Saturday, February 19, 2011

Irrational Exuberance: Chapter 9

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 attempts to debunk the Efficient Market Hypothesis (EMH). The idea behind this theory is that if there were profit opportunities in the market, smart people would exploit them, and therefore the wealth of these people would grow, resulting in a bidding up (down) of undervalued (overvalued) assets. In such a scenario, there would no longer be profit opportunities; thus, capital markets correctly reflect available information.

Shiller argues that this interpretation does not allow for periods of mispricing that take years or decades to correct; in such situations, smart people could not make money rapidly, and therefore these opportunities would not neccessarily disappear.

As counter-examples, the author discusses a few companies of the day that cannot possibly be priced correctly. For example, eToys traded for $8 billion in 1999, despite sales of just $30 million and negative profits. Shiller also discusses some of the other bubbles that have occurred in history, including Tulip Mania in Holland.

Finally, Shiller cites extensive research that has shown various systemic problems with EMH. For example, low P/E, low P/B, and high-dividend paying stocks appear to outperform the market. Furthermore, stock price volatility appears not to correlate well with dividend volatility; instead, price volatility is extreme in relation to dividend volatility, which should not occur if stocks are supposed to be worth the present value of future dividends.

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