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Irrational Exuberance
The conventional wisdom has it that technology is only good news for the American economy: Productivity and profits are rising. Investors, newly empowered by digitally-acquired information and transactional software tools, are enthusiastically pumping capital into companies they think will grow in value. And lots of these investors believe that the likeliest stocks to increase in value are technology companies. The tide of easily-available information allows them to feel well-informed and well-prepared, and reduces their fears of overpaying.
"Because knowledge once gained is irreversible," Federal Reserve Chairman Alan Greenspan told economists in a recent speech, "so too are the lowered risk premiums."
But in Irrational Exuberance, published by Princeton University Press, Shiller argues that stock markets are being driven by psychology and emotion -- in particular by an "irrational exuberance" fueled not by information but by impulse, herd behavior, dinner party chatter, intuition, media hype, fear of being cut out -- everything, in fact, but reason. Thus, he explains, there is a growing unease about the alleged, techno-driven Long Boom underway in American markets.
By historical standards, Shiller says, the U.S. stock market has rocketed to astonishing high levels. But if the history of high market valuations is any guide, the public may be profoundly disappointed with the market performance in the years to come.
This isn't just an economic issue for profit-hungry stock trawlers. How the market is valued affects the economic, political and social policies questions of society at large (and affects technology industries in particular). If a stock's value is exaggerated or climbs artificially high, then the country may invest too much money in business start-ups and too little in infrastructure, research, education, and other forms of "human capital." Thus if people lose faith in the market's future, they may associate that disappointment with technology.
The explosive growth of the Net and Web in the second half of the 90's has affected how Americans view the economy in general, and markets in particular, writes Shiller.
The Mosaic browser first became available to the public in l994. That date more or less marks the beginning of the Web, but only a few people had access to it. Large numbers of Web users didn't appear until l997, marking the very same years when the NASDAQ stock price index took off, tripling to the beginning of 2000, and price-ratio earnings entered unprecedently high territory. Net technology, writes Shiller, is unusual because it's a source of entertainment and preoccupation for so many people. It conveys, he argues, the sense of a changed future, of mastery of the world, which makes it plausible for people to assume that it also had profound economic importance.
"But we may question what impact the Internet and the computer revolution should have on the valuation of existing corporations," writes Shiller. "New technology will always have an impact on the market, but should it really raise the value of existing companies, given that those existing companies do not have a monopoly on the new technology?" The notion that existing companies will benefit from the Net revolution is belied, he argues, by the stories of E*Trade.com, Amazon.com and other upstarts, who didn't even exist a few years ago. What matters for a stock market boom isn't the reality of the Internet, but rather the "public impression" that the revolution creates.
This is a risky way to approach markets, he argues.
It also distorts the way people -- especially Americans -- view technology. The fixation on technology as force for wealth and economic growth is yet another distraction from the growing list of critical technological issues -- corporatization of technology, genetics, nano-technology, bio-tech, AI, supercomputing -- and other issues and concerns that are rarely discussed in mainstream media or political forums.
Shiller cautions that we might also become complacent in maintaining savings, improving the Social Security system or providing other social safety nets. We might also lose the opportunity to use our improving financial status to create slutions to real risks many Americans face -- to their homes, schools, cities and livelihoods.
This irrational exuberance (and its resulting complacency) is not only driven by the national obsession with computing technology, but affects the future of technology in a particularly direct way. The Internet, for all the hype, is still in primitive, nascent form. Some of the new technologies computing may spawn -- genetic research, nano-technology, bio-tech, supercomputing, AI -- will require vast amounts of capital that only a healthy stock market environment can generate. The collapse of this market, or doubts that it will grow and prosper, could have a devastating impact on the development of these new technologies.
Shiller warns in his book that a long boom may not be in the cards. By l999, he writes, the Dow Jones industrial average had more than tripled in five years. But personal income and gross domestic product each rose less than 30%, and almost half that increase was due to inflation. Corporate profits rose less than 30%. The size of the stock market's gains, he therefore cautions, may be unwarranted and unlikely to persist.
The mainstream media, as usual, has been far from helpful, lurching from one hysteria -- sex and thievery online -- to another -- dot.com investment hype. When it comes to grasping the impact of technology on society, the public has from the first stirrings of the Internet, pretty much been left on its own. One of the conclusions it has reached is that anybody with a computer and a modem can be a savvy, well-informed and ultimately profitable investor. This idea is at the core of the "irrational exuberance" Shiller is writing about. It it's true, we're in for many good and prosperous years, at least in terms of the economy. If it's not, and this feeling is illusory ...
Contemporary technology has, without a doubt, challenged historic ideas of how the economy works. Computing in particular is not only changing commerce, but revolutionizing access to markets by individual market investors, thus changing the markets themselves. The atmosphere surrounding technology is super-heated. It seems that half the country is buying tech stocks, the other feeling as if it should and could. E-trading has been in part responsible for the explosive growth in Americans use of the Net in the past two years, and also in the expectations of many Americans that technology is synonymous with growth and wealth.
Most of the current generation of technology leaders and workers has never really known recession, depression, or even much in the way of serious reversal. Unless people begin to invest in diverse and different ways, that could change, says Shiller.
He pleads for the expansion of the number and variety of securities and markets for them, to allow people to protect themselves against major economic risks. He favors new "macro-markets" that would include markets for long-term claims on national incomes for the world's major countries, and for truly diversified global portfolios, instead of limiting investors to securities that are claims on corporate profits, as is the case now.
"A doctor in Des Moines could take a short position in medical incomes and a short position in expensive Des Moines single-family homes," writes Shiller, "therefore effectively insuring against risks to both sustenance and shelter. At the same time, the doctor could buy securities linked to incomes around the world and to real estate around the world." These macro-markets would be bigger than current markets and far more diverse in the risks they present to people.
Irrational exuberance seems the right term for the atmosphere surrounding tech-driven markets. Millions of Americans are now using the Net to break open access to markets, even as they've driven prices up, they have clearly exposed themselves and their futures to risk.
It's almost impossible to pick up a newspaper or magazine without seeing more hype about the techno-boom and the wealth it's generating. This is dangerous, Shiller warns; it's a serious mistake for political and business leaders to acquiesce in such high stock valuations. It thus follows that it's not a good idea for the rest of us either.
"All of our plans for the future, as individuals and as a society, hinge on our perceived wealth," he warns, "and those plans can be thrown into disarray if much of that wealth evaporates tomorrow."
If you want, you can purchase this book at fatbrain.com.
On the one hand, Shiller claims that the markets are being driven more by emotion than by any reasonable measure, and that it can't last. I agree with that. When even the most solid high tech/high growth firms are trading at multiples of 100 (price/earnings) and well-established bricks and mortar retail chains that cannot realistically expect high growth at 40, something seems out of line. Traditionally, conservative companies have traded at 10-15, and growth companies more like 20-30.
I'm also concerned about a lot of other parallels with the late 1920's -- everyone's into playing the market, people talking about fundamental transformations of the economy, seemingly very low inflation in the price of material goods (as opposed to assets), increasing inequality, and such.
But then Shiller recommends more of the same medicine -- expansion of the financial markets, "to allow people to protect themselves against major economic risks." In an irrational boom, this would only add fuel to the fire. Yes, the doctor in Des Moines could take a short position in medical incomes and in Des Moines real estate (which amounts to shorting against the box, a conservative way of locking in a profit). But is that what the doctor would really do? I doubt it.
More likely, one of two things would happen:
1) The doctor would go long on both positions, as a way of leveraging his income.
2) Even if he shorted, the price of these securities would continue to rise in the short term, squeezing him (forcing him to cover his short position by buying the securities at a loss).
The net effect is that our hypothetical doctor is more exposed, not less exposed, to risk.
(There's also the little matter of what underlying assets these securities really represent. If they're merely trading instruments, with nothing backing them, then they're simply a form of betting and aren't hedging anything at all. Traditional options actually give the holder an option to purchase or sell a particular asset. Common stocks, while the connection is a bit more tenuous, do represent the ability of the issuing corporation to pay dividends, buy back its own stock, and otherwise benefit the shareholder. For this kind of scheme to work, a pool of doctors would have to pledge some fraction of their future income as ultimate payment on the security. That implies that they expect that income to be less than the price they write the option at. Uh huh.)
We've seen the trouble that even sophisticated corporations specializing in financial services have gotten themselves into with derivative securities. Other companies have gotten themselves into trouble because they think they're hedging against some risk, where in fact they're doing nothing of the sort. And Shiller expects individuals to do better? If people systematically make mistakes -- and part of "irrational exuberance" is that people are consistently taking an overly optimistic view -- then there's a lot of potential for, shall we say, adverse consequences when things turn. Positive feedback (leveraging is a way of accomplishing this) is incredibly dangerous. It's even worse if people think they're hedging (applying negative feedback to their portfolios) when they're doing nothing of the sort.
One of the things that fueled the crash in 1929 (whether it fueled the depression is another matter, but it's hard to see how it helped) was margin calls that led to what might be called a "death spiral". As the market dropped, people who bought stock on margin (with loans from their brokers) faced "margin calls" -- they had to pony up more cash because the value of the security was insufficient collateral for the loan. If they couldn't come up with the cash, they had to sell in order to raise the cash. The selling, of course, only drove prices down further, closing the feedback loop. Bad news. If the amount of the loans were less as a fraction of the value of the securities bought, there would be less risk of this because the market would have to fall further to trigger the margin calls that fueled the rout.
I think that Shiller himself is a victim of the exact irrational exuberance he claims to be concerned about. He's right to be concerned about the insanity of the high tech (particularly the internet) sector right now, but I'm afraid that he simply wants to drain the craziness into everything else. Allowing people to leverage their future income is potentially disastrous. What happens if their future income is insufficient to cover their bet? Or, for the bear, if their counterparty can't cover? Then even the supposed hedge turns out worthless, and even the bear loses. That, I think, is even more dangerous than the current high tech boom.
Call me a fuddy-duddy (at 36!), but I want to stay WELL away from that kind of nonsense.