Talking about Irrational Exuberance Econoday Focal Point 8/17/00 By Evelina Tainer, Chief Economist

In his book, Irrational Exuberance, Robert Shiller offers a slew of psychological, cultural and structural reasons why equity prices zoomed way past levels associated with economic fundamentals and into a speculative bubble. Shiller is a leader among behavioral economists -- including Richard Thaler, Daniel Kahneman, Andrei Shleifer, Matthew Rabin and the late Amos Tversky who have pointed out that consumers often diverge from the "rational" behavior that is assumed by conventional economics. The following roundtable discussion will comment on some of Shiller's thoughts and hypotheses. The roundtable features: Gib Bassett, Department Chair and Professor of Finance at University of Illinois at Chicago; Pat Rocco, head of research at Twin Capital Management; Mark Pender, financial writer and editor; Anne Picker, International Economist at Econoday and Evelina Tainer, chief economist at Econoday.

Evelina: Let met begin by welcoming everybody. I'm glad you all could make it. I thought we could go around and comment on what interests us most about Shiller's book. If someone wants to start, that would be great.

Gib: Why don't you start?

Evelina: Oh, great. (laughter) ... Well, I thought the twelve factors Shiller presents as major explaining factors of the speculative bubble were interesting. One particularly intriguing factor was the baby boom and its perceived effect on the market. Harry Dent has been the big guy arguing the baby boom created this. I guess he's not even talking about this as a bubble, but created this bull market because everyone's in the market now. And the whole market is going to collapse when everybody gets out. I always had a problem with that. Something doesn't click with me, but I've never been able to pin down exactly what it was.

Gib: My sense in talking to people in the generation right behind me is they can't wait to get the baby boomers dead. (laughter) ...I am being factitious, but only a little bit.

Evelina: What's the idea behind that?

Pat: They want to get their inheritances sooner.

Evelina: I didn't think of it that way. That means investors wouldn't really be selling. I think that the whole Harry Dent concept is that people would be selling the minute they retire. Is this something that blows a hole through that one?

Gib: I have no idea. But to play devil's advocate for just a second, as the baby boomers age and want to sell, if the economy is smoking hot and doing tremendous, then, being an old fogy and supposing the markets are somehow connected to fundamentals, it won't matter that everybody's selling because you will be able to buy claims on assets that are really valuable.

Evelina: That makes sense.

Gib: I don't know! It is just that I'm not entirely convinced by the demographic argument.

Evelina: I always thought that all these things should be factored in -- there is some kind of market efficiency. We could argue to what extent the markets are efficient, but my guess is that there is some kind of efficiency. So, I think that some of this money would be going somewhere else, something else would be become hot, and the money would be shifting. I'm not sure everything would fall apart in a rapid crash.

Anne: What you're suggesting is that the market is more dynamic than that.

Evelina: Yes. People could be going global or to real estate, though by Dent's argument the real estate market would fall apart for the same reason.

Mark: Shiller does point out that perhaps there is no sense to the baby boom argument, but that because it exists it has an influence on the market -- that people are talking about it.

Evelina: The other aspect stems from the fact that baby boomers seem to be less risk averse because they don't have a memory of a Great Depression.

Gib: But the baby boomers do remember the 70s well and the people who are portfolio managers today, a lot of them are 40, and they don't remember that the market did essentially nothing from 1970 to 1982.

Evelina: Yes! I was just going to say there is a distinction among the boomers: the older boomers would remember the 70s and the younger ones wouldn't. That is interesting and it still makes the younger set less risk averse.

Pat: The younger boomers may not remember the large inflation in the 70's that did so much damage to bonds as well as stocks. So they don't have a sense that either asset class could be that bad.

Evelina: And what scares me is that really young people manage so much of the money. I guess it would be more Generation X, wouldn't it? I mean people in their 30s.

Pat: Well, there are plenty of young portfolio managers, but there are plenty of folks who have stuck around awhile too. So, the collective wisdom among many of these firms goes quite deep. Perhaps an issue is how the younger folks that are in the business differentiate themselves. Do they offer some unique product to separate themselves from the crowd that might be more risky? Their performance gets picked up in the press and amplified by one of Shiller's favorite mechanisms, the media, and how they really play into all these schemes--both good and bad--that people come up with in terms of investing options.

Evelina: I particularly like the media aspect and it came in a couple of different views. Maybe Mark would like to comment on this topic since he's a member of the media?

Mark: Well, I'm surprised that he rates it so highly. (laughter) The backbone to the media is its access to the markets and its access to analysts. It reports on ideas and it also helps to formulate ideas as a mirror back to the market itself, but it's not the first mover. But he speaks of it as if it is. He makes the interesting point that bubbles didn't begin until newspapers arrived. It would seem to talk to the fact that these bubbles are almost a function of the volume of information that's traded. And the higher that turnover, the higher the market goes. I'm not completely convinced it's that simple, but the media does play an important role. And the fact that employment in the business press has grown so much over the last ten years, almost in line with the market itself. So, I think that there's something to it, but I think that he overstates it.

Evelina: I get that impression. He makes a couple of relationships that I don't know if he's just reporting something that he's heard or that he actually believes it. He attributed the arrival of the Internet with solid earnings growth. I never heard that concept before, that solid earnings growth was attributable to the arrival of the Internet. So in the same way, this whole idea of the news media, of the newspaper causing speculative bubbles, it's one of those things that just because two things are happening at the same time there's no cause and effect necessarily.

Mark: Well, I think there is a cause and effect that I think he overlooked a bit. He spoke of the advent of the Internet as increasing communication which in turn created more demand for stocks, much as any mention, word of mouth or advertising, as he says creates that demand. I also think though, that expectations developed around then or after then that many high tech companies would begin to out produce historical averages based on business demand and business growth arising from the web. He doesn't emphasize that very much, he talks about companies facing the Internet in a defensive way when in fact a lot of them are using it very aggressively to lower costs and improve profits. So I think that a part of the advent of the Internet in improving the stock market is a profit-based one.

Gib: You think he didn't play it up because that would not do well for his argument?

Mark: I don't know? I'm surprised he didn't mention it. I think it deserves to be mentioned, or at least deserves to be countered.

Pat: But I think there's the sense that would work through the normal channels. Earnings growth and historical relative valuations would respond to that particular benefit of the Internet. I think he's clued in more to the Internet as a public preoccupation: I use it, my neighbor uses it, I understand it and Peter Lynch and Warren Buffet tell me to invest in things I understand and see and can touch. And unlike insurance companies that are faraway or overseas investments, I can see the Internet in a way that puts it front of my TV screen, my kid's screen, and so anything connected to it I'll feel familiar with and therefore I'm more likely to invest in that. That's a different channel. That's sort of the bad side of the Internet, I think he would say. And the good side would filter through the traditional financial analysis.

Mark: Do you think there's any chance that the historical rate of corporate profit growth could increase. And he mentions that it's been pretty much stable at roughly 10-15 percent in nominal terms for 200 years or something. Is there any possibility out there that that rate will increase?

Gib: Was it 10 to 15 percent? That just seems high to me.

Evelina: No, it seems about right, if he's looking at GDP profits. We were in really bad shape in the 80s, when profits were at about an 8 percent share, although I think some of this may have been revised away by the Commerce Department.

Pat: In response to Mark's question, the problem is that for the corporate profit rate to really grow much faster, I think there would have to be a real change in the distribution of wealth between workers and capital. Workers in that environment I think would enjoy a smaller share of the national income and would probably be quite upset.

Mark: That's right, he did mention social injustice questions.

Evelina: I agree with that, though I wonder if it would help if workers were given more profit sharing.

Pat: Make them capitalists.

Evelina: Yes. Although it's funny. There's a lot of talk about stock options, yet when the second quarter employment cost index was released with the inclusion of stock options as compensation, the Labor Department found that stock options had only a minor impact -- less than one-tenth of one percent for the quarter. Stock options are highly touted, but I wonder how many workers really get them.

Back to business reporting. He talked about news events affecting the stock market but he never looked at economic indicators affecting the stock market, which I think he really missed. But the other aspect is this idea that all the reporters want to get scoops, and I have noted in the past 10 years that all the great run for scoops has caused more errors in news stories.

Mark: He mentions deadlines and writing before deadlines and he mention that a lot of the cause and effects are a little wobbly, and that's absolutely true. That's all part of what limits the importance of the media. But his argument would be that the audience out there accepts this at face value, as real. I'm not sure that people are that gullible.

Gib: Right. This gets to the behavioral finance argument that runs through the book. It allows you to tell stories. Another story related to what Mark said about gullibility is evolutionary psychology literature. There's a recent article by Leda Cosmides and John Tooby with the provocative title 'Are Humans Good Intuitive Statisticians?' The bottom line suggests that the biases and irrationalities exhibited in the context of specific laboratory experiments using probability language, are removed when people are presented the formally identical problems but in situations that are more like the situations they face in the real world. I don't recall that Shiller talks about that literature. If humans really are good intuitive statisticians then despite the irrational behavior in experimental presentations, they don't do the irrational acts in the natural settings of the real world. Perhaps people do understand that over the past ten years there has been a certain percentage of news items that are wrong and that's factored into their calculations so they just don't go immediately believing, with probability one, everything they read.

Evelina: Yes, that's interesting. I wonder how much people actually read. We're assuming people are making decisions on all the news that's being written. Maybe people are looking at different factors like the Peter Lynch, Warren Buffet concept: "I shop at The Limited so I know that The Limited is the kind of stock I'm going to buy." So it doesn't matter what the media says about them at all.

Pat: If that were true it would probably infuriate the advertisers and much of the broadcast/media industry who need to feel that they're influencing or at least getting in front of the eyes of people and holding their attention for some period of time.

Evelina: Well, I would distinguish between advertisers for consumers and investors making decisions.

Anne: What would classify CNBC then, Evelina? As a consumer or investor source of information?

Evelina: Investor. I could be wrong.

Anne: I'm puzzled about that. I went into my fish store the other day and they have CNBC on all the time. (laughter) And that tells me that the stuff is trying to reach both consumers and investors.

Gib: That may be playing into Shiller's point that the market has become the "thing" of the 90s. The bubble is the thing: you used to go to the fish market and they had the baseball game on, now it's the market.

Evelina: Remember what the people used to say from the 1929 stock market crash, when the shoe shine boy can give me a tip on the stock market then I know the market is too high. And I certainly have seen that, when people I know who have never cared about the stock market in the past are suddenly giving me stock tips, there's something wrong going on. So it could be that we've come to the point where there is an over abundance of all this stuff.

Anne: We've reached a saturation.

Pat: A saturation, exactly. A saturation between entertainment and news. Today, I think, we've talked about the news aspect of much of the financial media, but there is this entertainment aspect that is out there as well. Financial reporting replaces baseball games with the daily market wrap up and tallies the wins and losses as entertainment as much as it provides news and investment decision behavior.

Mark: That's right. He mentioned the similarity between sports reporting and financial news reporting, that they both produce an endless stream of interesting news which tells stories that people like. And I think if you tell stories, and this is part of the entertainment idea, that's good press or good advertising copy for stocks.

Gib: In Chicago, Cubs fans are entertained, but it is with endless stories of losses that they don't like. (laughter) So, it's not necessarily a good thing.

Evelina: And the other aspect of entertainment is the gambling. People like to gamble but gambling often has a bad connotation, but all of a sudden you're playing the market and it's investment not just gambling, even though I think day traders are gambling. So the gambling opportunity in the market makes it okay.

Gib: Just to follow up on that. I would like to hear if people noticed that at the beginning of the book Shiller talks about when Greenspan made the 'irrational exuberance' speech it spooked the market so much that the market fell, I think, he says 2.3 percent on that day. Two-point-three percent!

Mark: Isn't that hilarious!

Evelina: That really is.

Gib: I am looking at the computer right now and it says the Nasdaq is down 2! It just shows that the 2.3, which in 1996 was an unbelievable move, is like part of the unnoticed background radiation. The Nasdaq moves 3 percent every day, up and down, it seems.

Mark: When was the Dow at 3,600?

Evelina: The Dow was in the 6000s during the 'irrational exuberance' speech.

Gib: I think it was more like 4,500. I remember that because it's when I turned bearish! (laughter). If I hadn't read the book and somebody walked up to me and said, 'Do you remember when he made the speech about "irrational exuberance." I would have said, "Yeah, I remember the market tanked that day," and I would have said it tanked probably 8 percent day.

Mark: As a reporter of financial markets, people within the market too and it's just not reporters, tend to overstate the drama inside the market. They're there and they feel and they sometimes overstate how exciting it is or how important the movements are. And I think it used to be that the Nasdaq moved within plus or minus one percent on most trading days, perhaps two thirds but I don't remember the percentages. Plus or minus one percent now happens much more frequently.

Evelina: Right. Almost daily.

Pat: There was a time I think at least through June, when the overwhelming majority of the days were one percent moves on the Nasdaq, which was really unprecedented relative to past periods.

Evelina: Near the end of July, the Nasdaq dropped ten-and-a-half percent in just one week. A drop of ten-and-a-half percent! You'd think the markets would have been really worried but no, it's a buying opportunity still.

Gib: That raises the question, Has the bubble burst? If you had interviewed Shiller a year ago and you said to him, 'If the Nasdaq goes to 5,000 and then it goes to 3,000, does that count as the bubble having burst?"

Mark: But he was saying, when the bubble bursts we can expect to lose a year's worth of GDP, that the market could go in half. He was talking really glum, at least in the long term. But I think his image of the bubble bursting is pretty severe.

Evelina: Yes, it seemed like it was 25, 30 percent, or even more, going back to levels a few years ago, frankly losing a good portion of the past couple of years.

Anne: Not only that, he felt that it would remain at the lower levels a long time to come once the bubble did break.

Evelina. Yes, going back to the 70s situation.

Mark: This is along that same line. How much do you think his story was motivated as a writer as an opportunity to grab onto an interesting topic, and how much of that interest has been lost given the large scale back that we've seen. Is what he's saying as useful or as topical?

Evelina: I think it's still topical. What I've been seeing more and more of is the whole behavioral finance situation. There was an article in Business Week just a couple of weeks ago about Matthew Rabin who just won one of those John and Catharine MacArthur Foundation "genius" fellowships, and he's another one of these behavioral ...

Gib: I saw him on your email. I never heard of him. Who is he?

Evelina: I never did either until I read this article. (laughter) It's a great picture. He's sitting back and he's in a tie-dye shirt with a beard, a typical professor. University of California at Berkeley. He wears tie dye T-shirt every day. And does some of his best work, and I love this, at a counter of a San Francisco coffee shop. But I guess he's a mathematician, putting math equations into this behavioral stuff. It's from the July 31 issue.

Gib: Back to Mark's comment about whether Shiller just saw an opportunity to write a book. I've mentioned this to Pat I meant to go look this up, but about two years ago, my recollection is, and I'll check this before ...

Pat: Is it the Winter '98 article you're thinking about? It's in the Journal of Portfolio Management, I think.

Gib: And it's Shiller and somebody else.

Pat: It's Shiller and Campbell. I think your point, Gib, is that Shiller has been writing this book in serialized chapter form for about three years.

Gib: And hence, for about 5,000 Dow Jones points. (laughter)

Pat: He's been consistently wrong. It's never stopped him from writing the next iteration in either a new paper or book.

Gib: And that paper that's Pat talking about, it was amazing because academics never say anything unconditionally. Everything depends on this and that and if this happens then that, blah blah blah. Shiller and Campbell in the article say the market is going to go down during 1999 by 20 percent, I mean they even put a number on it. And they explain why the market's are going to go down and why the bubble's going to burst, anticipating many of the arguments that are in Shiller's book. It was a gutsy article to write. They really stuck their necks out. And they got them chopped off at least in the short run.

Pat: Exactly.

Gib: So, Shiller does believe what he's talking about genuinely, he believes it and is trying to convince people that there's this dangerous bubble out there.

Pat: Well, I think he's trying also to get government policymakers and other people that have influence, maybe that's the media, maybe that's investment experts, to really talk about the consequences of the bubble. Even if it doesn't burst, it's important to talk about the consequences.

Evelina: Talking about consequences and monetary policy, a couple of months ago Ray Fair wrote in Business Economics, on the topic of bubbles and should the Fed allow them to develop and would economic growth be better or worse off with the bubble. He concluded that bubbles weren't good for economic growth in the long run.

Gib: If the question is, Is it better to have a word without bubbles or a world with bubbles?, it seems pretty clear that most people would say it's better to have a world without bubbles. But then the question is, How do you know it's a bubble? You talk like it was a given fact and that everyone knew it was a bubble.

Evelina: Yes, right. The other thing that I think is interesting and I get this question all the time. Economic indictors come out and it's mixed, What does that mean? Well, what it means is that the economy is moderating, probably. People seem to think that if the economy is going to slow down, it means that all indicators are going to grow by half. They don't think that maybe one indictor will drop, another indicator will grow by half, another indicator's going to boom. And people always seem to want all the economic news to move in the same direction one way or the other to tell you what the economy is doing. So, it's along the same lines of, How do we know it's a bubble? Well, we don't know but the economy is going to grow in spurts, and so we might go backwards but it doesn't mean that we would lose all the growth.

Gib: I've heard the argument that the old economy was an economy in which all the sectors moved together. And so when the economy slowed everybody got affected more or less the same. But the resilient new economy is one in which you can have little pockets that can obviously slow down but there's not this correlation across all the sectors of the economy, so you can have sectors growing at 10 percent at the same time that other sectors are tremendously depressed. That didn't seem to be the case during the 50s, and 60s types of economic slowdowns.

Anne: I think it's the diversity of the economy that describes it, whether it's old or new. I think you have diversity now. We were more dependent on industrial growth of major industries -- steel, automobiles. It seemed if something affected them it permeated the whole economy. Now we have a much more diverse economy, and I think that's part of the difference.

Mark: Shiller doesn't talk about the changes and how the economy is now made up. And does that justify a greater confidence in the stock market and does that limit the possibility of a major downturn ahead?

Evelina: I agree that we don't really have knowledge about what's going on currently. We seem to. Everybody acts like they do. You either believe in the old economy and the old rules of thumb, or you believe there's a new era. This new era seems to wipe out all economic theory, which I think is bogus. Supply curves slope up, demand curves slope down. I don't think that's going to change.

Gib: When you go into class and you say that, the students look at you like you're an old fogy.

Evelina: You are, Gib. (laughter) Gib: I know, but I still might be right! There's demand and there's supply.

Evelina: I get frustrated. Is it or isn't a new era? Yes, it could be a new era that has a lot of the old rules of thumb that still hold true. I think one of the major problems that people aren't talking about enough is that we don't have statistics to describe the new economy. We just don't. So we're looking for the keys under the lamppost even though we dropped them across the street.

Mark: Also the bases are so small so when you're measuring something like Internet retailer revenues they have outrageous multiples but of course they're starting from nothing. And I guess statistically I would imagine that it would make it hard to measure exactly how high that slope is going to go.

Pat: One of Shiller's points I think is that even if there is a new economy, can the financial markets become unhinged from it? Returning to Gib's point about the bubbles, in some sense Shiller's chart in chapter one says you don't even need a bubble to have some fear and trepidation about the data. All you have to see is that there are peaks in the PE ratio and these are typically followed by long periods of under performance whether you classify them as bubbles or not. The thing that seems most troubling to him in the initial part of the book seems to be precisely the unlinking of stock price performance with what's going on in the economy. We might be measuring it wrong as Anne and Evelina were alluding to with the way our statistics count things, but even if we counted it right I have the sense that there'd still be a breakdown in the link between the economy and financial markets. Financial markets appear much more optimistic than justified by earnings, whether it's earnings from Internet startups or earnings from GM and Ford.

Evelina: So you would agree with him, or disagree with him? Would you say that you take these charts seriously, or not?

Pat: I take the charts reasonably seriously. The historical data is certainly a meaty part of the book. What those charts suggest in terms of past correlations between the PE ratio and how stocks have performed over the subsequent ten years is not good news.

Gib: What would make you not take it seriously?

Evelina: Well, again going back to the measurement problems. I think he was using the S&P 500 there, and the problem with these indices is how some of the stocks, in terms of market capitalization, get sorted through. So if you really have a couple of stocks that might have really high PEs that are unreasonable but the rest of the market doesn't, then maybe the PE isn't a realistic number. We go back to S&P growth in 1999 and it turns out more than half of the stocks in the S&P dropped. That tells you that certainly some of those PEs are not going to be out of whack. So I guess I worry whether we are having more problems measuring PE ratios now because of the stocks in the S&P than we might have had ten, twenty, thirty, or forty years ago?

Gib: If that is the case, the statistician in me says we just have to sit down and look at the data and we'll see what is the case. I haven't done that so I don't know. But you could easily look at the PE ratio of the bottom 400 cap S&P stocks.

Evelina: Well, I think I saw some statistics that show most of the PEs is really attributable to a small number of stocks, that's why I'm raising the issue. And unfortunately I don't have it in front of me.

Mark: What's your sense then of how the market is valued?

Gib: But before you do that, remember stocks like GE have existed for a long time, and in 1980 they were priced at 15 to 1 and now GE is 30 to 1, and it's still GE, not Yahoo!

Pat: A real company with real assets.

Gib: That's right. I might be actually expressing the behavioral biases that Shiller talks about by saying the PE is 30. I don't know have the number in front of me. So, I might be revealing whatever the name of the bias is when you don't remember old stuff and you filter it ...

Evelina: That's anchoring.

Gib: And I have so much to anchor to. (laughter). But 15 to 1, who knows what it was in 1980? But the point is if this really was an issue, somebody would have already written the rejoinder book, saying, "No, no, no, if you look at it just a little bit differently, there's no bubble." I've seen about four or five reviews of the book and nobody says that. The reviews that I've seen have tended to say, hey, the behavioral finance stuff is kind of cool. And it's good that Shiller brings it out.

Evelina: I actually think that this is a strong point to this book.

Anne: I do too.

Gib: I recall seeing Stultz's review, and I also think it's reviewed in the current issue of the New York Review of Books by Jeff Madrick. And the review is favorable. That just brings us back to figure one in the book...

Evelina: Right.

Gib: If it's a real bubble then what?

Evelina: But if it's real and everybody's seen that, then why haven't people said, "Oh, my God, we better sell everything off."

Pat: I think that's his point. There are supports in place. Call them feedback mechanisms and the sum total of small effects, that really don't lead people to want to do that. They believe in the baby boom argument that there are a lot of people who will support the market in the future and that this past graph that shows this negative relationship just doesn't matter. They're familiar with technology and they have confidence in the buying opportunities of the past. In the end, the media is hyping market performance to the extent that people just don't believe in a big correction. If everyone had seen this picture maybe they'd feel differently. He does have a very interesting comment to make about people, not just fancy behavioral finance theories but just from survey questions he's been sending out to people and finding the inconsistency that people have. He's got a great little piece towards the back that asks if market timing is a good idea, and everybody basically says no. How about picking individual stocks, Is that a great idea? More people sort of think it is, then he says, "What about picking mutual funds?" And everybody thinks that's a great idea--picking the mutual funds that are going to outperform. That's sort of inconsistent. So maybe there's a sense that people are not paying attention to Shiller's data and have bought into all of these little mechanisms that collectively push things up and keep it up.

Evelina: I still have a feeling based on all the people I come into contact with that there's still very little true knowledge or understanding of the market. There are still people who don't understand that mutual funds represent stocks. They think that if they are mutual funds, they are not stocks.

Mark: He found all sorts of interesting things. Like in the 401k plan, people tend, and I'm definitely guilty of this myself, that if you have five boxes, click four of them. (laughter)

Gib: So you're 80 percent in stocks because four of them were stock option categories. That's your asset allocation decision.

Evelina: I'm still curious as to that 401k stuff he found because again it was my experience that all the people I talked to were putting their money into fixed income investments and people were not in the stock market. That was as short ago as five years ago. So it's sort of interesting to see if things really have changed in the past five years and everybody's in the stock market.

Gib: It has changed. Everybody's in the stock market.

Anne: Yep.

Gib: Five years ago you were right, and now you're wrong, I think.

Pat: The mutual fund flow data really do show a big switch with the money flows going disproportionately into U.S. large cap, growth oriented stocks. Last year at times there were big net redemptions out of small cap value funds, all moving completely into very narrow classes of stocks, and we saw a very narrow market last year. So I think you're really on to something. I think it has really shifted in the last few years.

Evelina: Maybe the new lesson is to not put your money into stocks. That's the new lesson for the average person.

Gib: But that's what he says in the book.

Pat: But where is the average person going to hear that advice. From TV? Shiller talks about the media as contributing to a conspiracy of the get rich quick sham, and the fantasyland of stock riches. Where are folks going to hear the message to reduce the reliance on stocks in their portfolios.

Mark: That's right. Stocks are a much easier story to tell than a bond story.

Gib: After beating up on the news media, you also have to remember the publicity that Jeremy Siegel's book "Stocks for the Long Run" has received. I don't know if people have really read it or not, but the takeaway for most people is that holding a stock for 15 years, is like buying a 15 percent bond. A no-risk 15 percent bond!. That's what stocks for the long run means. And that's wrong. And I don't want to beat up Siegel too much because Shiller does make the point. So let's not beat up the media and CNBC too much. "Stocks for the Long Run" makes people think if I buy the stock and hold it long enough, it's going to behave, not a like a diddly 4 percent bond , but a 15 percent bond! So my asset allocation decision is cake -- all stocks!.

Evelina: And the funny thing is, people seem to forget that's supposed to be a 15 year bond because when they need to cash out the next year and the market's down, they wonder why don't they have their 15 percent return. People not only forget that it's not a 15 percent bond but they forget the fact that it's only for the long term.

Gib: Holding stocks for 15 years is not as riskless a proposition. Siegel's probably the most eminent and recognizable finance person around these days. So if he's saying that then of course I'm going to allocate my 401k into stocks.

Evelina: But is he saying to people, buy individual stocks, or is he saying, get into mutual funds? Who can hold an individual stock for 15 years? Companies go out of business, so that whole argument really doesn't hold water.

Gib: Shiller goes after that argument late in the book. I forget if it's Siegel who says that since 1800 there's only been one 20 year period where stocks didn't beat bonds.

Evelina: It's probably the Ibbotson studies.

Pat: Many studies have been done and really do show that in 20 year holding periods, even including the Great Depression, there's never been a losing 20 year period if you invested in the S&P 500 index.

Gib: But then I think what Shiller does is go to 10-year horizons.

Pat: Then you can have a couple (losing periods) and at five years you begin to lose more often, and that's the point: the path you travel to get to your 10 year return can be quite bumpy, and it's worth people remembering.

Evelina: Also wasn't there something in there about depending on when you retired. If you retired in 1970 or 1973, you would have been out of money after 20 years, but if you retired in 1980 that wouldn't have been the case with the great bull market.

Mark: He also talks about nominal gains, and how that creates a certain unrealistic perception of stock market gains relative to real gains. And I'm not so sure that people are that innocent. And a lot folks lived through the 70s and are very familiar with inflation, and maybe had wage clauses. They are actually expert at this. I think he was assuming that it was completely over the average investor's head, and that they were being fooled by the most obvious shadow.

Evelina: But that was the case. Actually in the 70s we had high inflation and low returns. So people didn't miss that. I guess that was the part I was a little confused about.

Mark: What did you make of Shiller's comment that a couple of days before Greenspan wrote that famous speech, that he had given a presentation and described the market as irrational?

Evelina: Yes.

Mark: Is he taking credit for this expression?

Evelina: I thought that was interesting, but would Greenspan actually come out and say, "No, he didn't." So it's a win-win for him, isn't it?

Mark: It's a little odd. It makes a little bit uneasy.

Pat: But it fits in with his thinking that really goes back to the late eighties. And it's something he's been pushing with this very special data set that he created and I can remember working with in graduate school. He really has been making this point for a long time. It's possible that it was nothing more than that. "I tried to make this point for years, no one picked up on it but the chairman of the Federal Reserve makes the point and instantly it's accepted." Or at least talked about if not accepted.

Gib: It goes back even before '89. Shiller's early work in economics, the reason he becomes so well known, is the material about three-quarters the way through the book on dividend volatility versus price volatility. If you think of a dividend discount model, intrinsic value, then you'd think that the variability in dividends and/or earnings might be about the same as in stock market prices which, according to the efficient market, is what it's supposed to be reflecting. But articles in the early eighties by Shiller show prices to be on the order of five times more variable than earnings streams. Explain that to me?

Mark: He says prices have a life of their own, a mind of their own. Is this the general opinion? I think I believe that.

Gib: You mean, do people in academics believe that?

Mark: Yes.

Gib: Oh no. (laughter)

Mark: Well, the efficient market theory. If you actually follow the market day-to-day, the efficient market theory is dogma.

Gib: I know. And I'm not a fan. The heyday of rational expectations is the late 80s, and the behavioral guys can't do anything. And now the behavioral people are out there a lot. But, could prices just go anywhere?

Mark: There's this belief that a lot of people, or at least it's contained somewhere in everybody's belief, that a price is correct because it is the price.

Gib: It's the price because it's the price someone will pay you for that.

Mark: That's right, and it must be perfect because it's the price. It's a tautology. And you see it all along. The market's perfect because there are prices in it. There are conventions in the market. Right now, the euro and dollar. We're supposed to be having diverging growth rates between the continents, yet the euro is sinking. Or, Japan has zero interest rates yet their currency is strong. So, when you have conflicts like this, and he talks about this -- co-existing ideas. But he doesn't get down on the analysts for having these contradictions contained in their analytical framework, he gets down on the average investor for jumping to conclusions, or having these other explanations by authorities already available that they can parrot or believe. The efficient market theory is a little bit dubious for me.

Gib: The strong form I think is dubious. But at some level, when you buy financial assets, it's a claim on the assets of those companies that are more or less worth something. That's what you're really buying.

Pat: There's a literature that suggests that when people invest they often think about buying good stocks and not good companies. The confusion that exists in investors' minds may be because they're looking at a stock as an exchangeable piece of paper that has value in itself just because you can turn around and sell it voluntarily to someone else. And they're forgetting about, although they shouldn't, that it is a claim on the future earnings of that particular firm. The idea of market efficiency has to be taken with so many grains of salt because it's partly a time-horizon issue. If I'm an equity manager and believe that all the information is incorporated instantaneously, I might as well get a tie-dye shirt and do something else. (laughter) Because I'd be wasting my time.

Gib: Wait a second, I saw you this morning and you were wearing a tie-dye shirt. (laughter)

Pat: No, it had sailboats on it! But in truth, if you consider a long enough time horizon then you could make a strong case that the market does behave more efficiently. This has been known in a lot of circles for a long time. That's why I think Shiller uses 10-year returns on his famous graph, and 10-year and 30-year smoothed earnings numbers. You just can't expect these relationships to hold in the short term. Of course, that's easy to say because I don't have to define the short term.

Evelina: The idea of efficiency. Even if there's not a strong version, which I don't think there is, but there's some kind of movement towards it. Whether it's the stock market or the bond market that reacts to economic indicators when they come out, there's a reaction trying to incorporate the new information, and I often think the reaction is either overdone or sometimes really screwy. But they're trying to incorporate the information and what it means inherently for the economy, what it means inherently about what the Fed's going to do, so there is some incorporation of new news that we see every day.

Gib: What would be really bizarre is if from '95 to '99 the market went from 5000 to 10,000 and the economy went into the tank. But now we're talking about details. The economy is strong, as strong as it's ever been over a five or nine-year horizon any body can remember. So, the question is, should the Dow be at 7,000 or 10,000?

Evelina: It does lead to the question, though, of anchoring. Who's to say that the market was right ten years ago? Or 20 years, or 30 years ago. Maybe it was too low. We're anchoring it a certain time in the past. Shiller makes the point that the economy grew what? Three times, five times as the market grew 10 times. I don't know. But the point was, who's to say that was a correct anchor. And secondly, we still have problems with economic data. Every time's there's a revision, it seems to be an upward revision to GDP. The past five years I think we've had upward revisions every single time. We keep finding new growth, so maybe the economy grew faster than we thought.

August 16, 2000
Stay tuned for the second installment of this Roundtable's discussion in the September Focal Point.