Irrational Exuberance
Third edition 2015 added a bond-market chapter.
Summary
Shiller published the first edition in 2000, timed almost exactly to the technology peak, and argued that stock prices were driven by psychological and structural factors rather than by fundamentals. The second edition in 2005 added housing and warned about that market before its collapse. Shiller received the Nobel Prize in economics in 2013.
His empirical foundation is the cyclically adjusted price to earnings ratio, which averages inflation-adjusted earnings over ten years to remove cycle effects, and which he shows has been a useful indicator of long-run subsequent returns while providing no timing information. His earlier work on excess volatility showed that stock prices move far more than the present value of subsequent dividends could justify, which is the finding that established his position against efficient markets.
His explanatory framework covers structural factors including the growth of defined contribution retirement plans, the expansion of financial media, and the reduction in trading costs; cultural factors including the amplification of narratives; and psychological factors including anchoring, overconfidence and herding. He also addresses the feedback loop mechanism, in which price increases generate the stories that justify further increases, which is his account of how a bubble sustains itself without any participant behaving irrationally in isolation.
The book is academic in register and the data chapters require attention. Shiller is explicit that the indicator cannot time anything, which many readers ignore, and the ratio has remained elevated for long periods without producing the reversion the framework implies. His housing warning was correct and unusually early. Later editions add material on the 2008 crisis and on bond markets.
Key takeaways 8
- Stock prices move far more than the present value of subsequent dividends can justify, which is the excess volatility finding.
- The cyclically adjusted price to earnings ratio predicts long-run subsequent returns while providing no information about timing.
- Price increases generate the narratives that justify further increases, which is the feedback mechanism sustaining a bubble.
- Structural changes including defined contribution plans, financial media expansion and lower trading costs increased retail participation and amplified price movements.
- Housing was in a bubble by 2005, which Shiller stated publicly and documented with the long-run real price series he constructed.
- Real house prices had been roughly flat over a century before the run-up, which undermines the belief that housing appreciates reliably.
- Bubbles do not require any participant to behave irrationally in isolation, since following the trend can be individually rational.
- An elevated valuation indicator can remain elevated for many years, which makes it useless for anyone whose horizon is shorter than a decade.
Who should read it
Investors who want the empirical case against efficient markets and the long-run valuation data, with the timing limitations understood.
About Robert J. Shiller
Sterling Professor of Economics Emeritus, Yale University; co-creator of the Case-Shiller home price indices; Nobel laureate in economics 2013
Excess-volatility work and Irrational Exuberance are the primary sources for the empirical case that asset prices move far more than fundamentals justify.
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