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Irrational Exuberance, as the title indicates, argues that the stock market is significantly overvalued by historical standards, and that equity investors are very much at risk of receiving flat or declining returns, perhaps for as long as one or two decades. While Shiller hedges his bets regarding what individuals should do, the clear implication of his book is that investors should look beyond stocks to diversify their savings, and perhaps withdraw from the market altogether.
Should Fools heed this advice? Does Shiller make a persuasive case that stocks are simply not going to be a great place for your long-term savings in the next 20 years? In my view, he does not. Irrational Exuberance is a thought-provoking book, and should be read by anyone planning to keep most of their savings invested in the market, but it is also deeply flawed in many ways.
Feedback Loops and Herd Behavior
Irrational Exuberance begins with a question: "Are powerful fundamental factors at work to keep the market as high as it is now... or is the market high only because of some irrational exuberance -- wishful thinking on the part of investors that blinds us to the truth of our situation?" Shiller believes it's a result of the latter, and he sketches out the following scenario: In recent years, 12 "precipitating factors" that form the "skin of the bubble," and that have no direct impact on corporate profits or other business fundamentals (in his view), have helped drive up stock prices. These 12 factors include the widespread use of 401(k) plans, the retirement savings of baby boomers, and increased media coverage of business developments and stocks.
These trends have been amplified by "positive feedback loops" among individual investors, which creates "naturally occurring Ponzi processes" as more individuals follow their friends and neighbors into stock investing. This process is aided and abetted by the news media, in particular the more interactive media on the Internet, which he considers much more effective at spreading ideas and encouraging people to act on them.
The result of all this is herd-like behavior among investors, which he also compares to an epidemic. Since the market has gone up so much as a result of investor psychology rather than fundamental economic factors, it therefore naturally follows that we have a speculative bubble, which Shiller defines as "a situation in which temporarily high prices are sustained largely by investors' enthusiasm rather than by consistent estimation of real value."
Finally, he argues that our current bubble is the fourth instance of overpricing to occur in the U.S. stock markets in the past 100 years, with the first three occurring in 1901, 1929, and 1966. In each of the three previous cases, stocks provided mediocre returns for at least two decades following the market's peak. Shiller sees no reason why this won't happen again.
By the last chapter, he is unequivocal: "The high recent valuations in the stock market have come about for no good reasons." This is where he is especially off base.
How Did We Get Here?
Irrational Exuberance argues that the most important explanation for our current bull market is investor psychology, not the Internet or other technologies, nor the globalization of the economy, nor the growth in corporate profits. While Shiller does make some interesting points about investor behavior, he exaggerates its impact.
For example, instead of arguing that individual investors are just following the crowd because they are ignorant, Shiller makes a more subtle point: Investors are following the crowd because they (we) are rational. His evidence for this includes a famous experiment from the 1950s in which subjects were placed individually into larger groups, and were then asked about the length of a line on a card. The rest of the group would deliberately give the wrong answer on most of the questions, even though the right answers were fairly obvious. This then required the subjects to contradict their larger groups if they wanted to answer correctly. In a third of the test cases, the subjects went along with the wrong answers.
While this experiment is generally seen as evidence of the power of social pressure, Shiller points out that in similar experiments, when subjects were separated from the larger group and simply told what answers the group gave, they nevertheless were almost as likely to go along with the wrong answers, even though they were under no pressure to conform.
This is because, as Shiller points out, "They were reacting to the information that a large group of people had reached a judgment different from theirs," rather than social pressure. He concludes, "This behavior is a matter of rational calculation… when a large group of people is unanimous in its judgment on a question of simple fact, the members of that group are almost certainly right." Shiller also uses restaurants as an example of rational "herd-like" behavior: If there are two restaurants next to each other, and one has visibly more customers than the other, most people, lacking any other information, will probably try the more popular one. This is not due to social pressure but because the fact of its popularity is considered relevant by subsequent customers, even though the more popular restaurant may not be the better one.
Therefore, Shiller's argument is that millions of individual investors may be investing in stocks because they have seen the success that others have had, and so their choice to do so is rational, but they're not actually performing any real analysis or adding to our collective knowledge of stocks and their pricing. This is interesting, but Shiller believes that this dynamic more or less explains the entire bull market.
He dismisses other trends, including the spread of the Internet and other technologies, and asks, "Should the advent of the Internet raise the valuation of the Dow Jones Industrial Average -- which until very recently contained no Internet stocks?" Shiller thinks not, but it should. Consider Wal-Mart (NYSE: WMT), for example, a Dow stock since 1997, which has utilized its tremendous databases and proprietary inventory management software to realize significant operating efficiencies. There are plenty of other examples, and the Dow (and certainly the S&P 500) is higher as a result. For Shiller not to consider overall improvements in business productivity as a factor behind the bull market, as Alan Greenspan clearly has, is a major oversight.
The "Overpriced" Market
Shiller has many other interesting points, though they are also not without flaws. For example, he has some impressive graphs in the first chapter of his book that would give pause even to the most dedicated market bull. One of them tracks price-to-earnings (P/E) ratios over the years; according to this chart, the S&P 500's P/E was 44.3 -- the highest ever -- in January 2000.
However, Gene Epstein in Barron's has pointed out that Shiller exaggerates the current P/E of the S&P 500 by using the average of the previous 10 years' earnings in his calculations. This significantly dilutes the heavy earnings growth of the past several years. Epstein shows that using the average of the past five years' earnings, rather than the past 10, reduces Shiller's December 1999 P/E by 20%, from 43.5 to 35.3. Of course, P/E ratios are usually calculated using four quarters of trailing earnings, and currently that's an even lower number: The S&P's P/E is about 28, which may still be high, but is a lot lower than 44.
Nevertheless, Irrational Exuberance is certainly worthy of investors' consideration. While Shiller doesn't really think like an investor, and his work is therefore of limited use in day-to-day decisions, Fools looking for a contrary view of stocks should check it out. Just be sure to take his conclusions with a large grain of salt.
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