Book of the Week: Irrational Exuberance

16 Aug 2015

This book is about speculative bubbles by Nobel Prize winning Yale economics professor, Robert J. Shiller. Each new revision of the book was close to a bubble that popped. The first edition was close to the stock bubble. The second edition was close to the real estate bubble. This third edition published in 2015 has news sections on the bond bubble. Shiller is known as the great predictor of bubbles. The later edition also comments on the previously predicted bubble that popped. I expect a fourth edition that covers a new bubble with commentary on the bond bubble that popped after the release of the third edition. The book is divided in sections that talk about the structural factors, cultural factors and psychological factors to lead to irrational exuberance.

If we exaggerate the present and future value of the stock market, then as a society we may invest too much in business start-ups and expansions, and too little in infrastructure, education and other forms of human capital.

Bubbles are bad, because they change our allocation of resources chasing after value that is no there. Nominal vs Real An important concept is the real interest rate. The nominal interest rate is the face value, but the real interest rate adjusts for inflation. Let’s say you loan a person $1 and expect $2 back in 10 years. Currently it costs $1 to buy a loaf of bread, but in 10 years it costs $3 to buy a loaf a bread. You’ve effectively lost money even though you have a bigger number. What you should care about is buying power. Positive nominal rates can have negative real returns, which is happening for some bonds. CAPE The cyclically adjusted price to earning ratio (CAPE) is the price divided by a 10 year moving average of earnings of a stock adjusted for inflation. This gives a better idea of a company’s true earnings in relation to it’s price. An overvalued company would have a high CAPE. The plot above is the CAPE of the S&P; 500 index. You can see peaks during stock bubbles. When talking about bubbles, you need financial tools to identify bubbles. Case-Shiller index The Case-Shiller index is a measure of home prices using repeat-sales of homes. That is the same property being sold, so you can compare apples to apples. Like how CAPE helps you identify stock bubbles, the Case-Shiller index is for real estate. The second edition was published in 2005 where you pointed out the bubble behavior.

Liquid public markets for home prices do not exist that would allow skeptics of housing bubbles to take short positions against these bubbles, which would, if were possible, have the effect of incorporating their doubts into the market.

The housing market can become irrational, because it is difficult to short sale. You need to allow people to profit on housing prices going down. That let’s people express their beliefs. If things are setup such that the only way is up, then it will keep going up until it pops. Short sales provide a feedback mechanism to keep things sane. Short selling provides a very important role. Unfortunately, government regulation has limited short sailing of stocks and there is no easy way to short sale a startup, so prices will keep going up, until things pop. China made the wrong move in blaming short sales for its market drop. Bonds

There must be some hard-to-pin-down cultural factors driving people to invest in bonds at a time when their yield is very low or negative and the stock market has been soaring.

If interest rate is cut, then the yield of the bond goes down and the price of the older bonds go up, because the older bonds give better returns, so people are willing to pay more for them. The interest rate has only been going down, so bonds have been profitable, but once interest rates go back up something is bound to happen. The bond yield curve describes the yield of a bond versus maturity date. Free-riding Analysts

Honesty was never a profit center on Wall Street, but the brokers used to keep up appearances. Now they have stopped pretending. More than ever, securities research, as it is called, is a branch of sales. Investor, beware - James Grant

There is a free rider problem in stocks. Everybody thinks everyone else is doing due diligence. What you really have is an analyst that is fresh out of college. Warren Buffet tells you how to read financial statements, but how many people who own stocks have read the balance sheet of their companies? The people who do think for themselves can succumb to herd mentality through social pressure. Maybe their ideas a wrong, because it contradicts with everyone else. This reminds me of the an elevator experiment when everyone in the elevator faces away from the door. [youtube https://www.youtube.com/watch?v=lxh_Bw2OsSE&w;=420&h;=315] Baby Boomers

Similarly, at a time when people are worried about the sustainability of their labor income, and there are not enough really good invest opportunities, they may tend to bid up process of all manner of existing longer-term assets in their efforts to save for the dangerous lean years seen ahead.

Baby boomer screw up everything like social security. You always have to think about their impact. But this part of the book got me thinking about myself and how people work. There are some instances where I would rather spend time than money, even though economically speaking it would be logical to spend money. What is going through my head is that spending that money means I would have to work marginally more to get that income, which I don’t have yet. If the difficulty to increase marginal income was lower, perhaps that anxiety wouldn’t exist. If I know I can login into a website, spend an hour and get compensated for it, then would my behavior be different? Things would be more efficient if the barriers to getting more work were lowered. Maybe there is something beneficial with the on-demand economy. News You may think news articles cause stocks to go up and down, but Shiller points out research showing that swings in the market are not strongly correlated with the news. News is the initiator, but never the cause of swings. News can start of a chain of thoughts, but those doubts and fears are already existing. It just brings them to the surface. New Era People always get excited about entering a new era. We are living in the age of the internet and it will change everything. This is happened before with computers, telecommunications, electricity, railroads, etc. This thinking of a vastly better future helps fuel speculative bubbles.