Sunday, January 23, 2011

Irrational Exuberance: Chapter 2

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.

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