March 24, 2000

Leap of Faith
How much longer before the stock market takes a plunge?

     by Robert Samuelson

Alan Greenspan faces long odds in trying to nudge the stock market to where he'd like it to go. The chairman of the Federal Reserve has argued that the buoyant market -- by making Americans feel so much wealthier -- has triggered a consumer spending spree that threatens inflationary wage pressures. To avoid that, Greenspan's Fed has been raising short-term interest rates. Tuesday, it increased the so-called Fed Funds rate to 6 percent. This was the fifth increase since June 1999, when it was 4.75 percent.

The idea is to dampen spending and the ravenous appetite for stocks. Anyone who thinks this will be easy should read "Irrational Exuberance," a new book by Yale University economist Robert Shiller. Beyond arguing that the present market is a "speculative bubble," Shiller contends that investor psychology is so given to herd behavior that it's almost impossible to manipulate or even influence. The market can "go through significant mispricing lasting years or even decades."

We know this from history. In the 1920s, stocks more than tripled. By 1929, they were highly overvalued; the economy was about to collapse. After World War II, the market barely budged for rive years, because people believed that the Great Depression of the 1930s might recur. It didn't.

My explanation (not Shiller's) is straightforward. It comes in three parts:

First: Stock prices reflect investors' collective prediction of the future -- future profits, business cycles, technologies and political conditions. But predicting the future is difficult and usually impossible.

Second: Investors fudge it. They project the present -- and recent past -- onto the future. If things are bad, they'll tend to stay bad. If things are good, they'll tend to stay good. People often embroider these stand-pat predictions with splashy theories of how the world has permanently changed. (Today's theory is the "new economy.")

Third: The future contradicts the predictions. Sooner or later, it stops mimicking the recent past- People then realize that their assumptions are wrong, either too optimistic or too pessimistic. Stock prices rise or fail. Typically, the process is gradual. Experience -- seeing is believing -- is usually a slow teacher. Meanwhile, stock prices can remain too low or too high for years.

I disagree with Shiller that the present stock boom has "come about for no good reasons." Precisely the opposite. Its origins lie in sound economic gains: lower inflation, higher profits, better management, new technologies. But just because much of the market's advance is sensible doesn't mean some of it isn't speculative. How much? There's the question.

Greenspan won't say these days whether he thinks stock prices are too high or just right. However, he has implied that they should take a pause. This (the theory goes) would slow the rise in people's paper wealth and, thereby, mute consumer spending and inflationary pressures. The economy would continue to expand but at a slightly slower pace. The trouble is that Greenspan's rate increases may not suffice to douse investors' enthusiasm.

The crux of his problem is the inertia of opinion. People believe what they believe. It might take harsh experience to convince them otherwise. Financial panics -- when everyone runs for the door at the same time -- are dramatic. But they're the exceptions, not the rule.

As Shiller argues, the current stock boom rests on two bedrock convictions: (a) the belief that stocks always outperform other investments; and (b) the faith that, if stock prices drop, they'll quickly rebound. These strong beliefs may explain why even sharp declines in the market have so far proved temporary. People are conditioned to "buy on the dip." No one wants to be out of stocks.

It doesn't matter that the core convictions of the pre-sent stock boom are untrue, as Shiller shows. Stocks usually outperform other investments -- but not always. Prices don't always rebound. They can drop or stagnate for years. At the end of 1966, the Dow closed at 910.88; at the end of 1982, it was 884.36. People in the1960s didn't anticipate the high inflation and poor corporate management that would destabilize the economy in the 1970s. Nor do people generally heed "experts." The title of Shiller's book -- "Irrational Exuberance" -- comes from Greenspan's famous 1996 remark. The market brushed off the suggestion then that prices might be too high. Skepticism from Warren Buffet, the country's most legendary investor, has also had little effect.

So Greenspan faces two dangers. The first is that what the Fed is doing may not work. If there is a speculative frenzy, it might continue with unpredictable consequences. The second is that the Fed might push rates too high. Then the economy and market might spiral down just as they have spiraled up. Stocks drop, paper wealth vanishes, consumer spending slumps. Doesn't sound good. There's not much room for error. Greenspan is running a very delicate experiment.