Irrational Exuberance


Part One: Structural Factors

Four: Precipitating Factors: The Internet, the Capitalist Explosion, and Other Events

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Mutual funds are a relatively new name for a very old idea.

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The U.S. Federal Reserve launched a series of “stress tests” of financial institutions, starting with the Supervisory Capital Assessment Program in 2009. Miraculously, these tests concluded that many bank holding companies had adequate capital to survive even an adverse economic scenario, and others were given an estimated amount of capital to raise so that they, too, could survive. The stress tests reassured markets.

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The anxieties of being out of the labor force (or suspecting that one might soon be) may help further propel the “reaching for yield” in investing that low interest rates have already encouraged: people may take greater risks with their investments to keep alive a hope of living comfortably for years into the future without employment. The meaning of the term “reaching for yield” seems to have shifted somewhat around the time of the New-Normal Boom. It was most often used to describe investing in high-interest-rate bonds or mortgages with diminished regard for their risk. Now, with real interest rates near zero, it is more often used to describe aggressive investing in risky stocks or complicated new investment products.

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economic theory (as explicated by Robert E. Lucas, for example) suggests just the opposite. 52 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.

Five: Amplification Mechanisms: Naturally Occurring Ponzi Processes

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generally when home prices are going up, the percentage who think real estate is the best investment also goes up. When home prices are going down, the percentage who think real estate is the best investment goes down too. This is feedback.

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People are accustomed to thinking that there is a basic state of “health” of the economy, and that when the stock market goes up, or when GDP goes up, or when corporate profits go up, it means that the economy is healthier, no more and no less. It seems as if people often think that the economy is struck by some exogenous maladies, akin to earthquakes or meteor impacts, or exogenous breakthroughs, such as sudden advances in technology, and that the movements in the stock market, in GDP or in profits, are just a reflection of such shocks. It is true that the economy is sometimes struck by such shocks. But people do not seem to perceive how often it is that their own psychology, as part of a complex pattern of feedback, is driving the economy.

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To provide evidence that such feedback mechanisms do play a role in financial markets, it is helpful to look at the example of Ponzi schemes, or pyramid schemes, by means of which hoaxers create positive feedback from putative current investment returns to future investment returns. These schemes have been perpetrated so many times that governments have had to outlaw them, yet they still keep popping up. They are particularly interesting since they are, in a way, controlled experiments (controlled by the hoaxer!) that demonstrate characteristics of the feedback that cannot be seen so plainly either in normal markets or in the experimental psychologist’s laboratory.

Part Two: Cultural Factors

Six: The News Media

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Very few of the aggregate price movements in the stock market show any meaningful association with headlines.

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Only 36 % said they had heard about the news before the crash; 53 % said they had heard about it afterward as an explanation for the drop; the rest were unsure when they had heard about it. Thus it appears that the news story may have tagged along after the crash, rather than directly caused it, and therefore, it was not as prominent as the media accounts suggested.

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Duncan Watts’s book. Everything is obvious.

Also the left brain vs right brain. Confabulation stories.

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The role of the news media in causing the stock market crash of 1929 has been debated almost since the crash itself. In fact, the puzzle facing historians and economists has been, by some interpretations, that just before the crash there was no significant news at all. Ever since, however, people have wondered how this record stock market crash could get under way with no news.

Seven: New Era Economic Thinking

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In a sense, the high-tech age, the computer age, and the space age seemed just around the corner in 1901, though the concepts were expressed in different words than we would use today. People were upbeat, and in later years the first decade of the twentieth century came to be called the Age of Optimism, the Age of Confidence, or the Cocksure Era.

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But a new era has come, the era of “community of interest,” whereby it is hoped to avoid ruinous price cutting and to avert the destruction which has in the past,

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One, a March 14, 2000, article in the Wall Street Journal by Jeremy J. Siegel, “Big-Cap Tech Stocks Are a Sucker Bet,” showed price-earnings ratios for large market capitalization stocks that were over 100. In this article, Siegel asserted that history shows “the failure of any large-cap stock ever to justify, by its subsequent record, a P / E ratio anywhere near 100.” This statement was very quotable, and was often quoted.

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Another article, in Barron’s, “Burning Up” by Jack Willoughby, included a ranking of Internet companies that were losing money, by the number of months it took until they had burned through all their cash. 55 Willoughby’s idea of ranking Internet companies this way made these companies’ problems suddenly vivid and clear, and was eminently quotable.

Part Three: Psychological Factors

Nine: Psychological Anchors for the Market

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Amos Tversky and Daniel Kahneman demonstrated this tendency clearly in an experiment involving a wheel of fortune: a large wheel with the numbers from 1 to 100 on it, similar to those used in television game shows, that is designed to stop at a random number when it is spun. Subjects were asked questions whose answers were numbers between 1 and 100, difficult questions such as the percentage of African nations in the United Nations. They were asked first to say whether the answer they would give was above or below the number just produced by the wheel of fortune. Then they were asked to give their answer. The experimenters found that the answer was quite substantially influenced by the random number on the wheel. For example, if the wheel stopped at 10, the median percentage of African nations according to their subjects was 25, whereas if the wheel stopped at 65, the median percentage was 45. This experiment was particularly interesting, because it was designed so that the subject clearly knew that the number produced by the wheel was purely random and, moreover, because the number produced by the wheel should have had no emotional significance for the subject.

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Parent A, the impoverished option, was described with the words “average income, average health, average working hours, reasonable rapport with the child, and relatively stable social life.” Parent B, the enriched option, was described with the words “above-average income, very close relationship with the child, extremely active social life, lots of work-related travel, minor health problems.” The experimenters found that the subjects’ choices depended on how they were asked about the two choices. When a group of subjects was asked to select the parent to whom they would award custody, 64 % chose Parent B. When a second group was asked to pick the parent to whom they would deny custody, 55 % again chose Parent B. The predominant answers given by the two groups are logically inconsistent, but they are consistent with a feeling that one must have a solid reason to justify a decision. The psychologists found that the same tendency occurs even for purely personal decisions that will never need to be explained to others.

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Recall the 1996 book The Millionaire Next Door, which was a best-seller throughout the stock market boom of the 1990s. It made the point that most millionaires in the United States are not exceptional income earners, but merely frugal savers: average folks who are not enticed by a new car every year, an extravagant house, or other such money pits. 11 This book was not only an interesting study of millionaires; it also projected a subtle message suggesting the moral superiority of those who hold and gradually accumulate wealth over a lifetime. It therefore provided an attractive reason to save and invest. The book offered no analyses of price-earnings ratios or anything remotely like specific investment advice, thus subtly reinforcing the impression that these are irrelevant. Instead, it offered lots of stories of successful, frugal people, many of whom prospered during the 1980s and 1990s bull market — stories with vivid details and great immediacy for readers. The book’s enticing story about investing millionaires who do not test the market by trying to cash out and consume their wealth was just the kind of moral anchor needed to help sustain an unusual bull market.

Ten: Herd Behavior and Epidemics

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They were reacting to the information that a large group of people had reached a judgment different from theirs, rather than merely the fear of expressing a contrary opinion in front of a group.

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These results were widely interpreted as demonstrating the enormous power of authority over the human mind. Indeed, the results may be understood partly on those terms. But there is another interpretation: that people have learned that when experts tell them something is all right, it probably is, even if it does not seem so. (In fact, it is worth noting that in this case the experimenter was indeed correct: it was all right to continue giving the “shocks” — even though most of the subjects did not suspect the reason.) Thus, the results of Milgram’s experiment can also be interpreted as springing from people’s past learning about the reliability of authorities.

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Ultimately, all such information cascade theories are theories of the failure of information about true fundamental value to be disseminated and evaluated.

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Court documents reveal, for example, that a sequence of word-of-mouth communications was touched off in May 1995, when a secretary at IBM was asked to photocopy documents that included references to IBM’s top-secret takeover of Lotus Development Corporation, a deal scheduled to be announced on June 5 of that year. She apparently told only her husband, a beeper salesman. On June 2, he told another person, a co-worker, who bought shares eighteen minutes later, and another friend, a computer technician, who initiated a sequence of phone calls. By the time of the June 5 announcement, twenty-five people connected to this core group had spent half a million dollars on the investment based on this tip. They included a pizza chef, an electrical engineer, a bank executive, a dairy wholesaler, a former schoolteacher, a gynecologist, an attorney, and four stockbrokers.

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The channels of human communication that we know today seem to favor the interpersonal face-to-face and word-of-mouth communication that developed over millions of years of evolution, during times when such communication was virtually the only form of interpersonal communication.

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people find it somewhat more difficult to react to these sources of information. They cannot give these other sources the same emotional weight, nor can they remember or use information from these other sources as well.

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For example, people widely believe that the stock market is unforecastable and that market timing is futile. But they also believe (as we saw in Chapter 5) that if the stock market were to crash, it would surely come back up. Such views are clearly inconsistent. One explanation for the fact that people are able to hold such conflicting views simultaneously is that they think they have heard both views endorsed by experts.

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A 1931 experiment by psychologist N.R.F. Maier will illustrate. Maier presented his subjects with the challenge of tying two cords together: cords that were suspended from the ceiling far enough apart that one could not reach them both at the same time unless they were somehow brought together. Subjects were given a number of tools with which to attempt this task and were asked to see how many different ways they could invent to tie the two cords together. One way to complete the task was to tie a weight to the end of one of the cords, set it swinging like a pendulum, grab the end of the other cord with one hand, and then catch the swinging cord with the other hand. When the experimenter himself set one of the cords swinging, many subjects quickly came up with this idea. But when asked how they had hit upon the idea, only a third of them mentioned having seen the swinging cord.

Part Four: Attempts to Rationalize Exuberance

Twelve: Investor Learning—and Unlearning

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Stocks have not always outperformed other investments over decades-long intervals, and there is certainly no reason to think they must in the future.

Part Five: A Call to Action

Thirteen: Speculative Volatility in a Free Society

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As the price increase during a bubble goes on through time, people constantly reassess their opinions. People who thought there was a bubble, and that prices were too high, find themselves questioning their own earlier judgments, and start to wonder whether fundamentals are indeed driving the price increase. Many people seem to think that if the price increase goes on for years after some experts have called the price increase a bubble, then maybe the experts were wrong. And they then feel that there is no alternative to thinking that it is really fundamentals that are driving the increase, and that these fundamentals will go on forever.