Book Review

The book “ Irrational Exuberance” takes its title from Alan Greenspan's 1996 catchphrase, which sent worldwide stock markets into steep decline. Irrational exuberance is the famous phrase uttered by Alan Greenspan to describe what he then viewed as an overvalued U.S. stock market. The book reviews structural and psychological factors causing the market to triple over five years to 1999. But most importantly, Shiller's book examines consumer perceptions, aspirations, mistaken impressions and herd behavior, such as the investors who drove the market upward at a headlong rate, making it so grossly overvalued as to be immensely precarious for all aboard the ship. Shiller's considered and persuasive view is not whether major corrections will happen, but how soon they can be expected.

Shiller evaluates the evidence casting doubt on man's ability to process information. In one experiment, subjects were asked to estimate the percentage of African countries in the United Nations. But before they answered, a roulette wheel was spun, and they were asked whether the number was larger or smaller than the number that came up on the wheel. The result? The larger the outcome on the wheel, the more countries people thought were in the U.N. even though the wheel's outcome was extraneous.

Delving into Wall Street's history, Professor Shiller comes up with some further sobering historical facts. First, share prices can go down, and stay down, for many years. Second, shares can become overpriced and under perform for many years. Third, though it's largely true that shares outperform other investments over the long run, they haven't always outperformed other investments over decades-long intervals. And there's no reason to think they must in the future.

Apart from these structural factors forming the first part of the book, Shiller pinpoints in the second part such cultural factors as the news media and new era economic thinking. The bullish forces are legion: the entrepreneurs who create the companies behind the stocks, the venture capitalists who fund them, the brokerages that take them public and the ubiquity of mutual funds that package up and diversify these investments. The forces are augmented by the rise of day traders, the intensified media coverage of investing, the expansion of legalized gambling and rapacious governments that collect taxes from the ever-rising prosperity. Last in line are the general public, who are blamed for jumping on the bandwagon.

Of the dozen precipitating forces, two (the Internet and the expansion of stock trading opportunities) will likely increase in strength, Shiller concedes. But the Baby Boom factor and perceived victory over foreign economic rivals will decrease, and the other eight factors will likely stay the same. Given all this, he concludes, "returns will remain confined to the low dividend yield we now see for stocks."

In Shiller's estimation, the most pernicious influence on today's investors is the efficient market theory. It holds that the price of stocks or the market as a whole is fair and rational at any point in time because those prices reflect the collective wisdom of legions of informed investors who assess the latest information affecting company profit prospects and impound that data into prices. Though most investors know little about the theory itself, they have assimilated the bedrock conclusion of efficient markets - namely, that it's a waste of time to try to time the stock market or make judgments about whether stock prices are too high or too low. Thus, according to Shiller, many investors continue to regard the market as a "free ride" to lush returns, despite its nosebleed valuation levels.

But for Shiller, the ultimate proof of the stock market's irrationality is the "excess volatility" it sometimes displays, soaring to manic heights or falling into abject funks with seemingly little news to justify the moves. In Shiller's bleak view, it's not that investors are stupid; it's that they're limited in their ability to react rationally to an ever-changing stream of events. Instead, they take shortcuts that can prove lethal in market settings. People tend to be unduly influenced by the actions of others (herd instinct) and prefer safety in numbers.

Shiller concludes by pointing that the current bull market has instilled several convictions in the investing public that will likely be cruelly dashed in the years ahead. One is that stocks over the long haul always outperform bonds and other asset classes. And the other is that market dips are always transitory and are great buying opportunities. He warns U.S. stocks may fall to the levels of the mid-1990s, Shiller closes the book with the requisite advice on what investors should do now: reduce holdings of U.S. stocks. While he doesn't say it explicitly, one can infer that what stocks and funds are retained by such an investor should be selected with more of a "value" orientation to investment fundamentals.

Surprisingly, Shiller's book never tells us what the right level of the market really is. How far does the Dow need to fall before Shiller calls an end to the bubble? His favorite valuation measure seems to be price divided by an average of the past ten years' earnings-an oddly backward looking variable for a market that is supposed to be forward-looking. By this measure, the market could fall by half and still look expensive.

Shiller gives little credence to the view that we are entering a new era of rapid growth. He makes a good case that such claims are common whenever the market valuations hit extreme levels, such as in 1901, 1929, and 1966. But is the market never right? The stock market collapse in 1973-74 did signal a new era-a new bad era of slow productivity growth that lasted more than two decades. Couldn't a stock market boom ever be a signal of good things to come?

However, certainly his book offers important insights into investment behavior from the perspectives of behavioral finance. His exhaustive research, substantially based on direct question and answer sessions with market professionals, was carried out ahead of the Nasdaq recent climb, and before most dotcoms were significant factors. Some could argue then that their spectacular rise and fall merely adds weight to his argument.