Irrational exuberance is written by Nobel
Laureate Robert J. Shiller who is currently a professor of economics at Yale
University. This book was first published by Princeton University Press in year
2000 which was coincided with the dot com boom period. It is a business book in which the author
tries to transparent the factors that caused the stock market booms in 1800s,
1920’s, 1950s-60s, and late 1990s. Beyond analyzing the factors that caused the
stock market booms, the author also offers readers solutions on how to deal
with future speculative bubbles. This book is one of the main critiques of
efficient market theory. The title of this book was named after Alan
Greenspan’s Speech in 1996 regarding the behavior of stock market
investors. It means unsustainable
investor enthusiasm that drives asset prices up to levels that are not
supported by fundamentals (INVESTOPEDIA, 2014).
After an introduction to stock market
historical context, the book was written into five parts. Part one was about
the 12 structural factors that influenced the market from 1995-2000. Shiller had identified 12 factors that are
not grounded in sensible economic fundamentals in explaining the surge of stock
market during 1990s. Part two of the book emphasized on cultural changes that
leverages stock market boom in late 1990s and other speculative booms. Cultural
changes was a result of the news media and of new era economic thinking. Part
three discussed about the basic psychological factors-psychological anchors for
the market and herd behavior that bear on the plausibility of speculative
bubbles. Part four of the book examined the arguments against irrational
exuberance. In other words, it focuses on the attempts to rationalize
exuberance. The last part of the book was about Shiller’s suggestions regarding
policy options and action that should be taken to prevent future speculative
bubbles.
Structural Factors
According to Shiller, there were 12 structural factors that influenced
the stock market boom from 1995 to
2000: dot com boom, the decline of foreign economics rivals, the cultural and
political changes favor business success, baby boomer effects, the decline of
inflation and the illusion of wealth, the growth of gambling over the years,
increased media coverage of business, overoptimistic stock analysts, the emerge
of defined-contribution pension plan (401k plan), the surge of mutual funds,
the expanding volume of trade, and the capitalist explosion and the ownership
society.
1) Dot com boom: In late 1990s, large number
of people had exposed to the internet and many people thought the internet has
a great influence on the economic performance. As a result, many people flocked
to invest in technology firms and made stock market of technological firms as
well as other firms to grow tremendously.
2) The decline of foreign economics rivals:
After the cold war, communist countries started to lose their power and many of
them decided to open up to capitalistic ways like US. In addition, there were
several ordeal events took place in Asian market such as Asian financial crisis
of 1997-98. These two events made people to increase their confidence in US
stock market and weakening market activities in foreign stock market.
3) The cultural and political changes favor
business success: People during the mid-1990s had placed value on materialistic
than ever before and they viewed successful businessman as favorable as or even
more than successful scientist, artist, or revolutionary. As a consequence,
there had been a surge in demand for stock during that time as people believed
investing in stock is a way to become rich quickly. The 1995 lawmakers were
also more pro-business than the previous ones and this in turn boosted public
confidence in the stock market. The Republican congress had simultaneously
proposed cutting the capital gains tax after they took on power. Many investors
anticipated further deduction in capital gains tax in the future and this made
investors to increase their demands for stock.
4) Baby boomer effects: There was an increase
in postwar birth rate in US after WWII, and this birth rate increased had
resulted in an unprecedented large number of people between the ages of 35 and
55 in 2000. Shiller came up with two theories that explain why a myriad of
middle-aged people tend to boost the stock market. One theory suggests that the
competition among those Boomers to buy stocks to save for their future
retirement had pushed up the stock price. Another theory explained that the
boomers had increased the amount of spending within the economy and this high
expenditures mean high profits for companies. Interestingly, Shiller found out
there is no relation between a baby boom and surging stock market. However, he
believed it was the public perception of the Baby Boom that drove up the stock
market price.
5) The decline of inflation and the illusion
of wealth: There had been a low and stable inflation rate starting from 1982
and according to Shiller, this low inflation boosted public perception about
the economy outlook and the stock market. A lot of investors failed to take
into account the inflation effect on their stock investment returns. The higher
return of the stock investments during 1990s were due to inflation; nothing at
all unusual was going in the stock market as people perceived.
6) The growth of gambling over the year: There
were a dramatic growth in gambling in 1990s and this increase in gambling had
changed people's attitude toward risk such as investing in equity market. When
people get involve in gambling, they usually increase their enthusiasm for
risk. As a result, people in 1990s viewed equity market as less risky than
before.
7) Increased media coverage of business:
Starting from 1983, many financial news channels and publications have spawn
up. The increase of media coverage about financial news had enticed people to
participate in stock market. In this way, the broadcast about financial news is
like an advertisement for stocks. Like an ads for a consumer product, the ads
for financial market indulge people to buy more stocks.
8) Overoptimistic stock analysts: In late
1999, analysts usually recommended their customers to hold their investments
and if their customers were capable to invest more, they should did so. There
were two reasons behind this buy and hold recommendations. Firstly, analysts
were afraid the companies would retaliate them by not allowing them to access
to key information about their companies. Secondly, many of those analysts
worked for investment banks that were affiliated with the company.
9) The emerge of defined-contribution plan:
Starting from 1981, define-contribution plan has gained popularity over
defined-benefit plan. In contrast with
the defined benefit plan in which employees promise a fixed pension from their
employers, the defined-contribution plan allowed employees to choose their own
investments and their pensions depended on their investments. The 401K plans
are the most popular defined-contribution plan. The 401k plans usually invest
heavily in stocks and this also had contributed to the boost of stock market in
1990s.
10) The surge of mutual funds: Mutual funds grew
dramatically from 1982 to 1998 (340 to 3513). Shiller had identified two
compelling causes that contributed the surge of mutual funds. First, the
explosive growth of 401K plans helped to expand mutual fund market since mutual
funds were part of the 401k plans. Second, there had been plethora of mutual
fund advertisements. The advertisements had lured investors to participate in
the market.
11) The expand volume of trade: There had been a
high turnover rate in stock market between 1982 and 1999. Part of the reasons
for this high return in stocks was due to the lower cost of stock trading and
the invention of online trading services. People were able to trade more
frequently and easily at a lower cost than before and this had encouraged
people to bid up the stock market.
12) The capitalist explosion and the ownership
society: The Bush administrator encouraged people to possess equities and
increased their investments in stocks. Labor unions had been declined and many
businesses were also having a hard time in which they lay off many workforces;
this had encouraged people to start their own businesses. Employees were
partially paid with stocks in order to increase their performance.
Amplification Mechanisms: Naturally Occurring
Ponzi Processes
In
this part, Shiller explained how the effect of the 12 structural factors is
amplified by mechanisms. First, investors in 1990s had intensified their
confidence in stock market. According to Shiller's research, people considered
stock investments more favorable than before and they also believed stocks were
a good long term investment. People indeed earned a high return from their
investments in stock market between 1995 and 2000; however, they started to
make a lost starting from 2001 to 2011. Second, the public had increased their
attention toward the stock market in the 1990's and as such, more and more
people started to participate in the stock market. There had been a dramatic
flow of investments into stocks. As the public veer their attention toward the
stock market, the media also increased their broadcasts about stocks. This
further provoke public's attention toward stock. Third, the stock had done
brilliantly to keep its momentum during the 1990's and this has provided a
feedback loop that kept investor interest in the stock market. The initial
price increases led to further price increases and this kept going on for a
long period of time before it burst. Shiller named these mechanisms as “Ponzi
Schemes” because it is based on the tenet of previous success.
Cultural Factors
Shiller
identified two cultural factors that influenced the boom of the equity market:
the news media and new era thinking. To begin with the news media, the increase
of media coverage about stocks had increased the public interest in stocks and
this in turn created the speculative bubble. As mentioned before, people
started to veer their attention toward the stock market in 1990s, so in order
to attract more or retain viewers, television, radio, newspaper, and internet
media had tremendously increase their shows about stocks. Naturally, people
usually do not like bad news, so the media broadcasted mostly only positive
things about the stock market and for the negative news about stocks, it tried
to find a fine tune excuse to explain the move to the viewers in order to
retain the public attention in stock market.
Shiller
argues that the news of price changes can affect investor behavior. In order to
prove his argument, Shiller decided to do a survey after the crash of 1987. In
his 1987 survey, he listed all the recent 10 news events that seemed relevant
to the 1987 stock market crash and ask investors to rate the events. Shiller
found out that the most significant news events were the stories pertaining to
the past price decrease. The 200-point drop in the Dow Industrial news was the
highly rate one. Shiller states in his book:
“Thus it appears the stock market had
substantially to do with a psychological feedback loop among the general
investing public from price declines to selling and thus further price
declines, along the lines of a negative bubble. The crash apparently had
nothing particularly to do with any news story other than that of the crash
itself, but rather with theories about other investors' reasons for selling and
about their psychology.”
New
era economic thinking was also one of the main causes for stock bubbles in
1800s, 1920's, and 1960's. New era notion made people feel optimistic about the
future and increased their transactions in the stock market. In 1901, the stock
market boom was fuelled by the development of technology, the innovation of
computer and the emerging of big industries. People saw these developments and
innovations as favorable which in turn makes them optimistic about the future
of the stock markets. For the 1920s optimism, it was related to the rapid
economic growth and the expansion of technological innovations usage. Lastly,
the new era thinking of the 1950s and 1960s was the result of a baby boom
effect, stable and low inflation rate, the dot com bubble, and the optimism
about the business future.
Psychological factors
According
to Shiller, there was a human tendency to invest in conformity to one another
in stock market. Investors usually rely on the opinion of others and recent
news when making their investment decisions.
They failed to use the economics theories that they had learnt at school
and their intuitions in judging their investments. During the boom or bust
period, there is a herd behavior that influences investors to increase or
decrease their investments. The heard behavior makes people forget about the
real situation of the business and the economy and they just act in accordance
to one another. Investors do not have their own independent behaviours as they
receive the stock market information from the same source.
Conclusion and Shiller’s recommendations
There
were a dozen of structural factors that influenced the stock market booms in
late 1990s. These factors could not explained by economics theories, but
Shiller believed they were clearly correlated to the stock market bubbles in
the past. The 12 structural factors were
supported by three mechanisms: the increase of investor confidence in stock
market, the surge of public attention toward stocks, and the robust performance
of stock market. The news media and new era thinking were two main cultural factors
that helped attract more investors into stock market which in turn created the
booms. In this way, the news media had increased their broadcasts about stock
market and most of their broadcasts were good news as their audiences did not
like bad stories. The increase of
positive broadcasts about stock markets made more and more people become
familiar with stocks and increased their desire to invest in stocks. New era
thinking made people feel confidence about the future. As people optimistic
about the future, they forecasted that the business would perform well in the
future. As such, investors had increase their involvements in stock market.
Shiller noticed investors usually make their investments based on their peers
and other recent news; they do not make investments regarding to their
intuitions. In order to prevent future speculative bubbles, Shiller has
recommended investors to try to create more opportunities to diversify their
asset holdings and take a precaution measure against future irrational exuberance.
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