Catching the bear by its horns

The book provides a comprehensive view of how markets become over-valued creating a bubble. It also gives insights into investor behaviour in the bull and bear phases of the markets over the last century, says R. Sree Ram.

R. Sree Ram | Print Edition: October 16, 2008

Irrational exuberance
Irrational exuberance

Price: Rs 473

Pages: 319

By: Robert J. Shiller

Published by: Broadway books

Target audience: Equity investors

Quick read tip: Read “A call to action” to know what steps to take in today’s volatile markets

Language: Easy

Style: Academic

Visuals: Tables

What goes up, eventually, does come down. And if all you are riding on is hot air, then the fall is bound to be devastating. This very simple premise is what Robert J. Shiller, the author of Irrational Exuberance, believes in wholeheartedly, especially when it comes to stock markets that are over-valued. He has picked up the term “irrational exuberance” from a speech delivered by Alan Greenspan in December 1996, who was then the Federal Reserve chairman. Greenspan coined the term when he defined the heightened interest in the equity markets as irrational.

So in 2000, when Shiller, a Yale university professor and economist, wanted to highlight the blind pumping of money in a flood of unproven IT companies, he aptly used the term as the title of his book. Shiller predicted that the dotcom boom was just a bubble waiting to burst. It was a timely warning because the Nasdaq crashed within a short time of the book being published.

Shiller defines irrational exuberance as wishful thinking on the part of investors that blinds them to the truth. Throughout the book he engages readers by giving insights into investors’ psychology and how they behaved at various times of economic distrust.

What has given Shiller even more eminence is another prediction made in the second edition of his book in 2005 about the brewing housing trouble. The author points out that the rise in home prices since 1998 has been much faster than the rise in incomes of the average household. He further explains that the innovations in financial products have not helped much as households need to contribute increased sums to mortgages, straining the family finances. In the eight most volatile years, from 1985 to 2002, the median price of a typical home rose from 4.9 years of per capita income to 7.7 years.

Realtors and property firms rebuffed Shiller’s contention since they believed it was nearly impossible for property prices to come down. But Shiller must have felt vindicated when the subprime crisis happened this year, resulting in shattering consequences for markets globally.

The author questions how Wall Street whizkids evaluate companies and the rosy forecasts that analysts arrive at in boom times. He also highlights the conflict of interest investment banks carry as they are more involved with the company rather than serving the interest of retail investors.

What makes the book more interesting are the snippets from the analysis of historical data that throw up signals which indicate a build-up of excessive pricing in the markets. For instance, the price earnings ratio, which is the inflation corrected S&P Composite Index divided by the 10-year moving average of real earnings on the index, spiked to 44.3 by January 2000. The closest parallel has been drawn at 32.6 in September 1929 (see graph). That year marked the beginning of the Great Depression.

Shiller analyses the various factors that led to the deluge of money into the stock markets. He cites “precipitating factors” such as the Internet, tax cuts and the rise of the baby boomers. He also indicates how to watch out for warning signals. As he says, “When one is not getting much in dividends relative to the price one pays for stocks it is not a good time to buy stocks.” According to his analysis, the record-high price earnings have always been matched by record-low dividend yields. In January 2000, before the dotcom bubble burst, the S&P dividends were 1.2% of the price, far below the historical average of 4.7%.

Shiller suggests several solutions to avoid future bubble-traps such as diversification and investing in assets that offset the risks associated with ones that you are already invested in.

Shiller’s words of wisdom

On the Fannie Mae and Freddie Mac bailouts

In November 2007
In light of modern financial theory, this would also be a good time to think about the nature of the implicit subsidies given to government-sponsored enterprises like Fannie Mae and Freddie Mac and whether they provide enough incentives for them to properly manage their own risks as guarantors of mortgages.

In September 2008
The gnawing problem is one of “good faith.” Economies prosper only on the perception that “good faith” exists. The current situation, in which speculative booms have driven the world economy— and, having collapsed, are now driving it into recession—suggests that there may have been a lot of bad faith by people promoting certain investments.

On the us housing bubble

In 2005
Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors.

In 2008
The failure to recognise the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the US and around the world. If people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.

 Read our review of the book: Invest like a shark

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