Irrational exuberance refers to extreme behavior enthusiasm, often compared to the stock market and investor behavior. Typically, it means investors are excited and driving up stock prices regardless of the fundamentals supporting 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 company’s fundamentals.
A perfect example is Tesla, which crossed the $1000 a share earlier, despite losing money and producing fewer cars than the other big car dealers.
Irrational exuberance has become associated with bubbles and the creation of unsupported asset prices. Leading to bubbles popping, 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 as a term came into the consciousness of investors from a speech given by Alan Greenspan in 1996. Greenspan operated as the Fed Chairman at the time, and the speech is known as:
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?”
Greenspan gave the speech in the mid-90s, which was the onset of the dot-com bubble, which is the perfect textbook definition of irrational exuberance.
To break down irrational exuberance a bit.
Irrational exuberance equals undue economic optimism, which remains widespread. Think about Bitcoin mania a few years ago; people not interested in investing started asking questions about Bitcoin.
When investors believe we have no risk in the market and the continuous price rise will continue. Creating 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, driving prices down sharply and very quickly. Think back to early March 2020 when reactions to Covid forced the economy 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, it can spark a recession as the panic increases. Usually, the biggest investors hurt the most when these bubbles burst are the optimists or bears who are overconfident the bull run will go on forever. Remember trusting a bull won’t ever turn on you is the best way to ensure you get gored.
Alan Greenspan first raised whether central banks should attempt to limit the effects of irrational exuberance by tightening fiscal policy. He believed the central bank should raise interest rates to avoid any speculative bubbles that might be taking shape.
The impact was immense once the bubble burst of dot-com in early 2000. 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 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. He is also a research assistant at the National Bureau of Economic Research, a post he 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 twelve years to recover and the Nasdaq about fifteen years to recover to the same highs.
As we will see, the book focuses on the 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 book’s best aspects 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 possible 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 stock market’s history in perspective relative to its levels 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 at 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 steadily, but the market level took off with a big spike.
Shiller explains 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 a negative correlation between the P/E and the returns over ten years. Based on the graph in the book, Shiller determined 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
Shiller explores factors impacting the market’s growth in the chapter. According to Shiller, growth has more than just one responsible factor. He thinks rather than a single factor, it is a combination of ratios unheard of before causing the rise in prices, some of which the investors 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, even though the growth had nothing to do with the internet. It reflected 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 slowed, which was considered good news for the stock market.
- Cultural changes contribute to business success– a spike in luxury purchases accompanies the bull market. For example, companies reward 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 a tax cut came, which drove up the stock market.
Chapter 3: Amplification Mechanisms: Naturally Occurring Ponzi Processes
In this chapter, Shiller describes the amplification mechanisms involving an investor’s confidence and returns expectations.
Shiller believes that the amplification mechanism created a positive feedback loop that drove the prices of the stock market up and up until 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. 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, newspapers impact creating speculative bubbles and play a very important role in creating 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 of 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 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 he is disappointed in the news stories the media presents as they relate the rise and fall of the market each day. Shiller points out these facts are fallacies and don’t help investors.
Shiller points out that the reported news is not unsurprising, but it is crafted to create emotional reactions keeping people coming back.
Chapter 5 – New Era Economic Thinking
In this chapter, Shiller comments on how investors’ optimism can change the stock market’s course.
For comparison, in 1901, everyone was extremely optimistic about new technologies changing their lives. In the 1920s, optimism raged as the future seemed incredible with the increased automobile production. As homes in the era embraced electricity, the prices of light bulbs, vacuum cleaners, and washing machines rose tremendously.
Shiller refers to the time as the “New Era,” as the introduction of new technologies happened 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 the time.
Chapter 6 – New Eras and Bubbles Around the World
Shiller describes some of the largest moves by stock markets worldwide in this chapter.
Shiller tracks returns over one-year and five-year periods and concludes one-year returns remain all over the place depending on the geographic location. He observes some strengths; for example, the ousting of a dictator and the subsequent strengthening of returns over a short period. In many cases, the overall returns over longer periods remain far stronger after the one-year declines.
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 points out markets can go up and come down just as quickly.
He states that this justifies the view that the current market conditions 2000 were ripe for a bubble bursting.
Chapter 7 – Psychological Anchors for the Market
In this chapter, Shiller discusses some psychological anchors influencing investors. He questions why the market trades at the levels it trades at and remains at those levels. Shiller states we can’t measure current market activity measured with any accuracy.
Shiller discusses some of the psychological biases in the stock market concerning investors’ reactions.
He questions whether investors will remain ecstatic with great returns and depressed during down returns. He challenges these beliefs and argues we have the wrong perception. He feels we have the wrong perception, and he thinks investors try to remain sensible and display behavior to help guide their actions.
Shiller goes on to discuss moral anchors and quantitative anchors playing a major role for investors. He argues quantitative anchors guide investors into believing certain asset prices should remain certain, whereas moral anchors give investors strong reasons compelling them to invest.
Chapter 8 – Herd Behavior and Epidemics
In this chapter, Shiller discusses herd behavior and the impact of epidemics. He states humans rarely do anything independently; we tend to do things because everyone else does them. Also known as herd behavior, investors remain as susceptible as anyone.
Others so influence investors that we often will change our opinions in the face of the majority of people with differing opinions. He points out several studies that prove that rational people believe the majority is correct compared to their own opinions.
For example, if we are asked to choose between two restaurants and have no information about them, we will randomly choose one. But if we are faced with the same decision and see someone enter the first restaurant and no one the second, we will choose the first because we believe that the 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 investing.
Chapter 9 – Efficient Markets, Random Walks, and Bubbles
Shiller discusses the EMH, or Efficient Market Hypothesis, that the prices reflected in stocks are always correctly priced. 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 consider mispricings in the market and how they 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 remained sky high in 2000, the idea that prices have gone up because investors continue putting more money into the stock market.
According to Shiller, these “learnings” have occurred at different times. Looking into different publications, he has discovered these learnings happened during other bubbles that happened in the past.
He says that although investors have learned about the advantages during the upside of bubbles, 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 ignore the market levels when they were as high as they were in 2000.
To outsiders, it would appear following a crash, 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 investors incredibly poor.
That wraps up our chapter-by-chapter review.
Common Criticisms of the Book
There are currently three editions of the book, with the latest occurring in 2015.
Overall, reactions to the book remained positive and a revelation at the time
because no one analyzed the markets in this way, and he predicted the sky was falling, and no one wanted to listen. But once the bubble burst, investors took the book 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.
- Plenty of statistics, charts, and graphs illustrate all the points. But we have no tests of strategies to help avoid bubbles, or better yet, how to take advantage of the bubbles.
- The book focuses on the investor’s irrational exuberance and illustrates the reasons for this vitality.
- The book is repetitive, with the same formula and material presented repeatedly, rather than exploring options to avoid or profit from the market bubbles.
Even though the book has been updated three times, not much new material has been added.
Irrational Exuberance by Robert Shiller is a must-read for any investor looking for historical data on the market’s returns and how to identify market bubbles.
Robert Shiller is still quite active in the investment world and teaches behavioral investing at Yale. Shiller is also famous for creating the CAPE ratio, which helps define the Shiller P/E, commonly referred to whenever anyone is discussing the valuation of the markets.
Here are some links if you want to see some of the data presented in the book and historical data on the stock market. It is fascinating stuff and is very enlightening.
If you would like to see a talk Shiller gave regarding irrational exuberance in today’s world, check this out:
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,