Irrational exuberance is a phrase used by the then Federal
Reserve board chairman Alen Greenspan during the dot com bubble of the 1990s. Mr.
Robert Shiller, the Nobel prize winning Yale university professor published a
book called “Irrational Exuberance” in March 2000, at the peak of dot com boom.
This book clearly states how the markets are overvalued and the various reasons
for such euphoria.
The book has mainly divided into 5 parts.
Before beginning the part 1, the author makes a clear
statement that the US market is highly valued compared to any other time in
history by taking various analogies. Author mentions that stock markets are not
obeying the fundamentals of stock pricing and explains the various reasons for
that in the coming chapters.
Part 1 (structural factors)
Part 1 explains the structural factors. The author explains 12
main factors which played a major role in shaping the valuations of stocks. The
next chapter further explains the Amplification mechanism involving the
investor expectations. Mr. Shiller mentions that there is a feedback loop
working in the stock market and this has a cascading effect on the market as a
whole.
Part 2 (cultural factors)
In part 2, the author explains the role of media and New era
economic thinking in shaping speculative bubbles. Mr. Shiller says that big
stock price changes not necessarily following big news events by taking several
examples.
The next chapters explains about how New Era economic thinking
that is the high level of expectations about the future technological
innovations helped market to reach high levels without giving any importance to
fundamental valuations. These types of
thinking were present in almost every part of the world, Shiller argues.
Part 3 (Psychological factors)
Mr. Shiller argues that there are definitely many
psychological factors behind this exuberance and says that investors are following
a herd like behavior. Mr. Shiller mentions that people do not have fully
independent judgment and there is an immense power of social pressure on
individual judgment. Even completely rational people too took part in herd behavior
even if they know that everyone else is behaving like a herd.
Part 4 (Attempts to rationalize exuberance)
Mr. Shiller argues that several theories such as “efficient
market hypothesis” and “random walk theory” tries to rationalize this stock
boom. But by taking numerous examples the author proves that mispricing still
exists in the market. He also defeats the arguments such as earnings changes
and price changes, dividend changes and price changes go hand in hand.
Another attempt to rationalize this exuberance was associated
with investor intelligence. There were theories that public at large learned
that the long term value of the market is really greater that they had thought
and as a result they are paying higher prices because they learned that in the
long run stocks always outperform bonds. But Mr. Shiller completely disagrees
with this statement. The chapter says that there is no evidence that stock
market will always outperform bonds over the long term. Mr. Shiller adds that
public has not learned fundamental truth, instead their attention was shifted
from some fundamental truths.
Part 5 (A call to action)
Mr. Shiller argues that a lot of possible new factors both
supportive and destructive of market values will emerge and investors have to
be very careful in stock market. The author concludes the chapter by giving
several suggestions about what individuals and as a society should do in maintaining
the market fundamentals.
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