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Issue 49, July 2000

Irrational Exuberance

    Bull runs past and present
    Muddling major and minor causes
    Recurring episodes of 'new era' fantasies
    A series of 'colossal mistakes'
    Prepare for a crash-landing

The unprecedented dimensions of the US financial bubble are shown in a recent study by the Yale economist Robert Shiller, Irrational Exuberance (Princeton University Press, £17-95), reviewed by LYNN WALSH. The bigger the bubble, the louder the bang?

A TIMELY BOOK! A week after Irrational Exuberance was published early in April, US stock markets began a precipitous fall, with a 40% drop in the Nasdaq index of technology stocks. The author, Robert Shiller, a professor of economics at Yale University, was immediately elevated to the status of a Wall Street guru, making dozens of media appearances. He presented an abundance of evidence showing that current share prices are absurdly overvalued and that the bubble must surely burst.

Yet within a few days the highly volatile market stabilised, at least for the time being. The share-price tumble was explained away as a healthy 'correction'. A fellow Yale economist came forward with the prediction that in the next 20 years the Dow index, currently around 10,600, will rise by nine times to 100,000. Shiller was quickly dismissed as a party pooper, an eccentric prophet of doom. This was a reaction he had already ruefully anticipated in his book: "In the current political and economic climate, one incurs a substantial risk of embarrassment if one goes on record saying that stock market returns will be low or negative in the coming years".


On 5 December, 1996, the chairman of the US Federal Reserve Board, Alan Greenspan, posed the question: 'How do we know when irrational exuberance has unduly escalated asset values?' This gnomic statement, which implied that share prices were seriously overvalued, was followed next day by falls of between 2% to 4% on major international stock exchanges. When there was no calamity, however, speculators carried on trading as if there were no tomorrow. The following year, Business Week (14 July, 1997) attributed the term 'new era economy' to Alan Greenspan, signalling the chairman's approval of high share values as the legitimate reflection of technological advances, globalisation and the universal triumph of the free market. Since then, most of Greenspan's enigmatic speeches have included allusions to both the marvels of the new economy and the dangers of irrational exuberance.

As far as Robert Shiller is concerned, however, there are no two ways about it. US and other international stock exchanges are dangerously dominated by 'irrational exuberance'. Investors everywhere are enthusiastically, wrecklessly buying shares that are dangerously over-priced in relation to the real economy. This view evidently had some effect on Greenspan, who made his 'irrational exuberance' speech two days after the Yale economist testified before the Federal Reserve Board. Shiller now sets out his arguments in his book, Irrational Exuberance.

The core of the book, and in my view its most valuable section, is his quantitative analysis of "the stock market level in historical perspective", which dramatically reveals the unprecedented dimensions of the current bubble economy. By contrast, his theoretical analysis is very weak, though he presents some very interesting historical comparisons.


top     Bull runs past and present

THE CURRENT BULL market is on a far bigger scale than previous bulls in US history. At the turn of the 20th century, there was a short surge in stock prices in 1900-01, following the US economy's emergence from the depression of the 1890s. But that was relatively limited. There were really three great bull markets, periods of sustained and dramatic stock price increases: the bull market of the 1920s, culminating in the 1929 crash; that of the 1950s and the 1960s, followed by the 1973-74 market debacle; and the current bull market, running from 1982 and rampaging after 1992.

Between early 1994 and early 2000, the Dow (the Dow Jones Industrial Average index of share prices, which is not corrected for inflation) rose from 3,600 to 11,700, an increase of over 200%. Did this reflect growth in the 'real' economy? During that time personal income and GDP rose by less than 30% (and by only around 15% once corrected for inflation). Corporate profits rose by about 60%, and that was from a low base during the recession which followed the 1990 downturn in the US economy.

Shiller presents a graph which puts the 'millennium bubble' in historical perspective. Based on Standard & Poor's (S&P) Composite Stock Price Index from January 1871 to January 2000, corrected for inflation, the chart shows that the US stock market has risen steadily ever since it bottomed out in July 1982. Far greater than the brief bull market between 1925 and the crash in 1929, the steep rise marks the most dramatic bull market in US history. After 1992 especially, the Price Index "looks like a rocket taking off through the top of the chart!"


But the precipitate rise of share prices was not matched by the growth of real earnings of shares (from dividends and capital gains). "No such spike in earnings' growth occurs in recent years. Earnings in fact seem to be oscillating around a slow, steady growth path that has persisted for over a century".

There was, Shiller shows, a sudden spurt in composite earnings growth in the five-year period 1992-97. Real (inflation adjusted) S&P Composite Earnings more than doubled, the most rapid five-year growth spurt of real earnings for half a century. (In the same way, there was a growth of real share earnings, in fact a quadrupling, between 1921 and 1926 following the post-world war one recession.) The 1992-97 spurt in earnings was probably an important factor in triggering the extraordinary rise in share prices, but the growth in real earnings has certainly not been sustained.

A second graph shows the trend in the price-earnings ratio of S&P shares between January 1981 and January 2000. The price-earnings ratio shows the relationship between share prices and company profits (earnings), calculated by dividing company earnings (profits) per share by the market price of the company's shares. High price earnings ratios suggest confidence on the part of investors that company profits will continue to rise rapidly.

"Note again", comments Shiller, "that there is an enormous spike after 1997, when the ratio rises until it hits 44.3 by January 2000. Price-earnings ratios by this measure have never been so high. The closest parallel is September 1929, when the ratio hit 32.6". The previous peak for the price-earnings ratio was in June 1901, when it reached a high of 25.2, before a sharp fall in share prices.


Shiller demonstrates that a peak price-earnings ratio is almost invariably followed by a decline in real earnings from shares. Averaged over ten years after 1901, the real rate of return in the stock market (including dividends) was 4.4% a year; averaged over the following 20 years, the average return was minus 0.2% a year.

The same thing happened after the 1925-29 bubble, when the price-earnings ratio peaked at 32.6% in September 1929. There was "a real drop in the S&P Index of 80.6% by June 1932. The decline in real value was profound and long-lasting. The real S&P Composite Index did not return to its September 1929 value until December 1958 [that is, when the long post-world war two upswing in the US was approaching its peak - LW]. The average real return in the stock market (including dividends) was minus 13.1% a year for the five years following September 1929, minus 1.4% a year for the next ten years, minus 0.5% a year for the next 15 years, and 0.4% a year for the next 20 years". Shiller does not offer any causal explanation of these correlations. Nevertheless, his data reveals a clear pattern, repeated during every long cycle.

During the Sixties, under Kennedy and Johnson, there was a five-year surge in share prices, from 1960-65, which pushed the price-earnings ratio up to a peak of 24.1. But earnings from shares remained relatively flat, and share prices subsequently fell 56% between the January 1966 peak and the December 1974 trough (during the slump triggered by the 1973 increase in world oil prices). Real stock prices, despite the 1980s Reagan boom, did not recover their January 1966 level until May 1992.


The clear conclusion that emerges from Shiller's data is that "years with low price-earnings ratios have been followed by high returns, and years with high price-earnings ratios have been followed by low or negative returns".

"Historically, when price was high relative to earnings..., the return in terms of dividends has been low, and when price was low relative to earnings, the return in terms of dividends has been high. The recent record-high price-earnings ratios have been matched by record-low dividend yields. In January 2000, S&P dividends were 1.2% of price, far below the 4.7 that is the historical average".

In recent years, as the bubble expanded, investors gained extraordinary returns from capital gains derived from rapidly buying and selling shares in the rising market. The return arising from capital gains, however, has always been much less predictable and dependable for investors than the gain from dividends. Historically, dividends represent the dominant part of the average return on stocks.

"Times of low dividends relative to stock price in the stock market as a whole", warns Shiller, "tend to be followed by price decreases (or smaller than usual increases) over longer horizons, so returns tend to take a double hit at such times, from both low dividend yields and price decreases". In the light of this data, speculators' current investment mania appears highly paradoxical, if not completely perverse. Why do investors continue to buy overvalued shares when overpricing has always been a harbinger of the decline and even long-term stagnation of earnings? This is the 'irrational exuberance' Shiller seeks to explain.


top     Muddling major and minor causes

SHILLER'S ANALYSIS IS very superficial. Really, it is fatally flawed from the outset by his attempt to restrict his analysis to "factors that have had an effect on the market that is not warranted by rational analysis of economic fundamentals". This implies an abstract, ideal model of the stock exchange in which share prices more or less accurately track the growth of production, profits, incomes, etc. Yet the historical material he presents shows that the stock exchange as a mechanism is inherently prone to episodes of speculative growth far exceeding the growth of the real economic base, followed by the extreme 'over-correction' of share prices in crashes.

Shiller identifies a number of 'structural factors', which he subdivides into 'precipitating factors' and 'amplifying mechanisms'. Precipitating factors include:

The spread of the internet at a time of prosperity, giving the public a strong impression of accelerated technological revolution, also widening access to market trading. Triumphalism, following the collapse of the Soviet Union, and the decline of foreign economic rivals, especially Japan: "The world", Shiller sums it up, "seems to be swinging our way, and therefore it starts to seem only natural that confidence in the premier capitalist system would translate into confidence in the market, and that the US stock market should be the most highly valued in the world".


Cultural changes favouring business, including manufacturing downsizing, the weakening of labour unions, and the growth of materialistic values: 'It's good to make money'. A Republican-dominated Congress, helping to push through pro-business legislation, cutting taxes on corporations and the wealthy. The 'baby boom', the demographic increase of the 35-55 age group, increasing the middle-class strata with the greatest propensity to save.

Expanded media reporting of business (more like ra-ra sports reporting than serious commentating) and increasingly optimistic forecasts from financial analysts, encouraging more and more investment in shares.

Pension options and tax provisions (401k plans, similar to British PEPS) encouraging investment in shares. The growth of mutual funds (roughly the equivalent of British unit trusts), providing a vehicle for an increasing number of investors. In 1982 there were 340 equity mutual funds in the US; by 1998 there were 3,513. In the same period, the number of equity mutual fund shareholder accounts rose from 6.2 million to 119.8 million.

Shiller's 'amplification mechanisms' really boil down to the combination of a high level of investor confidence and the bandwagon effect generated by a rapidly rising bull market. An obvious feedback mechanism operates, as huge profits from share trading generate more cash for investment and attract more and more people into playing the market.

All the factors outlined by Shiller undoubtedly have an effect. But his analysis of the 'confluence of factors' is completely eclectic, little more than a list with no attempt to attribute relative weight to the different factors, let alone to identify a chain of cause and effect linking all the factors together. Mutual funds, for instance, are clearly important for the growth of stock exchange investment. But are they any more than an effect of the growth of disposable incomes of the wealthy and the expanded opportunities for profitable investment on the stock exchange?


Triumphalism was clearly a major ideological-cultural factor behind the speculative boom. The triumphalism climate, however, reflected real and profound changes in international relationships: the collapse of the rival social system of Stalinism, the non-capitalist, centrally-planned economies run by a totalitarian bureaucracy. But most of the 'cultural' and 'psychological' factors, to which Shiller devotes a big chunk of his book - such as enthusiastic, uncritical media reporting of financial speculation - are secondary, reinforcing factors. The psychological factors discussed by Shiller are even more derivative. High levels of business confidence are the product of profitable speculation, and help stimulate the epidemic, herd behaviour of investors. These factors all play a role, and for short periods can assume extraordinary importance, but they are ultimately effects of the rise of the market, not driving causes.

Some of the real driving forces of the millennial bubble are touched on by Shiller, but not clearly delineated and analysed. For instance, Shiller does not grasp the full significance of triumphalism. The changed balance of forces internationally enabled US capitalism to push through neo-liberal economic policies, opening up almost the entire world to the unimpeded pursuit of profit by the US, European and Japanese corporations. Shiller refers to pro-business legislation in the US, but makes only a few scattered references to the generalised effects of neo-liberal measures. US capitalism's neo-liberal economic policies, implemented within the advanced capitalist countries and throughout the underdeveloped countries in the 1980s and 1990s, produced an upsurge in the profitability of the big corporations and accelerated the polarisation of wealth between rich and poor. These very real social changes, a reversal of post-war upswing trends, produced a resurgent capitalist class with an affluent middle-class periphery. The rich became super-rich, the super-rich became hyper-rich.


The upsurge of financial speculation was a key mechanism in this process. With relatively modest expansion of production, despite new technology and globalisation, the wealthy increasingly invested in property, government and private bonds (ie the debt market), and in company shares. Given the dominant position of the US economy internationally, and the fabulous profit opportunities available, wealthy bourgeois throughout the world invested heavily in the US. This produced a great 'wall of cash', a huge section of which flooded into Wall Street. It is this exceptional liquidity, arising from a shift in the distribution of wealth, that provided the key precondition of 'irrational exuberance'.

Does this massive shift imply that speculative activity can be sustained indefinitely, or at least for a prolonged period? Unfortunately for the capitalists, speculative activity sooner or later undermines the conditions of its own success. Increasingly, capital is diverted away from production, useful services and social infrastructure into purely speculative activity. Instead of funnelling capital into the real economy, the speculative casinos actually suck money out. Debt levels mount as speculators finance their activity through loans and the working majority increasingly rely on credit to sustain their living standards. Sooner or later, the weakening of the productive economy sets a limit to the expansion of the parasitic bubble.

Bubbles inflate most spectacularly (as Shiller shows) just at the moment when their foundations - as subsequently becomes clear - are most shaky. Any one of several factors can bring a sudden deflation: tightening interest rates, falling profits, lower investment rates, slowing consumer spending. What will actually cause the puncture cannot be predicted. The trigger could be an 'external shock': a sudden rise in world commodity prices, war, or the snapping of a weak link in the international finance system. More likely, it will be a combination of trigger events. The bubble, however, will burst and the 'new era economy' will be exposed as a chimera.


top     Recurring episodes of 'new era' fantasies

ONE CHAPTER PRESENTS some very interesting historical reflections on 'new era economy thinking'. The current 'new era economy' appears to have been launched by a Business Week cover story (14 July 1997), 'Alan Greenspan's Brave New World', which attributed the term to Greenspan. Despite being attacked by economists like Paul Krugman (Havard Business Review, August 1997), the new 'theory' quickly became the new conventional wisdom. The new technological revolution combined with the worldwide extension of free-market policies, it was claimed, was producing a new era of uninterrupted, inflation-free growth.

This was not so much a theory as a self-satisfied opinion: "The new era theory", says Shiller, "emerged principally as an after-the-fact interpretation of a stock market boom". Far from there being a new theory capable of explaining the surging stock market (systematic data and rigorous analysis being studiously avoided), the stock market was conjuring up a new 'theory', really just another glittering facet of 'irrational exuberance'.

Not surprisingly, all the previous market peaks in the US were accompanied by similar outbursts of 'new era' thinking. The first speculative frenzy of the 20th century, in mid-1901, was hailed as the dawn of a new era. The beginning of electrification and the advent of radio were heralded as a new technological revolution. The formation of numerous combinations, trusts, and mergers of a variety of businesses (steel, railroads, etc) was, it was claimed, introducing "a new era... the era of 'community of interests' whereby it is hoped to avoid ruinous price cutting and to avert the destruction which has in the past, when business depression occurred, overtaken so many of the competing concerns in every branch of industry". (New York Daily Tribune, 6 April 1901) Nevertheless, there was a stock market crash in 1907, and a massive fall in stock values between 1907 and 1920.


Later, rapid growth and financial speculation in the 1920s gave rise to another episode of 'new era' thinking. New products like automobiles and electrical appliances were widely disseminated, while electrification and radio broadcasting covered the whole country. Writing about the stock market in 1928, John Moody, head of Moody's Investors Service, proclaimed "a new age is taking form throughout the entire civilised world; civilisation is taking on new aspects. We are only now beginning to realise, perhaps, that this modern, mechanistic civilisation in which we live is now in the process of perfecting itself". (Atlantic Monthly, August 1928)

Just before Wall Street's peak level in 1929, professor Irving Fisher of Yale University, one of the US's most prominent economists, reportedly said that 'stock prices have reached what looks like a permanently high plateau'. Even after the 1929 crash, Fisher remained optimistic; the 'new era' was only laid to rest by the further massive falls that took the stock exchange down to its 1932 trough.

It was not until the mid-1950s, when the long post-war upswing was well established, that 'new era' thinking reappeared. "Once again the feel of a 'new era' is in the air. Confidence is high, optimism almost universal, worry largely absent". (US News and World Report, 20 May 1955) At least the Kennedy-Johnson bull market which followed was based on historically high levels of growth and productivity advances. "Investors bet on a Kennedy-sparked upturn", proclaimed Business Week (4 February 1961). "Kennedy's economic programme inspired confidence amongst many that the US was entering a 'new economy' in which businessmen can enjoy reasonably continuous prosperity indefinitely". Throughout the 1960s, however, the Dow Index hovered on a plateau around 1,000, and the 'new era' came to an end with the stock exchange slump of 1973-74.


During every bull market, there were a few economists and commentators warning that belief in a new dawn of continuous, unlimited growth was a foolish illusion. But they were always dismissed as woebegone Jeremiahs. Fantasies of unbounded wealth are the product of the profit-intoxication of the bourgeoisie during exceptional, usually quite brief, episodes of super-profitability. As with any manic, addictive behaviour, 'irrational exuberance' is not susceptible to any rational cure. That is why economists like Robert Shiller, who approach the phenomenon with very simplistic logical models of economic behaviour, fail to come up with any remedies, and even fall short of a convincing diagnosis of the condition.

top     A series of 'colossal mistakes'

SHILLER'S APPROACH, IT has to be said, is naively rationalistic. He is evidently perplexed by his isolation amongst financial economists. Why can't they see the implications of his data? Why don't investors behave in a rational way? True, he dismisses the ludicrous so-called 'efficient markets theory', understandably popular among speculators, according to which financial markets always accurately reflect all public information about the economy, supposedly ensuring that, given the current state of public knowledge, financial assets are always correctly priced. As evidence to the contrary, Shiller cites the glaring disparity - clearly revealed by publicly available information - between trends in share prices and trends in dividends.


While share prices have fluctuated considerably since 1900, dividends have maintained a fairly consistent long-term trend growth. Dividends have neither soared during bubbles nor plummeted during crashes. Between 1920 and 1929, for example, the S&P Index of share prices rose 415.4%, while dividends (measured as the 'dividend present value', calculated ex post facto, which gives the present value for real dividends paid over the subsequent year) increased only 16.4%. During the crash, from September 1929 to June 1932, the S&P Index fell 80.6%, while the dividend present value dropped only 3.1%. Thus, after the event, comments Shiller, "we know that the run up in the stock market from 1920-29 was a colossal mistake and the drop from 1929 to 1932 was another colossal mistake. Virtually nothing actually happened over either of these intervals to the dividend present value". This is where Shiller's 'rational' analysis itself becomes irrational, because his methodology is incapable of theoretically grasping the system's inner contradictions. He completely fails to recognise that the wild fluctuations produced by the market are not 'mistakes' but an innate characteristic of capitalism.

The language of this book is the polite, understated discourse of Ivy League academia. Nevertheless, Shiller warns clearly enough that the bubble will deflate, and he is clearly fearful about the consequences.

His 'precipitating factors' will not operate indefinitely. The kind of share earnings' growth that the US has seen since 1992 "requires that all systems remain go, that there remain no significant obstacles", but Shiller gives a long list of factors that could potentially cut across the bull market: heightened foreign competition, a resurgent labour movement, an oil crisis, environmental catastrophes, a depression abroad, systemic problems due to a failure of major banks or financial institutions, or a combination of various factors.


The Yale economist hints at some of the possible political consequences of the bubble bursting. The real losses, he says, could be comparable to the total destruction of all the schools in the US, or all the farms, or possibly all the homes. "There is the problem that the loss will not be borne equally". The uneven distribution of wealth caused by bubbles, and the unequal losses resulting from their collapse, "may even cause many of us, at times, to question the very viability of our capitalist and free-market institutions". "It was... resentment [against business] after 1929", he says, "in encouraging the growth of Socialist and Communist movements, that created an unusually uncertain and unstable atmosphere for the economy in the 1930s". This leads him to issue 'A Call to Action' at the end of the book.

top     Prepare for a crash-landing

SO WHAT IS to be done, according to Shiller? Describing himself as a "strong free-marketeer" and "one of the most extreme zealots for expanding markets" (Observer, 28 May), Shiller is against any further state regulation of financial markets. He urges, however, that public figures should not 'acquiesce' in excessive stock market valuations but should warn of their adverse consequences. The US government should not invest social security (state retirement pension) funds in the stock market, nor should private pension plans excessively invest in shares. "But ultimately, in a free society, we cannot protect people from all the consequences of their own errors". This, of course, offers no consolation to the majority, the working people who produce the wealth, who will suffer most from the 'erroneous' speculative activity of the wealthy minority.


Shiller's 'action' is merely a plea for 'public figures' to educate the investing public. "The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom".

After all his elaborate economic, sociological and psychological analysis, Shiller blames 'irrational exuberance' on the ignorance of the investing public. He makes no distinction between different classes of investors. The broad range of middle-class investors, who only own a small fraction of total shares, are not merely following their own noses. They are following the example of the millionaires and billionaires who dominate financial markets. True, "their all-too-human behaviour is heavily influenced by the news media"; but who owns the media?

Faced with the likely prospect of the bubble contracting, individuals and institutions should, says Shiller, adopt a more responsible, rational policy. "So what should investors do now?... The natural first step may be... to reduce holdings of US stocks... [or] at the very least diversify thoroughly". Straight away, however, he has to admit "there is fundamental difficulty with advising individuals and institutions to get out of the stock market. If such advice were suddenly taken by large numbers, it would cause an immediate drop in the level of the market. In fact, we cannot all get out of the market. We can only sell our shares to somebody else. Somebody must be left holding the outstanding shares. As a group, those unfortunate people who bought in at a market high have already made their mistake, and we cannot correct it for them as a group after the fact".


Shiller recognises the trap set by the bubble. The Yale professor, however, is trapped within his own 'rational' model, unable to comprehend the irrational, contradictory essence of late capitalist society. Speculative bubbles are not 'mistakes'; they arise from the capitalists' lust for profit, the system's ultimate driving force. Nor are booms and slumps 'mistakes'; they are the inevitable product of the anarchic workings of the capitalist market. No amount of enlightenment will change this.

In the end, the best that Shiller can offer is the kind of prudent, homespun advice you might get from your local bank manager: cut your expenditure, reduce your debt, start saving, and brace yourselves for the crash-landing.

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