This version: 28 July 2000
Quiggin, J. (2000), Taking stock of irrational exuberance, Australian Financial Review, 1 September, Review of Dow 36000 by Glassman and Hassett and rrational exuberance by Shiller.
Australian Research Council Senior Fellow
Department of Economics
Faculty of Economics and Commerce
Australian National University
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The most striking feature of the economic boom in the United States is the renascence of the stock market. From a level of 1000 in the early 1980s, the Dow Jones index has risen to more than 10 000, and technology-based indexes like the Nasdaq have risen even further. The renascence is even more striking in popular terms. There was a time when talking about stocks was a faux pas in many social circles. Now such talk is a standard conversational gambit, similar to discussion of sporting teams. As with sports, stockmarket talk provides an easy icebreaker for complete strangers, as well as a basis for subtly demonstrating superior expertise. Not surprisingly, there is a ready market for those willing to tell us what we should think about the stock market.
The most popular story today is that astutely chosen investments in the 'New Economy' represent the road to riches. Although business models have come and gone, the basic idea that technology will eliminate transactions costs, end the cycle of boom and bust, and deliver huge profits to those who get in on the ground floor has not. Because of the mercurial nature of the New Economy, this story is better told in the fevered atmosphere of chat rooms and the breathless Web pages of e-zines than in the pages of a printed book.
For those of us still lagging in the Gutenberg era, however, there are still plenty of books offering to inform our choices. Both optimists and pessimists are well catered for. On the optimistic side, Glassman and Hassett argue that a buy-and-hold strategy based on the blue-chip stocks that make up the Dow Jones index will yield 300 per cent returns over the next few years. Shiller views suggestions with alarm and suggests staying on the sidelines until the current bout of 'irrational exuberance' comes to its inevitable end.
The ghost at the feast in all of these stories is the 'efficient markets hypothesis',the official religion of capitalist society. The hypothesis states that at any time and place, the market price of an asset is the best available measure, incorporating all available information, of the value of that asset.
When applied to stock markets, the efficient markets hypothesis is an austere creed. The colourful language of the chartist, with its tops and bottoms, heads and shoulders, channels and support levels, is dismissed as so much mumbo-jumbo, playing on the innate propensity of humans to see patterns in clouds, tea-leaves or random data marks. Since information on past price movements is publicly available, the efficient market hypothesis tells us, it can have no predictive power.
Fundamental analysis of stocks based on projections of earnings and revenue is in just as much trouble. According to the efficient markets hypothesis, any publicly available information that affects a company should already be priced into the stock. At most, the profits available from trading based on fundamental analysis should only be sufficient to supply the wages of the analysts, as determined by a competitive market for their services.
Even inside information, a seemingly guaranteed route to trading profit, is in trouble. Efficient market theorists make the following argument: Relative to its long-term trend growth rate of around 5 per cent per year, the stock market is equally likely to go up or down on any given day. Hence, a child tossing a coin can not only break even, but earn the average 5 per cent return. The only way a skilled investor, even one with inside information, can outperform this market average is to trade with people so stupid that they do worse than a child with a coin. According to the efficient markets hypothesis, such suckers will rapidly be driven out of business.
The fundamental implication of the efficient markets hypothesis is that it is impossible to write a book about the stock market that is both interesting and useful. Practitioners may need texts on such mysteries as the Black-Scholes theory of option pricing and the details of corporate tax structure. But for the ordinary investor, there is nothing to do but diversify your portfolio, select the appropriate trade-off between risk and return, and consume the proceeds. Not surprisingly, most authors of books about the stockmarket reject this drab hypothesis.
For the technophiles, the efficient markets hypothesis is an example of linear Old Economy thinking. In a new era, when events before 1995 are as irrelevant as the Dark Ages, the idea of markets as efficient aggregators of information is passé. The Internet is viewed as a cornucopia which will make everyone involved with it rich. All that is required is faith and stock options.
By contrast, Glassman and Hassett want to believe in efficient markets, with one important exception. They believe that both investors and official commentators have misperceived stocks as a risky investment which should require a premium return, when compared to 'safe' investments such as government bonds.
Glassman and Hassett admit that stocks are risky in the short term. In any given year, there is always the possibility of a crash like those of 1929 and 1987. Over longer periods of twenty to thirty years, however, stocks almost always outperform bonds. In fact, the last thirty-year period when the dividends and capital gains accruing to an investor in the Standard and Poors bundle of 500 stocks failed to exceed the return to government bonds was in the early 19th century, between 1831 and 1861.
While many economists would regard this argument as overstating the safety of stocks, the magnitude of the 'equity premium', that is, the difference between the rate of return on government bonds and the rate demanded by investors in private equity, has long been a puzzle. The extra risk associated with stocks does not seem sufficient to justify an equity premium of around 6 percentage points, the average over the last century.
Glassman and Hassett have a simple explanation for the stock market boom of the 1990s. Investors are finally waking up to the fact that stocks are safe investments and are gradually reducing the rate of return they expect. Fortunately for the readers of Dow 36000, this process is incomplete. If stocks and bonds were treated as equally risky, Glassman and Hassett argue, the Dow Jones index would be around 36000. Hence, anyone who gets in now and stays for the long haul, can expect returns of around 300 per cent (in addition to the normal interest rate) as the rest of the market wakes up. Once this historic correction is over, the efficient markets hypothesis will hold sway, and the stockmarket will become boring again.
One objection raised by a number of economists critical of Glassman and Hassett is that their estimates effectively double-counts the retained earnings of companies in estimating their future value. The basic point is that the growth in earnings on which they rely is, at least in part, financed by the component of earnings that is not paid out as dividends. At least in principle, the analysis in Dow 36000 overcomes this objection. Their valuation estimates are based on projections of growth in dividends or free cash flows, rather than of earnings as a whole. Hence, the procedure is designed to count only once those earnings that are reinvested in the enterprise.
There is, however, a more subtle objection. Glassman and Hassett argue, in essence, that the return on stocks and bonds should be the same. They calculate their 'Dow 36000' estimate on the assumption that the average real rate of return on stocks will fall until it is equal to the real bond rate (about 3 per cent). There is an alternative possibility, however. Suppose instead that the real bond rate rises until it is equal to the rate of return on stocks. In that case, there will be no change in the value of the stock market.
The present consumption boom in the United States, based largely on expectations of future income growth, is possible only because the Europeans and Japanese are pessimistic savers. If they, too, wake up to the wealth available through stock market investment, they, too, will want to consume some of the proceeds. Only an increase in interest rates will call forth the necessary savings. But if the imbalance between stocks and bonds is resolved by a permanent increase in real interest rates, say to 8 per cent, the Dow will not see 36000 in the lifetime of today's investors.
Another interesting implication of the Dow 36000 argument relates to the debate over privatisation. Kim Beazley argues that Telstra should not be sold because the earnings it generates are worth more than the sale price the government can obtain. If the argument of Glassman and Hassett is accepted, Beazley is absolutely right. Until the equity premium is eliminated, governments should not privatise profitable enterprises, in the absence of a large premium from the buyers.
Shiller has the advantage of the last word. He was present at the birth of the phrase 'irrational exuberance', which was rocketed into fame by Allan Greenspan in 1996, when the Dow was at 6000. Since then, Greenspan has apparently accepted some combination of the 'new economy' and 'end of the equity premium' arguments. Shiller has not. His book consists of a general critique of the efficient markets hypothesis, leading to the claim that the present stockmarket boom is a bubble of a kind that has arisen in asset markets many times before and will continue to do so in the future.
Shiller first attacks the New Economy enthusiasts, pointing out that every boom from the Dutch tulip mania onwards has been accompanied by a similar story, usually with some, but not enough, basis in fact. He has some interesting, if not entirely new, discussion of the boom of the 1920s.
A more striking point relates to the powerful force of the Internet in creating an illusion of mastery over the world. Shiller argues that because of the vivid and personal impression the Internet makes, people find it plausible to assume that it also has great economic importance. This is surely correct, though it is important to observe that expectations about the Internet are a mirror of the culture. In the 1980s and 1990s when the Internet was the domain of vaguely countercultural academics, their expectations were just as extravagant. However, they had much more to do with personal and collective liberation than with instant stockmarket riches.
Shiller points to a number of other factors that have contributed to irrational exuberance including American triumphalism following the end of the Cold War and the weakness of European and Japanese economies during the 1990s. He correctly points out the self-correcting nature of the international balance of power, which is already producing a reaction against American dominance.
Shiller presents a damaging critique of the claim that stock market investments are, in the long haul, safer than bonds. As he points out, even though stocks have outperformed bonds in the US in every thirty-year period since 1861, this period contains only four separate thirty-year spans. In the US between 1831 and 1861 and in many other countries since, stocks have yielded low returns for long periods.
The most dramatic feature in Shiller's book comes early on with a chart showing the price-earnings ratio for the Standard and Poors 500. The last five years show an unprecedented peak, dwarfing even that of 1929, just before the Great Crash. The graph is even more dramatic when it is recalled that the use of accounting manipulations to boost reported profits is now the norm, just as it was in 1929.
Shiller presents a convincing case, but he is stronger in attack than in defence. That is, he presents convincing arguments to support his claims, not only that stock markets are frequently affected by irrational exuberance, but also that the present boom is a classic example. On the other hand, in the absence of any proper explanation of the equity premium puzzle, Shiller can't and doesn't say what a rational level for the stockmarket would be, though a return to the 6000 level prevailing in the early days of 'irrational exuberance' gets a mention.
It would be a brave reader who bet unreservedly on either Dow 6000 or Dow 36 000 let alone the blue sky of the 'New Economy'. Most of us will probably try to place a bet each way and wait to see what happens.
In this respect, the behavior of the stock market during the year 2000 has something for everybody. The collapse of e-commerce stocks in April supports Shiller's scepticism about the stockmarket in general and the New Economy in particular, but the continued strength of the Dow is good news for Glassman and Hassett. Even the New Economy enthusiasts can point to this year's events, and the fact that the Nasdaq has bounced back from the demise of so many dotcoms as evidence the long-awaited 'consolidation' from which the Internet economy will emerge stronger than ever. The future,as always, remains opaque.
Irrational Exuberance, Robert J. Shiller, Princeton University Press, Princeton xxi+296pp
Dow 36000, James K. Glassman and Kevin A. Hassett, Times Books, New York x+294pp