Irrational Exuberance (Revised and Expanded Third Edition)
392
Irrational Exuberance (Revised and Expanded Third Edition)
392eBookRevised and Expanded Third (Revised and Expanded Third)
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Overview
Why the irrational exuberance of investors hasn't disappeared since the financial crisis
In this revised, updated, and expanded edition of his New York Times bestseller, Nobel Prize–winning economist Robert Shiller, who warned of both the tech and housing bubbles, cautions that signs of irrational exuberance among investors have only increased since the 2008–9 financial crisis. With high stock and bond prices and the rising cost of housing, the post-subprime boom may well turn out to be another illustration of Shiller's influential argument that psychologically driven volatility is an inherent characteristic of all asset markets. In other words, Irrational Exuberance is as relevant as ever. Previous editions covered the stock and housing markets—and famously predicted their crashes. This edition expands its coverage to include the bond market, so that the book now addresses all of the major investment markets. It also includes updated data throughout, as well as Shiller's 2013 Nobel Prize lecture, which places the book in broader context. In addition to diagnosing the causes of asset bubbles, Irrational Exuberance recommends urgent policy changes to lessen their likelihood and severity—and suggests ways that individuals can decrease their risk before the next bubble bursts. No one whose future depends on a retirement account, a house, or other investments can afford not to read this book.
Product Details
| ISBN-13: | 9781400865536 |
|---|---|
| Publisher: | Princeton University Press |
| Publication date: | 01/25/2015 |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Pages: | 392 |
| Sales rank: | 312,101 |
| File size: | 4 MB |
About the Author
Read an Excerpt
Irrational Exuberance
By Robert J. Shiller
PRINCETON UNIVERSITY PRESS
Copyright © 2015 Robert J. ShillerAll rights reserved.
ISBN: 978-1-4008-6553-6
CHAPTER 1
The Stock Market in Historical Perspective
When Alan Greenspan, then Chair of the Federal Reserve Board, used the term irrational exuberance to describe the behavior of stock market investors, the world fixated on those words. He spoke at a black-tie dinner in Washington, D.C., on December 5, 1996, and the televised speech was followed the world over. As soon as he uttered these words, stock markets dropped precipitously. In Japan, the Nikkei index dropped 3.2%; in Hong Kong, the Hang Seng dropped 2.9%; and in Germany, the DAX dropped 4%. In London, the FTSE 100 was down 4% at one point during the day, and in the United States, the next morning, the Dow Jones Industrial Average was down 2.3% near the beginning of trading. The sharp reaction of the markets all over the world to those two words in the middle of a staid and unremarkable speech seemed absurd. This event made for an amusing story about the craziness of markets, a story that was told for a time around the world.
The amusing story was forgotten as time went by, but not the words irrational exuberance, which were referred to again and again. Greenspan did not coin the phrase irrational exuberance, but he did cause it to be attached to a view about the instability of speculative markets. The chain of stock market events caused by his uttering these words made the words seem descriptive of essential reality. Gradually they became Greenspan's most famous quote—a catch phrase for everyone who follows the market.
Why do people still refer so much to irrational exuberance years later? I believe that the words have become a useful name for the kind of social phenomenon that perceptive people saw with their own eyes happening in the 1990s, and that in fact, it appears, has happened again and again in history, when markets have been bid up to unusually high and unsustainable levels under the influence of market psychology.
Many perceptive people were remarking, as the great surge in the stock market of the 1990s continued, that there was something palpably irrational in the air, and yet the nature of the irrationality was subtle. There was not the kind of investor euphoria or madness described by some storytellers, who chronicled earlier speculative excesses like the stock market boom of the 1920s. Perhaps those storytellers were embellishing the story. Irrational exuberance is not that crazy. The once-popular terms speculative mania or speculative orgy seemed too strong to describe what we were going through in the 1990s. It was more like the kind of bad judgment we all remember having made at some point in our lives when our enthusiasm got the best of us. Irrational exuberance seems a very descriptive term for what happens in markets when they get out of line.
Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, and, in the process, amplifies stories that might justify the price increase and brings in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others' successes and partly through a gambler's excitement. We will explore the various elements of this definition of a bubble throughout this book.
Greenspan's "irrational exuberance" speech in 1996 came during the biggest historical example to date of a speculative upsurge in the U.S. stock market. The Dow Jones Industrial Average (from here on, the Dow for short) stood at around 3,600 in early 1994. By March 1999, it passed 10,000 for the first time. The Dow peaked at 11,722.98 in January 14, 2000, just two weeks after the start of the new millennium. The market had tripled in five years. Other stock price indices peaked a couple of months later. The real (inflation-corrected) Dow did not reach this level again until 2014, and, as of this writing, the real Standard & Poor's 500 index has still not quite returned to its 2000 level. It is curious that this peak of the Dow (as well as other indices) occurred in close proximity to the end of the celebration of the new millennium—it was as if the celebration itself was part of what had propelled the market, and the hangover afterward had brought it back down.
Figure 1.1 shows the monthly real (corrected for inflation using the Consumer Price Index) Standard and Poor's (S&P) Composite Stock Price Index, a more comprehensive index of stock market prices than the Dow, based, since 1957, on 500 stocks rather than just the 30 stocks that are used to compute the Dow. Inflation correction was used here because the overall level of prices has been very unstable over parts of this period (the government printed a lot of money, which pushed all prices up) so that the uncorrected numbers would give a misleading impression of the real increase in the stock market. The stock prices are shown from 1871 through 2014 (upper curve), along with the total earnings (corporate profits per share) that the corporations that comprise the index made in doing their businesses (lower curve) for the same years.
This stock market chart is unusual: most long-term plots of stock prices are not this long term, and most are done in nominal terms, without inflation correction. On this chart, the magnitude of the boom beginning in 1982 and peaking in 2000 stands out especially well. It is a unique event in history.
The 2000 Millennium Boom peak in world stock prices was followed by the Ownership-Society Boom, 2003–7, which I have named after a slogan used by George Bush in his 2004 presidential campaign. This peak was followed by the world financial crisis in 2008–9. Starting in 2009, after the crisis lessened, there was another major upswing in world stock markets, which I will call the New-Normal Boom, after a phrase popularized by Bill Gross, then of PIMCO, in 2009. The news media have shown a tendency since 2000 to dramatize the "new records" set in stock markets in 2007 and 2014. But, in fact, these post-2000 booms were not record setting. The biggest-ever upswing in the real (inflation-corrected) U.S. stock market was from July 1982 to August 2000, when the market went up 7.7-fold, dwarfing the 5.2-fold upswing from December 1920 to September 1929, and also dwarfing the 5.1-fold upswing from June 1949 to December 1968. The upswings from 2003 to 2007 (1.5-fold) and from 2009 to 2014 (2.3-fold) are mild by comparison. For the purpose of understanding irrational exuberance, I will emphasize the 1982–2000 Millennium Boom, particularly its later years, when this exuberance became most palpable.
The stock market increase from 1994 (when the real stock market had already more than doubled since 1982) to 2000 could not obviously be justified in any reasonable terms. Basic economic indicators did not come close to tripling. Over the same interval, U.S. gross domestic product rose less than 40%, and corporate profits rose less than 60%, and that from a temporary recession-depressed base. Viewed in the light of these figures, the stock price increase appears unwarranted.
Large stock price increases occurred in many countries at around the same time, and the peaks in the stock markets were often roughly simultaneous in many countries in early 2000. Figure 1.2 shows the paths of stock prices for ten countries and for the world as a whole from 1995 to 2014. As can be seen from Figure 1.2, between 1995 and 2000 the real stock market valuations of Brazil, France, China, and Germany roughly tripled, while that of the United Kingdom roughly doubled. In 1999, the year before the peak, real stock price increases averaged 58% over the ten countries shown in Figure 1.2. The prices of all countries went up sharply in 1999; in fact, the smallest increase, occurring in the United Kingdom, was still an impressive 16%. Stock markets in Asia (Hong Kong, Indonesia, Japan, Malaysia, Singapore, and South Korea) and Latin America (Chile and Mexico) also made astounding gains in 1999. It was a truly spectacular worldwide stock market boom.
The end of the 2000 boom brought stock markets down across much of the world by 2003, as can be seen in Figure 1.2. Once again, the next boom, peaking in late 2007 or early 2008, had huge impacts over much of the world. After that, the world slipped into the most serious recession since the Great Depression of the 1930s, economic growth rates faltered, and the post-bubble weakness of the world economy continued for years after. Despite the weak- ness of the world economy, the third stock market boom that began around 2009 affected many countries.
Looking back to Figure 1.1, which shows a longer history for the S&P Index, we can see how differently the market behaved up to 2000 compared with the long past. The spiking of prices in the years 1982 through 2000 was most remarkable: the price index looks like a rocket taking off through the top of the chart, only to sputter and crash. This—the largest stock market boom ever—may be referred to as the Millennium Boom or, now that it is over, the Millennium Bubble.
The boom and crash in the stock market in the years after 1994 are clearly related to the behavior of earnings. As can be seen in Figure 1.1, S&P Composite earnings grew very fast in the late 1990s before they crashed after 2000, rose again until 2007, utterly crashed in 2009, and then rose with the market. Earnings seem to have been oscillating around a slow, steady growth path that has persisted for over a century.
Inspection of Figure 1.1 should make it clear that nothing like the Millennium Boom had ever happened before in the entire stock market history since 1871. There was of course the famous stock run-up of the 1920s, culminating in the 1929 crash. Figure 1.1 reveals this boom as a cusp-shaped price pattern for those years. If one corrects for the market's smaller scale then, one recognizes that this episode in the 1920s does somewhat resemble the recent stock market increase, but it is the only historical episode that comes even close to being comparable.
Price Relative to Earnings
Figure 1.3 shows the cyclically adjusted price-earnings ratio (CAPE), that is, the real (inflation-corrected) S&P Composite Index divided by the ten-year moving average of real earnings on the index. The points shown reflect monthly data from January 1881 to June 2014. The price-earnings ratio is a measure of how expensive the market is relative to an objective measure of the ability of corporations to earn profits. John Campbell and I originally defined CAPE using the ten-year average, along lines proposed by Benjamin Graham and David Dodd in 1934.
The ten-year average smooths out such events as the temporary burst of earnings during World War I, the temporary decline in earnings during World War II, and the frequent boosts and declines that we see due to the business cycle. Note again that there was an enormous spike after 1997, when the ratio rose until it hit 47.2 intraday on March 24, 2000. Price-earnings ratios by this measure had never been so high. The closest parallel was September 1929, when the ratio hit 32.6.
In 2000 earnings were quite high in comparison with the Graham and Dodd measure of long-run earnings, but nothing here was startlingly out of the ordinary. What was extraordinary in 2000 was the behavior of price (as also seen in Figure 1.1), not earnings.
Part of the explanation for the remarkable price behavior between 1990 and 2000 may have to do with the unusual behavior of corporations' profits as reflected in their earnings reports. Many observers remarked then that earnings growth in the five-year period ending in 1997 was extraordinary: real S&P Composite earnings more than doubled over this interval, and such a rapid five-year growth of real earnings had not occurred for nearly half a century. But 1992 marked the end of a recession during which earnings were temporarily depressed. Similar increases in earnings growth following periods of depressed earnings from recession or depression have happened before. In fact, there was more than a quadrupling of real earnings from 1921 to 1926 as the economy emerged from the severe recession of 1921 into the prosperous Roaring Twenties. Real earnings doubled during the five-year periods following the depression of the 1890s, the Great Depression of the 1930s, and World War II.
It was tempting for observers in 2000, at the peak of the market, to extrapolate this earnings growth and to believe that some fundamental changes in the economy had produced a new higher growth trend in earnings. Certainly, expansive talk about the new millennium at the time encouraged such a story. But it would have been more reasonable, judging from the cyclical behavior of earnings throughout history, to predict a reversal of such earnings growth.
The bust in corporate profits between 2000 and 2001, the biggest drop in profits in percentage terms since 1920–21, is certainly part of the story about the drop in the market. This drop certainly diminished support for the notion that the new high-tech economy was infallible. But there is a question of how to interpret the drop in earnings. As we shall discuss in Chapter 5, the drop in earnings could be seen in many dimensions, and in part, as just an indirect consequence of the changes in investor psychology that produced the decline in the market. Part of the crash in earnings after 2000 was also just a technical accounting reaction to the stock price decline, since companies were required by accounting rules to deduct from earnings the impairment in value of some of their stock market holdings, holdings that were far reduced in value after the crash in the stock market.
Other Periods of High Price Relative to Earnings
There have been three earlier times when the price-earnings ratio as shown in Figure 1.3 attained high values, though never as high as the 2000 value. The first time was in June 1901, when the price-earnings ratio reached a high of 25.2. This might be called the "Twentieth Century Peak," since it came around the time of the celebration of the new century. (The advent of the twentieth century was celebrated on January 1, 1901, not January 1, 1900.) This peak occurred as the aftermath of a doubling of real earnings within five years, following the U.S. economy's emergence from the depression of the 1890s. The 1901 peak in the price-earnings ratio occurred after a sudden spike in the ratio, which took place between July 1900 and June 1901, an increase of 43% in eleven months. A turn-of-the-century optimism appeared—associated with expansive talk about a prosperous and high-tech future.
After 1901, there was no pronounced immediate downtrend in real prices, but for the next decade, prices bounced around or just below the 1901 level and then fell. By June 1920, the stock market had lost 67% of its June 1901 real value. The average real return in the stock market (including dividends) was 3.4% a year in the five years following June 1901, barely above the real interest rate. The average real return (including dividends) was 4.4% a year in the ten years following June 1901, 3.1% a year in the fifteen years following June 1901, and -0.2% a year in the twenty years following June 1901. These returns are lower than we generally expect from the stock market, though had one held on into the 1920s, returns would have improved dramatically.
The second instance of a high price-earnings ratio occurred in September 1929, the high point of the market in the 1920s and the second-highest ratio of all time. After the spectacular bull market of the 1920s, the ratio attained a value of 32.6. As we all know, the market tumbled from this high, with a real drop in the S&P Index of 80.6% by June 1932. The decline in real value was profound and long-lasting. The real S&P Composite Index did not return to its September 1929 value until December 1958. The average real return in the stock market (including dividends) was -13.1% a year for the five years following September 1929, -1.4% a year for the next ten years, -0.5% a year for the next fifteen years, and 0.4% a year for the next twenty years.
(Continues...)
Excerpted from Irrational Exuberance by Robert J. Shiller. Copyright © 2015 Robert J. Shiller. Excerpted by permission of PRINCETON UNIVERSITY PRESS.
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Table of Contents
List of Figures and Tables ixPreface to the Third Edition xi
Preface to the Second Edition, 2005 xix
Preface to the First Edition, 2000 xxv
Acknowledgments xxxi
1 The Stock Market in Historical Perspective 1
2 The Bond Market in Historical Perspective 11
3 The Real Estate Market in Historical Perspective 18
Part 1 Structural Factors
4 Precipitating Factors: The Internet, the Capitalist Explosion, and Other Events 39
5 Amplification Mechanisms: Naturally Occurring Ponzi Processes 70
Part 2 Cultural Factors
6 The News Media 101
7 New Era Economic Thinking 123
8 New Eras and Bubbles around the World 150
Part 3 Psychological Factors
9 Psychological Anchors for the Market 165
10 Herd Behavior and Epidemics 175
Part 4 Attempts to Rationalize Exuberance
11 Efficient Markets, Random Walks, and Bubbles 195
12 Investor Learning—and Unlearning 214
Part 5 A Call to Action
13 Speculative Volatility in a Free Society 225
Appendix Nobel Prize Lecture: Speculative Asset Prices 239
Notes 281
References 321
Index 339
What People are Saying About This
This is an excellent book by a distinguished scholar. It raises an issue of the utmost importance for the U.S. economy and presents a persuasive case that the U.S. stock market may be significantly overvalued. It is well written for a popular as well as a professional readership.
While Irrational Exuberance may overstate the extent of "overpricing"
and predictability in the market, it presents a message investors would be wise to heed: Make
sure your portfolio is adequately diversified. Save more and don't count on the
double-digit gains of the past decades continuing to bail you out during retirement. Mr. Shiller's
book offers a dose of realism -- particularly if you have been reading books like "Dow 36,000,"
"Dow 40,000" and "Dow 100,000" -- that serious investors will ignore at their peril."
—Burton G. Malkiel, author of Random Walk Down Wall Street, in a review for the Wall Street Journal, April 4, 2000
Interviews
Author Essay
Connecting the Booms: The Stock Market Boom and the Baby Boom
A prominent theory for the remarkable boom in US and European stock markets is that it is connected to another boom: the famous "baby-boom." After World War II, the birth rate in the US increased sharply. Then, after the mid 1960s or so, the US birth rate dropped dramatically. Although in Europe the increase in birth rates after the War was not so strong or consistent as in the US, the decline afterwards was just as dramatic, and so we might say that the baby boom is a factor in Europe too. As a consequence of this baby boom, there is a high proportion of middle-aged people today, as a fraction of the population.
By this baby boom theory, the boomers, who are now middle-aged, are affecting the stock market and the economy in such a way as to lift the market. The idea of explaining the stock market boom in terms of such demographics is inherently attractive. Demographics are fundamental; they are a potentially powerful force that affects everyone.
But, this theory of the stock market boom has never been properly worked out. While there are a number of popular books advancing such a theory, there are no more than a handful of research studies on the relation between these two booms, none really authoritative. It may seem surprising that more time and energy is not going into understanding such deep demographic forces, but perhaps the reason is that our understanding of the forces that shape speculative markets is so rudimentary that it is difficult to be systematic.
One theory that is offered why the baby boom should lift the market is that the boomers are now in their peak earnings years, when they are most skilled and effective and still energetic, and so should bring on a great period of economic growth. But, there has not been striking economic growth in recent years in the US or Europe, no sudden increase that would seem to justify a four-fold increase in real inflation-corrected stock prices since 1988. In this connection, it is worth recalling that in the 1950s -- when the boomers really were babies -- the baby boom was thought to be a reason for the rising stock market of that time. The large number of babies meant that parents had to work very hard to provide homes and schools for them, thereby stimulating the economy to rapid growth. If we followed that theory forward in time to today, it would suggest that today, with fewer children to support, people would be taking it easy and thus we would expect low growth now, hardly suggesting a stock market boom.
Another theory why the baby boom should lift the market is that the boomers are now approaching retirement, and therefore are desirous of saving for retirement, and in their zeal to save for retirement, bid stock prices up. There may indeed be some truth to this theory, but it does not explain why the level of the stock market has gone up so much relative to that of other savings vehicles, such as bonds or real estate. If demographically induced demand alone explained asset pricing, then there would have to be a boom in the price of all assets together.
Yet another theory why the baby boom should lift the market is that the boomers, in their most confident earnings years, are just not scared by the risks inherent in stock market investing. Because they are less risk averse, they demand stocks more, and bid up their prices. But, on the other hand, one would think that it is the youngest people, not the middle-aged people, who are least risk averse, and it is the youngest people who are relatively in short supply.
None of these theories seems to have any ability to explain the sudden and sharp increases in real stock prices in the last five years. The decline in the birth rate occurred for the most part over twenty-five years ago, and patterns have been steady since then.
Any of these theories, if true, would seem to imply that the stock market will decline in coming years when the numerous middle-aged people of today finally retire and try to sell their stocks to support themselves in retirement. There will be relatively few young people to sell them to, and therefore it would seem that the stock market should crash then. Possibly this will happen. But, if this is going to happen, one wonders how the baby boom explains the current stock market boom, since markets should ideally anticipate future drops and thus be low, not high, today.
There are other factors that might offset the baby-bust effect in coming years. If the rapid growth of the less developed countries continues, we might hope that demand from them for our stocks will materialize then to support the markets. Moreover, if there is substantial domestic economic growth, then, the frugal subset of the population who have accumulated a lot of wealth in the form of stocks may not really spend much of it down when they retire; there is a good chance they will instead leave most of it to heirs.
As this list of alternative factors affecting the impact of demographics on the stock market suggests, there are lots of hard-to-quantify issues that have to be considered when judging the long-run outlook for the markets. There is fundamental uncertainty about these factors.
Another of these factors is public perception of the baby boom itself. Popular advice books about the stock market often feature the baby boom as a reason to expect the market to increase for awhile. For example, in a series of bestselling books starting in 1992, such as the recent The Roaring 2000s, Harry S. Dent Jr. predicts that, because of the baby boom effects, the Dow will rise, to above 21,500 by 2009, and then will fall. Public belief in such a story appears thus to be part of the impulse behind the current stock market boom.
It is ultimately public perceptions that determine the demand for stocks, and these perceptions are only tenuously related to fundamental economic facts such as demographic trends.
(Robert J. Shiller)
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