2nd edition, Robert J. Shiller, 2005.

Irrational Exuberance claims that there is no rational explanation for the 1990s stock market boom, that it was simply human nature taking its due course. In this second edition, Shiller attempts to broaden the applicability of this hypotheses towards other markets, in particular, real estate.

Structural Factors for Irrational Exuberance

• Increased legalization of gambling. The increased social acceptance of gambling (casinos, track betting, state lotteries) has made it a natural progression for people to participate in other forms of risk taking: speculation in securities.
• Increased media coverage and mispresentation of the stock market’s true “value”. All graphs show that “the stock market goes up”. However, these graphs are almost never corrected for inflation. While the stock market’s nominal value has indeed increased over time, its real value has increased nowhere near as much. Fred’s Intelligent Bear Site (heh) serves up some nice eye-candy graphs of the DJIA with nominal and inflation-corrected values graphed over time (5.1% vs. 1.6% return, before taxes), along with a healthy side of stock market doom-and-gloom.
• Related to misrepresentation, analyst bias (or “recommendation inflation”). In 1999, only 1.0% of recommendations were “sell”. In 1989, the figure was 9.1%.
• Amplification Mechanisms. Interest in the stock market tracks its performance (unsurprisingly); various surveys show close correlation between market performance and things like numbers of registered social investment clubs, and mentions of the “stock market” in the media. The repeated exposure of and public attention to the market simply increases demand for participation in the market, which drives it up. These gains lead to an increase in consumption, which gets reported in the media as signs of a “strong economy”, and the cycle feeds back on itself, until the inevitable point at which price increases stop. These positive feedback loops are simply natural manifestations of Ponzi schemes.
• Applicability to real estate. Worldwide, real estate booms have been shown to trail stock market booms. The stock market winners are simply diversifying their enthusiasm (and winnings) into real estate, while the stock market losers, tiring of waiting for a recovery, are cutting their losses and looking for another “safer” investment vehicle. Either way, demand for real estate rises.

Cultural Factors for Irrational Exuberance

• News media and crashes. Shiller finds that the biggest news stories on days of significant market crashes (October 1929 and October 1987) is news about past price declines – a negative feedback loop.
• “New Era” thinking and booms. The first major peak in market P/E ratio was in June 1901, at the turn of the century; radio was a new technology, and household electricity was introduced. The next peak of July 1929 was immediately preceded by automobiles, commonly-available household electricity and electrical appliances, mainstream radio, and talking movies. The plateau of the 1950s-60s was accompanied by television, the baby boom, JFK’s promise of landing on the moon, and the Dow reaching for 1000. The 1990s had the internet and sock puppets, and Y2K.
• Applicability to real estate. Railroad companies brought a real estate boom to southern California in the late 1880s. The automobile brought warm-climate-seeking retirees to a regional real estate boom in Florida in the 1920s. In the late 1970s, “new era” political changes brought a real estate boom to California (again) with zoning changes that restricted new-home construction, and a Proposition 13 that cut property taxes.

Psychological Factors for Irrational Exuberance

• People have a tendency towards overconfidence in one’s own beliefs (“70% of people believe they are above-average drivers”), which encourages speculative behavior.
• Nonconsequentialist reasoning is a phenomenon where people are unable to reach conclusions based on hypothetical events; people cannot decide on courses of action until events actually occur. People can think ahead in logical games (chess, checkers), but in real life, emotions cloud their thinking. News stories about the markets evoke emotions that then spur actions in the markets that would not have been taken otherwise.
• Herd behavior is very powerful. For example, people will tend to patronize the more-crowded restaurant, even if the first patron made a random choice between the two. The stock market is not a reflection of people’s rational behavior (as the Rational Man would behave); people are simply electing not to waste their time and effort to exercise any judgment.
• Interpersonal two-way communication is much more powerful than one-way media communication. The 1920s’ telephone spawned “boiler rooms” that enabled brokers to encourage their clients to do stock trading. Today’s internet chat rooms and web forums facilitate a great amount of day trading.

Attempts to Rationalize Exuberance

• Efficient Markets and Random Walks. All financial prices accurately reflect all public information at all times. Price changes (“random walks”) are unpredictable because they only occur in response to genuinely new information, which by definition is unpredictable. Evidence supporting “efficient markets” is simply that it is difficult to “buy low and sell high”; everyone else (“smart money”) would have already done so (competing against other smart money), stabilizing prices. The problem is that efficient markets does not necessarily preclude the possibility of markets going through extended periods of significant mispricing (booms) where smart money can’t make a profit because no one sells low and everyone is buying high. Even if the smart money tries to short the stock of a valueless company, irrational investors can still bid up the stock, causing the smart money to lose.
• Investor Learning and Unlearning. This theory states that today’s exuberance is simply due to the public’s increased awareness of the value of the markets; the markets were inefficient before, but are becoming more efficient now. This is easily argued against with the fact that there have been multiple booms; either this “investor learning” theory is false, or investors are quick to forget what they have learned from the past …

A Call to Action

The concluding chapter is what really destroys the book for me. Shiller makes a bunch of recommendations that might help avoid speculative bubbles, all along the lines of a government behaving paternalistically towards its uneducated mob-like citizens (fine, he is entitled to a bleeding-heart opinion). But then the last paragraph cops out in a big way with “[u]ltimately, in a free society, we cannot protect people from all the consequences of their own errors”, so we end up back where we started – bubbles will happen and we can’t do anything to stop them.

Shiller’s book is fine as a walk through the market history and human psychology. It makes a decent argument that markets are in fact not governed by the Rational Man, but rather by irrational human beings. But beyond that, it is rather weak in simply describing anecdote after anecdote of how humans are in fact irrational, which really should not be news to anyone. Finally, the “second edition” expansion of these ideas beyond the stock market to other speculative markets (he only ever mentions real estate) is also rather weak. The real estate examples always seem contrived and duct-taped on to the end of the stock-market discussions.

Irrational Exuberance never pretended to promise entertainment value (although the cheeky title inspired unfulfilled hopes for snarky commentary), but it also falls somewhat short of its expected educational and thought-provoking value, which leads to my ultimate conclusion that I am disappointed with having spent time reading this book.