The Boston Globe
BUSINESS
Money Matters/Economic Principals

THE WARNING

By David Warsh

If anyone can be said to speak for the accumulated learning of technical economics on the subject of today's stock market, it is probably Robert J. Shiller. He is centrally located in the profession: trained at Massachusetts Institute of Technology, professor at Yale University, a deacon of the famous Cowles Foundation for research in economics. He is distinguished: In 1996 his "Market Volatility and Macro Markets" won the first Paul Samuelson Award for the year's best writing on finance. He is practical, a partner in the prosperous firm of Case Shiller Weiss Inc., which sells market data to the real estate industry. He's still young enough, 53, that when he makes a prediction his reputation is at stake.

Most significant, he is self-aware. Shiller operates in the shadow of what surely is the most famous prediction by an economist in the 20th century. It was in October 1929 that Yale's Irving Fisher - the best-known economist of his day - pronounced that stocks had reached a new and permanently high plateau.   That he lost a considerable personal fortune in the ensuing crash only buttressed Fisher's place in history as a symbol of the shortcomings of economists. Yale had to buy his house to save him from eviction. The very real contributions Fisher had made to deepening economic understanding were overlooked for the rest of his lifetime.

Thus it is an event of some significance that Shiller has written a crystal-clear and tough-minded critique of the factors that have driven US stock markets to their current levels and called his book "Irrational Exuberance." In it, he argues that Federal Reserve chairman Alan Greenspan had it exactly right when he uttered the famous phrase in a speech in 1996.

The current high levels of the market don't represent a consensus judgment by a cadre of sober experts, says Shiller. Instead, today's market is sky high because of wishful thinking by millions of people, egged on by professionals in and around Wall Street whose incentives all run in the direction of the more the merrier.

The speculative frenzy is comparable to periods during which the stock prices peaked (measured in terms of price-to-earnings ratios) in 1901, 1929, and 1966, says Shiller. It simply is not likely to last. And though he is careful not to say when he expects the fever to break, he is clear that he expects it to happen within the next few years.

"There is a lack of sobriety about its downside and the consequences that would ensue" if the Dow Jones insustrial average dropped to, say, 6000 and stayed there for some years, he writes. The harmful effects would be enormous - to individuals, pension funds, college endowments, and charitable organizations.

The Dow Jones average tripled between 1994 and 1999. Nothing else in the economy tripled during those years. So Shiller surveys a dozen factors he says have contributed to the self-fulfilling psychology of the bull market in stocks. Taken together, he says, they comprise the "skin" of the bubble.

The arrival of Internet technology at a time when corporate earnings already were high has given rise to an exaggerated sense of technical change.

The decline of foreign rivals and the resultant surge of American triumphalism has given rise to a pattern in which all news is viewed as good news.

Cultural changes favoring business, trends in the compensation of executives in particular, have fastened ever-greater attention to market capitalization.

A Republican Congress, having made capital gains tax cuts in 1997, has intimated the possibility of further cuts, leading investors to hold on to appreciated assets they otherwise might have sold.

The sheer size of the baby boom generation is widely believed to have a salutary effect on the market (though its likely ultimate effect may be a mixed bag).

An expansion in media reporting of business news, including sports page-style coverage of market ups and downs, has stimulated increased demand for stocks.

Analysts' increasingly optimistic forecasts show a distinct upward bias, something like "grade inflation" in the nation's schools.

The expansion of defined contribution pension plans has dramatically increased interest in the stock market as individuals take responsibility for their own pensions.

Mutual funds have all but replaced bank accounts as a vehicle for savings.

The decline of inflation has accentuated the distortion economists know as "money illusion" since stock prices are rarely expressed in terms of constant dollars.

The expansion of trade through the introduction of discount brokers, day trading, and round-the-clock trading possibilities has lowered the cost of trading and contributed to the near-doubling of the turnover rate since 1982.

The advent of widespread new opporunities for gambling -- everything from riverboat and Indian reservation casinos to off-track betting, video poker, and all manner of Internet games -- has fostered a get-rich-quick mentality.

Shiller's book is a fascinating tour of insights gleaned from anthropology, sociology, psychology, and other skeins that recently have been joined to form the field known as behavior finance. (Shiller is co-director with Richard Thaler of the University of Chicago of a pioneering project in the field sponsored by the Russell Sage Foundation.) He is downright withering when describing the breathless business coverage and the proliferation of various "new era" scenarios - key factors in the propagation of bubble-thought.

To the reason most often ventured by serious economists for a plausible change in the investing regime -- the rise of an ever-broader global market -- Shiller's answer is that considerations of fairness and resentment may give rise to corporate and governmental strategies abroad that undercut American dominance.

Suppose you accept Shiller's analysis. What should investors do now? Lighten up on stocks, of course - rigorous diversification is always a good idea. But we can't all get out of the market, he rightly observes. And those who have bought at market highs have already made their mistake. So the best step individuals can take would be to increase their personal savings rate -- as much as an additional 10 percent of pretax income maintained for a number of years.

Shiller acknowledges in his book that he runs a substantial risk of embarrassment by arguing that stock market returns will be low or negative in coming years. Still, he argues, it seems to have been quite possible to tell when returns were inappropriately high or low during earlier bubbles and subsequent busts.

Thus, he continues, "An observer who remains silent about unjustified high values because he or she could be wrong about the outlook is no better than a doctor who, having diagnosed high blood pressure in a patient, says nothing because the patient might be lucky and show no ill effects." Shiller's book might be wrong -- but it has no peer as a differential diagnosis of today's stock market.

Besides, even doctors who send their patients away with good news ringing in their ears may sometimes change their minds -- after the stroke has occurred. Irving Fisher, it should be remembered, modified his views as the Great Depression deepened. In 1932 he characterized the problem as an innovation-led boom that got out of hand, culminating in a recession, aggravated by poor monetary policy and heavy debt burdens into a depression -- an analysis that stands up quite well today.