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Book Review by Malcolm Inglis: Irrational Exuberance

  • October 9, 2024

Malcolm InglisEditor’s Note: This is the 20th review in our Get Paid to Read contest series! If you missed last week, we featured Maxwell Austin’s review of Flash Boys by Michael Lewis.

You can check out our growing Reading List section here.

This week, we’re diving into the classic book Irrational Exuberance by Nobel Prize-winning economist Robert J. Shiller and reviewed by Malcolm Inglis.

Malcolm is an investor focused on various arbitrage strategies following 15 years of investment banking and corporate finance experience.  He previously studied economics at McGill University and the University of Alberta.


Irrational ExuberanceRobert Shiller’s book, Irrational Exuberance, examines the notion that human behavior and psychology have repeatedly driven asset market bubbles throughout history. Shiller has been credited as having identified the “dot com” bubble prior to the crash around the turn of the millennium, as well as the real estate crash that followed several years later.

The book begins with historical perspectives of the stock, bond, and real estate markets. Shiller focuses on periods of rapidly increasing prices and subsequent crashes. He posits that such price increases cannot always be explained by fundamental economic indicators and that there is an element of irrational behavior contributing to the formation of bubbles.

Shiller outlines several structural factors that create bubbles and cause them to persist. He offers a list of precipitators of recent market booms, including widespread adoption of internet technology, increased media coverage of financial markets and loose monetary policy. He argues that these increases can then be amplified by “naturally occurring Ponzi processes”, in which increasing investor confidence and expectations of future performance persist through a feedback loop. Shiller also argues that the same phenomenon can be true in reverse, where a “negative bubble” can create cascading price declines.

Shiller next focuses on cultural factors, including how narratives of a “new era”, amplified by news media, spur investor overconfidence and create bubbles. Optimism over a change in government, or a sudden positive change in economic circumstances, can cause the market to get ahead of itself. Shiller points to a long list of historical stock market increases, including a 400% increase in Taiwan’s stock market in 1986-87, which was driven in part by excitement over growing exports and a burgeoning high-tech manufacturing sector. He further noted that once the exuberance eventually wore off, the Taiwanese stock market suffered a -74.9% decline in 1989-90.

The discussion of cultural factors is followed by psychological anchors and herd behavior that contribute to the formation and propagation of bubbles. Shiller discusses how psychological contagion can be modeled like an epidemic, where the rate of spread of word-of-mouth information can determine how fast a bubble will grow.

A particularly entertaining example of anchoring is Shiller’s reference to a study by Tversky and Kahneman, where a “wheel of fortune” spin produces a random number from 1 to 100, after which the participant is asked a difficult question where the answer is a percentage. The study found that the answers of subjects were significantly influenced by the random numbers from the wheel.

Following his discussion of underlying behavioral factors, Shiller debates the ability of the efficient market hypothesis (“EFH”) to properly explain price movements. His assertion that bubbles can exist directly opposes the EFH, which was popularized by economist Eugene Fama. Both Shiller and Fama were awarded the Nobel Prize in 2013 for their work on asset pricing, as was Lars Peter Hansen.

Shiller raises several arguments, both anecdotal and through reference to academic literature, and points to findings where stocks that outperform over some period of time will proceed to underperform in a type mean reversion. This segues into a discussion of Shiller’s cyclically adjusted price-earnings (“CAPE”) ratio, a smoothed P/E ratio which uses 10-year average earnings. Shiller finds that periods of high CAPE ratios tend to be followed by periods of low stock market returns.

Shiller’s most recent version of Irrational Exuberance was published in 2015, and therefore only covers data up to 2014. A high CAPE ratio around the time of publishing predicted low returns between 2014 and 2024, though Shiller suggests in the book that stocks could very well go higher. Stocks did in fact go much higher, as the S&P 500 total return index nearly quadrupled over the past 10 years.

S P Composite CAPE Ratio

Source: Shiller Data – US Stock Market data from January 1871-September 2024

It could still be however, that we are in line for a period of low future returns, as the CAPE has kept climbing from the mid-20s in 2014 to the mid-30s in September 2024, levels which have rarely been witnessed in history. As with previous large stock price increases, it seems impossible to predict when a crash might occur.

Shiller concludes Irrational Exuberance with examples of how investors “learn and unlearn” that stocks always tend to go up after they go down, and that this ends up being wrong, only to be relearned in the future.

In order to fix bubbles, Shiller suggests several actions, some of which include increased transparency of opinions on asset mispricing by market participants, monetary policy changes that lean against bubbles, and more effective ways for the public to hedge risks.

Overall, Shiller’s book offers many insightful examples of human behavior and its impact on markets, using both historical anecdotes and references to academic literature, including his own. There are only a couple of areas that I found could be more balanced for the reader.

For instance, mentioned in the book is an assumption used by some financial advisors that US stock market returns should be about 8%-10% per year, and that it may be inappropriate to treat this as conventional wisdom when modeling individual outcomes. While one can accept that it is dangerous to take these assumptions at face value without acknowledging the risks associated with equity investments, historical data shows over long periods of time that returns of this magnitude are fairly realistic. Perhaps there is some middle ground where one caveats the return assumption with a statement about risk, but where one is still able to use average
historical returns as a guidepost.

In another example, Irrational Exuberance’s chapter on news media suggests that a Boston housing boom spread to London, Paris, and Sydney. One reason for this, Shiller suggests, is that the news stories of the boom were copied from the first markets to experience a boom into these new markets. At the same time, Shiller notes that Berlin and Tokyo did not see the same stories published by their respective media, as the stories would not have been seen as credible given the prevailing local economic conditions. Though plausible, little evidence is provided in the book to suggest why this is actually true, rather than just a potential explanation of a perceived correlation.

Whether or not one agrees that a bubble has actually occurred or whether investors are acting irrationally at a given point in time, Shiller offers a well thought out, accessible review of the behavioral mechanisms that drive seemingly unjustified asset price run-ups and crashes. It is for this reason that I would recommend Irrational Exuberance to anyone interested in the psychology and history of asset pricing in the stock and real estate markets.

Sources:

1. S&P 500 (TR) – Yahoo