, April 2000.