Grinstead Review

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Irrational Exuberance.
Robert Shiller Princeton University Press, 2000

This book takes its title from a phrase uttered by Alan Greenspan, chairman of the Federal Reserve Board, on December 5, 1996. He was characterizing the behavior of investors in the (U. S.) stock market. The title implies, and Shiller argues, that stock markets do not always behave in a rational manner, and that psychology plays an important role in the pricing of stocks by the market.

The author is a professor of economics at Yale University, is the author of several other books on markets, and is well-known as an expert on volatility of markets. This book is especially timely reading for those among us who wonder how long the current bull market will continue.

As Shiller himself says, for every statement made by an "expert" about the market, one can find another "expert" who will make exactly the opposite statement. Thus, this book represents a point of view about the market. As such, it will resonate more with those who basically share this point of view.

Shiller's main thesis, which is not original with him, is that the present U. S. stock market is significantly over-valued. It is in a "speculative bubble" phase, and sooner or later (Shiller thinks sooner), the air will be let out of the bubble, leading to significant declines in the values of stocks. In fact, in an interview that appears in the current issue of "In The Vanguard", a publication sent to all shareholders of Vanguard mutual funds, Shiller is quoted, in answering the question "How big a drop in the market do you think is plausible?" as saying:

A drop in the range of 50% to 60% is not implausible. If you ask me for a forecast of the Dow in 2020, I'd say as good a guess as any is 10,000. For comparison purposes, as this review is being written, the Dow stands slightly higher than 10,500.

Shiller begins by reviewing some standard economic theory about the stock markets. One of the central tenets of market theory is that the price of a share of stock of a company, while set by investors, is correlated to the current (and probable future) earnings of the company. Of course, future earnings are very difficult to predict, but one can make some reasonable assumptions about the rate at which a company's earnings can increase (at least in the near future). Since future earnings are discounted, the earnings in the distant future are less important in determining the current value of a share of stock.

The average price-earnings ratio of the stock market (specifically, the S&P 500) are higher today than at any time in the last 120 years. In fact, until 1996, the price-earnings ratio was higher than 23 only three times during this period (1901, 1929, and 1966), and each time, the real return of the stock market over the 20-year periods following these peaks were -0.2%, 0.4%, and 1.9%, respectively. The current price-earnings ratio is above 40.

If standard economic theory is to be believed, the above figures are scary. Yet there are many people who believe that the markets have undergone fundamental changes, and that we are entering a new era. James K. Glassman, a journalist, in the same issue of "In The Vanguard," is quoted as saying

It is very hard to deny that something profound has been happening in the stock market. It's gone from 777 on the Dow in August 1982 to over 10,000 today. That's a 13-fold increase. We've had five years in a row in which the S&P 500 Index has returned more than 20% in each year. Never before had it done so for more than two years in a row. Shiller gives similar quotes from books written in 1929. For example, in the book "New Levels in the Stock Market", Charles Amos Dice wrote of a "new world of industry," a "new world of distribution," and a "new world of finance." One of the most eminent economists at the time, Professor Irving Fisher (coincidentally at Yale), wrote in 1929 that "stock prices have reached what looks like a permanently high plateau."

Of course, for every statement that this has all been seen before, someone can construct an argument as to why this time, it is different. The question as to who, if anyone, is closer to the truth is impossible to answer. As to who is to be believed, it depends upon the perceived strengths of the arguments, and also on the psychological makeup of the listener. This reviewer is certainly impressed by Shiller's work in the psychological basis of stock prices. For example, Shiller went through newspapers that were printed in the months preceding both the October, 1929 and October, 1987 stock market crashes, searching for any news items that might be thought to have precipitated these crashes. In 1987, he was able to survey institutional and individual investors as to what they were thinking about when the crash came.

In neither case could he come up with any item, or set of items, that was a clear cause for the crashes. Shiller claims that such events as the 1929 and 1987 crashes are best explained in terms of changes in the psychological makeup of the bulk of investors. There are contradictory ideas in the minds of most investors, and these ideas compete for attention. Which ones hold sway at any given moment may depend, to a large degree, upon what other people are thinking. When enough people change their feelings about the direction in which the market will go, most of the remaining people will change their feelings quite quickly. This creates a large difference between the numbers of buyers and sellers, and can lead to sudden, substantial movements in stock prices.

What does this have to do with probability and statistics? The leading arguments against the theory that psychology is an important factor in the pricing of stocks are those that involve the ideas of efficient markets and random walks. The efficient markets theory states that stock prices accurately reflect the true value of the stocks, given the current public information. According to this theory, stock prices are unpredictable and describe random walks through time, since new public information is generally unpredictable. Shiller claims that this theory has been statistically rejected many times in various scholarly journals of finance and economics. In addition, he says that "the efficient markets hypothesis does not tell us that the stock market cannot go through periods of significant mispricing lasting years or even decades." Thus, even if the "smart money" knows that a certain stock is mispriced, unless many people can be convinced of this fact it is not possible to make money from this knowledge. While it is true that eventually this knowledge will probably become public, the theory does not say how long this will take.

What does Shiller suggest that people who believe his arguments do with their money? Certainly, if one believes that over the next 20 years the stock market returns will be just a few percent annually, then one should switch much of one's investments to other vehicles, such as bonds or real estate. At several points, Shiller states that if one wants a totally riskless investment one should buy government issued inflation-indexed bonds. His point, and it is a good one, is that such bonds are impervious to changes in the market as well as being immune to the effects of inflation. He also suggests investing in stock markets outside of the country, since such markets do not always move in tandem with the U. S. markets. He certainly believes, unlike some analysts today, that stocks are not low-risk investments, and therefore one's portfolio should contain a significant amount invested in safer places.


What do you think this reviewer did with his stocks after writing this review?