April 3, 2000
He's Not Just a Bear -- He's a Grizzly
By William Wolman, Chief Economist
Faud no, hype yes: The U.S. stock market, in an ascending orbit for the past two decades, is headed for a black hole. That is the conclusion of Irrational Exuberance, a dazzling, richly textured, provocative, and possibly wrongheaded new book by Yale University economist Robert J. Shiller. It is by far the most important book about the stock market since Jeremy J. Siegel's 1994 Stocks for the Long Run, offering a cogent statement of the bears' view of events to come.
The market's fate, says Shiller, is sealed by history. The current orbit is by far the most spectacular ever seen, but in the century since the end of the Civil War, it has been preceded by three similar periods of levitating stock prices: one ending in 1901, one in 1929, and one in 1966 (chart). What scares Shiller is not so much the probability of a short-term crash. Rather, it is the possibility that such a crash will be followed by a prolonged grind. In the 20 years following the 1901 peak, the real return to stocks, including dividends, was -0.2%. It was 0.4% a year for the 20 years following 1929, and 1.9% for the 20 years following 1966. These numbers are all way below the real return that Siegel calculated at 7% over the entire history of the stock market dating back to 1802. And they are obviously way below what the average investor expects today: 12%, according to a BUSINESS WEEK survey that was conducted in December.
Levitating stock prices result from a blend of economics and psychology. In the early stages of the takeoff, rising prices are based on a genuinely good economic story: There were major technological breakthroughs in the late 19th century, the 1920s, and in the current period. The stock market boom of the early 1960s, says Shiller, was based on the adoption of a "new economics" in the Kennedy years that demonstrated that government policy could simultaneously stimulate the economy, tame inflation, and moderate the business cycle. Good markets, as even skeptic John Kenneth Galbraith pointed out in his book The Great Crash 1929, begin with an "irreducible element of fact."
But then comes the trouble with prosperity: Economic fact gives way to psychological fantasy. Analyzing the causes and consequences of this kind of delusion is the consuming passion of Shiller's book.
The culprits in what Shiller regards as the ridiculous overvaluation of the current market are not primarily Wall Street hype merchants. Rather, they are the believers in the New Economy, the media, finance professors in the nation's leading business schools, and, strangely enough, Dr. Irrational Exuberance himself, Federal Reserve Chairman Alan Greenspan.
Together, says Shiller, they act like an informational daisy chain, an "amplification mechanism." They turn what is unquestionably a good story -- high productivity and corporate earnings -- into a tale featuring soaring price-earnings ratios and ever-higher stock prices that are simply too good to be true.
The villains in Shiller's account have emerged as new Ponzis. Unlike the original improper Bostonian, Charles, the new Ponzis do not practice fraud. Rather, he says, they promote the belief that it is always safe to buy stocks, not because of any intrinsic value they might have, or, God forbid, because of the dividends they may pay, but because they can always be sold to someone else at a higher price. This is a potent message in a country where stock ownership is expanding to the point where it now involves a majority of American families.
The media play a crucial role in Shiller's book. Journalists, he says, may "present themselves as detached observers of market events," but "they are themselves an integral part of these events." The author's research shows that the history of speculative bubbles begins roughly with the advent of newspapers, which he says helped to create the first bubble of any consequence, the Dutch tulipmania of the 1630s.
The chattering goes on to the present day. What Shiller calls natural Ponzi schemes can occur, he says, "only if there is similar thinking among large groups of people" -- and the news media, "essential vehicles for the spread of ideas," help effect this. The press, as Shiller recognizes, loves the stock market because it is a story that can be reported every minute on TV and every day in the papers, much like a sports story. Cisco Systems, Intel, and Microsoft are like the Yankees, the Lakers and the Tennessee Titans -- except that stock market companies are on everybody's home team. So there is a spread tendency to cheer them on.
This reviewer has been called many things during his life -- but never an44 amplification mechanism" or a "natural Ponzi," at least not BS (before Shiller). Yet it appears that, as an editor of BUSINESS WEEK, I am both. Shiller correctly credits this magazine with discovering and delineating the New Economy of the 1980s and '90s and its huge effect on productivity growth. (The term appeared in BUSINESS WEEK as early as 1981. He does not say, however, that the magazine has consistently warned that the New Economy does not guarantee prosperity (Cover Story, Mar. 31, 1997). The new Economy is, on the contrary, likely to give rise to a new business cycle caused by swings in the rate at which business invests in new technology.
By itself, of Course, BUSINESS WEEK is not powerful enough to bring about a Ponzian saving in the psychology of the market -- that required an assist from Greenspan, the subject of a July 14, l997, cover story that ran only seven months after Greenspan made his now-legendary remarks about the stock market's "irrational exuberance." "The term new economy," says Shiller, "did not have any currency" until the magazine attributed it to Greenspan, "marking an alleged turning point in his thinking" about the New Economy. That terminology, the author adds, "has been in regular use ever since." The effect, of course, was to suggest that Greenspan subscribed to the optimistic view of the New Economy, allaying fears that the Fed would act decisively to rein in the market. Such notions persist to this day, frustrating the Fed chairman's recurring efforts to put a lid on investor zeal.
Shiller's final amplifier is the coterie of finance professors who subscribe to the theory of efficient markets. Their mantra is that a stock market can never be overvalued or undervalued because prices rationally incorporate all the publicly known facts at all times. The notion of an infinitely wise market appeals because it makes market bubbles based on overly optimistic expectations impossible. Much recent academic research has served to undermine efficient-market theory, along with its corollary that no one can ever predict the markets direction. But the theory continues to be enormously influential in academe as professors gleefully observe one Wall Street guru after another fail in their attempts at soothsaying.
For the long-term investor, the crucial question is whether Shiller is right in forecasting a long period of stagnation or decline in stock prices. And in the end, as Shiller recognizes, that depend -- heavily on whether the New Economy has unprecedented potential for productivity growth. It just may be that the Information Revolution is so profoundly different from what has gone before that it will continue to produce super gains in productivity and profit. Some top-flight analysts, including BUSINESS WEEK economics editor Michael J. Mandel, have argued that the information economy benefits from increasing returns to scale in a way that earlier technological revolutions did not.
Shiller is not merely a bear -- he is a grizzly. He says he cannot foresee the date, but a grim decade of stagnation will come sooner rather than later. His investment advice: Place your faith in bonds, particularly the U.S. Treasury's new inflation-indexed bonds that guarantee a real rate of return of 4%. Fight hard against the political movement to privatize social security. And hunker down.