<html><head /> <style type="text/css"> <!-- .style1 { font-size: x-small; font-weight: bold; } --> </style> <body> <META http-equiv="Content-Type" content="text/html; charset=UTF-16"><title>Irrational Exuberance</title><meta name="keywords" content="shiller,states,theories,united,US,wealth,stock,market,1987,board,book,crash,declines,earnings,exuberance,federal,feedback,finance,history,index,internet,irrational,loop,media,money,nineteen,eighty-seven,price,psychology,reserve,robert,"><table style="font-family:Verdana; font-size:larger; " align="center" border="0" width="50%"><tbody><tr> <td style="background-color:silver; border-color:white; border-left-style:none; border-style:none; " width="730"><span style="font-family:Verdana; font-size:larger; ">Irrational Exuberance</span></td> </tr> <tr> </tr> </tbody></table><br><table style="font-family:Verdana; font-size:medium; " align="center" bgcolor="white" border="0" width="50%"><tbody><tr> <td height="131" width="669"><p align="left"><span style="font-family:Verdana; font-size:x-small;"><strong>Editors Introduction</strong></span><span style="font-family:Verdana; font-size:x-small; "><IMG SRC="auth_Shiller.jpg" WIDTH="80" HEIGHT="110" ALT="Shiller" VSPACE="10" HSPACE="5" BORDER="0" ALIGN="right"> In his latest book, <I>Irrational Exuberance</I>, Yale economist Robert Shiller (right) offers an unconventional interpretation of recent US stock market highs. He examines the public fascination with the stock market, and draws attention to a combination of precipitating factors that drive stocks higher. Shiller views the current market as vastly overvalued. He argues that the factors conspiring to construct and magnify this event--"the baby boom effect"; the public's infatuation with the Internet; "new era theories," in which the popular perception is that the future is brighter or less uncertain than it was in the past; and the rise of the mutual fund industry--mean that the market will most certainly fall.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">The title of this book comes from a talk that Alan Greenspan, the chairman of the Federal Reserve Board, in Washington, gave in December of 1996. He actually only used the words "irrational exuberance" once, and this came in the form of a question like "How do we know whether the stock market is going through irrational exuberance?" And despite this being an awfully innocuous thing to say, markets all over the world dropped; they dropped sharply in Tokyo, Hong Kong, Frankfurt, Paris, London and New York. So it had quite an effect.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">The question is, why did that simple question have an effect all over the world? One view is that Greenspan was trying to indicate that the Fed might tighten credit, but I don't think that's the reason. I think it's because people are concerned with the possibility that markets might be doing something that could be seen as "irrational exuberance," and a lot of people are concerned about this. Thus, when someone like Alan Greenspan gives approval to this view, it has an effect. This, incidentally, is also his most famous quote, and when the next edition of <I>Bartlett's Quotations</I> comes out, it will most probably be in there.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">I think that, although he stated it only as a question, he was right in his premise that the markets are in something that we might call irrational exuberance. And I prefer the term "irrational exuberance" to other terms that are commonly used, like "speculative mania" or "speculative orgy," because they kind of overstate. There's a tendency for people who are interested in market psychology to overstate the case and they lose credibility--it doesn't sound right--but "exuberance" is just about the right word.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">There are a lot of newspaper and magazine articles claiming that something excessively exuberant is going on in the market, but they tend not to be too convincing. What I wanted to do in this book was to write a treatise on the topic and amass all of the evidence that I could. There's a lot of difference in opinion about the level of the market, especially now, and usually people have different convictions about it. Generally, when there's such a difference of opinion it's because different people are aware of different facts. So I tried to lay out a complete case that presents all the facts.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">I also argue in the book that the stock market level is a very important national and international issue. It affects society at large in fundamental ways. When the market is overvalued, it distorts economic decision making. One effect is that people today are less concerned about their other sources of income; they're tending to preserve their human capital, their skills and their job position. They tend to feel that we're all richer now, that we can all get rich through the stock market.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">There's also a tendency not to save much, feeling that they've got all this wealth from the stock market. I think there's not enough attention paid to designing social insurance, as there's a hope that the Social Security problem can be solved by investing in the stock market, rather than looking at the serious issues of maintaining our livelihoods.</span><br> <br> <span style="font-size:x-small;"><strong>The stock market crash of 1987</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">So I began work on this book in 1987--a long time ago--and I was interrupted. I don't know if you remember what happened in that year. My timing wasn't as good that time, so I set it aside. Well, the stock market crash of 1987 occurred, and when that happened I thought, this is bad, but in a sense it's wonderful, because it offered a chance to study stock market crashes. The 1929 crash was behind us, but here was a new one! I've often believed, long believed, that economists do not ask people why they do things often enough. Milton Friedman said you should never ask, because people will never tell you the truth or are incapable of telling you, but I think somebody ought to ask.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">So, when the crash happened, I set up some questionnaires about the crash, asking people what they were thinking, why they were buying and selling. I sent out 3,000 questionnaires to individual and institutional addresses and I got back 1,000 responses. In a nutshell, what happened in October 1987? Well, what I concluded was that it wasn't really a reaction to any news. I asked about all the news events that were in the newspaper on the morning of the crash, and I got bland uniform responses: "Everything that was in the news was important." But when I asked open-ended questions like "Can you name the news story?" nobody could name any news stories. They either said, "The market's overpriced"--believe it or not, that was a common theme in 1987--or they said something about market psychology, "People are going crazy," or something like that.</span><br> <br> <span style="font-size:x-small;"><strong>The feedback loop</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">But the most important story that they mentioned was the price declines themselves. So, it appears that what happened in October of 1987--partly because of portfolio insurance but also substantially because of individual and institutional investors' behaviour--was a feedback loop. Initial price declines attracted attention and caused further price declines. People sold in response to the price declines.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">From the form it took on that day, nobody could figure out what was happening. You heard about the price declines in the morning, you knew that there were bad price declines last week, so you called your broker and the broker said, "I don't know what's going on." You talked to a number of friends, nobody could tell you what was going on, and you had to reach a decision. And on that day the decision for more and more people was to sell, and the question all day long was when it was going to turn around, and there was absolutely no answer, no definitive answer. It was just anybody's guess, and it stopped when people started to guess that it was going to turn around.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">That was a downward feedback loop. I argue in the book that part of what's going on now is the reverse: it's an upward feedback loop. The price increases have been generating investor interest and that generates more price increases. This is operating over a slower time frame, over years, and is maybe a little bit different, but it can go either way.</span><br> <br> <span style="font-size:x-small;"><strong>Precipitating factors</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">As I said, this book is attempting to be a treatise on the market, so I tried to be systematic about the current stock market level. So these are the chapters in the book: in the first chapter I talk about stock market level in historical perspective and argue that we are in a record-high, almost unique stock market experience right now. Then in Part One I talk about structural factors, and the first thing is precipitating factors. This is something that's very important. What was ultimately different that caused us to be in this situation? It's not enough to say that there's feedback, because you might say, "Well, why is it any different now than at other times?" And this is where I think a lot of popular accounts of the irrational exuberance fall short. They kind of suggest that we all went crazy recently, and we know that's not true. Something had to cause this.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">I argue here that there are many precipitating factors, not just one. The history is complicated, and usually when major historical events occur it's because of many factors all operating at once and the consequence of these many factors causes the major effect. Why did the Roman Empire fall? Some of you may have read the treatise that Gibbon wrote. But you probably can't think of the one-liner about why it fell. History is complicated like that; that's why it continues to puzzle us and amaze us. Nonetheless, I think I can come up with a list of factors.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">One factor is the "amplification mechanism," which works through a feedback loop, where the effect of factors is amplified by mechanisms involving investor confidence, investor expectations for future market performance and related influences on investor demand for stocks. In terms of cultural factors, I argue that the news media are essential to any speculative bubble, and part of the form it takes is "new era economic thinking." Professional economists will tell you after a stock market boom why it is that we are experiencing a new era. And the remarkable thing is that if you look at history, there are many speculative bubbles around the world and each of them has its "new era theory." And when you see them, one after the other, it gives you a better perspective on the new economy that we are venturing into now.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">There are psychological factors. I talk about evidence from psychology, research by psychologists about limitations of human judgment that we have to bear in mind in order to judge the plausibility of some of these irrational-exuberance theories. And I talk about herd behaviour. And this is the case, the basic case.</span><br> <br> <span style="font-size:x-small;"><strong>Rationalising exuberance</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">Then I come back and reply to critics. There's the famous "efficient-markets theory" in finance, which says that the stock market is wonderfully efficient. It's associated with "the random-walk hypothesis," and it says that the prices incorporate all information optimally. There's a whole list of arguments that are interpreted as supporting this theory, but I regard the theory as only a half-truth. It doesn't take away from the fact that we are going through a strange period, an irrational period right now.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">Chapter 10 is about investors learning. A lot of people believe that people have suddenly become smart. I question the theory that everyone is suddenly getting smart. Irving Fisher made the same claim in 1929. There's a beautiful passage I can read to you from him, in which he says, "People are much more sophisticated about investing now, they're not vulnerable to panics, and they know that the stock market has always outperformed other investments." I think that the apparent learning is really actually part of the feedback mechanism, and that the new facts are much more current because of the situation in the market.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">Finally, I come back to a call for action, what outlook and actions to take. Well, that is to basically get out of the market if you're an individual, or don't be so reliant on the market and save more. I've mentioned before that maybe the government should encourage saving and should reform Social Security.</span><br> <br> <span style="font-size:x-small;"><strong>Statistical analysis</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">Then we get on to the first chapter about the situation. In Graph 1 (below) you can see the US stock market, and it kind of tells the story. The upper series is the real (inflation-corrected) Standard and Poor (S&amp;P) Stock Price Index--corrected for inflation using the Consumer Price Index (CPI)--from 1871 to January of 2000. The lower series is the real S&amp;P Composite Earnings, January 1871 to September 1999. This is the Bureau of Labour Statistics Price Index. You don't see it plotted for the whole period in real terms very often.</span></p> <p align="center"><br> <span style="font-family:Verdana; font-size:x-small; "><IMG src="1598_graph1.jpg" id="3374" type="3" align="center" width="400" height="227" url="1598_graph1.jpg"></span></p> <p><span style="font-family:Verdana; font-size:x-small; ">Now, I don't know if you notice what I intend you to notice in this diagram. There's a kind of anomalous behaviour that's not a plotting error. If you look at the graph, you can mark out where Alan Greenspan made his statement, incidentally, and you can see what it's done since. The market looks pretty extraordinary! It has tripled, essentially, in the last five years. When was the last time that the US stock market did that? Well, the last time that it tripled to a regular level was in 1929, so it tripled from '24 to '29, and there's really no other experience where it has gone up quite this dramatically.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">I've also got here the S&amp;P earnings data on the lower series, of Graph 1, which is the earnings for the index. You can see that earnings have done better. They came out of the '91 recession era and just kept going up. So they looked good, they looked above trend. But the price response seems to be more extraordinary. This is the thing that's really puzzled me: the prices move a lot more than earnings have.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">Graph 4 (below) shows the stock price indexes for five countries, and you can see that it's not specifically a US phenomenon. You can see that in the UK it's only doubled in the last five years. France and Germany are up there with the US; they've really done the same thing. It's not everywhere, though. If you look at Japan, you can see that it's fallen in half instead of going up over that period. So it's not quite a worldwide phenomenon, but it's an international phenomenon.</span></p> <p align="center"><br> <span style="font-family:Verdana; font-size:x-small; "><IMG src="1598_graph4_xls.jpg" id="3376" type="3" align="center" width="398" height="297" url="1598_graph4_xls.jpg"></span></p> <p><span style="font-family:Verdana; font-size:x-small; ">Graph 2 (below) shows the price-earnings ratio in the United States, from 1881 to the present. I actually compute the price-earnings ratio in a way that's not conventional today. It's actually the way that was recommended in 1934 by Benjamin Graham and David Dodd. They wrote a classic textbook, called <I>Securities Analysis</I>, in '34. They said that people usually compute price-earnings ratios by dividing price by last year's earnings, but since last year's earnings are so volatile it tends to be depressed in recession, so you tend to get high price-earnings ratios in recession.</span></p> <p align="center"><br> <span style="font-family:Verdana; font-size:x-small; "><IMG src="1598_graph2.jpg" id="3375" type="3" align="center" width="400" height="226" url="1598_graph2.jpg"></span></p> <p><span style="font-family:Verdana; font-size:x-small; ">Graham and Dodd said you should average the earnings over five or as much as 10 years. If you look at the graph, you can see the real price divided by the 10-year average of the real earnings. The graph shows four peaks: 1901, 1929, 1966 and 2000. In each of those peaks the market did poorly afterwards.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">When you have a ratio of price divided by earnings, it can come back to its normal level, which is around 15, either by the price going down or the earnings going up. So guess which one it is? "The efficient-markets theory" would say it's got to be earnings going up, because prices are random walk, and can't be predicted, but, in fact, it's not. As John Campbell and I showed in another paper, it's because the price goes down.</span><br> <br> <span style="font-size:x-small;"><strong>The Internet</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">Having established that we're in an unusual situation in the market, what are the ultimate reasons that we're in a different situation? I have a list of precipitating factors. They mainly concern the United States, but a lot of them can be applied to Europe and other places.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">I'll just mention the first one. The World Wide Web became available to the public in 1994. The World Wide Web is viewed by many people as an important technological advance, and correctly so. It is one of a series of important technological advances that we've seen in history: the Bessemer process for steel, the railroad, the airplane, the automobile, the telephone, the telegraph and nuclear power. You can even talk about other ones that sound smaller by comparison but are maybe as important as the Web: expressways, superhighways or jet engines on aircraft. They might be viewed as being as important as the Web.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">All these advances are important, but somehow the World Wide Web has made a very strong impression on the market. I think the main reason for this is that the World Wide Web is something we use every day and have experience with at a level different from that of these other inventions. Many of us are on the Web every day, and we're doing things, we're not passive, we're getting things done, so we see the power of it. In contrast, I wonder how many people here have ever operated a nuclear reactor? And even if you did, did you do it every day for a period of years? Another thing is that the Internet came at the same time that we were recovering from the recession of '91, so we saw a lot of earnings growth at the same time. But that earnings growth had nothing to do with the World Wide Web. So it's a plausible-sounding reason to expect a new era.</span><br> <br> <span style="font-size:x-small;"><strong>The baby-boom effect</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">Another precipitating factor is the baby boom. In the United States after World War II there were a lot of babies born. They're supposed to be middle-aged now and buying stocks. That's basically the theory.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">In the US, the number of babies being born went up and stayed up until around the mid-1960s, when it fell. But this is not really a worldwide phenomenon, because you don't see the same happening so strongly in France, Germany, Japan or the UK.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">The thing you do see is that--and this is a very important worldwide phenomenon--the birthrate is dropping in most developed countries. So that might mean that the market will go down when these people retire.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">Harry S. Dent has made a career out of--in fact, he now charges $50,000 a lecture, I'm told--telling the story of how to get rich in the stock market by buying now and selling before the year 2008, when he says it will crash. I think Harry S. Dent is as important a factor as some of these others in boosting the market. The baby boom is constantly coming up when people think about the market; they think the market can't go wrong because you have all these baby boomers with their demand for stocks.</span><br> <br> <span style="font-size:x-small;"><strong>Irrational overconfidence</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">I'd like to talk about amplification mechanisms. I have already mentioned feedback, but let me just give a little bit of evidence about it. The feedback, I believe, operates in a number of channels. One of them is expectations and the other one is confidence; I have some evidence here about confidence. What I'm saying is that the experience of seeing prices rise again and again--really since 1982, but especially in the last five years--and seeing every drop reversed has created a strong sense that the market can only go up.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">I gave some questionnaire items in 1999 to US high-income individual investors. It was a random sample throughout the US which I think showed a remarkable situation of overconfidence. The first question was "Do you agree that the stock market is the best investment for long-term holders, who can just buy and hold through the ups and downs of the market?" If you had added together the number of the first and second answers to this question--"Strongly agree" and "Agree somewhat"--the result would have come to 96 percent. Answers four and five together--"Disagree somewhat" and "Strongly disagree"-- would have come to only 2 percent. This is quite remarkable, because there's a lot of other investments that people have liked in the past--like real estate or gold or something else--and now it's the stock market.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">Another item on the questionnaire was "If there is another crash like 1987, the market will surely be back up to its former levels in a couple of years or so." Ninety-one percent agreed, and only 6 percent disagreed. This was quite remarkable, since the finance professors have been lecturing for the last 20 years that the stock market is a random walk. You would have to answer "Strongly disagree"; that's the correct answer in the finance world, right?</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">If the Dow dropped 3 percent tomorrow, I would guess from my results that the day after tomorrow the Dow would increase 56 percent, and then it would decrease by 19 percent. So it's three to one. I asked the same question in 1989, and it was almost equally split between up and down. So there's no real mystery why the market is valued so highly now. People think they can't lose. This is the standard thing. I don't think they fully believe it, because otherwise they would all put in 100 percent stocks, but an increasing number of people are putting in 100 percent stocks.</span><br> <span class="style1"><br> Popular media and the "new era theories"</span><br> <span style="font-family:Verdana; font-size:x-small; ">Let me just say something about cultural factors. I argue in the book that the media--the news media--are fundamentally important to speculative bubbles. But it's not just--as we might imagine--because of the reporting of objective facts; it's because they're the shapers of stories. The markets generate news and data, millions of observations of data which none of us can comprehend ourselves; it has to be interpreted for us. The news media are story writers, they're attention grabbers, in a competitive business. To survive as a newspaper or a magazine or whatever, you have to attract attention, and if you don't, if you write boring stories or stories that people aren't interested in, you disappear. So the effect they have is to generate things like "new era theories."</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">As far as "new era theories" are concerned, I did a Nexis search of English-language publications and looked for stories--which appeared around 1997-- that had the words "new era economics," and they were widely cited in the media. Every one that I found mentioned the stock market.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">You don't see stories about the new era that don't mention the stock market, because people are not interested in some economist coming on and saying the growth rate is going to be higher. Who cares? I mean, that's boring. You're interested in somebody who's going to tell you that you're going to be rich. Right? Or that you're going to make a lot of money.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">In fact, the whole of the media have changed their tilt. In many cases they changed the name of the business section from Business to Your Money, and they changed the way they write articles. They used to write boring articles, like "Ford Motor Company Opens New Wing of River Ouse Plant." Right? Who reads that? Well, it's guys who work in the auto industry, who look at plants or something! But now the articles don't say that; now they say, "Analysts say this is a buy opportunity for Ford stock"!</span><br> <br> <span style="font-size:x-small;"><strong>Psychological factors</strong></span><br> <span style="font-family:Verdana; font-size:x-small; ">Psychological factors: I'll just mention a few things that psychological research has done that makes my view of irrational exuberance more plausible. One is something that psychologists call "anchoring," which refers to people's tendency, when forced, to make ambiguous judgments. People anchor their answers to something, anything.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">Let me tell you about a famous experiment that the psychologists Daniel Kahneman and Amos Tversky did. They asked people to answer difficult questions, such as "What percent of African nations belong to the United Nations?" Most people don't know that. They have no idea. But then they said, "Wait a minute, don't answer yet. We're going to spin a wheel of fortune," one of those quiz-show wheels that generate a random number from one to 100. And they said, "OK, you see this number, now tell me your answer." The people's answers were heavily influenced by the wheel of fortune, and that's because they had no idea.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">The same is true with the Dow. In making judgments about the level of stock prices, the most likely anchor is the most recently remembered price. The tendency of investors to use this anchor enforces the similarity of stock prices from one day to the next. For example, say the Dow is at 10,800. I'll believe it. I mean, it could be 4,000, it could be 20,000, and we'd all believe it, but it's not necessarily the real number of the Dow.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">Another factor is overconfidence. Psychologists have documented that there is a syndrome called inferiority complex. There are people who think that everyone else is better than they are and don't trust their own judgment. However, these people are outnumbered by the other side, the overconfident side.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">In the October 1987 crash, I was struck by one of the questions: "Did you think at any point that you knew when the market would rebound?" About 30 percent said yes. The next question was "Why did you think you knew it would rebound?" And the essay answers that I read were insipid. People weren't convincing; they said it was intuition, gut feeling or a judgment of the psychology!</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">Another thing is attention. Psychologists have reported on people's attention. Think of the errors that you've made in life and how often they're due to inattention. It's an important faculty of human intelligence that we can direct our attention appropriately, but there are limitations to it. There's also a social basis to attention and we tend to pay attention to what other people are paying attention to. There may be some evolutionary advantage to that, but it's also a limitation.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; ">So in the US, after the O.J. Simpson trial got started, it seemed like everybody was paying attention. Have you heard of O.J. Simpson? Well, Princess Diana you must have heard of, and I'll tell you that, in the US, she was on everybody's mind for quite a while. The same thing happens with regard to lots of other things, notably the stock market. Right now we're in a phase in which there is incredible public attention to the stock market, and you can hardly avoid it. I like to play a game with my wife when we're eating out at a restaurant: I keep one ear cocked for the words "stock market" and usually at one of the adjacent tables someone will talk about the stock market. So that's the situation we're in now.</span><br> <br> <span style="font-family:Verdana; font-size:x-small; font-style:italic; ">This story is taken from a public lecture given by Yale economist Robert Shiller at the London School of Economics and Political Science on June 5, 2000. Copyright The London School of Economics and Political Science.</span></p> </td> </tr> </tbody></table> </body></html>