Sunday, February 25, 2001

Stock Market Psych Out

By Walter Kita, Register Staff

If you're feeling anxious about the nation's economy, Yale economics Professor Robert Shiller has something for you to ponder: It's the psychology, stupid.

A specialist in the emerging field of behavioral economics, Shiller and his still small contingent of peers believe the economy behaves at times more like a rampaging elephant than a finely tuned Ferrari.

Its movements are frequently chaotic, directed not by logic, but subtle "irrational" forces. In those times, the economy doesn't perform as the user manual says it should. And it isn't easily fixed.

This, Shiller believes, is one of those times.

And nowhere is the uncertainty better reflected than in the current chaos on Wall Street.

What will happen in the months ahead is unclear. But if the behaviorists are right, bad times may lie ahead: A stock market collapse, maybe even a crippling recession.

"People, including some economists, have this idea that the stock market must keep going up, but there is no mathematical evidence, no model, that confirms that notion," said Shiller, author of the book "Irrational Exuberance," a primer on behavioral finance and economics. "The idea that psychology plays a role in investing seems obvious to many people -- except most economists."

The behaviorists' views contrast sharply with those of more traditional theorists, whose belief in a rational "self-correcting" market has held sway for the past half century.

Yale -- along with Harvard, Stanford, MIT, Princeton and the University of California at Berkeley-- is recognized as one of the hotbeds of the new field.

Apart from psychology, behaviorists draw on biology, anthropology, sociology, game theory and other disciplines to explain how the economy is influenced by individual decisions about such matters as whether to save or invest.

John Maynard Keynes wrote of the influence of psychology in economics more than 50 years ago. But the idea is only now, beginning to gain acceptance among professional economists.

George Akerloff, one of the first to rediscover the theory in the -- 1970s, received his undergraduate degree from Yale. One of his early papers, "The Market for Lemons," analyzed the, psychological interplay between the buyers and sellers of cars. Akerloff's analysis showed how buyers could be duped into paying more for a car than it is worth. Unlike the sellers, they didn't know much about the quality of the vehicle.

Traditional economic theory assumes that both parties enter into the transaction with equal knowledge, and that as a result the agreed upon price is fair.

Behaviorism since then has been used to explain such habits as reckless spending and altruism.

"Psychology plays a role in economics on many levels," said Robert Eldridge, professor of business and finance at Southern Connecticut State University. "Standard economic theory holds that wages are lowered in times when jobs are plentiful. But employers don't do that because it's in their best interest to retain good employees by keeping salaries where they are, or raising them a bit."

Marketing also relies heavily on psychology to create demand for new products.

Ads for Apple's colorful iMac computers, for example, are targeted at a different class of consumers than those inclined toward standard beige desktop machines.

Increasing demand is significant not only for a company's survival, but also for the health of the overall economy. It means increased productivity and more jobs, Eldridge said.

For the economy at large, the psychological forces at work in the nation's two primary investment markets, the New York Stock Exchange and the Nasdaq Stock Market are getting a lot of attention lately.

Shiller likens the situation to a poker game in which every player is trying to anticipate the others' next moves. For the last two years, the hottest action has been on high-tech stocks in the Nasdaq exchange.

It's not the first time investors have become smitten with new technologies, said Fairfield University economics Professor Edward Deak. Railroads, the telegraph, radio and the telephone all were once touted as the next big thing, he said.

As in the past, many market mavens have been tempted to scarf up tech stocks without much thought, believing that, in time, they would become rich.

With increased demand, the value of a stock shoots up. It tumbles -- or crashes -- after investors begin measuring its worth against conventional standards, such as profits and earnings per share.

That began happening after last March, when the "speculative bubble" peaked, then burst, Shiller said.

Dozens of dot-com companies that a year ago were awash in venture capital have been lost in the calamity. The carnage is reflected in a precipitous drop in the Nasdaq's value over the last 12 months.

But the older New York Stock Exchange, dominated by "Old Economy" companies, has suffered only a modest 10 percent decline.

"Psychology does play a role in the decision making, but the situation isn't necessarily all doom and gloom," said Deak.

Complicating the investment climate further, is the sheer number of gamblers playing at Wall Street's table. Many of them lack the knowledge to bet wisely, Shiller said.

The presence of these amateurs -- many do all their own trading on the Internet -- has "bid up" the market to the highest point in history. With each new headline trumpeting the potential of the "New Economy," more and more investors have been lured into the game.

Late entrants stand to lose the most when reality sets in, according to Shiller.

"The window of opportunity closed months ago, but they didn't realize it," he said.

Carolyn Frzop, a stockbroker and vice president with Janney Montgomery Scott brokerage in Fairfield, said her clients are much more cautious now than they were at the same time last year.

The "herd-mentality" of 2000has given way to more sober decision making, she said. Investors short on cash, market savvy and willpower have dropped out, or are now getting professional advice.

"Many people thought the stock market was a quicker, easier way to get rich than going to a casino," Frzop said. "(Now) they understand it's not a game. Your emotions shouldn't play a role in your investment decisions."

Behaviorists, however, con-tend it's just not possible for an investor to turn off his or her emotions.

If everyone were to get skittish at about the same time and decide to throw in his cards at once, the market could take a serious nose-dive.

Shiller estimates the financial markets could lose as much as one-half of their present value over the next decade. The Nasdaq has tumbled 57 percent since last March. Last week it continued to show signs of turmoil.

A sudden plunge, he warns, could have a devastating ripple effect on the overall economy.

It's happened once already, during the Wall Street collapse of 1929. Investors pulled out. Companies cut back. Consumer spending dropped.

Other factors contributed to the ensuing Great Depression, but historians view the crash as one of the key events responsible for the economic woes that plagued the nation for more than a decade.

Japan, Shiller noted, is still suffering from the effects of an economic tsunami triggered by the crash of the Nikkei stock market in 1988.

It's also possible that nothing much will happen should another crash occur anytime soon.

When the New York exchange dropped 500 points on a single day in 1987, investors didn't panic, at least, not for long. After a downturn that lasted into the early 1990s, the economy rebounded then began soaring.

Behaviorists aren't bothered by such uncertainty. In fact, they argue that conventional economists are wrong to put all their faith in statistical models developed to predict market behavior.

"That stuff is useful, but only to a point," said Shiller. "There had to be a balance between the numbers and psychology. Many economists want to believe that the stock market functions according to rules like particle physics. It doesn't work that way."