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 final chapter, Shiller warns of the dangers of ignoring the high price level of the market. While to the observer it may seem that all a stock market crash would do is bring prices back in line with where they were a few short years ago, Shiller notes that the losses would be particularly harsh on certain groups. For example, someone who invested early and has been selling will do just fine; but someone who invested all their money at the end of the bull market will face devastation.
Shiller discusses a few factors which could derail the market. Among them are the following (keep in mind that he wrote this in the year 2000):
- foreign competition
- an oil crisis
- newly discovered problems with the longer-run consequences of incentive-based compensation for employees
- a war
- a terrorist attack (this was written just a few months before 9/11)
- systemic problems due to a failure of major banks
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.
There is another prevailing theory at the time of writing (the year 2000) that has been used to justify the apparent high stock prices: the public has learned about the benefits of investing in the stock market. Shiller explores this idea in this chapter.
Armed with historical statistics spanning decades and even centuries, investors of the year 2000 may have finally learned that stocks do provide strong returns over the long-term. As such, the theory would argue that stocks will no longer go down to their previous levels, as the risk premium built into stocks is now all but gone.
Shiller notes that this "learning" that has apparently taken place in the late 1990's also took place at other points in history. He cites numerous publications where these arguments have been made in previous bubbles decades earlier! Shiller points out that if the public did indeed learn that stocks provide strong returns over the long-term, they have learned it before, and they have also un-learned it during periods of deep decline.
Shiller also debunks the myth that investors have accepted that stocks outperform bonds over all lengthy periods. Furthermore, his surveys of both institutional and individual market participants demonstrate that investors have learned an awful lot of untruths that they may soon unlearn.
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.
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.
This chapter is about herding and epidemics. Shiller explores the idea that humans (including investors) do not necessarily think independently, which leads to similar thinking and therefore similar investment decisions.
Shiller cites experiments by Deutsch and Gerard that illustrate that individuals will side with the opinions of a large group of people over even their own opinions! The experiments demonstrate that people believe the majority view to be accurate even when it conflicts with their own independent conclusions.
Even rationally-behaving people can fall victim to herding as a result of an "information cascade". Shiller describes an example where a customer encounters two empty, identical restaurants. He must choose randomly between the two, with no other information to go on. But the next customer that arrives has the benefit of seeing the choice of the first customer, which, absent other information differentiating the restaurants, may sway him to choose the same restaurant, on the basis that the first customer knew something he didn't. This cascade can continue as more customers arrive, resulting in one full and one empty restaurant, despite there being no discernible difference between the two.
People also accept long-standing sayings as fact, as a result of trusted word-of-mouth communication. Such myths usually start with the words "They say that...", and are believed by those who both hear and speak them. Shiller debunks a few of these common sayings: that only 10% of the human brain is used by most people, that the birth rate jumped after a power blackout, and that there were an unusually high number of suicides during the 1929 crash. People prefer to take a free ride on items like these; they will believe that some expert has confirmed it, and so they will go along with it. They are likely employing these same behaviours when they invest.
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.
Shiller now takes on the question of why the market is at the level it is at. This is an interesting question because it is not known to any degree of accuracy what the right market level should even be.
First, Shiller takes issue with popular accounts of investing psychology. These accounts would have you believe that investors are euphoric during booms, and panic-stricken during busts. But Shiller argues that this is not the case; instead, investors during these periods are trying to be sensible, but perhaps have certain modes of behaviour that guide their actions during periods of uncertainty.
But why would the Dow be priced at 14,000 as opposed to 4,000? What is causing the market to choose one level over another? Shiller believes two psychological anchors in particular play prominent roles: quantitative anchors and moral anchors.
Quantitative anchors have to do with what prices or price changes investors may believe to be appropriate, even if those beliefs are sub-conscious. Examples include yesterday's price, P/E levels of similar companies, and previous highs or lows. Quantitative anchors make the investor think an asset's price should be at a certain price.
Moral anchors, as defined by Shiller, have to do with the investor's opportunity cost for his money. Would the investor rather have X number of dollars tied up in the market, or has it reached such a level that he believes he should sell some shares to improve his standard of living? Moral anchors in the aggregate make this determination for the market.
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.
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.
It is generally believed that times of extreme optimism result in booming stock markets. The author, however, turns this theory around and argues that strong stock prices cause a society to look for reasons to explain the booming market. In this chapter, the author takes the reader through some of the "new era" thinking that has pervaded the stock market booms throughout the last 100 years.
In 1901, there was huge optimism about how technology was about to change lives for the better. The first transatlantic radio transmission occurred in 1901, and the future was seen as bright: "trains [will be] running at 150 miles per hour,...newspaper publishers will press the buttons and automotive machinery will do the rest,...phonographs as salesmen will sell goods in the big stores while automatic hands will make change."
Furthermore, a recent spell of mergers had reduced competition and increased profit margins. But the level of profits was too high for the people. Antitrust legislation was used against monopolistic companies, and corporate taxes were instituted.
The 1920s were another time of renewed optimism on the basis of technology. The number of automobiles on the road tripled during this period, and US homes had become wired for electricity, resulting in soaring sales for items such as light bulbs, vacuum cleaners and washing machines. Shiller quotes a number of extremely positive articles and books from the period, where the expectation is that civilization is embarking on a new era. Stock projections were parabolic.
"New era" thinking once again permeated during the mid-1950's and 1960's. Growth in the use of devices such as televisions helped fuel exuberance. Ideas that stocks were now held in "strong hands" (mutual funds and institutions) gave confidence that crashes were now a thing of the past. Demographics (namely the Baby Boomers) were cited as further reasons for why "it's different this time".
Following each "new era" came a bout of extreme pessimism. Feelings were often widespread that the US was losing its preeminence to other countries (e.g. Japan). Interest in Communism grew following each crash. Capitalism was often seen as having failed.
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.
The media's role in the creation of the hi-tech stock bubble of the year 2000 is discussed in this chapter. Shiller points out that the history of speculative bubbles begins roughly with the advent of newspapers! While the media present themselves as detached observers of the stories they cover, they are a major player in these events.
Shiller argues that bubbles can only occur if there is similar thinking among large groups of people. The media helps make this happen. With everyone on the same page, markets are free to rise and/or fall by large amounts.
Shiller also takes issue with some of the media's explanations for market occurrences. For example, on a given day the financial media always has an explanation ready for why the market fell or rose. But Shiller presents data that suggests these after-the-fact links are fallacious. He argues that when there is a big market event, though the media will emphasize some news item it has picked to be the cause of the event, it is actually the price change itself that is the news. Shiller takes the reader through news items preceding the 1929 and 1987 crashes, demonstrating that nothing out-of-the-ordinary was occurring in the news, though the media did attribute the causes of the crash to various current events of the time.
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 discusses the amplification mechanisms involving investor confidence and expectations that he believes are contributing in a major way to the speculative stock bubble of the year 2000. He argues that these amplification mechanisms work through a positive feedback loop, reinforcing each other until what he predicts will be a stock price collapse.
First, Shiller establishes through survey evidence that investor confidence has indeed increased in the late 1990's as compared to other periods. For example, groups of investors expected higher stock returns in the future than similar groups had in the past.
He then discusses why this may have happened, suggesting that regret (from not participating in the recent gains), a tendency to extrapolate short-term results into the long-term, the recounting of stories of those who have made riches in the market, and a tendency to ignore inflation (and therefore think of nominal stock returns only, which have been much higher than real returns over time) are leading to investor confidence that is currently higher than it should be.
Currently (at the time of writing, in the year 2000), Shiller argues that as prices continue to rise, investor confidence and expectations are going through a feedback loop. Higher stock prices are leading to higher expectations which are leading to higher prices. Shiller calls this process a naturally occuring Ponzi scheme: investors are presented with a plausible story about how great profits will be made (the reasons discussed in Chapter 2), they start by investing small, and as their returns rise, they become willing to invest more and more money. The payoffs to the investors come entirely from new money that is entering the market! A fraudulent manager isn't even required for this natural Ponzi scheme to grow wildly.
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.
Since the growth of the economy or firm earnings are not responsible for the stock market's huge growth rates in the late 1990's, Shiller attempts to determine other factors that may be playing a role in the market's growth. Shiller makes the point that there is likely no one single factor at play, but rather a confluence of a number of factors that are causing investors to bid up prices to never-before-seen ratios.
Shiller discusses the following twelve factors as possibly playing a role in the market's exuberance:
1) Arrival of the internet during a period of solid earnings growth
2) Decline of foreign economic rivals
3) Cultural changes favouring business success
4) Republic Congress and tax cuts
5) Perceived effect of the Baby Boom generation
6) Expansion in media reporting of business news
7) More optimistic analyst forecasts
8) Expansion of defined contribution pension plans
9) Growth of mutual funds
10) Decline of inflation
11) Increased trading volume (discount brokers, day traders, 24-hour trading)
12) Rise in will and willingness to gamble
Shiller warns that correlation between these factors and the stock market's growth should not be confused with causation. Nevertheless, he believes many of these are contributing to the market's growth, if only psychologically.
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.
Shiller begins by putting the stock market level, as it stood in the year 2000, in historical perspective. While the Dow Jones Industrial Average (the Dow) had more than tripled since 1994, GDP and personal income was only up 30%. Corporate profits were up less than 60% over the same period.
A chart is shown illustrating the level of two variables: the stock market level and the market's earnings. Earnings had continued on their steady path, but the market level had taken off on a vertical spike at the time of writing. Shiller illustrates that the ratio of stock prices to earnings (a 10-year average of earnings in order to smooth out volatility, as discussed here) is at an absurd level. The PE 10 ratio is at 44 at the time of writing; the closest parallel is the 33 PE 10 ratio the market hit in September of 1929, just before it crashed.
Shiller then explores the question of whether there is any relevance to the market's P/E. To do this, he plots the market's PE 10 for all years since 1890 against its subsequent 10-year real returns. The resulting graph demonstrates that there is a relationship between a market's PE 10 and its subsequent returns. Based on the graph, negative returns over the next 10 years could have been expected from the year 2000. (As it turns out, returns over the next 10 years were indeed negative.)
