VideoOn December 3, 1996, Robert J. Shiller, the Stanley P. Resor Professor of Economics at Yale University, made a sobering presentation to the Board of Governors of the Federal Reserve System. The stock market, he warned, was priced beyond reason; valuation ratios had reached historical extremes. If history was a reliable guide, the market would be a poor investment over the next 10 years. Evidently, Shiller's testimony made a deep impression on Alan Greenspan. Two days later, the Fed chairman delivered the speech in which he coined the famous phrase, "irrational exuberance."
That was then, when the Dow Jones Industrial Average hovered around 6,400. This is now, and the Dow has skyrocketed, exceeding 11,200 in early September. Today, Greenspan isn't talking much aboutinvestor irrationality (in public, at least). Instead, he's cautiously optimistic about the productivity-boosting effects of information technology and the Internet, and he seems to lend support to the widespread notion that a new era of the economy is at hand. Professor Shiller, on the other hand, is more worried than ever, and earlier this year, he published a book on the state of the stock market. Its title? Irrational Exuberance (Princeton University Press).
Written for a nonacademic reader, the book examines the stock market boom from the point of view of a behavioral economist--someone who believes that describing how investors actually think and behave, and how various forces shape that thinking and behavior, can yield far more insight into the "messier aspects of market reality" than elegant mathematical models can. No devotee of efficient-markets theory, Shiller draws on the disciplines of psychology, sociology, demography, and history to explain why people invest the way they do--and how market values can soar to irrational levels.
Of course, not everyone thinks that the stock market is grossly overvalued. Indeed, many observers believe that the U.S. economy is poised on the cusp of an even longer boom, and that the greatest bull market in history will continue unabated for years to come. Is this rational optimism, or more irrational exuberance? Recently, CFO articles editor Edward Teach discussed this question with the 54-year-old Shiller in his office on the Yale campus in New Haven, Connecticut.
You write that today's stock market is "a speculative bubble of historic proportions." What's the evidence for this belief?
Well, I think the evidence is many-faceted. Calling something a speculative bubble is a judgment call.
The common view is that the market is the outcome of a vote among many people who are trying to guess at value, and therefore, since so many people have voted, it must be an accurate indicator of value. So, in order to understand whether that is a plausible argument, you have to look at the whole picture and what people are doing and what kind of information the typical person is using. And looking at the whole picture, it seemed obvious to me that it is not a vote of people carefully trying to evaluate the value of the market. Instead, there are social, historical, and institutional forces that shape their decisions.
Let's compare historical numbers. I'm struck by a couple of charts in your book. One displays the monthly price/earnings ratio of the S&P Composite Stock Price Index from 1881 to January 2000. The second-highest peak is September 1929, when the P/E reached 33.6. The highest peak, by far, is January 2000-- 44.3.
The other chart, a scatter diagram, suggests that the price/earnings ratio predicts 10-year returns. That is, the higher the P/E of the S&P Composite Index in January of a given year, the lower the ensuing 10-year real return of the index. The lower the P/E, the higher the 10-year returns.
Yes, this is a very important part of the argument because there is so much attention paid to the random-law theory. The random-law theory would imply that there should be nothing in that scatter, no sense of slope.
According to the scatter diagram, which slopes downward from left to right, the annualized 10-year real return following January 1929-- the farthest point along the x- axis--is practically zero. What does that suggest about the 10-year annualized return of the S&P in 2010?
That's a good question. I've fitted lines through this--I just did it with your business card--it comes out to about minus 10 or 15 percent a year. But I never felt comfortable about extrapolating that line out of samples so far. This is a fundamental dilemma; we're out of the historical range. And some people would say, "Well, that proves we're in a new era. History is irrelevant."
Maybe we are in a new era, thanks to the Internet. Investors seem to think so.
If you go through any decade in U.S. history--excluding maybe the war decades, World War I and World War II--there was always some thing that was a really important transformation. We have to remember that whenever a new technology appears, it fuels growth for a time, while it's being adopted, and then it becomes mature, and then it's done.
An example that I've been thinking about lately is the interstate highway system. In 1919, the U.S. Army decided to send a truck and military car convoy coast-to- coast as an experiment. It took them 62 days. This made a big impression on the young Eisenhower, and later, after he saw the Autobahn, he decided to build this highway system, which created 43,000 miles of highway. It changed the whole structure of the economy.
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