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Irrational Exuberance: A Book Review

Irrational exuberance refers to extreme behavior enthusiasm, often compared to the stock market and investor behavior. Typically, it means that investors are excited and driving up stock prices regardless of the fundamentals that would support those increases.

Irrational exuberance is the perfect analogy to illustrate the market reaction to the current Covid-19 pandemic, with many companies stock prices rising at crazy rates regardless of the fundamentals of the company.

A perfect example of this is Tesla, which has crossed the $1000 a share earlier this year, despite still losing money and producing fewer cars than any of the other big car dealers.

Irrational exuberance has become associated with bubbles and the creation of unsupported asset prices. All of which leads to those bubbles popping and leads to further market panic and “blood in the street.”

In today’s post, we will learn:

  • The Origin of the Term “Irrational Exuberance”
  • Robert Shiller and Irrational Exuberance
  • Key Takeaways from Irrational Exuberance
  • Common Criticism of the Book

Ok, let’s dive in.

Origins of the Term “Irrational Exuberance”

Irrational exuberance is a term that came into the consciousness of investors from a speech given by Alan Greenspan in 1996. Greenspan was the Fed Chairman at that time, and the speech is known as:

The Challenge of Central Banking in a Democratic Society

An excerpt from the above speech which contains the most famous phrase:

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?”

The speech was given in the mid-90s, which was the onset of the dot-com bubble, which is the perfect, textbook definition of irrational exuberance.

To breakdown irrational exuberance a bit.

Irrational exuberance is undue economic optimism, which is widespread. Think about Bitcoin mania a few years ago, everyone who had never expressed any interest in investing was asking questions about Bitcoin.

When investors start to believe there is no risk in the market and that the continuous rise in prices will continue. All of this creates a positive feedback loop of ever-rising prices.

All of the exuberance creates a problem because it can cause asset prices to rise. But, when the bubble pops, investors start panicking and selling. All of this drives prices down sharply, and very quickly. Think back to early March 2020 when the economy was forced to shut down suddenly, asset prices fell off a cliff, and in some cases was warranted. But in many others, it was panic selling, pure and simple.

All of the panic selling sells to other asset classes outside of the dot-com bubble, for example. And in many cases can spark a recession as the panic increases. Usually, the investors that are hurt the most when these bubbles burst are the optimists or bears that are overconfident that the bull run will go on forever. Remember that trusting a bull won’t ever turn on you is the best way to ensure you get gored.

Alan Greenspan first raised the question of whether central banks should attempt to limit the effects of irrational exuberance with tightening fiscal policy. He believed that the central bank should raise interest rates to head off any speculative bubbles that might be taking shape.

Once the bubble burst of the dot-com in early 2000, the impact was immense. The Nasdaq index fell 76% from its high on March 10, 2000, to the low of October 4, 2020. By the end of 2001, most of the dot-com stocks had gone bankrupt, and the damage spread to the blue-chip stocks such as Cisco, Intel, and Oracle, which lost around 80% of their value.

In fact, it would take 15 years before the Nasdaq would recover to its dot-com peak, which wasn’t until April of 2015.

All of that brings us to our introduction of Robert Shiller.

Robert Shiller and Irrational Exuberance

Robert Shiller was born in March of 1945, and he is an economist, Nobel Laureate, and the best selling author of multiple books:

  • Irrational Exuberance
  • Phishing for Schools
  • Animal Spirits
  • Narrative Economics

Shiller is ranked among the most influential economists in the world and currently serves as a professor at Yale University. Additionally, he is a research assistant at the National Bureau of Economic Research, a post has held since 1980. Shiller also manages money through his investment firm, MacroMarketsLLC.

Shiller wrote the book Irrational Exuberance right before the bubble burst of the 2000 dot-com bubble. As we now know, this was at the height of the market bubble, but Shiller was ahead of the curve, as no one was writing about the bubble bursting at the time.

Shiller was proven right, and it took the market overall twelve years to recover and the Nasdaq about fifteen years to recover to the same highs.

As we will see, the book focuses on fundamentals and the history of the stock market, and his ideas are that those who fail to learn from the lessons of history are doomed to repeat them.

One of the best aspects of the book is that it explains in depth the fluctuations of the stock market and the reasons behind those fluctuations.

Let’s dive in and see what we can learn from the book.

Key Takeaways from the Book

To learn as much as we can from the book, we will go chapter by chapter and pick out the more important points. I will use quotes from the book from time to time as well.

Chapter 1: The Stock Market Level in Historical Perspective

In this chapter, Shiller puts the history of the stock market in perspective, relative to the levels it was at in 2000.

He points out that the Dow had tripled since 1994, while the GDP and personal income had only grown 30 percent in the same time. Also, profits from companies had grown 60 percent in the same time.

Using many charts and graphs, Shiller explains in-depth two variables, market earnings, and the market level. You can see in the charts that earnings are growing at a steady rate, but the market level took off with a big spike.

Shiller explains that he thinks that the ratio between stock prices and earnings is ridiculous. He wonders if there is any relevance to the market P/E and plots the PE against returns since 1980.

The graph reveals that the correlation between the P/E and the returns are negative, over ten years. Based on the graph in the book, Shiller determines that returns would be negative over the next ten years, and he was correct.

Chapter 2: Precipitating Factors: The Internet, the Baby Boom, and Other Events

In this chapter, Shiller explores some factors that could impact the growth of the market. According to Shiller, the growth has more than just one responsible factor. He thinks that rather a single factor, it is a combination of ratios unheard of before that cause the rise in prices, some of which the investors just can’t resist.

The factors, according to Shiller:

  • The internet – corporate profits rose 36 percent in 1994, and by comparison 8 percent in 1995 and 10 percent in 1996. The growth in 1994 coincided with the advent of the internet and even though the growth had nothing to do with the internet. It was a reflection of the public’s perception, which drove the growth.
  • Economic rival decline – the US experienced economic growth while several of the growth of their economic rivals slow, which was viewed as good news for the stock market.
  • Cultural changes contributing to the success in business– the bull market is accompanied by a spike in luxury purchases. For example, companies give bonuses to employees who participate in operations when they buy shares.
  • Tax cuts and Republican Congress – From 1994 to 1997, investors held onto their capital gains as there was a tax cut coming, which drove up the stock market.

Chapter 3: Amplification Mechanisms: Naturally Occurring Ponzi Processes

In this chapter, Shiller speaks in detail about the amplification mechanisms that involve an investor’s confidence and expectations for returns.

Shiller believes that the amplification mechanism created a positive feedback loop which drove the prices of the stock market up and up, until such point it was unstable and the bubble burst.

He noted that investor confidence had grown such that the expectation of increasing returns in the early 1990s continued to grow.

Shiller felt that investors were encouraged to invest small amounts with the understanding that as their returns grew, they could invest more money. In effect, this effect created a Ponzi scheme that would feed on itself as investors invested more money; they were encouraged to invest even more.

Chapter 4 – The News Media

Shiller discusses in this chapter the impact the news media has on irrational exuberance.

According to Shiller, he believes that newspapers have an impact on creating speculative bubbles and play a very important role in the creation of the bubbles.

When many people in large groups start to believe the same things, there are a lot of chances that a bubble will occur. Consequently, as the numbers of people grow, the impact on causing the markets to rise or fall increases.

Anyone who lived through the Great Recession had a front-row seat to this phenomenon. Every day the news on TV spread the fear and doom which caused the even bad situation to become even worse, as people heard the doom and gloom they became fearful themselves, which caused more downturn in the market.

Shiller remarks that he is disappointed in the news stories that the media presents as they relate the rise and fall of the market each day. Shiller points out that these facts are actual fallacies and don’t help the investors.

Shiller points out that the news that is reported is not unsurprising, but it is crafted to create emotional reactions that keep people coming back.

Chapter 5 – New Era Economic Thinking

In this chapter, Shiller comments on how the optimism of investors can change the course of the stock market.

For comparison, in 1901, everyone was extremely optimistic about new technologies changing their lives. In the 1920s, optimism rages as the future seemed incredible with the increased production of the automobile. As the homes in that era embraced electricity, the prices of light bulbs, vacuum cleaners, and washing machines rose tremendously too.

Shiller refers to this as the “New Era” as new concepts were introduced at an incredible pace. Think about it, radio, automobiles, electricity, airplanes, light bulbs, washing machines, telephones, and vacuum cleaners were introduced. Nothing in our lifetime compares to the speed of innovation at that time.

Chapter 6 – New Eras and Bubbles Around the World

Shiller describes some of the largest moves by stock markets all around the world in this chapter.

Shiller tracks returns over one-year periods and five-year periods and comes to the conclusion one-year returns are all over the place depending on the geographic location. Some strengths are observed; for example, a dictator is ousted, and the subsequent returns are strengthed over that short period. In many cases, after the one-year declines, the overall returns over longer periods are far stronger.

However, when returns are examined relating to extreme price changes over five years, it is clear to Shiller there is a bubble effect.

Shiller uses the returns of the market in the Philippines following a regime change, which shot up 1253 percent over one year. Shiller is pointing out that markets can go up and can come down just as quickly.

He states that this justifies the view that the current market conditions in 2000 were ripe for a bubble bursting.

Chapter 7 – Psychological Anchors for the Market

In this chapter, Shiller discusses some of the psychological anchors that influence investors. He questions why the market is trading at the levels it is trading at, and why it is at those levels. Shiller states that current market conditions can’t be measured with any accuracy.

Shiller discusses some of the psychological biases that exist in the stock market concerning investor’s reactions.

He questions whether investors are ecstatic when returns are great and are depressed when returns are down. He challenges these beliefs and argues that it is the wrong perception. He feels that is the wrong perception, and he thinks investors try to be sensible and display behavior that helps guide their actions.

Shiller goes on to discuss moral anchors and quantitative anchors that play a major role for investors. He argues that quantitative anchors guide investors into believing that certain asset prices should be a certain price where moral anchors give investors strong reasons that compel them to invest.

Chapter 8 – Herd Behavior and Epidemics

In this chapter, Shiller discusses herd behavior and the impact of epidemics. He states that we humans rarely do anything independently, and rather we tend to do things because everyone else is doing them. That behavior is known as herd behavior, and investors are as susceptible as anyone.

Others so influence investors that we often will change our opinions in the face of the majority of people that have a differing opinion. He points out several studies that prove that rational people believe the majority is correct when compared to their own opinions.    

For example, if we are asked to choose between two restaurants and have no information about them, we will choose one of them at random. But if we are faced with the same decision and we see someone enter the first restaurant and no one the second we will choose the first because we believe that first-person knows something the rest of us don’t know.

Shiller concludes that most of us only use 10 percent of our brains, especially when we are investing.

Chapter 9 – Efficient Markets, Random Walks, and Bubbles

Shiller discusses the EMH or Efficient Market Hypotheses that the prices reflected in stocks are correctly priced at all times. The theory states that smart people will always find great opportunities in the market by bidding prices up and down.

Shiller disagrees with this theory and states it doesn’t take into account mispricings in the market and how those mispricings can take long periods to correct, in some cases, decades.

Shiller uses several examples to illustrate his views. For example, eToys in 1999 were traded for $8 billion when the company’s sales were around $30 million and had negative earnings.

Shiller also refers to the Tulip Mania, which took place in Holland in the 1600s as another example to prove his point.

Shiller points to much of his analytical work concerning the history of the markets to illustrate his belief that the EMH is wrong and has several systemic problems.

Chapter 10 – Investor Learnings-and Unlearning

Shiller exposes another idea that while stock prices were sky high in 2000, the idea that prices have gone up because investors are putting more money into the stock market.

Shiller believes that as a result of extensive research and data that indicates that long-term benefits of investing in the stock market may have been known for a longer time than previously known.

According to Shiller, these “learnings” have shown up at different times in history. Looking into different publications, he has discovered these learnings happened during other bubbles that happened in the past.

He says that althought it appears that investors have learned about the advantages during the upside of bubbles, it appears they didn’t learn a thing once the bubbles burst.

Chapter 11 – Speculative Volatility in a Free Society

In this final chapter, Shiller discusses the risks and dangers involved when you ignored the market levels when they were as high as they were in 2000.

To outsiders, it would appear that following a crash that markets would rebound back to where they were before, but as we know, it can sometimes take decades to return to prior levels.

He also discusses the two sides of a crash, one side making an investor incredibly rich, and the other side making that investor incredibly poor.

That wraps up our chapter by chapter review.

Common Criticisms of the Book

There are currently three editions of the book published, with the latest occurring in 2015.

Overall reactions to the book have been positive and it was a revelation at the time because no one was analyzing the markets in this way, and he was predicting the sky is falling and no one wanted to listen. But once the bubble burst, the book was taken far more seriously.

Some criticisms of the book:

  • The arguments in the book are on the whole conceptual, as opposed to techniques to avoid these circumstances.
  • There are plenty of statistics, charts, and graphs to illustrate all the points. But there are no tests of strategies to help avoid bubbles, or better yet, how to take advantage of the bubbles.
  • The focus of the book is on the investor’s irrational exuberance and illustrating the reasons for this exuberance.
  • The book is repetitive, the same formula and material presented over and over again, rather than exploring options to avoid or profit from the market bubbes.

Even though the book has been updated three times, not much new material has been added over the years.

Final Thoughts

Irrational Exuberance by Robert Shiller is a must read for any investor who is looking for historical data on the returns of the market and how to identify market bubbles.

Robert Shiller is still quite active in the investment world, and he teaches behavioral investing at Yale. Shiller is also famous for creating the CAPE ratio, which helps define the Shiller P/E, which is commonly referred to whenever anyone is discussing the valuation of the markets.

Some links if you want to see some of the data presented in the book, as well as historical data of the stock market. It is fascinating stuff and is very enlightening.

Irrational Exuberance

If you would like to see a talk Shiller gave regarding irrational exuberance in today’s world, check this out:

Shiller Talk Regarding Irrational Exuberance

That is going to wrap up our discussion on irrational exuberance.

As always, thank you for taking the time to read this post, and I hope you find something of value to help you with your investing journey.

Until next time, take care and be safe out there,

Dave