May 22, 2000

The New Dr. Doom

If this economist is right, investors ultimately will be far from exuberant

By Jonathan R. Laing

For years Yale economist Robert Shiller toiled in relative obscurity as a leading light in a narrow sectarian discipline called behavioral finance. His flood of articles and two books -- Market Volatility and Macro Markets Creating Institutions for Managing Society's Largest Economic Risk -- were so loaded with stochastic equations and academic jargon as to be unintelligible to the typical lay reader.
       That all has changed, and spectacularly so, in the past several months, however. For some time, Shiller had been working on a book geared to the general public, describing the insensate rise in stock-market prices daring the late 'Nineties and what he considers the dire consequences facing stock investors over the next 10-20 years as a result of this bubble. And by the time his publisher, Princeton University Press, sent out the first review copies of the work, grandly entitled Irrational Exuberance, in early March, a nearly 20% slide in the Dow 30 industrials from their record January close above 11,700 had reviewers champing at the bit to publicize the book.
       So Princeton Press moved up the official publication date from May 7 to April 8. By then, the high-octane Nasdaq Composite was in the throes of a free fall of its own, crashing more than 30% from the 5078 level reached on March 24 to a trading low of 3227 on April 17. That helped bring public interest in the book to a fevered pitch.
       Suddenly, a work that normally might have quickly landed on the remaindered table was receiving lengthy and largely laudatory reviews from publications such as Business Week, Barron's, the New Yorker, the New York Times and the Financial Times. It has since rocketed to 14 or the New York Times bestsellers' list for hardcover non-fiction.
       Moreover, seemingly overnight, the soft-spoken, 54-year-old author became a red-hot media property. In the space of just two weeks, he appeared on CNN's Money Week, ABC's World News Tonight, PBS' News Hour and C-Span's book tour program. This was followed by a recent segment on This Week with Sam Donaldson and Cokie Roberta, with the conservative columnist George Will serving as Shiller's somewhat dyspeptic interlocutor. As always, Shiller proved an able foil, with an air of beguiling diffidence and scholarly reserve.
       Only adding to the author's gravitas was the book's clever choice of title. Long stories in both the New York Times and The Wall Street Journal picked up Shiller's claim that an ominously bearish briefing he and a colleague had given Federal Reserve Chairman Alan Greenspan back in December 1996 had resulted in Greenspan's now-famous speech two days later in which he asked whether investors' "irrational exuberance" had unduly pushed up stock prices. Equity markets around the world dropped markedly the following day, causing Shiller's psychologist wife, Ginny, to observe in the family's Christmas letter that year: "Recently, Bob has been troubled by the thought that he may have caused a worldwide stock-market slide."
       Shiller vouchsafed this piquant detail in interview's with Barron's and virtually every other publication of late. Whether a Jeremiah or a Paul Revere, Shiller does little to disabuse credulous financial writers that he is the likely source of Greenspan's spasmodic concerns over high stock prices since 1996.
       Stocks have long been a source of fascination for economists. The market provides a profusion of daily trading data available in newspapers going back many years. Even better for economists like Shiller, who are interested in observing the play of human psychology in different economic markets, stocks offer a precise seismological record of the waxing and waning of the speculative impulse.
       Most telling, perhaps, is a chart that is the centerpiece of Shiller's book. It traces the rises and falls of price-to-earnings ratios for the S&P Composite Index (now the S&P 500) over the past 120 years. Writ large in the chart is what investors have been willing to pay on an inflation-adjusted basis for a single dollar of S&P earnings over the sweep of mod-era U.S financial history. The figure has varied sharply, of course, from around five times earnings during the dark days of the 1920-21 recession and the Great Depression to the vertiginous 44.3 times reached in January 2000.
       The latest measure of speculative fervor dwarfs the previous record of 32.6 hit in September 1929 on the eve of the Crash. Likewise, today's reading makes molehills out of the 1901 peak of what was then known as the Age of Optimism and the 1966 highwater mark of the Kennedy/Johnson New Economics era.
       But it was the sad denouement of those three previous peaks in stock-price multiples that fills Shiller with such foreboding. For in the 20 years following 1901, the stock market lost 67% of its real value as stocks (even with dividends taken into account) delivered a negative return of 0.2% a year. Nor were the 20 years following the disaster of 1929 much better. By Shiller's reckoning, the Great Crash cost the S&P 80.6% of its value in real terms by January 1912. The 20-year return following 1929 averaged a paltry 0 4% per year And the 20-year average real return, following the January 1966 P/E peak of 24 1, measured a disappointing 1.9%. And that was after a powerful assist from tour years of strong bull-market lift following 1982.
       Thus, if history is any guide, as Shiller thinks it is, investors can now expect years and years of poor stock-market returns. He doesn't predict just how this nasty hand will be dealt, but it could come from a market grinding steadily lower, as in the first two decades of the 20th century, or from a gut-wrenching crash like those of 1929 and 1973-74. Or perhaps from some combination of the two.
       In any event, real returns following the three previous P/E peaks fell far short of the annual real return of around 7% or so that Wharton economist and Shiller buddy Jeremy Siegel, in his 1996 bestseller, Stocks for the Long Run, calculated U.S. stocks had generated since 1803. And these days, virtually every survey shows that investors are expecting a continuation of double-digit returns for years to come.
       Nonetheless, Shiller was somewhat coy in his forecast during a long interview in the offices of Barron's, following his appearance at the New York Society of Security Analysts across the street at the World Trade Center. "I can't predict short-term stock-market moves because market bubbles like we're experiencing can go on for a lot longer than people think," he observed. "But clearly, we're in a non-sustainable situation. It's certainly plausible to me that the Dow could be trading at the current level of 10,000-11,000 20 years from now. After all, real stock prices at the end of World War II were at about the level they were 50 years earlier. As for the S&P, which has tripled in the past five years, and the Nasdaq, which has grown sixfold in the same period, they could undo much of those gains should we experience a serious market crash"
       Of course, it's easy to discount much of what Shiller says. History never repeats itself precisely His critics never tire of pointing out that he was just as bearish in 1996, when the Dow stood around 6400. Investors who heeded him then missed out on succulent subsequent returns, especially in the Nasdaq

In addition, the unabashed euphoria evident among investors at previous market peaks may not exist today. Virtually every major financial publication has weighed in with admonitory articles about today's tech-stock mania And the very success of Shiller's book argues against its underlying thesis The irrationally exuberant don't have much truck with doom and gloom.
       Moreover, Shiller's methodology has received some knocks. Barron's Economics Beat columnist Gene Epstein pointed out in the May 3 edition that Shiller had materially bloated the level of the current P/E peak by a "skewed inflation-adjustment" factor and by using 10 years of trailing earnings as the denominator in his computation of P/E ratios. The big earnings serge of recent years thus gets submerged, shriveling the divisor used to compute the ratio. Shiller denies any attempt to supercharge the current P/E ratio, arguing that by using consistent methodology over the 120 years he examined, the chart fairly represents the entire period.
       Edward Yardeni, chief economist and global investment strategist for Deutsche Bane Securities, argues that the S&P's current P/Es, based on projected 2000 earnings, aren't at fearsome levels.
       The approximately 430 non-tech stocks in the index are selling for about 17 times this year's earnings, which isn't far from their historic average. And he claims to be able to justify the average P/E of around 40 for the S&P's 70 tech names. "The outstanding growth prospects for this group -- my conservative forecast calls for five-year annual earnings growth of about 25% -- means that the investor at these P/E levels is paying only 1.7 times the growth rate. Some might find this a little rich, but I don't think so, given technology's bright global prospects and decreasing cyclicality," he observes.
       Likewise, Yardeni contends that Shiller's depiction of today's stock market as being in the throes of a full-fledged mania is much overblown. In fact, he says, the market has shown commendable discipline by pricking investment bubbles in groups like the e-tailers and the B2B, dot.com and biotech sectors, sending their prices careening dramatically lower. "Macro-economists like Shiller tend to be so focused on the big picture that they miss the dynamics of the current business scene," says Yardeni, who also boasts a Ph.D. in economics. "This era may really be different, with the technology revolution just in its infancy."
       Other economists are more sympathetic to Shiller's views.
       Nobel Laureate Paul Samuelson was one of Shiller's dissertation advisers at MIT in the 1970s. Like his former advisee, he sees the possibility of a nasty stock-market correction, though he doesn't know when. Nor does he think current investors in high-priced technology stocks will fare as well as they anticipate. As famed economist Joseph Schumpeter theorized more than a half-century ago, technological innovation and development ultimately benefit society by improving real wages, lowering prices and increasing the quality and quantity of goods and services. But at the same time, profits from innovation are quickly abraded by fierce competition, government actions and, eventually, new technological development that supersedes the old. "Thus, ultimately, innovation ends up helping Main Street a lot more than creating wealth on Wall Street," Samuelson observes.
       Yet Samuelson, never a Pollyanna during his days as a magazine columnist, insists that Shiller is too bearish, Samuelson believes any correction or spell of desultory price action is likely to be followed by a retain of stock prices to the current "regimen" of high P/Es. "One must acknowledge that we've seen a genuine increase in productivity of late, along with a recovery that's clearly more than of a normal cyclical nature," Samuelson contends. "I don't think the stock market bubble is nearly big as Shiller thinks."
       Wharton economist Siegel, while acknowledging the current nuttiness in technology sector prices, still thinks Shiller is somewhat off the mark in his pessimism. Most important, he argues, stocks deserve to trade at a higher than historical P/E range.
       For one thing, the general economy has never showed greater stability. "We now know how to avoid depressions like in the 'Thirties and the ruinous inflation of the 'Seventies and just keep a record-length economic expansion chugging along," Siegel insists.
       Siegel and other bulls also contend that investors have become willing to pay more for $1 of earnings than they once were. Why? Because history shows the stock market to be far less risky than previously had been believed, compared to other investments like bonds. Of course, the higher the P/E accepted by investors, the skimpier the future total returns from stock investments.
       Certainly, there's plenty for investors to be optimistic about. The economy remains strong; inflation, subdued. The information revolution, which has begun to yield dramatic boosts in productivity and profitability, is still in its infancy. Many past speculative bubbles were commodity-related and doomed to cal-lapse once high prices resulted in substitutions and triggered punishing new waves of supply. However, the central metaphor of the New Economy is the "network effect." It holds that the more personal computers, personal digital assistants, cell phones, wireless appliances, servers, printers and faxes that are shipped to customers, the more valuable the total network becomes, as a consequence of exponential increases in usage.

Shiller obviously doubts the durability of the New Era stock market In his estimation, investors' expectations are proving just as scalable as network systems Otherwise, the American public wouldn't still be getting so torqued over what he considers to be shopworn investment themes like the rise of the Internet, the triumph of the U.S. over communism and the Asian Tiger economies, the flow of Baby Boomer retirement money into stocks and the supposed salubrious impact of tamed inflation and interest rates.
       Never mind, for example, that the Internet hasn't yet contributed much to the surge in corporate profit growth "Clearly, Americans are making a spurious association between the 'Net and the bull market in stocks because so many folks are active participants in surfing the 'Net," Shiller says, dismissively. "This factor alone gives investors an exaggerated personal sense of a New Era."
       In Irrational Exuberance, he notes the startling similarities between the current market and past equity-price peaks, as delineated in the P/E chart on page 38. Most obvious, of course, were the transforming technologies that fired the imaginations of investors at each of the previous market peaks. In 1901, electrification, symbolized by the 389-foot illuminated Electric Tower at the Pan American Exposition in Buffalo, proved a powerful source of optimism. Moreover, that was the year that Marconi made the first transatlantic radio transmission and newspapers hailed the promise of 150-mile-per-hour trains and robotic factories.
       The Roaring 'Twenties saw an explosion in the manufacture of vacuum cleaners and other household appliances and, of course, cars that even the common man could afford. Radio broadcasting surged from just three stations in 1920 to more than 500 just four years later. And the 'Fifties and the 'Sixties brought the television era and the Space Race with all of its exciting technological byproducts.
       But more than technology inspired investor confidence at the previous New Era stock-market peaks in 1901, 1929 and 1966. All three eras saw major changes in corporate organization that were heralded at the time as sources of huge efficiency, economies of scale and financial flexibility. At the dawn of the 20th century, the newly-formed U.S. Steel was just one of the industrial behemoths that commentators saw bringing order and economic might to American industry. In the 'Twenties, many economists and writers sang the praises of the new trusts and holding companies that were exploiting techniques of mass production, mass distribution and sophisticated market research to deliver an untold bounty of affordable products to Americans. And the 'Sixties gave rise to conglomerates and to scientific management theories that proponents claimed would dramatically increase profitability.
       New Era optimism in these periods was fanned by the conviction that improved macro-economic policies would smooth out the business cycles that had previously proved so ruinous.
       At the beginning of the 20th century, it was thought U.S. Steel and the other industrial giants would form "communities of interest" with the requisite muscle to end the Darwinian price competition and chronic deflationary spirals of the 19th century's Industrial Age.
       Likewise, many commentators in the 'Twenties were convinced the Federal Reserve System would stabilize economic cycles. Shiller cites one popular writer of the day' who described the Fed as a governor on a steam engine, able to regulate the economy's speed. And of course, who could forget the sense of optimism that prevailed during the New Economy days of the Kennedy and early Johnson Administrations. It was thought that the economy could be kept humming on an even keel through judicious dollops of Keynsian fiscal stimulation.
       Sadly, each of these New Eras died a quick, ugly and unexpected death. The probusiness President William McKinley was assassinated while attending the Pan-American Exposition, and his successor, Theodore Roosevelt, soon embarked on a campaign of trust-busting and business regulation that effectively ended the "community of interest" era for a generation. Huge mistakes in macroeconomic policies helped transform the promise of the 'Twenties into the nightmare of the 'Thirties Great Depression. And the 'Sixties boom and bull market ultimately gave rise to the grinding stagflation of the 'Seventies, as a result of the guns-and- butter policies of both Johnson and Richard Nixon and "exogenous" supply shocks delivered by OPEC and the Goddess of Grains.
       What could end the latest New Era economy and bull market? Shiller demurs on that question. Maybe it will be an unanticipated war, a depression abroad, a failure of a major technological initiative, a terrorist threat that hampers business activity, an unstoppable computer virus, a major telecommunications breakdown or some natural disaster. Or maybe it will be a backlash against the increasing share of GDP garnered by American business and its shareholders, like the one that occurred in the early decades of the 19th century.
       Shiller lists such possibilities without much conviction. After all, as soldiers like to say, you never hear the round that gets you.
       Shiller is perhaps on his firmest ground when dissecting the mindset of today's investors, who have fueled the greatest stock-market boom in history, As a specialist in behavior, he tries to draw insights from fields as disparate as psychology, sociology and history to explain the current market exuberance.
       Not surprisingly, his diagnosis is harsh and uncompromising. "The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their emotions, random attentions, and perceptions of conventional wisdom," he writes.
       In Shiller's estimation, the most pernicious influence on today's investors is the efficient market theory. It holds that the price of stocks or the market as a whole is fair and rational at any point in time be-cause those prices reflect the collective wisdom of legions of informed investors who coolly assess the latest information affecting company profit prospects and impound that data into prices.
       Though most investor's know little about the theory itself, they have assimilated the bedrock conclusion of efficient markets -- namely, that it's a waste of time to try to tune the stock market or make judgments about whether stock prices are too high or too low. Thus according to Shiller, many investors continue to regard the market as a "free ride" to lush returns despite its nosebleed valuation levels.
       Shiller and other important figures in behavioral finance, like the University of Chicago's Richard Thaler and Nicholas Barberis, have been poking holes in efficient market theory for years. If, for, example, the stock market is so darned rational, why did so many "anomalies" or tradable profit opportunities like the January effect (stock prices tended to rise early in most years) persist for so many years?
       Other studies have shown that enormous inertia exists in the views of investors and analysts toward different stocks. Invariably, the market underreacts to news like earnings surprises, dividend changes and shifts in long-term earnings trends. All this affords nimble traders the chance to beat the market averages by exploiting this phenomenon.
       But for Shiller, the ultimate proof of the stock market's irrationality is the "excess volatility" it sometimes displays, soaring to manic heights or falling into abject funks with seemingly little news to justify the moves. The madness of crowds in markets is something he knows well.
       In the immediate aftermath of the 1987 Crash, he polled a number of institutional and individual investors to glean their impressions as to why prices had fallen so dramatically that baleful Monday in October. Barely mentioned were all the explanations subsequently offered up by the media and later the Brady Commission, such as program trading, proposed tax legislation deemed to discourage corporate takeovers and bad news on the US currency and trade fronts. Seemingly, the 22,6% market slide that day was triggered by a "negative feedback loop" in which selling provoked more selling, which, in torn, spurred even more selling. At least that's what the questionnaires seemed to indicate.
       Stocks aren't the only investments bought and sold in a market beast by ignorance and irrationality. In the late 'Eighties, when Shiller and another professor surveyed homeowners in four markets, they found that these folks had only a superficial understanding of the fundamentals influencing residential property prices in their areas. For example, interest rates were cited as the most important factor dictating recent price trends, even though prices were soaring in one of the cities (San Francisco) and merely bumping along in another (Milwaukee). And interest rates were largely the same in both places. Clearly, news follows price and not vice versa in the real world.
       In Shiller's bleak view, it's not that investors are stupid; it's that they're limited in their ability to react rationally to an ever-changing stream of events. Instead, they take shortcuts that can prove lethal in market settings. People tend to be unduly influenced by the actions of others (herd instinct) and prefer safety in numbers.
       Humans pay undue homage to the opinions of self-styled experts and authorities. Remember the infamous Yale psychologist who persuaded subjects to administer seemingly painful electrical jolts to a confederate secretly working with the psychologist, whenever that confederate gave the wrong answer to a question? Shiller does. Bland assurances by the psychologist that the jolts would cause no permanent damage were enough to keep many of the subjects happily zapping the moaning "victim." Clearly, authority figures can sometimes override both moral scruples and the direct evidence of the senses.
       Other experiments cited by Shiller illustrate the all-too-human tendency to act illogically or nonsensically. A wheel of fortune spun to random numbers just before subjects were to reply to current-events questions involving numerical answers ended up heavily influencing the numerical range of the responses. The behaviorists love to talk about "magical thinking" and a phenomenon called "representativeness heuristic." The latter describes the human tendency to see patterns or trends, even in completely random data. Fans cry for an NBA player on a hot streak to keep shooting. Investors pile into a stock because they overconfidently extrapolate two quarters in a row of strong earnings increases far into the future.
       According to Shiller, the current bull market has instilled several convictions in the investing public that will likely be cruelly dashed in the years ahead. One is that stocks over the long haul always outperform bonds and ether asset classes. And the other is that market dips are always transitory and are great buying opportunities.
       Shiller, in fact, points out that the two 10-year periods following the 1929 and 1966 market peaks and the 20 years following the 1901 peak all saw short-term interest rates outpace stock gains. And Jeremy Siegel can talk all he wants about how the absurdly overpriced stocks of the early 'Seventies (the Nifty-Fifty) actually matched the performance of the S&P between 1970 and 1996 despite their utter collapse during the 1973-74 bear market. Yet even Siegel concedes that the 25 companies of the group with the highest P/Es lagged the market over the same stretch. And who, pray tell, had the intestinal fortitude to stay in these stocks over the entire period after getting toasted for 70% or 80% losses in the mid-'Seventies?
       Shiller's obdurate pessimism isn't without risk. He invites ridicule if the stock market proves him wrong. He's well aware of the obloquy that still attaches to the name of another Yale economist, Irving Fisher, for declaring Just before the 1929 Crash that "stock prices have reached what looks like a permanently high plateau."
       But should he be proven wrong, Shiller would face only the painful regret of opportunity loss. Fisher's misjudgment, in contrast, cost him a personal fortune, his heiress wife's money and his New Haven mansion (Yale ended up buying it and leasing it back to the Fishers), "I also have tenure," Shiller adds with a chuckle, something educators generally didn't have in the 'Twenties.
       And let's not forget the handsome royalties Shiller figures to earn from his runaway best-seller. Regardless of whether time bull or bear prevails, he'll make out like a fox.