‘Irrational Exuberance’ striking again?

Prof. Robert Shiller
Prof. Robert Shiller

I thought today’s economic environment was perfect to reread Irrational Exuberance, the book written by Nobel Prize-winning Yale University professor Robert Shiller. Prof. Shiller made himself known to the general public by predicting the ‘dot-com’ bubble in the 2000s as well as the housing market collapse in 2007-2008. Coincidentally, no later than last year Prof. Shiller granted us with a third revised edition of his book which analyses the two aforementioned events to identify behavioural patterns leading to market instabilities.

Chapter Four, ‘Precipitating Factors: The Internet, the Capitalist Explosion, and Other Events‘, lists and discusses the triggering factors that were specific to the economic context at that time. The section entitled ‘Twelve Precipitating Factors That Propelled the Late Stages of the Millennium Boom, 1982–2000‘ resonates way too well in the light of the rise of ‘disruptive’ technologies and social media. Below are some quotes which I found particularly striking.

Because of the vivid and immediate personal impression the Internet makes, people find it plausible to assume that it also has great economic importance. It is much easier to imagine the consequences of advances in this technology than the consequences of, say, improved shipbuilding technology or new developments in materials science. [...] It could not have been the Internet that caused the growth in profits: the fledgling Internet companies were not making much of a profit yet. But the occurrence of profit growth coincident with the appearance of a new technology as dramatic as the Internet created an impression among the general public that the two events were somehow connected.

Do not get me wrong: some of the largest technology companies (by market capitalisation) completely justify their valuation because of the value they create. Nonetheless, one cannot help but think that some of the technology-related ventures created over the last couple of years (with a special attention to loss-making ‘unicorns’) were lifted by the abundance of liquidity in the market and the investors’ search for yield in a depressed environment.

New technology will always affect 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? Should the advent of the Internet have raised the valuation of the Dow — which at the time contained no Internet stocks?

The impact of social media and ‘Uberisation’ still remains to be quantified, as the impact of the Internet was in the early 2000s. But here again caution is paramount. As an example, asset-light Fintech companies were expected to put the traditional banks out of business. We now see that those companies have benefited from an extremely favourable credit environment and struggle as soon as the tailwinds fade.

What matters for a stock market boom is not, however, the reality of the Internet revolution, which is hard to quantify, but rather the public impressions that the revolution has created. Public reaction is influenced by the intuitive plausibility of Internet lore, and this plausibility is ultimately influenced by the ease with which examples or arguments come to mind. If we are regularly spending time on the Internet, then these examples will come to mind very easily.

This sentence is very applicable to today’s trend. A vast majority of the successful emerging companies target the B2C market and actually very often make the ‘B’ closer to the ‘C’ by ousting intermediaries – think about Uber or Deliveroo. The change has settled in our everyday life, which makes the examples even easier to remember.

Anticipation of possible future capital gains tax cuts can have a favorable impact on the stock market, even when tax rates actually remain unchanged. From 1994 to 1997, investors were widely advised to hold on to their long-term capital gains, not to realize them, until after the capital gains tax cut.

Calls for a fiscal stimulus as a way to reinforce the already-implemented monetary ‘quantitative easing’ have been growing. Although in the UK the next budget will only affect the corporate tax rate, investors are right to believe that the fiscal burden may loosen soon on capital gains as well.

Although there is no doubt at least some truth to these theories of the Baby Boom’s effects on the stock market, it may be public perceptions of the Baby Boom and its presumed effects that were most responsible for the surge in the market.

Structural drivers such as demographics are indeed among the most popular discussion topics when it comes to predict the outlook of both the stock and the housing markets. Prof. Shiller nonetheless warns us that our (sometimes) self-fulfilling anticipations and expectations may actually be stronger than the real effect.

As further evidence that the media growth was boosting the stock market, we now know that after the peak in the market in 2000, business reporting took a major hit in reaction to declining public interest. Hip business magazines like Red Herring, the Industry Standard, and others went out of business.

As sole writer of this blog I have to plead guilty. As many other media, I have probably paid a disproportionate amount of interest to the evolution, past and future, of the housing market.

In a non-experimental setting, where people’s focus of attention is not controlled by an experimenter, the increased frequency of price observations may tend to increase the demand for stocks by attracting attention to them. [...] The rise of gambling institutions, and the increased frequency of actual gambling, had potentially important effects on our culture and on changed attitudes toward risk taking in other areas, such as investing in the stock market.

Our environment, including social media conversations, provides us with many opportunities to be part of the stock market ‘game’ and many platforms have leveraged the parallel with gambling, making their platforms increasingly entertaining.

In a survey of home buyers in 2004, Karl Case and I asked: “Do you worry that your (or your household’s) ability to earn as much income in future years as you expect might be in danger because of changes in the economy (someone in China competing for your job, a computer replacing your job, etc.)?” Nearly half of our 442 respondents (48%) said they were worried. Some of them said that one motivation for buying their house was the sense of security that home ownership provides in the face of the other insecurities. [...] One might call this a “life preservers on the Titanic theory.” When passengers on a ship think the vessel is in danger of sinking, a life preserver, a table, or anything that floats may suddenly become extremely valuable, and not because these assets have changed their physical attributes. Similarly, at a time when people are worried about the sustainability of their labor income, and there are not enough really good investment opportunities, they may tend to bid up prices of all manner of existing long-term assets in their efforts to save for the dangerous lean years seen ahead. They may not manage to save more in real terms. They may hold such assets even if they now believe the assets are overpriced and in danger of losing value in the future.

The sense of geopolitical and economic insecurity remains persistent – today a poll revealed that 86% of French people believed that the situation “had not improved for the French population in general”. In that context individuals tend to rely on ‘safe’ investments such as real estate and bonds, despite the very poor returns offered by the latter.

Sans titreWill we witness another 2000-type market crash in the short-term? I do not believe so. However, I do think that the Central Banks’ decision to open the liquidity tap to an extent never been witnessed before has led investors, i.e. the general public, to increasingly disconnect their thinking from the real fundamentals of our economy. The way the two converge again will tell us whether we are heading towards a ‘soft landing’ or a ‘bubble burst’.

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