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Irrational Exuberance

Book Review

Group 4: Gaurav Pandey(PGP13023), Virender Singh(PGP13063), Naman Agarwal (PGP13097),


Rakesh Krishna V (PGP13108), Anuranjan Tirkey (PGP13130)

Executive Summary
Irrational Exuberance by Robert Shiller dissects the state of the market and tries to find the
reasons for the extreme highs and lows seen by the markets: a trend seen again and again in the
stock market dating back even to 1800s. In this book he is trying to find whether there are some
pertinent fundamental factors such as technology, demography etc. taking the market to new highs
or is it simply because of the irrational exuberance shown by the market (irrational because many a
time markets have overreacted to both positive as well as negative events). He brings to light that
todays (as in 2000) investment culture is such that millions of investors invest in the stock market
as if the price level is always going to go up and believe that even if it comes down it wont remain
there for long. He has tried to find what makes investors behave in such a way. He has challenged
the basic fundamental factor, on which most of the financial theory is built upon, that people are
rational with the help of an emerging field of behavioral finance. These factors alludes that the
market is reaching to new heights due to speculative bubbles formed because of over enthusiasm of
investors rather than by any estimation of real value of the market.
But why Mr. Shiller wants to justify the irrationality of the market and what is his objective.
According to the book Mr. Shiller thinks that the way we value the market would influence economic
and social policy decisions in the future. He thinks that if the market is overvalued then people might
invest too much on startups and expansion instead of on the factors which are the pillars of country
like education and infrastructure. From a birds eye perspective these factors will make investors
more vulnerable to the risks associated with stock markets overvaluation.
The book is divided into five parts where parts I II III discuss the factors which has oversized
effect on the market. In these three parts various subjects are being touched upon as role of
technology and demography in shaping the markets behavior, impact of news media on the
investors sentiment, behavioral factors and a mindset of new era among the investors. All these
factors collectively often lead to formation of speculative bubbles. Part IV attacks the ideologies of
academicians who have time and again tried to justify the markets behavior via different theories. In
the last part the author has discussed the implications of such behavior on investors and
governments. He has also given few suggestions to lower risk exposure to burst bubbles.

Part 1: Structural Factors


Precipitating Factors: The Internet, the Baby Boom and Other Events
The growth in economy itself does not justify the increase in the value of stock market since
1982. Shiller here looks into the factors that contributed to surge in stock markets that lead to
highest price-earnings ratio in the history of US stock market. Shiller here omitted rational factors
such as the growth in earnings, the change in real interest rates, etc. but considered factors that help
us understand the extraordinary recent situation in the stock market.
a) The Arrival of the Internet at a Time of Solid Earnings Growth
The advent of internet coincided with the rise in earnings around 1994 although high earnings
growth levels cannot be attributed to internet advancement it made an impression among the
general public that technology as dramatic as the internet has something to do with it. Also due to
the vivid and immediate personal impression the internet makes, people find it plausible to assume
that it also has great economic importance. The notion that existing companies will benefit from the
internet revolution contributed to surge in stock market prices.
b) Triumphalism and the decline of foreign economic rivals
With Soviet Union breaking up into smaller nations in 1991 and also with all the economic rivals
of US in prolonged slump, there is a feeling in US investors that US market should be the most highly
valued market in the world. Moreover media has always showed the competition between US and
its economic rivals where in only one winner is possible this has led to a triumphalism which made
investors to go bullish on America.
c) Cultural Changes favouring business success or the appearance thereof
People perceived that good life can be ensured through lot of money. Materialistic values are on
rise during this period. The idea that investing in stocks is a road to quick riches has a certain appeal
to born again materialists. With downsizing happened during late 1980s and early 1990s, loss of jobs
have encouraged people to take control of their lives and rely less on employers. Adding to these are
shifts in management policy on compensation such as use of ESOPs has started which encouraged
managers to look and improve the company valuations to benefit on their ESOPs. All these cultural
changes have impacted in surge of stock market.
d) A Republican congress and capital gains tax cuts
When Republicans came to power in 1994, sensing the changed public attitudes that had elected
them, these lawmakers were much more pro-business than their democratic predecessors. They
have cut down capital gains tax rate from 28% to 20%. With the anticipation of future tax rate cuts
everyone held on to their long term investments in order to gain from future tax cuts. This indeed
strengthened the market.
e) The Baby Boom and Its perceived effects on the Market
Following World War II, there was substantial increase in the birth rate in US which continued till
1966. This baby boom from 1946-66 have ensured that in year 2000 US has unusually large number

of people between the ages 35 to 55. Two theories suggest that the presence of so many middleaged people ought to boost todays stock market. One theory justifies high price-earnings ratios is
due to competition among boomers to buy stocks to save for their eventual retirement and other
theory says that it is spending on current goods and services that boost stocks through a generalized
positive effect on the economy.
Moreover the people in their forties are less risk averse than the older people because they have
no memory of great depression of the 1930s or of World War II. Hence boomers are considered as
lifters of the stock market.
f)

An Expansion in Media Reporting of Business News

Expansion in media reporting of business news has led to increased demand for stocks, just as
advertisements for a consumer product make people more familiar with product, remind them of
the option to buy and ultimately motivate them to buy.
g) Analysts increasing optimistic forecasts
Analysts have significantly decreased recommendation of sells on stocks. The reasons for
reluctance to roll out sell recommendations can be one among these. Analysts might fear that sell
recommended companies can retaliate by refusing to talk with analysts during future course.
Another reason is most of analysts are employed by the firms that underwrite securities so an
analyst cannot give a sell recommendation on the stock that his own company is underwriting. Even
the next year earnings forecasts given by analysts are over optimistic but when the immediate
earnings are observed they predict less than the original earnings so that companies can show the
performance that exceeded the estimates. Thus analysts as well are indirectly contributing to surge
in Stock market.
h) The expansion of defined contribution pension plans
Earlier pension plans had usually been of the defined benefit type, in which the employer merely
promised a fixed pension to its employees when they retired. With 401(k) plans employees are
offered the opportunity to have contributions to a tax-deferred retirement account deducted from
their pay checks. These investments must be allocated to stocks, bonds and money market accounts.
This made more and more employees to get awareness of stock market and ultimately motivated
them to investment more in stock markets. The fact that there are more stocks related choices for
employees when compared to bonds and money markets significant portion of 401(K) investments
are maintained in stocks.
i)

The Growth of Mutual Funds

Mutual funds proliferated during this period. More and more nave investors put their money
into mutual funds hoping that experts would be managing their investments. 401(k) pension plan
also helped people to gain awareness on mutual funds which resulted in non-401(k) funds also being
invested into mutual funds.

j)

The decline of inflation and the effects of money illusion

High inflation is perceived as a sign of economic disarray, of a loss of basic values, and a disgrace
to the nation, an embarrassment before foreigners. On the other hand low inflation is viewed as a
sign of economic prosperity, social justice and good government. Therefore a lower inflation rate,
which was observed during mid 1990s, boosts public confidence, hence stock market valuation.
k) Expansion of the volume of trade: discount brokers, day traders and twenty four hour
trading
As technological advancements and organizational changes were set into motion trading costs
got lowered significantly and frequency of stock price reported increased. With the increased
frequency of reporting of stock prices public attention was attracted by stocks. This resulted in more
demand for stocks.
l)

The Rise of Gambling Opportunities

Gambling institutions were encouraged during this period. This led to rise in actual gambling which
had potential effects on culture and on changed attitudes toward risk taking. This had a spillover
effect on stock market as well.
Amplification Mechanisms: Naturally Occurring Ponzi Processes
Above discussed precipitating factors has surged the stock market which led to increase in
the investor confidence and expectations. This in fact bid up stock prices further, thereby enticing
more investors to do the same, so that the cycle repeats again and again resulting in an amplified
response to the original precipitating factors.
Higher investor confidence means that people seem to think that they have discovered a
safe and lucrative investment, one that cannot lose. They perceive no real downside risk, and this
explains their willingness to buy stocks even when, by conventional measures such as price-earnings
ratio, they are so greatly overvalued.
The people who were sceptical about markets and predicted it to go down and stay down
became sensitized to their bad feelings from being repeatedly wrong year after year. This caused lot
of reputation loss and made the formerly pessimistic to want to settle on different view that markets
will always regain their original positions.
Although markets were high still the expectations on the future returns were higher and at
least remained as strong as they were in 1989. This is mainly due to consistent returns stocks are
providing during this period.
The fact that how one has regretted if he was out of the market and has not participated in
the profits that others have recently enjoyed has motivated them to invest without much
deliberation.
Shiller explains this amplification effect through feedback loop theory. Initial price increases
lead to more price increases as the effects of the initial price increases feedback into yet higher

prices through increased investor demand. This self fulfilling prophecy can also be seen as a
speculative bubble.
Shiller also takes into account that investors are aware of the speculative bubble but in their
attempt to ride on the wave and leave it before the bubble bursts they anyhow participate in the
speculative bubble. Only problem with this strategy is they never know when the bubble bursts.
Finally Shiller compares this speculative bubble with the Ponzi scheme where first wave of
sceptical investors invest their money and were paid back through investments of second wave of
investors. The benefit achieved by first wave of investor motivates many more investors to invest in
Ponzi scheme which continues till a last wave of investors who are way large in number gets
defaulted on by the Ponzi schemer. Similarly in a speculative bubble initial investors do get
extraordinary returns motivating other investors to invest and this chain continues till the bubble
bursts and significant number of investors lose their investments.

Part 2: Cultural Factors leading to speculative Bubbles

In this section on cultural factors, the author explored the justifications people have given,
at various points in history, for changing market valuations, and the evidence of the transitory
nature of these cultural factors

The News Media


Although the news medianewspapers, magazines, and broadcast media, along with their
new outlets on the Internetpresent themselves as detached observers of market events, they are
themselves an integral part of these events. Significant market events generally occur only if there is
similar thinking among large groups of people, and the news media are essential vehicles for the
spread of ideas.
News media do play an important role both in setting the stage for market moves and in
instigating the moves themselves. Many news stories in fact seem to have been written under a
deadline to produce somethinganythingto go along with the numbers from the market. The
typical such story, after noting the remarkable bull market, focuses on very short-run statistics.
a) Record Overload
Data that suggest that we are setting some new record (or are at least close to doing so) are
regularly stressed in the media , and if reporters look at the data in enough different ways, they will
often find something that is close to setting a record on any given day. In covering the stock market,
many writers mention record one-day price changesmeasured in points on the Dow rather than
percentage terms, so that records are much more likely

This record overloadthe impression that new and significant records are constantly being
setonly adds to the confusion people have about the economy.
b) Do Big Stock Price Changes Really Follow Big News Days?
Many people seem to think that it is the reporting of specific news events, the serious content of
news, that affects financial markets. But research offers far less support for this view than one would
imagine.
c) Tag-Along News
News stories occurring on days of big price swings that are cited as the causes of the changes
often cannot, one suspects, plausibly account for the changesor at least not for their full
magnitude. Many times it has been seen that the news reported to be the reason for major price
swings is not at all related to the stock market.
d) News as the Precipitator of Attention Cascades
The role of news events in affecting the market seems often to be delayed, and to have the
effect of setting in motion a sequence of public attentions. These attentions may be to images or
stories, or to facts that may already have been well known. The facts may previously have been
ignored or judged inconsequential, but they can attain newfound prominence in the wake of
breaking news. These sequences of attention may be called cascades, as one focus of attention
leads to attention to another, and then another.
But the striking thing is that the most highly rated news stories among those listed as the
reasons for price swings were those about past price declines themselves. The role of the news
media in the stock market is not, as commonly believed, simply as a convenient tool for investors
who are reacting directly to the economically significant news itself. The media actively shape public
attention and categories of thought, and they create the environment within which the stock market
events we see are played out.
New Era Economic Thinking
According to the author the new era thinking played a substantial role in creating speculative
bubbles.
a) The 1901 Optimism: The Twentieth-Century Peak
In a sense, the high-tech age, the computer age, and the space age seemed just around the
corner in 1901, though the concepts were expressed in different words than used today. People
were upbeat, and in later years the first decade of the twentieth century came to be called the Age
of Optimism, the Age of Confidence, or the Cocksure Era.
The 1920s were a time of rapid economic growth and, in particular, of the widespread
dissemination of some technological innovations that had formerly been available only to the
wealthy. The automobile came into common use at roughly this time. In 1914 there had been only
1.7 million automobiles registered in the United States, but by 1920 there were 8.1 million and by
1929 there were 23.1 million. The automobile brought with it a new sense of freedom and

possibility, and a widespread awareness that these personal values could be attained by new
technology.
The 1920s were also the time when the electrification of the country was extended beyond the
major cities, which had already been electrified. By 1929, 20 million U.S. homes were wired.
Kerosene lamps were out; electric light bulbs were in. By 1929, nearly half of all wired homes had
vacuum cleaners, and a third had washing machines. Moreover, the 1920s saw the expansion of
radio broadcasting and the development of radio as a mature national entertainment medium. In
1920 there were only three radio stations in the entire United States; by 1923 there were over five
hundred .
b) New Era Thinking of the 1950s and 1960s
In a development strongly paralleling the evolution of radio in the 1920s as the vehicle for a
mass national culture, the early 1950s had seen the widespread introduction of television. In 1948
only 3% of U.S. families owned television sets; by 1955 76% did. Like the Internet, television was a
vivid technological innovation that captured the imagination of almost everyone. It was evidence for
technological progress that could not be overlooked; within a few short years the majority of
Americans began regularly spending hours watching an electronic device.
c) New Era Thinking during the Bull Market of the 1990s
Michael Mandel, writing in Business Week in 1996 in an article entitled The Triumph of the New
Economy, listed five reasons for his belief that the market is not crazy: increased globalization, the
boom in high-tech industries, moderating inflation, falling interest rates, and surging profits.
A prominent theory during this boom has been that low inflation makes for a strong market
outlook. In the 1990s, theories about inflation dominated discussion of the market outlook just as
they did in the 1960s, but now the prevalent theory has been reversed. In the 1990s, it was thought
that if inflation were to break out the market would go down rather than up. The idea that the stock
market is a good investment because it is a hedge against inflation (i.e., that it will go up if there is
an outbreak of inflation) was dead.
New Eras and Bubbles around the World
The stock market increase in India from April 1991 to April 1992, began just as the
assassination of Rajiv Gandhi in May 1991 ended the thirty-eight-year Nehru family dynasty.
Gandhis successor immediately appointed Manmohan Singh, a former professor at the Delhi School
of Economics, as finance minister, and the new government announced a deregulation plan that was
viewed as a substantial turn away from socialism. Foreign investment was now invited. Singh
presented a budget plan that exempted financial assets from the calculation of the wealth tax.
Previously, managers had tried to keep their companies share prices as low as possible to avoid
taxation; now they took steps to encourage high prices. The budget plan also reduced regulations on
the pricing and timing of new stock issues.
This was also a time of widespread attempts at stock price manipulation. The machinations
of Harshad Big Bull Mehta, a Mumbai stockbroker, set off a national scandal in 1992, after the
market peak had been reached. He was described as creating a vortex effect in individual stocks by

buying in the market, selling at depressed prices to friendly institutions, and then buying again in the
now-diminished pool of available shares, thereby pushing prices up. The 1992 rise in Indian stock
prices is now referred to as the Mehta Peak. It was indeed a peak, since the market fell 50.3%
during the following year.
a) Ends of New Eras and Financial Crises
The sequel of the extraordinary price increases described earlier were highly variable. They
were frequently followed by dramatic reversals, but this is by no means always the case. Do the
increases carry the seeds of their own destruction, or are the interruptions due to other causes?
Often the ends of bull markets appear to be caused by concrete events unrelated to any irrational
exuberance in the stock market. Notable among these are financial crises, such as banking or
exchange rate crises.
b) What Went Up (Down) Usually Came Back Down (Up)
The data confirm for countries the result first discovered by Werner De Bondt and Richard
Thaler: that winner stocksif winner status is measured over long intervals of time such as five
yearstend to do poorly in subsequent intervals of the same length, and that loser stocksif loser
status is measured over equally long intervalstend to do well in subsequent intervals of the same
length .

Part 3: Psychological factors


Often market behavior is not explained by the fundamental factors discussed earlier.
Investors hardly spend time thinking on what the correct level of prices would be. So the question is
what binds the market to its current levels. What determines the correct prices? Shiller delves into
the psychological aspect to answer these questions. Research has shown that there exists pattern of
human behavior which suggests anchors for the market. He mainly talks about two anchors namely
quantitative and moral anchors.
Quantitative anchors gives indication to people whether a particular price for a stock is good
buy or sell. People generally figures this out by comparing current prices with past prices or based on
the last days index movement. To validate this point further Shiller mentions an experiment
performed by Nobel laureates Amos Tversky and Daniel Kahneman in which they showed that
peoples decisions in ambiguous situations are influenced by existing anchors or any other anchor at
hand. In this experiment these psychologists asked people to spin a wheel of fortune (on which
random numbers were written) and then some bizarre questions such that there was no relation
between the numbers on wheel of fortune and answers of questions asked later. They found that
the answers were heavily influenced by the number on the wheel of fortune. This type of anchoring
explains why stocks move on a day to day basis.
Moral anchors drives the people desire to buy or sell a particular asset. They compare the
intuitive forces to invest now against their perceived need for money to spend later. People
generally use stories to reach a decision whether to invest or not instead of evaluating based on the

quantitative factors. People behave this way because this is how human mind works. We usually
create a story to justify our decision.
Another reason which makes people behave in an awry fashion is overconfidence. Human
beings have a tendency to behave as if they know more when in reality they know very less. In an
experiment when people were asked some factual questions and then were asked to choose the
probability they think their answer is right, most people replied 80%.How does this affects the stock
market. Well each participant in the stock market thinks that he knows where the market will move
and keeps on investing which pushes the prices up or down and creating positive or negative
bubbles.
Next what Shiller talks about is the herd behavior. This shows that people in general tend to
follow each other instead of thinking rationally for themselves and then deciding. He mentions an
experiment conducted by Salomon Asch in which Mr. Asch showed how social pressure affects
personal judgment. This experiment shows how people tend to believe in the majority view when
their individual judgments contradict with that of the majority. Another perspective to the
experiment shows that people rely too much on the authorities and experts judgment and then
later become overconfident about them and hence investors ends up investing solely on the basis of
experts decision. This creates an information cascade. Herd behavior clubbed with excess reliability
on experts is often responsible for creating asset bubbles in the market.

Part 4: Attempts to Rationalize Exuberance


In this part Author talks about the Efficient Market theory that says prices are the reflection
of the information available in the market and whether prices seem overpriced or underpriced
market is always correct. There have been several studies in this regard and model is statistically
rejected never the less the model is popular and widely used academically because it is the closest
explanation of our markets.
Stock prices are open to valuation and its valuation is subjected to investors judgment. The
term Value Investor coined by Graham Bell are those who can find opportunities in the market.
They are specialized in buying low and selling high and the money supplied by them is described as
Smart Money. If smart money is effective then market would have been dominated by it and all the
opportunities had been exploited and no undervalued stock would have been available. But in reality
undervalued stock are available at any given point of time due to the fact that Efficient Market
theory has failed to explain that market can go periods of mispricing lasting decades. So the strategy
of buying low and selling high has little success in making money.
The underlying assumption in Efficient Market theory is that intelligence plays no role in
making money out of the market. One supporting argument is that smart money has already
dominated the market and everything is priced correctly so theres no scope of price correction. Not
so smart money due to limited profit potential has very little influence over the market. Intelligent
and not so intelligent investors both have the same chance of making money. The other supporting
argument in this regard is that individual investors tend to get advices from Institutional investors
and advisory services although they get the information with a lag but they are well informed too,
professional advices indeed has value and that makes them indifferent. But according to a research
conducted on well performing investment managers and their SAT scores theres indeed a positive

relationship between them, investment manager with good SAT score tend to make more profit
than their peers but they will continue to do so in the long term it is doubtful.

Mispricing
Sometimes there are market forces that value an asset way more than its intrinsic value and
they outnumber the market. The example cited by author is the ecommerce toy company eToys,
which although was earning way less than its brick and mortar counterpart R but priced insanely
higher. Continuing Nifty fifty which is inscribed of glamorous companies like McDonald and Coca
Cola which are known for high PE ratio was mentioned and then the famous Tulip mania bubble.
It is argued that all of them were overpriced and all of them shared the common factor the
glamorous story. Ecommerce is some businesses an average investor come across everyday unlike
steel manufacturing and fireworks business, in the same way Nifty fifty companies were quiet known
companies and in the same way tulip story was shared with lots of benefits. The other argument
favoring Efficient Market theory was all of them posses some unique benefits which were
responsible for their high prices, like Nifty Fifty after 1996 came at par with S&P 500 and they were
underpriced compared to same PE value companies. Likewise Tulip mania was concerning a very
rare trait which was having discoloration and they were culturally very important to Dutch people.
Although there are many popular stories about mispricing but theres very little evidence for or
against Efficient Market theory.
Statistically it has been said that the firms those were overvalued by conventional measures
tend to perform poorly in the near future. Value investors who are long term investors exploit such
opportunities and eliminate the relation between stock price and their returns. There are other ways
to value other than the conventional methods, market as a whole would try to capitalize such
opportunities. Value investors tend to put out their money when there is little effect of value on
return but they retain their money when the market as a whole behaving in the same way.
Price Change
Historical evidences suggest that earnings rarely culminate into price change and out of
three bull runs only one was supported with high earnings. First great bull market from 1920 to
1929, S&P real composite earning increased three times and real stock price increased seven times
as a reaction that could be considered as an over-reaction. In the second great bull market the
relation between earnings and price were not so clear, composite earning increased merely 16% and
that corresponded price to grow three fold. In the third Bull Run from 1982 to 1999 prices more or
less rose but not earnings.
But evidence suggests that real dividends indeed have influence over the real price whether
or not dividends depend on earnings. Author stated that co-movement between real price and real
dividend follow the intrinsic bubble model which says that stock prices overreact to the change in
dividends. Against the price overreaction to the dividend, author argued that movement in both of
them is due to the same factor that might include speculations in future potentials. Payout ratio,
which is the percentage of earning paid as a price is set by the managers who are part of the same
community the investors represents, thus biased by the market sentiments. So we can say that

correlation between them tells nothing but that the dividends are the poor representation of prices.
Prices are independent and just by ability to predict the future earning potential wont lead to
substantial returns.
Excess Volatility the big picture
Although Efficient Market theory is widely accepted and there are many evidences
supporting it but many evidences are also found against it. Anomalies such as January effect, small
firm effect and the days of the week effect talk against market efficiency. But these anomalies also
talk in the favor of Efficient Market theory, first supporting argument is that these anomalies have
small impact on the market and dont culminate into bear or bull market, the other supporting
argument that suggests the market is efficient is that, these effect disappeared after they were
discovered.
The dividend present value over the years had been smooth relative to the stock prices this
suggest markets are not efficient because volatile market prices cant be explained with volatile
dividends and dividends are the fundamental representation of stock prices. The dividend present
value smoothness is partly because its extending far into future and partly because they dont move
hyper as stock prices. Most of the dividends fluctuations were temporary and their effects might be
lost while calculating their present value.
In the short run stock fluctuation say nothing about the business cycle. If the Efficient
Market theory is correct then temporary recession should have no impact on the prices but only new
information available on dividend in the long run.
The major breakthrough like nationalization and confiscation of stock market that can
impact dividend several fold is not witnessed so far that could show the similar fluctuation in both,
thus the discussed concerns are inadequate to conclude. Moreover much of the fluctuation in the
market might be due to the future concerns about the dividend or earning. It is stated that only 27%
of the annual return volatility of the U.S stock market is due to the genuine information about the
future. In the recent time the stock prices have shoot much more relative to dividend compared in
the past without the spike in the dividend present value which have been awaited to prove the
authenticity of efficient market.
Investor Learningand Unlearning
The historical performance of the stock market and the investment skills like diversification
has encouraged the investors in such way that now they are ready to put their money for the less
risk premium. It is evident that investors now perceive the stock market less risky than the past and
hence less reluctant about putting their money. The past return pattern of the stock market
encourage investor to keep their money, even if market goes down for a certain period investors
retain their belief that it will bounce back to even higher level. Much of the supernormal stock
return led to investors believing blindly that past will be repeated in future with no strong evidences.
If we look at the 30 year of historical returns in the past it is evident that stock market has
outperformed the bond market. If the average return is reduced to 10 years bonds have few times
over performed the stock market. In the past wars have devalued the currency and the recent times
inflation is at its higher level.

Mutual funds are the new fad that is keeping investors interest in the market. Now
investors are looking return in the long term and they have the tendency to keep rolling their money
in the best performing investment fund in spite of transfer fees. Investors have learned from that
past that market may go down for short or longer period but it will bounce back, much of the faith
comes from the mutual fund which are backed by the management team that have proven records,
but only time will tell that how long this wisdom will retain until it is proven wrong with empirical
evidences.

Part 5: A call to Action


Market not always represents the consensus judgments of experts but the effect of
irrational moves made solely on the basis of gut feeling or by following herd behavior or the impact
of positive atmosphere created by media. The valuation of stock market is a very important issue
and experts commit mistake by not correcting the myopic forecasts of short term predictors and
being silent on the long term implications of such moves. The bubble burst also leads to uneven
distribution of wealth thus adversely affecting the future plans of the individuals and society and so
we must be clear on prospects of such unfavorable events while deciding the individual and national
policy regarding this.
The outlook at the beginning of new millennium and possible new factors
Of the already discussed 12 factors while describing the .com bubble burst, if we consider
precipitating factors which will hold the market at its current level, then the only return will be
dividends which yield less than 1% in US which is quite unattractive. If other factors work in the
direction of stock price increase and dividend increase does not cope with that pace, it will again be
unattractive.
One of the most attractive factors was Internet which gives a sense of technological promise
but as we move in the 3rd millennium and get introduced to new technology, it will become ordinary.
But one very important aspect of internet is that it facilitates the online trading of stocks and
transactions to be completed in fractions of a second. It is thus not only instrumental in increasing
the volume of trade but also for speculative higher valuations of the market. One other important
factor is media. It focuses on what public is interested and thus it is highly uncertain if the Money
section of newspapers and such TV programs can hold the public attention for long. Low inflation
rates also lower the nominal yield and hence it is unlikely that the financial institutions will allow it
to dip further. There is a belief in US that government supports baby boomers and thus investment
in stocks from their funds increase the demands of such stocks thus increasing the value but it is also
expected that they soon will need to divest their investments and need the cash and so the impact
of governments stance on baby boomers is uncertain. The sense of perceived victories of
competitors symbolize new gains and losses but no victory can be everlasting and thus the
fluctuations in these perceived victories will decrease the strength of stock market. But the absence
of any predictable change does not mean that there will not be any predictable change. The market
is at the current level because of the precipitating factors combined by positive feedback and
without the growth in these precipitating factors, it is very unlikely that market will be able to
sustain its current growth and this gives a poor long term outlook for the stock market but it is also
true that new factors (either constructive or destructive) will surely develop. Some of these may be

the impact of technology failure of the introduction of new technology, war, terrorist attack, oil
crisis, foreign competition, labor movement, decrease in employee morale and productivity,
antitrust activities, foreign policies, natural disasters, epidemics, etc. Many of these factors can lead
to the occurrence of others as well.
Issues of fairness and resentment & s haring the limits to growth
A large proportion of GDP going as the corporate profits will lead to at least some public
resentment which may bring down the morale and productivity thus hampering the earnings growth
in US. Also the foreign resentment towards US (probably because of technology dominance and
sense of technology exclusion in rest of the world) can encourage the non US countries to strongly
compete or exclude US corporations and thus present another hurdle in US earnings growth.
Although the intent of US in Asian financial crisis was positive but it had some negative value as well,
increasing the resentment towards US.
Also, the pollutants in environment will grow with the pace of the development across the
world but the economic costs of suggested measures will mainly be borne by rich countries but the
pain in cutting these emissions will be greater than cost as most of the increase will be contributed
by developing countries and thus presenting a downside potential for US and other wealthy
countries earnings.
What should the investors do now?
Another downturn in US stock market will not cause the wealth of investors to erode by
trillions of dollars but the real losses can be comparable to the destruction of all
schools/farms/homes of the country. Though there are debates about the physical impact of loss but
one thing for sure is that problems will arise of that loss is not borne equally by all. Imagine the
implications of uneven wealth distribution of wages level, career of children, their education level,
life of retirees, college and foundations who have lost all their funds in stocks, etc. So, considering all
these implications, the million dollar question that comes out is that what should investors do
now?
Shiller presents some solutions like reducing the dependence on US stocks or at least
holding a well-diversified portfolio (but if even this advice is taken by masses, the market will crash),
individuals should consider more on increasing their saving rates (as it is expected that the amount
of savings needed to offset the possible market downturn will be quite large) and
college/endowments should reduce their payout rates.
Retirement Plans & Social Security
The shift towards defined contribution plans, though having the advantage of offsetting
inflation effect in defined benefit plans, has encouraged the employees to choose an investment
scheme from variety of options but mainly stock related and mimic some popular strategies for
superior returns. Authorities who are responsible for pension plans should come out much more
strongly against putting all or almost all of ones plan balance into the stock market. They should
instead recommend greater diversification and suggest that a substantial fraction of balances be put
into safe investments, such as inflation-indexed government bonds and make available inflation-

indexed retirement annuities and urge retirees to take their retirement income in this form.
Companies can even consider the low income workers for defined benefits plan again.
Social security system is an intrafamily risk sharing organization in US. It replaces individual
contracts among family members with contractual obligations between generations at large.
Instead of investing the contributed money, it gives it to individuals who need it now and this goes
on and this way, it also mimics the traditional family system which did not rely on investments. It has
the advantage of greater uniformity and reliability and the criticism of windfall gains can be offset by
reduced levels of care from children. Reform of Social Security should take the form not of investing
(options of stock or real estate as it is basically the hope of market doing good) but of making the
system more responsive to economic risks, so that the system promotes better risk sharing among
economic groups within our population and not that in bad times, the needs of retirees are funded
by increasing tax rates. Contribution rates and benefit rates should vary over time depending on the
relative needs of workers and retirees. Both contributions and benefits should be indexed so as to
financially offset windfall gains.
Monetary policy and the stabilizing authority of opinion leaders
There have been occasions where the tightening of monetary policy has been associated
with bursting of stock market bubbles. Although precise links are not evident, it can be seen that
interest rate policy directly affects the entire economy in the fundamental way and is not targeted
towards any particular bubble. Also genesis of bubble is a slow process and small changes in interest
rates do not have any predictable significant effects. A well proven way of checking speculation in
financial markets is to call for public attention on under/over-priced securities by intellectual and
moral leaders. There is no way of judging success of such events in the past as we cannot measure
how volatile the markets could have been if we had not received the advices of the then opinion
leaders in the market. One problem with this approach is that the views are never universally held
and thus there is small stabilizing effect of such statements in market.
Dealing with bubbles by interrupting/discouraging or expanding/encouraging trade
Another method of reducing market volatility is to shut the markets in times of rapid price
change. Circuit breakers, uptick rule for short sales etc. are examples of this method. The underlying
logic for this is to put constraint on the trade to be completed or shutting the market for some time
so as to signal some information to the public and they may correct their decisions in the meantime
thus reflecting the same on security prices. Another way to discourage short term speculators may
be transaction taxes (suggested by Tobin). But it is not certain to work as real estate markets have
high transaction taxes but they are in fact more vulnerable to bubbles and crashes.
A counter policy to stabilize markets is to broaden the scope of things traded and broaden
the number of people trading, as far as possible. If the foreign territories are also involved, the rise in
prices due to bubble may affect investors of one location but not the other and they may take
positions such that net effect of bubble burst will offset the losses. If done correctly, the expansion
of market adds information about fundamentals and diverts public attention to prospects way from
short term speculation.

Also, due to certain constrains(like that of capital-gains-tax consequences of trading), it is


may times not possible not possible for an investor to get out of market thus there is a need for
creating new institutions which make it easier for individuals to get out of their exposure in stock
markets. This in broader terms means creating the number and variety of markets (like macro
markets) and trading the major risks that are untradeable today. Though there is possibility of
occasional speculative bubbles in macro markets as well but the immense diversification
opportunities and attention focused on fundamental risks can be helpful in stabilizing our economies
and thus our lives.
Altering conventional wisdom about diversification and hedging
While many experts chant the need of diversification but they do not stress on what
diversification genuinely mean. In order to encourage proper risk management, the advice given by
public authorities should emphasize on genuine diversification. It means hedging against the
exposure of assets you are already locked into but it is difficult to change public mindset driven
mainly by conventional wisdom. Thus attitudes can be and need to be changed by public leaders.
Policy towards speculative volatility
The policy formulation to deal with bubbles require deep understanding of bubble formation
but this phenomenon is quite complex and changing so the role of one variable in one bubble
formation cannot be taken as for sure for every bubble. Market interruption mechanisms are
sometimes useful but cannot always be used as priority solutions as they interfere with market
functions as well. Ultimately in a free society, we cannot protect the people from consequences of
their irrational exuberance and their own errors. Policies dealing with speculation are little
analogous to political parties where we set them free and rely on the intelligence of voters. Hence a
better move can be to facilitate more trade and design better form of social insurance and create
better financial institutions to manage risks effectively. But focus on dealing with speculative
volatility alone should not distract us from other important tasks.