Let’s Get Rational
Yale Economist Campaigns for Stock Market Prudence

In his new book Irrational Exuberance, economist Robert J. Shiller analyzes today’s soaring U.S. stock market and the factors he says could cause its eventual downturn.

By Roland Jones, ABCNEWS.com from TheStreet.com

April 27,2000— Most major historical events, from wars through revolutions, do not have simple causes. And the same rings true for the state of the current stock market. That’s the premise of a scathing new book by Yale University economist Robert J. Shiller.

Shiller, in Irrational Exuberance — borrowing the 1996 phrase of Federal Reserve Chairman Alan Greenspan that rocked the stock market — analyzes today’s soaring U.S. stock market and the factors that could cause its eventual downturn.

Overconfident Investors

“Rome wasn’t built in a day, nor was it destroyed by one sudden bolt of bad fortune,” Shiller muses. Instead, it grew and fell because of a plurality of factors, some large and some small, some remote and some immediate, but all conspiring together toward the end result.
     Like the fall of Rome, a number of disparate factors have driven up the price of stocks to giddy heights over the last two decades, he writes. These factors, as diverse as the fall of communism and the development of the Internet, have encouraged swelling investor confidence, and could ultimately lead to a drop in the market.
     In Shiller’s view, an “irrational exuberance” has in turn caused a “speculative bubble” that is highly likely to burst. Indeed, despite the market’s recent volatility, confidence in its future growth is still absurdly strong, he suggests.
     In truth, the forecast for the stock market is likely to be rather poor, he adds: “Perhaps even dangerous.”

No ‘New Era’

Shiller appears to have done his homework, including his own examinations of investor confidence. One straw poll, for instance, assesses the percentage of people who thought that the Dow would increase in 1999 (nearly three times the percentage that thought it would decrease). That’s far more than the two-to-one increase-to-decrease ratio he found in 1996.
     Indeed, for Shiller the present economic danger lies in the prevailing idea that the U.S. economy is moving into a “new era,” making it impervious to stumbling blocks. Bearish to a fault, Shiller aims to dispel this belief by comparing the current market to other times of great optimism in U.S. economic history.
     His focus is not on the history of economics or the intricacies of the stock market, but other drivers: history, economics, and more contentiously, psychology and sociology. He examines lessons learned about the current market upswing from these disciplines in an attempt to explain how speculative bubbles come about, and how they sustain themselves.
     “Much of the evidence is drawn from the emerging field of behavioral finance, which, as the years go by, is looking less like a minor subfield of finance and more and more like a central pillar of serious financial theory,” Shiller writes.

Cultural Factors

Shiller examines a range of cultural factors as well, most particularly what he characterizes as Wall Street’s propaganda merchants — journalists, analysts and legislators — who circulate the idea that we are entering that “new era” of economic prosperity he seeks to discount.
     The author also presents evidence that psychological anchors and herd behavior further inflate the speculative bubble, and takes aim at academics and popular thinkers who put forward research to show that the market has “learned” how to become efficient.
     “Some of this so-called research often seems no more rigorous than reading the tea leaves,” writes Shiller. “Arguments that the Dow is going to 36,000 or 40,000 or 100,000 hardly inspire trust.”

Examining Exuberance

Shiller does offer some ideas for policy changes and ways investors can minimize their exposure to the consequences of a burst bubble. For him, a re-examination of government policies toward the stock market is of uppermost importance.
     “How we value the stock market now and in the future influences major economic and social policy decisions that affect not only investors but also society at large, even the world,” writes Shiller. “If we exaggerate the present and future value of the stock market, then as a society we may invest too much in business startups and expansions, and too little in infrastructure, education, and other forms of human capital.”
     His arguments are, for the most part, solid. But at times they seem to stand on shaky ground. For example, Shiller attributes the rise in stock market speculation to the growth in the number of U.S. state lotteries, which have grown from 13 in 1975 to 37 in 1999.
     But given that this work is more concerned with building a portrait of how investors have become more irrationally exuberant, and not with building an economic argument, Shiller can be forgiven for not bombarding us with numbers and statistics.
     “I have therefore tried in this book to present a much broader range of information than is usually considered in writings on the market,” writes Shiller, “and I have tried to synthesize this information into a detailed picture of the market today.”
     In that endeavor, he has certainly succeeded.