Irrational Exuberance Book

This is a book that needs to be reread in order for the points to absorbed.

Shiller starts out with three chapters that present statistics showing that stocks and real estate are not investments that people can count on to earn a good long-run return. He shows that if people got into the market at the wrong time they could end up having to wait for a long time before the value of stocks returned to the price that people paid for the stocks. He shows similar statistics for real estate.

In the chapter on bonds he talks about how bonds do not do a good job of forecasting future inflation rates.

In Chapter Four and Five he presents his view of how booms get going and how they are amplified. It took me a few readings to understand his main point. I believe his main point is to show that sometimes the price of stocks and the price of real estate go up for no good reasons.

In Chapter Four he identifies precipitating factors that he argues are not connected to fundamentals. They are factors that should not drive prices upward. In Chapter Five he talks about how booms are like Ponzi schemes--and there is sometimes fraud and sometimes just people telling a story that is not supported by any evidence.

Shiller presents detailed examples that are designed to show that when prices fall rapidly they do so for reasons not connected to anything that would justify the price declines. Further, he argues that the metaphor of a bubble is misleading: the bubble doesn't suddenly burst. Instead a decline might be followed by a brief recovery, a time of stability, and then further decreases in the price.

I think Shiller argues this because he wants to demonstrate that prices change for no good reasons--either in an upward or downward direction.

Shiller argues that every time there are booms in stock prices that someone will talk about their being a New Era that justifies the rise in stock prices. One explanation for the boom would be that there really was a New Era and as people tried to take the consequences of the New Era into account they would bid up prices too high. Once they realized what was going on then stock prices would fall.

Shiller rejects this argument. He argues that in almost all the cases stock prices first go up and then after the fact people start to put stories together to justify the rise in stock prices.

Below is what I prepared for class to discuss this:

One point that comes up again and again the book is that investing in stocks and real estate is not a strategy that can be counted on to generate high returns.

Even if we accept this claim we might argue that at least if put money into the stock market that we can count on getting a return that exceeds the return on bonds. That claim is addressed by the author in Chapter Eleven of his book'the chapter Efficient Markets, Random Walks, and Bubbles.

In addition to these two claims, the last chapter in the book: Speculative Volatility in a Free Society, is of great importance

It is important for three reasons.
(1) It states one of the main themes of the book: there are times when high stock prices and high real estate prices come about "for no good reasons." A corollary (or maybe it is an analogy) of this is that when prices fall they do so "for no good reasons." (p. 225)
(2) Bubbles do real damage to people's well-being. "All of our plans for the future, as individuals and as a society, hinge on our perceived wealth, and plans can be thrown into disarray if much of that wealth evaporates tomorrow." (p. 227) The chapter contains a great example of the damage stock market bubbles have done: we have saved too little and underfunded pension obligations. Why? Because of the belief that home prices would continue to rise and stock prices would continue to rise and therefore we didn't need to save as much.
(3) Instead of giving investment advice to individuals that is not supported by the evidence, we should work on developing financial instruments that would help people hedge against risks that they face from interruptions in their flow of income.

Who is Shiller Arguing With and What is the Basis of the Argument
We have talked about efficient markets and in Chapter Eleven Shiller explicitly introduces the theory of efficient markets.

Economists who believe in the theory of efficient markets argue that when market prices go up or down we should be able to point to fundamental factors that can account for the change in the price. The fundamental factors are connected to the current and future cash flows. While economists believe that future prices of financial and real assets are unpredictable, they believe that after the fact we can explain the changes in prices: they must have changed because something that mattered in the world around us.

It is that claim that that Shiller is attempting to show is false.

Much of what is contained in the book is directly related to Shiller's attempt to show that the claim is false. Here are some examples:

(1) From the very beginning Shiller is interested in showing how changes in stock prices, real estate prices, and bond prices cannot be accounted for by changes in fundamentals. I view this as clearing the decks. If we think fundamentals explain most of the changes in stock prices then there is no need for any other explanations.

Shiller in the chapter on efficient markets focuses on examples of where assets were mispriced and remained mispriced for a long period of time.

I think this is also the reason why Shiller doesn't believe that the housing boom resulted from the introduction of new financial instruments.

(2) Given that efficient markets is the accepted theory, even if Shiller is able to cast doubt on this theory, people are not going to abandon it unless there is a compelling alternative explanation. In two critical chapters, Chapters Four and Five, Shiller offers an explanation of how we can see volatility in prices without there being anything having to do with fundamentals. I missed this the first few times reading the chapter. But on p. 40 Shiller states that "I will concentrate here mostly on factors that have had an effect on the markets not warranted by rational analysis of economic fundamentals."

I read Chapter Four as offering explanations about how things can get going and Chapter Five as offering an explanation as to how we can get a sharp boom. If we buy what is being said we have an explanation as to why stock prices and real estate prices can go up "for no good reason." (And that is why I believe that understanding the stories of Ponzi schemes is crucial to understanding Shiller's point. A Ponzi scheme is based upon fraud. He is arguing that while there is no fraud going on that the same mentality and dynamic is occurring when we have amplifying factors that push stock prices up.)

(3) Shiller spends much time going through detailed examples that only make sense if you realize his main point: stock prices do not change for good reasons.
• The chapter on New Era thinking is an attempt to show that stories as to why prices rose were after the fact storytelling.
• The chapter on herd behavior and epidemics is an attempt to show how people are drawn into the market not because of changes in fundamentals but because of the influence of authority, because of behavior that can be described by models of epidemics.
• The chapter on the news media (which you were not assigned) goes through examples that are designed to show that there was no news that could have justified the stock price changes that occurred.
• The chapter on whether people have a new view of the stock market presents his argument that this isn't an adequate explanation: stock prices rise "for no good reasons."

(4) When bubbles collapse they so for reasons that are not related to fundamentals. In addition Shiller makes two other points.
First: there is a gap between the collapse and any financial crisis.

Second: the collapse isn't a complete collapse but rather there are downturns and then upturns.

Some other points that arose during class today:

(1) People believe things that are not supported by evidence (in particular they believe that stock prices and land prices will rebound, but there is no basis for such a belief).
(2) Role of emotions. In Chapter Nine Shiller states that "popular accounts of the psychology of investing are simply not credible. Investors are said to be euphoric or frenzied . . . [I]n both booms and crashes, investors are described as blindly following the herd like so many sheep." But Shiller argues that "people are more sensible during such financial episodes than these accounts suggest. Financial booms and crashes are, for most of us, not emotion-laden events."

But at various points Shiller talks about the role of emotions. I don't believe Shiller is inconsistent. On p. 80 of the third edition he talks about the emotions of regret and envy. Those emotions he argues play a key role in how people behave. I believe Shiller is rejecting that people lose control of themselves and act like some out of control mob.

(3) Shiller gives examples that are designed to show that prices are much more volatile than we would expect if prices are driven by fundamentals.

(4) Shiller has a statistic that is of great relevance to his argument. If markets are efficient then stock prices of firms in the same industry, even if they are located in different regions, should have great volatility then the stock prices of firms in different industries who are located in the same region. However, if some of the arguments made in Chapter Ten (Herd Behavior and Epidemics) are correct then we would expect the exact opposite. Be able to explain why the different theories have different predictions and be able to explain what results Shiller finds.