About Robert J. Schiller's book, Irrational Exuberance (2000; 2nd ed., 2005), it's hard to say enough good things. First Schiller, who is Stanley B. Resor Professor of Economics at Yale University, had uncanny timing. His warning on the excesses of the technology bubble stock market came out at its very peak, in mid-March of 2000. He wrote in an afterward to the paperback edition (2001) that as he made publicity visits to bookstores in April of 2000, a large carnage had already occurred in the market, particularly for tech stocks and e-business names. Second, he writes in a transparent style. Third, he and his team, instead of tossing out opinions about what they think investors do, carry out frequent sample surveys of both individual and institutional investors. Fourth, he undergirds his hypothesis with numerous insights from economics, psychology, game theory and history. Finally, he gives many cross-references to booms and busts around the globe.
The second edition points to over-valuations in the U.S. real estate market that Schiller believes were comparable to the excesses of the dot-com era in stocks. This prediction may prove to be accurate as well, but the unraveling so far has not proceeded in so dramatic a fashion as did the technology crash.
From what valuation method does Schiller proceed his analysis of stocks? Fundamentally, he bases it on price-earnings ratios. (Price-earnings ratios have been shown to be a crucial characteristic in predicting long term stock portfolio performance; see James P. O'Shaughnessy, What Works on Wall Street [1998, rev.]). More precisely, he uses as his numerator the real (inflation-adjusted) S&P (Standard & Poor's) Composite Stock Price Index. For the denominator, he uses the moving average of the past ten years of real S&P Composite Earnings. Advantages of these data series: the source is considered reliable; they go back to 1841 continuously; they are inflation-adjusted.
Using the price-earnings data and ratio as defined above, a first great cyclical high can be seen in June 1901: a P/E ratio of 24.5 times. Subsequently, P/E declined, and stocks performed in a desultory fashion, until June of 1920. The second great peak, occurring at the end of the Roaring Twenties, was 32.6 times--reached during September of 1929. The Great Crash followed. A third peak occurred during the so-called "go-go" era of the 1960s: 24.1 times in January of 1966. This too came a cropper, followed by years of stock market underperformance--bottoming out in terms of P/E ratio in the early 1980s. The US stock market P/E ratio at the height of the technology boom in 2000 reached an unprecedented 44.3 by January of 2000. Then, boom-boom, out went the lights!
Schiller explores from many perspectives just how markets sometimes reach such giddy highs. One "amplification mechanism" is likened to a naturally occurring Ponzi process. Charles Ponzi attracted 30,000 investors and $15,000,000 within seven months during 1920. Ponzi promoted his scheme by cashing out some early investors, which excited many followers. Ponzi schemes always involve an attempt to pyramid investor inputs while wasting or defrauding much of the principal outside of the touted investment theme. Schiller points out that rapidly rising stock markets can bring in an unintended Ponzi dimension, as late-comers seek to replicate earlier investors' apparent success.
Such feedback loops lead to circles of investor behavior, which can promote the expansion of a bubble, but also can lead to its rapid deflation. Schiller also shows how news media attention to feedback loops can intensify their force and expand the volume of participation by investors. Often, behind investment fads, there are popular ideas about "new eras" that supposedly render irrelevant any historical comparisons. Feedback loops are facilitated by the demonstrated over-confidence of many individuals in their judgments as well as by evolved patterns of mass behavior.
Generally, markets threaten to become untethered whenever investors' principal focus is on price performance rather than fundamental value criteria. In such an atmosphere, it can be imagined that trees truly can grow to the sky. Or at least that there will be a "greater fool" who will take you out of your investment in a timely fashion.
Schiller does not purport to offer a rule of thumb for market trading practice. Indeed, any scheme that could be used continuously and in static form to operate a successful trading system (a putative "money machine") would surely be arbitraged away by perceptive traders. Instead, he lays out a more intuitive case for how to avoid investing in major market excesses when they occasionally occur. His proposed solutions included a salutary emphasis on hedging activities. Some of the hedges he lays out are novel but may not be practical to implement, owing to the problem of illiquidity (lack of ability to trade).
(The author of this review, Andrew Szabo, is founder of MindBodyForce.com)