Saturday, February 5, 2011

Irrational Exuberance: Chapter 5

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.

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