Irrational Exuberance | Robert J. Shiller

Irrational Exuberance | Robert J. Shiller | Dangerous real estate bubble?

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Irrational Exuberance

	Irrational Exuberance Robert J. Shiller Broadway Books, 2006 - 336 pages average customer review:based on 89 reviews view larger image
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highly recommended

Presents the Evidence!

This is the second edition. The book opens with some great charts of real-estate appreciation corrected for inflation over the years. I have looked for such a chart for a long time over the web but never found one! The author also presents a simliar chart for stocks (this I've found very often in other places). The author uses these charts to back up his statements making his case very convincing!

Good reading for those who like evidence-based presentation of ideas!

Dangerous real estate bubble?

I read this book to find out how potentially dangerous the real estate bubble is. According to the professor the bubble is based on mass psychology. More and more herdlike investors buy just because prices are going up and up. That sure sounds dangerous. But what will happen next? Forecasters are uncertain about price levels of homes in one year's time, and for 5 to 10 years, they have no idea. There is danger out there but we don't know when it will hit us. No one knows how to forecast a turn in mass psychology. This all does not make real estate sound as solid as it is supposed to be. But if you are investing for the very long run as I do, don't sell in a panic, because on page 16 Professor Schiller writes: "Real estate home prices showed remarkable stability over the whole boom-and-bust cycle of the stock market surrounding 1929." So real estate is a solid investment after all.

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Anatomy of a Speculative Bubble

"Irrational Exuberance" is an expression that was actually coined by Robert J Shiller, and was used in his briefing of Alan Greenspan in 1996 before the Chairman of the Federal Reserve immortalized it in a public setting. The expression was used as a warning against a possible speculative bubble in stock market prices. As we know now, the market continued to climb until 2000 when it collapsed. The first edition was published just before the dramatic fall of the market, making Shiller somewhat of a guru of speculative bubbles.

Shiller points out that the Dow Jones had gone from 3,600 in 1994 to 11,700 in 2,000; the price-earnings ratio had reached an incredible 44.3. When the stock market crashed in 1929 the p-e ratio was at 32.6. By 1932 the market had lost 80% of its value. As we have seen, the bubble of 1929 pales in comparison to the bubble of 2000.

Traditional financial theory assumes that people act rationally when they make investment decisions. Investors ideally examine financial statements, calculate returns, evaluate economic factors, and then determine whether to buy or sell.

Shiller is an economist who specializes in behavioural finance and thus tends to emphasize cultural and psychological factors that cause people to invest in assets that have risen over and above levels justified by rational theory.

He identifies twelve factors that have led to the bubble in 2000:

1) The fall of the Berlin Wall and China's shift to a market economy, which led to the triumph of capitalism.

2) People are more materialistic than they were in the past. According to polls, everyone wants to get rich.

3) New technologies led people to believe that they were at the dawn of a new age prosperity.

4) Monetary policies encouraged a bubble rather than choking it off.

5) It was believed that the impact of the baby boomers on the market would be profound and lasting.

6) There was more media coverage of people getting rich during the boom, thus creating a "positive feedback loop."

7) The analysts were giving positive reviews of stocks, not because of fundamentals, but because the stocks were being underwritten by their employers.

8) Pension funds were speculating in the market trying to get better returns than the traditional fixed rate.

9) The enormous growth of mutual funds fueled the boom.

10) The persistence of low inflation was a factor.

11) The introduction of online trading expanded the opportunities for speculation.

12) The general mentality of casino society has set in with the huge increase of gambling.

With the publication of the second edition of his book, Shiller argues that many of these factors are at work in the real estate market boom. The prices of US homes have increased 52% from 1997 to 2004. Historically this is unprecedented. Today people are speculating in the real estate market like they did in stocks in the 1990's, and much like the stock market, the phenomenon is global. It is happening in London, Vancouver, Moscow, Shanghai, and elsewhere. All the indicators of a speculative bubble are present.

The problem I have with this book is that Shiller tries to explain increase in market value only in terms of psychology, and fails to take into account the real value that has been added on a scale unprecedented in history. Globalization, as Thomas Friedman describes it in "The World is Flat," has created new and lasting efficiencies in the global economy that resulted from the internet and other technologies. Even though technology stocks crashed in 2000, the internet and all of its benefits did not disappear, it in fact supercharged the global economy. The Dow Jones is almost back to where it was five years ago.

Shiller, however, is cautious about predicting a similar collapse of the housing market. He does warn against the false belief that home prices will inexorably increase because of growing populations and widening prosperity. Instead he advises to diversify into many classes of assets to dilute risk.

This book does not advise you to sell your home or any other property you may own, nor does it give any specific investment advice; it does, however, give an excellent overview of all the indicators of a speculative bubble.

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Fascinating material, curious conclusions

While reading this book, I was reminded of the three laws of thermodynamics:
The First Law: You can't get anything without working for it.
The Second Law: The most you can accomplish by working is to break even.
The Third Law: You can only break even at absolute zero.

Most engineers can recite something a little more down to earth:
1) You Can't Win.
2) You Can't Break Even.
3) You Can't Quit.

Dr. Shiller does a good job of arguing our investment portfolios, on average, must obey laws 1 and 2, but suggests we can escape law number 3. I'm not convinced

The book starts very well, documenting a strong historical relationship between 10 year annualized growth and the ratio of 'stock price' divided by either earnings or dividends. He covers this material several times, and always makes good use of it. In short, the high price-earning ratios of 2000 were not sustainable. The title argument is proven in chapter 1.

The middle of the book is occupied by less compelling material. First, we review what Shiller called structural factors. These are facts such as the Internet and baby boomer demographics. This includes a detour into popular delusions caused by our natural tendency to get excited by the enthusiasms of others, honest or otherwise. Next, we cover what Shiller calls 'cultural' factors: news, popular concepts (both high-brow and faddish). Not willing to rely on these simple distinctions, Shiller call psychology a 3rd area of interest. In this section he covers what might be called 'behavioral finance' (psychological anchors and herd behavior).

Much of this is fascinating material and highly recommended. Unlike chapter 1, the implications are somewhat vague.

Finally, after reviewing what amounts to thermodynamic laws 1 and 2 applied to average investment portfolios, Shiller concludes the government can do a better job. Very specific comments on Social Security reform dominate the final chapter. Unfortunately, none of the book lays any foundation for his policy advocacy (he hates privatization). I suspect one's political persuasion will determine how one reacts to the argument, since there is almost no background or survey of policy options provided. For me, the sudden change in paces was an attempt to change the subject and avoid talking about thermodynamic law #3.

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Correct conclusions,but nothing new or original

Shiller's book presents conclusions that are correct.However,all of these conclusions have been arrived at by other scholars long before Shiller published his book.The best general exposition is in the 3rd edition of Kindleberger's Manias,Panics,and Crashes(1996).Kindleberger is mentioned in one footnote in Shiller's book.The best technical exposition is Benoit Mandelbrot's Fractals and Scaling in Finance(1997).Mandelbrot is mentioned in one footnote in Shiller's book.Since the mid-1950's,Mandelbrot has shown that the financial markets are subject to wild risk,based on the approximate use of a Cauchy Distribution,and not the mild risk of the normal probability distribution ,the use of which is supported by no empirical results.The best short exposition of this problem is contained in chapter 12 of John Maynard Keynes's The General Theory of Employment,Interest and Money(1936;GT).Keynes (and later,Daniel Ellsberg)showed that the main problem in the stock markets is the existence of ambiguity and/or uncertainty about the future expected returns.Nowhere in this book is the fundamental analysis provided by Keynes in the A Treatise on Probability(1921) and applied in the GT given even a footnote.According to both Keynes and Ellsberg, fully rational decision makers are confronted with the necessity of making decisions on the basis of unreliable,vague,unclear,ambiguous,and underweighted probabilities in short periods of time.Such decision makers attempt to obtain additional relevant information by incorporating the views of experts whom they think are more knowledgeable than they are.This leads to crowd,group,herd and/or cascade effects that leads to the creation of bubbles,manias,panics,and crashes.This is not the reason given by Shiller.Instead,Shiller bases his claims on the so called "new" behavioral economics of Tversky,Kahneman ,Thaler,etc.This group of academics base their analysis on the claim that decision makers are hopelessly irrational and ignorant(they do not understand how to correctly apply statistics and probability based on applications of the normal probability distribution and its variants).Such irrational decision makers resort to a host of heuristics,mental shortcuts,and rules of thumb ,combined with their emotions and fears,in order to make decisions.There is obviously a major conflict about what the major reasons are for the boom-bust nature of the stock markets and all other FINANCIAL MARKETS.Shiller appears to have attempted to hide these major differences in this book.The conclusions are correct,but the reasoning supporting these conclusions is flawed and incomplete.

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