Sunday, February 6, 2011

Irrational Exuberance: Chapter 6

In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.

In this chapter, Shiller examines the 25 largest stock market index moves around the world, both over one-year and five-year periods. He then tracks the subsequent returns that occurred following these periods of abnormally strong and weak returns.

Following the strongest one-year returns around the world, subsequent one-year returns for the same markets have been all over the map. Often, extreme strength in these markets has been the result of a regime change that has seen a citizenry oust a dictator or military and regain control of its government.

In the one-year period following the largest one-year declines, however, stock returns around the world are decidedly positive, with only 6 of the 25 instances showing negative in the subsequent year.

Subsequent five-year results following extreme five-year price changes are far more convincing of the "bubble" effect. Following the largest five-year increases, almost all five-year subsequent returns were negative. There were exceptions, however. For example, in the Philippines, a 1253% increase over five years (starting in 1984) was followed by another 43% increase over the next five years. This was the result of a regime change in which a Communist dictator was ousted. In the other exceptions, extreme price gains were the result of extreme losses in previous years.

What went up (down) usually came back down (up). From this evidence, and considering the huge stock run-up of the late 1990's, Shiller surmises that the possibility that the US is currently (at the time of writing, in the year 2000) in the midst of a major speculative bubble cannot be ignored.

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