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am 15. April 2000
Professor Shiller's excellent book provides food for thought, addressing the timely question of whether stocks are overvalued. He notes that P/Es are at historically high levels, and that high P/Es in the past have led to subsequent subpar returns, while low P/Es have led to excellent returns. For example, P/Es were high before the great depression, and low at the beginning of the eighties.
Shiller then goes on to explain a bit about the psychology of bubbles and manias, a field in which he is expert. He intersperses fascinating data that he has collected over the years, especially from the crash of '87, on whether market moves are due to the arrival of new economic information about firms' profitability or whether the market and its participants have a psychology of their own.
Still, I am not going to heed Shiller's advice to sell all my stocks right now. Before doing so, I would like to see him address the following issues (perhaps in Shiller's next best-selling book?):
(1) "The Fed Model" of stock valuations: Shiller uses P/E as a benchmark, rather than comparing yields available on stocks to those available on bonds. Greenspan's famous Irrational Exuberance speech used this benchmark rather than pure P/E (which doesn't compare stocks to alternative investments).
Also, is the nominal bond interest rate relevant for comparing stock to bond investing? The real interest rate? What have researchers discovered on this front?
(2) Shiller does not admit the possibility that there is anything different in today's economy from historically. I'm not convinced. Presumably, the following should be taken seriously, rather than dismissed out of hand:
First, firms are ramping up extremely rapidly in new industries, faster than ever before. It is quite reasonable to expect faster profit growth than the 11% long term average.
Second, reported profits are not what they used to be, they're better: Firms now expense R&D rather than depreciating it, and because R&D has been growing rapidly, reported profits are now much below what they would have been under old accounting standards.
Third, the cost of investing, especially of diversification through US and international mutual funds, has fallen precipitously, making stocks a more attractive investment.
Fourth, the world economy may very well be more stable now than in the past.
Fifth (and I have no idea if this is true), if people are really investing more for the long run than before, then their greater interest in stocks might be warranted, since stocks beat bonds much more consistently over long time horizons than over short horizons. Given this, it is important to know the source of the stock risk premium. Is it based on people's need for liquidity? Are people more or less in need of liquidity from their stocks now than tradiationally? How does the baby boom generation fit into all this?
Still, it's a fascinating book. Will the 35% fall in Nasdaq over the last few weeks be called the Shiller Effect a century from now?
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am 5. Juli 2000
This book is very commented upon, so I'll try to make this short.
First - it walks like a duck, but is it a duck? In a book entirely devoted to the subject of overvaluation, I'd expect better proof than aggregate P/E ratios and circumstantial evidence from psychological research. The industry - self-interested as it is - routinely produces valuation measures by sector, including eg P/E to growth which should be a better gauge than P/E alone. Doing this places most of the blame on TMT segments, not on the whole market.
Second - policy implications are weakish. Although the investing-for-retirement issue is important, most of the advice is "do not put all eggs in the equity basket", which is just fine, and "buy TIPS", which is also fine, but overall the policy chapter reminds a bit of the mountain giving birth to a mouse.
Third - the book is clearly written, well documented, and tries to look beyond the US scene (though most of the "behavioral" stuff is in fact very American). Which is fine as most US writers do not give a damn for evidence from the rest of the world.
Fourth - stars should measure the book's usefulness, not its adherence to what the reviewer thinks. If you sift the reviews with this criterion (taking out the angry and the hagiographic ones), the average star grade increases.
This says the book should be read, and that's my conclusion too. I even irrationally bought it before it was discounted, but maybe that will be the market's story too, in a few months!
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am 21. Mai 2000
Shiller's historical review of markets brings the reader to the question: Is there such a thing as too high a price? Many investors today believe there is not -- in fact, it has become the conventional wisdom. "Buy stocks regardless of the price because they always go up". Shiller's historical evidence is that people have thought this once every generation or two in the past. In the past they have always been disappointed.
Shiller is not a raging bear as pundits have labeled him. He is not predicting another depression. His assertion is simply that when prices are high it is unlikely to be a profitable time to invest compared to investing when prices are low.
The thinking that we are in a "new era" permeates today, as he shows it has during previous market peaks. And although "new eras" do revolutionize the way we live, they have never ended the economic principle of competition preventing any enterprise from earning extraordinary profits for long. (Is the internet really a greater revolution than the invention of electricity? of the telephone? of affordable cars?)
There is no such thing as a risk free, predictable and effortless way to great wealth. Shiller provides a thoughtful examination of why from time to time it appears to people that there is such a thing and compares "what were they thinking then" to "what are we thinking now" with good effect.
A long term perspective, thoughtfully presented in a very approachable style.
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am 22. September 2001
Shiller wrote his book with the sobriety of an academic. That's why I enjoyed reading his book so much. While the efficient-market theory seeks to explain the rational side of share-price valuations, Shiller focuses on irrational aspects thereof. The efficient-market theory owes its mathematical rigor to some simplifying assumptions. Shiller provides compelling evidence that the stock market is not as efficient as many "financial experts" might have you believed. Most disquietingly, inefficiet market-behavior shows up not only in the short run, as will be admitted by many advocates of the efficient-market model, but also on rather long time scales (e.g., a decade or so). Shiller carefully covers many aspects and manifestations of this fact.
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am 25. März 2000
Speculating on a Bubble
Taking his cue from Federal Reserve Chairman Alan Greenspan, Yale economics professor Robert Shiller delivers a dirge for the longest-running bull market in American history. Irrational Exuberance tells the reader why today's market is overvalued, how it got that way, and what policymakers should do about it. Along the way, he takes some well-aimed swipes at efficient markets and so-called rational expectations. These latter theories, derived by (and largely confined to) academia, would have us believe that investors always behave rationally and that stock prices always reflect all pertinent information.
Professor Shiller is well known for his research into behavioral finance, including his many surveys seeking to uncover the thought processes of today's investors, both individual and institutional. It is understandable, then, that the bulk of the book, and its strongest part, concerns the ways and means by which human behavior, irrespective of economic fundamentals, leads to stock market bubbles. Peer pressure, herding, emotions such as regret and envy, perceptions shaped by personal contacts and by the media, all contribute to a psychological "positive feedback" loop whereby high stock prices beget still higher stock prices.
My gripe with the book relates to Professor Shiller's downgrading of the role played by mechanical "positive feedback" dynamic hedging strategies which are based on academic, Nobel Prize winning theories on the pricing of derivatives. Shiller states (p. 93) that these strategies are of interest to us "only because it shows us concretely how people's thinking can change in ways that alter the manner in which feedback from stock price changes affects further stock price changes, thereby creating possible price instabilities." My book, Capital Ideas and Market Realities (Blackwell, 1999), finds, after a thorough review of the role of dynamic hedging in the 1987 crash and in the volatility in the 1990s, including the downfall and Federal Reserve brokered rescue of the giant arbitrage hedge fund Long-Term Capital Management, that such trading strategies can be crucial elements in both stock market bubbles and stock market crashes. Rather than being merely symptomatic of a psychological feedback loop, such trading mechanisms create their own positive feedback loops, as well as crystallizing and amplifying some of the psychological factors cited by Professor Shiller.
Others may consider of greater consequence the book's failure to address the "two tier" nature of today's market-the so-called "new economy"/"old economy" schism. This is particularly troubling because much of Professor Shiller's quantitative evidence of over-exuberance in market pricing rests on various measures of corporate dividends-which, of course, are notoriously shunned by most "new economy" companies. As the book's overall argument can be (simplistically) summarized as "the future will eventually repeat the past," I would have liked to see him grapple more explicitly with what appear to be real qualitative differences between past and present.
I liked Professor Shiller's concluding summary of solutions and issues for investors and policy-makers. Some of these, including his thoughts on Social Security and on the need for diversification and diversifying investment vehicles, deserve to be brought to the forefront of public debate. It would also help matters if, as Professor Shiller suggests, the so-called "experts," as well as the media generally, raised the level of public discourse on the stock market and the economy-issues critical to all of us, whether we are investors or not.
Bruce I. Jacobs (, Principal, Jacobs Levy Equity Management, and author of Capital Ideas and Market Realities (Blackwell, 1999).
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am 5. Mai 2000
Schiller's case rests on a rich mix of quantitative and qualitative research and analysis. (By qualitative, I include his surveys of fund managers with small sample sizes). He challenges a great many points of conventional wisdom, showing them to be neither conventional nor wise.
One thing he fails to do, however, is systematically refute the hypothesis that high valuations (especially for tech stocks) are justified. Real option pricing, for instance, does demand an approach completely different to that of traditional discounted cash flows: if an investor wishes to take on the risk of an unproven business model, with its attendant uncertainty but large potential upside, that is not necessarily irrational.
Schiller's answer is that the P/E ratios are so far off the historical norms that it's not worth discussing further. And the option pricing view can't hold for the whole market.
The challenges to efficient market theory, and to Jeremy Siegel's (of the Wharton School at U Penn) views in "Stocks for the long run" are similarly one step short of complete.
That said, this book serves the invaluable function of challenging the complacency that pervades popular opinion and the media. My own favourite manifestation of this is the Economist's observation that when stocks rise, newspapers describe them as "strong"; when they fall, they are "volatile". What's in a name? Market sentiment, which drives prices to unsustainable levels.
This book was written because the author cares. Both as an academic and as an observer of public policy, he rightly fears the effects of a collapse in the markets. He deserves to be read.
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am 18. April 2000
I bought this book the moment it came out on Amazon, even before it was discounted. I was rather disappointed; it feels like it was rushed to press and could have used a few more rounds of editing. It has had the (apparently) unintended effect of making me feel very bullish about the market.
Some of the arguments could be used to justify either higher prices or to explain a monumental crash sometime in the future. In other words, twenty years from now people can read this to undertand how NASDAQ went from 1700 to 1,000,000 (or whatever) in 22 years OR they can read it to understand why people kept buying stocks before the market tanked. Because the author seems to take a crash as some kind of inevitability, he views his evidence as supporting his case. For example, just because people are becoming more adjusted to gambling their money by investing in the stock market does not mean that the stock market is going to go down. I really think this book may have been written to explain a (real) crash that has not occurred yet, but the publisher wanted to get it out ASAP for commercial reasons.
The most interesting aspect of this book to me is that a trained economist, a Yale professor, could miss such obvious market influences as the effects of 1986 tax reform, or the simple fact that with online trading, you can not only buy and sell stocks for $12 a trade, but do it without actually talking to a human. There is some interesting stuff here, but not much. You can learn as much or more about investor psychology by participating in chat rooms.
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am 11. Mai 2000
Dr. Shiller has performed a service for those investors who have never endured a bear market and who have forgotten the meaning of risk.He makes a strong and convincing argument for the overvaluation of the stock market, however, he fails to explore in depth the similiarities between the state of the current market and the psychology prior to the crash of 1929. John Templeton once said that the most expensive words in the English language are "this time its different". The internet mania, the day traders, the popularity of CNBC,the massive increase in margin debt, the number of books proclaiming "Dow 36000, Dow 40000 and Dow 100,000, the intense interest in "How to Be a Millionaire", the lionization of Alan Greenspan, the internet millionaires, the bad breadth in the stock market and proclamations of a new era while interest rates are rising should give cause for concern. Dr. Shiller has written an excellent book but it stops short as to historical parallels which support his hypothesis. The problem with theory and practice, is that it is difficult to predict the timing of a crisis from psychological data. Markets continue to flow against the tide of human reason far longer than is anticipated from evidence to the contrary. Like Babson, who predicted the crash of 1929 for many years prior to the actual crash, the markets seem to be responding to Shiller's words of caution. There need not be a crash but a return to normalcy in the marketplace. This is a major contribution to investors.
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I found the second half of this book to be better than the first.
Professor Shiller emphasizes two points: (1) US Stock prices are overvalued, and (2) stock prices have been driven high by psychological feedback. I've made the same speculation in my recent article The Futility of Utility, where I've pointed out that gambling in the market is essentially different from mechanical acts like tossing dice or drawing cards: the amount of betting on a stock determines a buyer's success or failure in the latter case, but certainly not in the former one.
The weakness of the book is the first claim, that stocks are very much overpriced. In support of that point he presents an impressive graph (pg. 8) of P/E vs. time from 1860-2000 that shows that typical market P/E's were around 25-35 just before the big US market crashes, historically, and that the present market P/E is around 45. The difficulty with the viewpoint is that he assumes that "value" makes sense, although he doesn't define "value" of a stock. Unless we can more or less uniquely define "value" we can't say whether a stock is overpriced or underpriced. This is a serious problem that has not been solved either by neo-classical economics or by modern finance theory. We would all likely agree that Intel at 30 would look cheap these days whereas Intel at 200 would not look cheap, but what is the "true value" of Intel?
I have argued in Futility of Utility that "Value" is undefined because it is not unique. Like the notion of price as a function of demand, it is a bad idea, both theoretically and empirically. Professor Shiller seems to have in mind the old pre-theoretical finance (pre-Osborne, pre-Black-Scholes) idea of dividend-discounted stock prices when he speaks of "value". This is a dead idea, still taken seriously only by a few professors within the academic economics profession. It's a useless notion because (1) no one buys stocks for dividends, and (2) it's impossible to define the idea of dividend-discounted price, because even next year's expected return is random and complex enough that it cannot be known or accurately estimated in advance. It is very easy to give at least three more definitions of "value", none of which agrees with the other three (see my larger review of Shiller's book on the June 2000 web site [...] What is missing in the book is pinning down the real reason why stock prices are historically high, and why business activity is at such a high level. My uneducated guess is that it has a lot to do with the amount of money in circulation, much or most of it credit-originated in one way or another.
Professor Shiller doesn't like traders. In his ideal world there are only rational long-term investors willing to settle for 3-5% a year, or whatever the rational market produces (people with enough money can certainly afford that luxury, and typically buy bonds). The book ends on a Spenglerian note, reminiscent of the Arrow-Debreu program in neo-classical economics and Merton's program of inventing hidden options: Professor Shiller wants to monetize a lot of stuff. In his rational world (part 5, "A Call to Action"), you could short Houston's booming housing market, the Japanese economy, the US economy, or whatever else you might want to choose. This is a call for an even greater free market/market freedom, based on the assumption that we, as economic animals, will benefits from fewer, not more, restrictions on markets, in (questionable) analogy with our functioning as voters in representative democracies.
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am 5. April 2000
'Irrational Exuberance' will no doubt consolidate Robert Shiller's position within his chosen field, but the book is also of considerable value to the intelligent lay person. Other writers have drawn attention to the market's overpriced level. Other writers have also done the numbers and concluded that stock returns are not likely to out pace bond returns, for example, over the next decade. But no other writer provides such a detailed and convincing analysis of the factors that have stoked our mania for stocks and brought us to the top of a speculative bubble. Shiller's account of what academics such as Prof. Irving Fisher thought of stock market valuations in the 1920s is a useful reminder that even the experts can get it wrong. More importantly, his analysis of past decades suggests a cyclical movement in the all too human desire to believe in a new economic age. Among the truths which Americans evidently have not learned is that new economic eras do not result in permanent stock market booms. That technology enables more efficient production which in turn helps keep inflation low has been acknowledged publicly by Alan Greenspan. But the market's reaction extends way beyond what this fundamental change might warrant, for all of the reasons Shiller cites.
While Prof. Shiller's analysis is highly credible, his suggestions for the individual investor are, in places, difficult to understand. Indeed his discussion of diversification may only be deciphered by his fellow economists. Lay men and women can hardly be expected to know what "...taking short term positions in claims on income aggregates," means. Nor can they regard his advice to invest in markets that do not yet exist as practical guidance. These, however, are minor quibbles. Unlike many market commentators these days, Shiller's underlying social conscience puts him on the side of the little guy. Yet even so, this books is aimed primarily at policymakers who have the power to influence public behavior for the good. The prospect of thousands of retirees living on the margins because they invested too much of their 401(k) money in the stock market is surely one which will compel their attention.
Jim Sanders Annandale, Virginia
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