In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.
Chapter 1.
Shiller begins by putting the stock market level, as it stood in the year 2000, in historical perspective. While the Dow Jones Industrial Average (the Dow) had more than tripled since 1994, GDP and personal income was only up 30%. Corporate profits were up less than 60% over the same period.
A chart is shown illustrating the level of two variables: the stock market level and the market's earnings. Earnings had continued on their steady path, but the market level had taken off on a vertical spike at the time of writing. Shiller illustrates that the ratio of stock prices to earnings (a 10-year average of earnings in order to smooth out volatility, as discussed here) is at an absurd level. The PE 10 ratio is at 44 at the time of writing; the closest parallel is the 33 PE 10 ratio the market hit in September of 1929, just before it crashed.
Shiller then explores the question of whether there is any relevance to the market's P/E. To do this, he plots the market's PE 10 for all years since 1890 against its subsequent 10-year real returns. The resulting graph demonstrates that there is a relationship between a market's PE 10 and its subsequent returns. Based on the graph, negative returns over the next 10 years could have been expected from the year 2000. (As it turns out, returns over the next 10 years were indeed negative.)
Chapter 2.
Since the growth of the economy or firm earnings are not responsible for the stock market's huge growth rates in the late 1990's, Shiller attempts to determine other factors that may be playing a role in the market's growth. Shiller makes the point that there is likely no one single factor at play, but rather a confluence of a number of factors that are causing investors to bid up prices to never-before-seen ratios.
Shiller discusses the following twelve factors as possibly playing a role in the market's exuberance:
1) Arrival of the internet during a period of solid earnings growth
2) Decline of foreign economic rivals
3) Cultural changes favouring business success
4) Republic Congress and tax cuts
5) Perceived effect of the Baby Boom generation
6) Expansion in media reporting of business news
7) More optimistic analyst forecasts
8) Expansion of defined contribution pension plans
9) Growth of mutual funds
10) Decline of inflation
11) Increased trading volume (discount brokers, day traders, 24-hour trading)
12) Rise in will and willingness to gamble
Shiller warns that correlation between these factors and the stock market's growth should not be confused with causation. Nevertheless, he believes many of these are contributing to the market's growth, if only psychologically.
Chapter 3.
In this chapter, Shiller discusses the amplification mechanisms involving investor confidence and expectations that he believes are contributing in a major way to the speculative stock bubble of the year 2000. He argues that these amplification mechanisms work through a positive feedback loop, reinforcing each other until what he predicts will be a stock price collapse.
First, Shiller establishes through survey evidence that investor confidence has indeed increased in the late 1990's as compared to other periods. For example, groups of investors expected higher stock returns in the future than similar groups had in the past.
He then discusses why this may have happened, suggesting that regret (from not participating in the recent gains), a tendency to extrapolate short-term results into the long-term, the recounting of stories of those who have made riches in the market, and a tendency to ignore inflation (and therefore think of nominal stock returns only, which have been much higher than real returns over time) are leading to investor confidence that is currently higher than it should be.
Currently (at the time of writing, in the year 2000), Shiller argues that as prices continue to rise, investor confidence and expectations are going through a feedback loop. Higher stock prices are leading to higher expectations which are leading to higher prices. Shiller calls this process a naturally occuring Ponzi scheme: investors are presented with a plausible story about how great profits will be made (the reasons discussed in Chapter 2), they start by investing small, and as their returns rise, they become willing to invest more and more money. The payoffs to the investors come entirely from new money that is entering the market! A fraudulent manager isn't even required for this natural Ponzi scheme to grow wildly.
Chapter 4.
The media's role in the creation of the hi-tech stock bubble of the year 2000 is discussed in this chapter. Shiller points out that the history of speculative bubbles begins roughly with the advent of newspapers! While the media present themselves as detached observers of the stories they cover, they are a major player in these events.
Shiller argues that bubbles can only occur if there is similar thinking among large groups of people. The media helps make this happen. With everyone on the same page, markets are free to rise and/or fall by large amounts.
Shiller also takes issue with some of the media's explanations for market occurrences. For example, on a given day the financial media always has an explanation ready for why the market fell or rose. But Shiller presents data that suggests these after-the-fact links are fallacious. He argues that when there is a big market event, though the media will emphasize some news item it has picked to be the cause of the event, it is actually the price change itself that is the news. Shiller takes the reader through news items preceding the 1929 and 1987 crashes, demonstrating that nothing out-of-the-ordinary was occurring in the news, though the media did attribute the causes of the crash to various current events of the time.
Chapter 5.
It is generally believed that times of extreme optimism result in booming stock markets. The author, however, turns this theory around and argues that strong stock prices cause a society to look for reasons to explain the booming market. In this chapter, the author takes the reader through some of the "new era" thinking that has pervaded the stock market booms throughout the last 100 years.
In 1901, there was huge optimism about how technology was about to change lives for the better. The first transatlantic radio transmission occurred in 1901, and the future was seen as bright: "trains [will be] running at 150 miles per hour,...newspaper publishers will press the buttons and automotive machinery will do the rest,...phonographs as salesmen will sell goods in the big stores while automatic hands will make change."
Furthermore, a recent spell of mergers had reduced competition and increased profit margins. But the level of profits was too high for the people. Antitrust legislation was used against monopolistic companies, and corporate taxes were instituted.
The 1920s were another time of renewed optimism on the basis of technology. The number of automobiles on the road tripled during this period, and US homes had become wired for electricity, resulting in soaring sales for items such as light bulbs, vacuum cleaners and washing machines. Shiller quotes a number of extremely positive articles and books from the period, where the expectation is that civilization is embarking on a new era. Stock projections were parabolic.
"New era" thinking once again permeated during the mid-1950's and 1960's. Growth in the use of devices such as televisions helped fuel exuberance. Ideas that stocks were now held in "strong hands" (mutual funds and institutions) gave confidence that crashes were now a thing of the past. Demographics (namely the Baby Boomers) were cited as further reasons for why "it's different this time".
Following each "new era" came a bout of extreme pessimism. Feelings were often widespread that the US was losing its preeminence to other countries (e.g. Japan). Interest in Communism grew following each crash. Capitalism was often seen as having failed.
Chapter 6.
In this chapter, Shiller examines the 25 largest stock market index moves around the world, both over one-year and five-year periods. He then tracks the subsequent returns that occurred following these periods of abnormally strong and weak returns.
Following the strongest one-year returns around the world, subsequent one-year returns for the same markets have been all over the map. Often, extreme strength in these markets has been the result of a regime change that has seen a citizenry oust a dictator or military and regain control of its government.
In the one-year period following the largest one-year declines, however, stock returns around the world are decidedly positive, with only 6 of the 25 instances showing negative in the subsequent year.
Subsequent five-year results following extreme five-year price changes are far more convincing of the "bubble" effect. Following the largest five-year increases, almost all five-year subsequent returns were negative. There were exceptions, however. For example, in the Philippines, a 1253% increase over five years (starting in 1984) was followed by another 43% increase over the next five years. This was the result of a regime change in which a Communist dictator was ousted. In the other exceptions, extreme price gains were the result of extreme losses in previous years.
What went up (down) usually came back down (up). From this evidence, and considering the huge stock run-up of the late 1990's, Shiller surmises that the possibility that the US is currently (at the time of writing, in the year 2000) in the midst of a major speculative bubble cannot be ignored.
Chapter 1.
Shiller begins by putting the stock market level, as it stood in the year 2000, in historical perspective. While the Dow Jones Industrial Average (the Dow) had more than tripled since 1994, GDP and personal income was only up 30%. Corporate profits were up less than 60% over the same period.
A chart is shown illustrating the level of two variables: the stock market level and the market's earnings. Earnings had continued on their steady path, but the market level had taken off on a vertical spike at the time of writing. Shiller illustrates that the ratio of stock prices to earnings (a 10-year average of earnings in order to smooth out volatility, as discussed here) is at an absurd level. The PE 10 ratio is at 44 at the time of writing; the closest parallel is the 33 PE 10 ratio the market hit in September of 1929, just before it crashed.
Shiller then explores the question of whether there is any relevance to the market's P/E. To do this, he plots the market's PE 10 for all years since 1890 against its subsequent 10-year real returns. The resulting graph demonstrates that there is a relationship between a market's PE 10 and its subsequent returns. Based on the graph, negative returns over the next 10 years could have been expected from the year 2000. (As it turns out, returns over the next 10 years were indeed negative.)
Chapter 2.
Since the growth of the economy or firm earnings are not responsible for the stock market's huge growth rates in the late 1990's, Shiller attempts to determine other factors that may be playing a role in the market's growth. Shiller makes the point that there is likely no one single factor at play, but rather a confluence of a number of factors that are causing investors to bid up prices to never-before-seen ratios.
Shiller discusses the following twelve factors as possibly playing a role in the market's exuberance:
1) Arrival of the internet during a period of solid earnings growth
2) Decline of foreign economic rivals
3) Cultural changes favouring business success
4) Republic Congress and tax cuts
5) Perceived effect of the Baby Boom generation
6) Expansion in media reporting of business news
7) More optimistic analyst forecasts
8) Expansion of defined contribution pension plans
9) Growth of mutual funds
10) Decline of inflation
11) Increased trading volume (discount brokers, day traders, 24-hour trading)
12) Rise in will and willingness to gamble
Shiller warns that correlation between these factors and the stock market's growth should not be confused with causation. Nevertheless, he believes many of these are contributing to the market's growth, if only psychologically.
Chapter 3.
In this chapter, Shiller discusses the amplification mechanisms involving investor confidence and expectations that he believes are contributing in a major way to the speculative stock bubble of the year 2000. He argues that these amplification mechanisms work through a positive feedback loop, reinforcing each other until what he predicts will be a stock price collapse.
First, Shiller establishes through survey evidence that investor confidence has indeed increased in the late 1990's as compared to other periods. For example, groups of investors expected higher stock returns in the future than similar groups had in the past.
He then discusses why this may have happened, suggesting that regret (from not participating in the recent gains), a tendency to extrapolate short-term results into the long-term, the recounting of stories of those who have made riches in the market, and a tendency to ignore inflation (and therefore think of nominal stock returns only, which have been much higher than real returns over time) are leading to investor confidence that is currently higher than it should be.
Currently (at the time of writing, in the year 2000), Shiller argues that as prices continue to rise, investor confidence and expectations are going through a feedback loop. Higher stock prices are leading to higher expectations which are leading to higher prices. Shiller calls this process a naturally occuring Ponzi scheme: investors are presented with a plausible story about how great profits will be made (the reasons discussed in Chapter 2), they start by investing small, and as their returns rise, they become willing to invest more and more money. The payoffs to the investors come entirely from new money that is entering the market! A fraudulent manager isn't even required for this natural Ponzi scheme to grow wildly.
Chapter 4.
The media's role in the creation of the hi-tech stock bubble of the year 2000 is discussed in this chapter. Shiller points out that the history of speculative bubbles begins roughly with the advent of newspapers! While the media present themselves as detached observers of the stories they cover, they are a major player in these events.
Shiller argues that bubbles can only occur if there is similar thinking among large groups of people. The media helps make this happen. With everyone on the same page, markets are free to rise and/or fall by large amounts.
Shiller also takes issue with some of the media's explanations for market occurrences. For example, on a given day the financial media always has an explanation ready for why the market fell or rose. But Shiller presents data that suggests these after-the-fact links are fallacious. He argues that when there is a big market event, though the media will emphasize some news item it has picked to be the cause of the event, it is actually the price change itself that is the news. Shiller takes the reader through news items preceding the 1929 and 1987 crashes, demonstrating that nothing out-of-the-ordinary was occurring in the news, though the media did attribute the causes of the crash to various current events of the time.
Chapter 5.
It is generally believed that times of extreme optimism result in booming stock markets. The author, however, turns this theory around and argues that strong stock prices cause a society to look for reasons to explain the booming market. In this chapter, the author takes the reader through some of the "new era" thinking that has pervaded the stock market booms throughout the last 100 years.
In 1901, there was huge optimism about how technology was about to change lives for the better. The first transatlantic radio transmission occurred in 1901, and the future was seen as bright: "trains [will be] running at 150 miles per hour,...newspaper publishers will press the buttons and automotive machinery will do the rest,...phonographs as salesmen will sell goods in the big stores while automatic hands will make change."
Furthermore, a recent spell of mergers had reduced competition and increased profit margins. But the level of profits was too high for the people. Antitrust legislation was used against monopolistic companies, and corporate taxes were instituted.
The 1920s were another time of renewed optimism on the basis of technology. The number of automobiles on the road tripled during this period, and US homes had become wired for electricity, resulting in soaring sales for items such as light bulbs, vacuum cleaners and washing machines. Shiller quotes a number of extremely positive articles and books from the period, where the expectation is that civilization is embarking on a new era. Stock projections were parabolic.
"New era" thinking once again permeated during the mid-1950's and 1960's. Growth in the use of devices such as televisions helped fuel exuberance. Ideas that stocks were now held in "strong hands" (mutual funds and institutions) gave confidence that crashes were now a thing of the past. Demographics (namely the Baby Boomers) were cited as further reasons for why "it's different this time".
Following each "new era" came a bout of extreme pessimism. Feelings were often widespread that the US was losing its preeminence to other countries (e.g. Japan). Interest in Communism grew following each crash. Capitalism was often seen as having failed.
Chapter 6.
In this chapter, Shiller examines the 25 largest stock market index moves around the world, both over one-year and five-year periods. He then tracks the subsequent returns that occurred following these periods of abnormally strong and weak returns.
Following the strongest one-year returns around the world, subsequent one-year returns for the same markets have been all over the map. Often, extreme strength in these markets has been the result of a regime change that has seen a citizenry oust a dictator or military and regain control of its government.
In the one-year period following the largest one-year declines, however, stock returns around the world are decidedly positive, with only 6 of the 25 instances showing negative in the subsequent year.
Subsequent five-year results following extreme five-year price changes are far more convincing of the "bubble" effect. Following the largest five-year increases, almost all five-year subsequent returns were negative. There were exceptions, however. For example, in the Philippines, a 1253% increase over five years (starting in 1984) was followed by another 43% increase over the next five years. This was the result of a regime change in which a Communist dictator was ousted. In the other exceptions, extreme price gains were the result of extreme losses in previous years.
What went up (down) usually came back down (up). From this evidence, and considering the huge stock run-up of the late 1990's, Shiller surmises that the possibility that the US is currently (at the time of writing, in the year 2000) in the midst of a major speculative bubble cannot be ignored.
