Irrational Exuberance

1
Irrational Exuberance
2
The Basic Issue

• Figure 1.1, and 1.2 suggest that price is much
  more volatile than earnings.
• Something needs explaining
• Figure 1.3, which you produced for homework,
  shows that P/Es are strongly mean-reverting.
• Shiller was very concerned with the large spike
  during the internet boom... dwarfing even 1929.

3
New Era Thinking

• Shiller derisively refers to the notion that this
  spike is justified by the internet as new era
  thinking
• He demonstrates (I think quite effectively) that
  this same line of reasoning in all the previous
  major spikes
• 1920s industrialization of the South, emergence
  of large scale production and chain stores...
  everything is big and efficient. The future
  looks bright!
• 1950s/ early 60s Stability through better
  government Technocrats at the Fed had finally
  figured out how to micromanage the economy to
  perfection. The future looks bright!

4
Chicken or the Egg?

• Shiller argues that often these explanations crop
  up ex-post, after the stock market run-up, as a
  strong psychological need to attach meaning to
  these trends, and justify them. (pg. 98-99)
• But sometimes these lead to nonsensical timing.
  (pg. 20 on the timing of the internet vs. the
  stock market run-up that was attributed to it)

5
Precipitating Factors (Ch. 3)

• The arrival of the internet at a time of rapid
  earnings growth.
• The baby boom and its perceived effect on
  valuations
• Expansion in media reporting of business news
• Increasingly optimistic analysts forecasts
• Decline of inflation / money illusion

6
Prevailing Explanations

• Due to Stocks for the Long Run (and other
  unabashedly enthusiastic book like it) investors
  have finally learned the truth about the
  riskiness of stocks. This pushes P/Es up.
• Shillers Answer No. Rather
• Investors over-weight recent evidence, and come
  up with ad-hoc attempts to rationalize recent
  patterns they see.
• Investors hold many ill-founded and (worse)
  self-contradictory views...

7
Investors Views

• 83 say you cant reasonably expect to time the
  market.
• They have been told about market efficiency
• Yet 91 said that given a severe stock market
  crash, the market would quickly regain its level!
  (page 46)
• After the stock market slide of 2000 began, this
  number this number dropped to 80 (pg. 237).
  Further evidence that investors rapidly change
  their opinions based on the most recent events.

8
Investors Views Cont.

• Shiller used Oct 19, 1987 as an experiment and
  asked investors what they thought caused it.
• Individual investors 71.7 said they thought the
  market was overvalued
• Institutional investors 84.3 said they thought
  the market was overvalued.
• Perhaps theyre making this up ex-post as an
  explanation for what they saw happen (Shillers
  thesis). Rationalizing the event.
• Alternatively, maybe theyre telling the truth
  about how they felt at the time... which is just
  as scary.

9
More Evidence

• ... That investors views are not based on a
  scientific analysis of the long-run performance
  of historical stock markets (or on current
  fundamentals).
• When asked what the return will be on the market
  next, the average answer is 15. (pg. 53)
• When asked what the level of the market will be
  next year with no suggestion that the return
  be positive the answer is 5.

10
Adaptive Expectations

• People dont know what to expect from the market,
  so they wait to see what it delivers.
• But if a stock market surge is caused by a few
  (or many) overconfident investors this can cause
  a bubble, as people expect high returns going
  forward.
• And, yes, overconfidence seems to be part of
  human nature.
• Barber and Odeans study of investors who
  switched from phone trades to internet trades
  suggests this as well.

11
Price Movements as Nearly Meaningless

• Many of the most famous price movements have no
  connection with fundamentals.
• Oct 28, 1929 12.8 one day, 11.7 the next day.
• News of the day was mixed and even upbeat
• Ditto Oct 19, 1987.
• One natural alternative explanation is that there
  is a separate, transitory component to stock
  prices that reflects a market psychology. This
  can go rapidly up or down at any time for no
  reason,

12
Price changes vs. Fundamentals

• Again, see figure 1.1 (Earnings vs. Price)
• Very little connection, contemporaneous or
  lagged.
• Ditto dividends vs. price in Figure 9.1.
• The price chart has much more volatility than the
  present value of dividends chart.
• He terms this puzzle excess volatility.
• One of the most noted critics of this concept
  that markets are too volatile relative to
  fundamentals is Robert Merton, who went on to
  financial disaster at LTCM. (Maybe Shiller was
  right?)