(1) Read and summarize chapter "Efficient markets, random walks, and bubbles" in R. Shiller's
book Irrational Exuberance.
Format: 2-page, 1” margin, Times New Roman font size 12, double space.
This is an individual assignment and everyone should read it. Make sure you cover each
section in the chapter in your summary.
Attached is a copy of the older version of the book.
(2) Pick 2 incidents that interest/surprise you most from Table 16-2 (class handout), and find
more details of the incidents.
Format: 1 page, 1” margin, Times New Roman font size 12, double space.
Irrational
Exuberance
Robert J. Shiller
Princeton University Press
Princeton, New Jersey
Contents
Copyright © 2000 Robert J. Shiller
Published by Princeton University Press, 41 William Street, Princeton,
New Jersey 08540
In the United Kingdom: Princeton University Press, Chichester, West Sussex
All Rights Reserved
Library of Congress Cataloging-in-Publication Data
Shiller, Robert J.
Irrational exuberance / Robert J. Shiller.
p.
cm.
Includes bibliographical references and index.
ISBN 0-691-05062-7 (cloth : alk. paper)
1. Stocks—United States. 2. Stock exchanges—United States.
3. Stocks—Prices—United States. 4. Risk. 5. Dow Jones industrial
average. I. Title.
HG4910.S457 2000
332.63'222'0973—dc21
99-088869
This book has been composed in Adobe Palatino and Berkeley Old Style
Book and Black by Princeton Editorial Associates, Inc., Scottsdale,
Arizona, and Roosevelt, New Jersey
List of Figures and Tables
Preface
Acknowledgments
One
Printed in the United States of America
The Stock Market Level in Historical Perspective
3
Part One
Structural Factors
Two
Three
Precipitating Factors: The Internet, the Baby Boom,
and Other Events
Amplification Mechanisms: Naturally Occurring
Ponzi Processes
17
44
Part Two
Cultural Factors
The paper used in this publication meets the requirements of ANSI/NISO
Z39.48-1992 (R1997) (Permanence of Paper)
http://pup.princeton.edu
ix
xi
xix
Four
Five
Six
The News Media
New Era Economic Thinking
New Eras and Bubbles around the World
10 9 8 7 6 5 4 3 2 1
vii
71
96
118
viii
CO N TEN TS
Part Three
Psychological Factors
Seven
Eight
Psychological Anchors for the Market
Herd Behavior and Epidemics
135
148
Figures and Tables
Part Four
Attempts to Rationalize Exuberance
Nine
Ten
Efficient Markets, Random Walks, and Bubbles
Investor Learning—and Unlearning
171
191
Part Five
A Call to Action
Eleven
Speculative Volatility in a Free Society
Notes
References
Index
235
269
283
203
Figures
1.1
1.2
1.3
9.1
Stock Prices and Earnings, 1871–2000
Price-Earnings Ratio, 1881–2000
Price-Earnings Ratio as Predictor of Ten-Year Returns
Stock Price and Dividend Present Value, 1871–2000
6
8
11
186
Tables
6.1
6.2
6.3
6.4
Largest Recent One-Year Real Stock Price Index Increases
Largest Recent One-Year Real Stock Price Index Decreases
Largest Recent Five-Year Real Stock Price Index Increases
Largest Recent Five-Year Real Stock Price Index Decreases
ix
119
120
121
122
xii
Preface
T
his book is a broad study,
drawing on a wide range of
published research and historical evidence, of the enormous recent
stock market boom. Although it takes as its specific starting point
the current situation, it places that situation in the context of stock
market booms generally, and it also makes concrete suggestions
regarding policy changes that should be initiated in response to
this and other booms.
The need for such a book is particularly urgent today, in view
of the widespread and quite fundamental disagreement about
the stock market. When people disagree at such a basic level, it is
usually because they possess only pieces of the overall picture. Yet
meaningful consensus can only be achieved by laying out all the
available facts. I have therefore tried in this book to present a much
broader range of information than is usually considered in writings
on the market, and I have tried to synthesize this information into
a detailed picture of the market today.
Why did the U.S. stock market reach such high levels by the turn
of the millennium? What changed to cause the market to become
so highly priced? What do these changes mean for the market
xi
PR EFAC E
outlook in the opening decades of the new millennium? Are powerful fundamental factors at work to keep the market as high as
it is now or to push it even higher, even if there is a downward
correction? Or is the market high only because of some irrational
exuberance—wishful thinking on the part of investors that blinds
us to the truth of our situation?
The answers to these questions are critically important to private and public interests alike. How we value the stock market now
and in the future influences major economic and social policy decisions that affect not only investors but also society at large, even
the world. If we exaggerate the present and future value of the stock
market, then as a society we may invest too much in business startups and expansions, and too little in infrastructure, education, and
other forms of human capital. If we think the market is worth more
than it really is, we may become complacent in funding our pension plans, in maintaining our savings rate, in legislating an
improved Social Security system, and in providing other forms of
social insurance. We might also lose the opportunity to use our
expanding financial technology to devise new solutions to the genuine risks—to our homes, cities, and livelihoods—that we face.
To answer these questions about today’s stock market, I harvest
relevant information from diverse and, some would say, remote
fields of inquiry. Insights from these fields too often go unnoticed
by market analysts, but they have proved critical in defining similar market episodes throughout history, as well as in other markets
around the world. These fields include economics, psychology,
demography, sociology, and history. In addition to more conventional modes of financial analysis, they bring potent insights to bear
on the issues at hand. Much of the evidence is drawn from the
emerging field of behavioral finance, which, as the years go by, is
looking less and less like a minor subfield of finance and more and
more like a central pillar of serious finance theory.
I marshal the most important insights offered by researchers in
these fields. Taken as a whole, they suggest that the present stock
market displays the classic features of a speculative bubble: a situation in which temporarily high prices are sustained largely by
investors’ enthusiasm rather than by consistent estimation of real
PREFA CE
xiii
value. Under these conditions, even though the market could possibly maintain or even substantially increase its price level, the outlook for the stock market into the next ten or twenty years is
likely to be rather poor—and perhaps even dangerous.
I do not purport to present a wholly new conception of financial market behavior. This book is a work neither of economic theory
nor of econometrics, although it partakes in both. Rather, it is an
attempt to characterize the complex nature of our real markets today,
considering whether they conform or do not conform to our
expectations and models. By assembling the most relevant evidence,
economic and otherwise, on the state of the market, I hope to correct what I consider to be the perilous policy paths now being followed by legislators and economic leaders. I also hope to challenge
financial thinkers to improve their theories by testing them against
the impressive evidence that suggests that the price level is more
than merely the sum of the available economic information, as is
now generally thought to be the case.
Within the past generation the branch of financial theory that is
derived from the assumption that all people are thoroughly rational and calculating has become the most influential analytical
device to inform our mastery of the market. Those financial theorists who consider the market price to be a cunningly efficient
processor of financial information have had a profound effect on
the systematic management of the world’s wealth, from the corner stockbroker right up to the Federal Reserve. But most of these
scholars of finance and economics shrink from public statements
about the level of the stock market (although they are often more
loose-lipped in expressing their opinions at lunch and over beers)
because they do not want to be caught saying things in public that
they cannot prove. Assuming the mantle of scientific detachment,
these financial economists tend to fall back on the simple but
elegant model of market efficiency to justify their professional
position.
However, there are serious risks inherent in relying too heavily
on such pristine models as the basis for policy discussion, for these
models deal only with problems that can be answered with scientific
precision. If one tries too hard to be precise, one runs the risk of
xiv
PR EFAC E
being so narrow as to be irrelevant. The evidence I present in the
following chapters suggests that the reality of today’s stock market is anything but test-tube clinical. If the theory of finance is
to grow in its usefulness, all economists eventually will have to
grapple with these messier aspects of market reality. Meanwhile,
participants in public debate and economic policy formation must
sort out this tangle of market factors now, before it is too late.
Among the unanticipated consequences of today’s investment
culture is that many of the tens of millions of adults now invested
in the stock market act as if the price level is simply going to keep
rising at its current rate. Even though the stock market appears
based on some measures to be higher than it has ever been,
investors behave as though it can never be too high, and that it
can never go down for long. Why would they behave this way?
Their logic is apparently consistent with the free-rider argument.
That is, if millions of researchers and investors are studying stock
prices and confirming their apparent value, why waste one’s time
in trying to figure out reasonable prices? One might as well take
the free ride at the expense of these other diligent investors who
have investigated stock prices and do what they’re doing—buy
stocks!
But unknown to most investors is the troubling lack of credibility
in the quality of research being done on the stock market, to say
nothing of the clarity and accuracy with which it is communicated
to the public. Some of this so-called research often seems no more
rigorous than the reading of tea leaves. Arguments that the Dow
is going to 36,000 or 40,000 or 100,000 hardly inspire trust. Certainly
some researchers are thinking more realistically about the market’s
prospects and reaching better-informed positions on its future, but
these are not the names that grab the headlines and thus influence
public attitudes.
Instead the headlines reflect the news media’s constant attention to trivial factoids and “celebrity” opinion about the market’s
price level. Driven as their authors are by competition for readers,
listeners, and viewers, media accounts tend to be superficial and
thus to encourage basic misconceptions about the market. A conventional wisdom of sorts, stressing the seemingly eternal dura-
PREFA CE
xv
bility of stocks, has emerged from these media accounts. The public has learned to accept this conventional—but in my view shallow—wisdom. To be fair to the Wall Street professionals whose
views appear in the media, it is difficult for them to correct the
conventional wisdom because they are limited by the blurbs and
sound bites afforded them. One would need to write books to
straighten these things out. This is such a book.
As noted earlier, the conventional wisdom holds that the stock
market as a whole has always been the best investment, and always
will be, even when the market is overpriced by historical standards.
Small investors, in their retirement funds, are increasingly shifting their investments toward stocks, and the investment policy of
100% stocks in retirement funds is increasingly popular. They put
their money where their mantra is. This attitude invites exploitation by companies who have an unlimited supply of equities to sell.
“You want stocks? We’ll give you stocks.”
Most investors also seem to view the stock market as a force of
nature unto itself. They do not fully realize that they themselves,
as a group, determine the level of the market. And they underestimate how similar to their own thinking is that of other investors.
Many individual investors think that institutional investors dominate the market and that these “smart money” investors have
sophisticated models to understand prices—superior knowledge.
Little do they know that most institutional investors are, by and
large, equally clueless about the level of the market. In short, the
price level is driven to a certain extent by a self-fulfilling prophecy
based on similar hunches held by a vast cross section of large and
small investors and reinforced by news media that are often content to ratify this investor-induced conventional wisdom.
When the Dow Jones Industrial Average first surpassed 10,000
in March 1999, Merrill Lynch took out a full-page newspaper ad
with a headline saying, “Even those with a disciplined long-term
approach like ours have to sit back and say ‘wow.’” In the bottom
left corner of the page, next to a stock plot ending up at 10,000,
appeared the words “HUMAN ACHIEVEMENT.” If this is an achievement worth congratulating, then we should congratulate employees whenever they submit glowing self-evaluation reports.
xvi
PR EFAC E
At present there is a whiff of extravagant expectation, if not irrational exuberance, in the air. People are optimistic about the stock
market. There is a lack of sobriety about its downside and the consequences that would ensue as a result. If the Dow were to drop
to 6,000, the loss would represent something like the equivalent
value of the entire housing stock of the United States. There would
be harmful and uneven effects on individuals, pension funds,
college endowments, and charitable organizations.
We need to know if the price level of the stock market today, tomorrow, or on any other day is a sensible reflection of economic reality,
just as we need to know as individuals what we have in our bank
accounts. This valuation is the future food on our tables and
clothes on our backs, and nearly every decision to spend money today
ought to be influenced by it. We need a better understanding of the
forces that shape the long-run outlook for the market—and it is such
an understanding that this book is intended to provide.
Outline of This Book
After an introductory chapter placing the current stock market into
historical context, Part I discusses precipitating events: factors
outside the stock market, such as technology and demography, that
nevertheless shape the market’s behavior. It also covers amplifying mechanisms that cause these precipitating factors to have such
an outsized effect on the market. These mechanisms can reinforce
confidence in the market despite its already high price by creating
situations in which price changes cause further price changes, thus
beginning the speculative bubble.
Part II introduces cultural factors that further reinforce the structure of the speculative bubble. These factors include accounts of
the economy that contend that it has moved into a “new era” that
makes it impervious to downside forces, accounts that are amplified by the news media. Examples of similar “new era” thinking
at each of the previous market peaks in the twentieth century are
recounted, as are numerous examples from other countries.
Part III discusses the evidence we have collected about the psychological anchors and herd behavior that further define the speculative bubble.
PREFA CE
xvii
Part IV investigates attempts on the part of academic and popular thinkers to rationalize the recent market levels through, for
example, the efficient markets theory and the “learning” of certain
“facts” about the behavior of the market.
Part V analyzes the implications of the current speculative
bubble for individual investors, institutions, and governments. Several prescriptions for urgently needed policy changes are offered,
as are suggestions for ways in which individual investors can
lower their exposure to the consequences of a “burst” bubble.
Acknowledgments
J
eremy Siegel, while clearly not
agreeing with me on all points,
urged me to set down my ideas in this book. He is its real instigator.
Jeremy has been a lifelong friend. Our families regularly vacation
together, and I learned a distinctive approach to finance from him
while strolling the beach together or watching our children fish.
John Campbell, my former student, then co-author on a dozen
scholarly papers on financial markets, and for years a close friend,
has been my intellectual other half in formulating many of the ideas
that led to this book. My original work on volatility in financial markets was refined and significantly advanced with his collaboration.
He has also offered many helpful suggestions for this book and comments on the manuscript.
Peter Dougherty, my editor at Princeton University Press, has
been an extremely important formative influence on the book,
helping to define the fundamental aspects of its structure. He has
been a great colleague and more—really almost a collaborator. Peter
Strupp of Princeton Editorial Associates was an unusually helpful
copy editor.
xix
xx
A CK N O WLED G M ENTS
I was fortunate to have several excellent research assistants to
help me during the writing. Peter Fabrizio unearthed the truth about
many of the historical events discussed. Yuanfeng Hou performed
careful data analysis. Luis Mancilla was a skillful fact finder.
Steven Pawliczek was the source of many important ideas.
I am also blessed with a number of friends and colleagues who
read drafts of the manuscript and provided extensive comments:
Stefano Athanasoulis, John Geanakoplos, William Konigsberg,
Stephen Morris, Sharon Oster, Jay Ritter, Martin Shubik, and
James Tobin.
My colleagues at the Cowles Foundation for Research in Economics at Yale University—Donald Brown, Stefan Krieger, and
William Nordhaus—have been a great help. I must also take this
occasion to express gratitude to our late founder, Alfred Cowles
III, an investment manager in the early part of this century and
patron of mathematical economics, who tabulated the pre-1926 dividend and earnings data used in this book.
Help from my colleagues at the new Yale International Center
for Finance—its director, William Goetzmann, as well as Zhiwu
Chen, Roger Ibbotson, Ivo Welch, and Jeffrey Wurgler—is also
acknowledged. Roger, who is currently giving talks entitled “Dow
100,000” and predicting a brilliant future for the stock market, has
been a willing foil for my ideas.
Support from my colleagues at Case Shiller Weiss, Inc.—its
president, Allan Weiss, as well as Karl Case, Neel Krishnaswami,
and Terry Loebs—is much appreciated. As a team, they are attempting to put into practice some of the improvements to our society’s
risk management institutions that I describe at the end of this book.
I am grateful to the Russell Sage Foundation for sponsoring the
behavioral finance workshops that Richard Thaler and I have
been organizing for the past ten years at the National Bureau of
Economic Research. The term behavioral finance refers to research
on financial markets that takes into account the details of human
behavior, including human psychology and sociology. This book
benefits immeasurably from the work of the many scholars in the
emerging field of behavioral finance, which is now beginning to
take a solid place in university finance departments.
ACKNO WL EDGM ENTS
xxi
The U.S. National Science Foundation has supported much of
my basic research on financial markets. Their continuing support
of my work for over twenty years now has enabled me to focus
attention on issues independent of financial pressures.
I am also grateful to Brad Barber, Scott Boorman, David Colander, Ray Fair, Peter Garber, Jeffrey Garten, Trevor Greetham, Stefan
Krieger, Ricky Lam, Benoit Mercereau, Stephen Morris, William
Nordhaus, John Rey, Colin Robertson, and Mark Warshawsky for
helpful discussions, and to my assistant Carol Copeland and typist
Glena Ames for much help. Yoshiro Tsutsui of Osaka University
and Fumiko Kon-Ya of the Japanese Securities Research Institute have
collaborated with me for the last dozen years on questionnaire survey research exploring investor attitudes in Japan as well as the
United States. Help from Josephine Rinaldi and Walt Smietana at
CompuMail has been much appreciated. I should certainly also
thank the numerous investors who have taken the time to fill out
questionnaires for me.
To my wife, Virginia Shiller, who is a clinical psychologist, I owe
fundamental gratitude for getting me really interested in psychology and convincing me of its importance in economics. She has
given the most careful reading and criticism to the entire book and
has helped me greatly in articulating my ideas. She also kept the
home fires burning while I spent long days and nights working.
4
One
The Stock Market Level
in Historical Perspective
W
hen Alan Greenspan, chairman of the Federal Reserve
Board in Washington, used the term irrational exuberance to describe
the behavior of stock market investors in an otherwise staid speech
on December 5, 1996, the world fixated on those words. Stock markets dropped precipitously. In Japan, the Nikkei index dropped
3.2%; in Hong Kong, the Hang Seng dropped 2.9%; and in Germany,
the DAX dropped 4%. In London, the FT-SE 100 index was down
4% at one point during the day, and in the United States, the Dow
Jones Industrial Average was down 2.3% near the beginning of trading. The words irrational exuberance quickly became Greenspan’s
most famous quote—a catch phrase for everyone who follows the
market.
Why did the world react so strongly to these words? One view
is that they were considered simply as evidence that the Federal
Reserve would soon tighten monetary policy, and the world was
merely reacting to revised forecasts of the Board’s likely actions.
But that cannot explain why the public still remembers irrational
exuberance so well years later. I believe that the reaction to these
words reflects the public’s concern that the markets may indeed
3
THE S TOCK M AR KET LEV EL I N HISTORI CA L PERSPECT IV E
have been bid up to unusually high and unsustainable levels
under the influence of market psychology. Greenspan’s words
suggest the possibility that the stock market will drop—or at least
become a less promising investment.
History certainly gives credence to this concern. In the balance
of this chapter, we study the historical record. Although the discussion in this chapter gets pretty detailed, I urge you to follow its
thread, for the details place today’s situation in a useful, and quite
revealing, context.
Market Heights
By historical standards, the U.S. stock market has soared to extremely high levels in recent years. These results have created a sense
among the investing public that such high valuations, and even
higher ones, will be maintained in the foreseeable future. Yet if the
history of high market valuations is any guide, the public may be
very disappointed with the performance of the stock market in coming years.
An unprecedented increase just before the start of the new millennium has brought the market to this great height. The Dow Jones
Industrial Average (from here on, the Dow for short) stood at
around 3,600 in early 1994. By 1999, it had passed 11,000, more than
tripling in five years, a total increase in stock market prices of over
200%. At the start of 2000, the Dow passed 11,700.
However, over the same period, basic economic indicators did
not come close to tripling. U.S. personal income and gross domestic product rose less than 30%, and almost half of this increase was
due to inflation. Corporate profits rose less than 60%, and that from
a temporary recession-depressed base. Viewed in the light of these
figures, the stock price increase appears unwarranted and, certainly
by historical standards, unlikely to persist.
Large stock price increases have occurred in many other countries
at the same time. In Europe, between 1994 and 1999 the stock
market valuations of France, Germany, Italy, Spain, and the United
Kingdom roughly doubled. The stock market valuations of Canada,
too, just about doubled, and those of Australia increased by half.
TH E STO CK MA RK ET LEV EL IN H ISTO RICA L PERSPECTIV E
5
In the course of 1999, stock markets in Asia (Hong Kong, Indonesia, Japan, Malaysia, Singapore, and South Korea) and Latin America (Brazil, Chile, and Mexico) have made spectacular gains. But no
other country of comparable size has had so large an increase since
1994 as that seen in the United States.
Price increases in single-family homes have also occurred over
the same time, but significant increases have occurred in only a few
cities. Between 1994 and 1999 the total average real price increase
of homes in ten major U.S. cities was only 9%. These price increases
are tiny relative to the increase in the U.S. stock market.1
The extraordinary recent levels of U.S. stock prices, and associated expectations that these levels will be sustained or surpassed
in the near future, present some important questions. We need to
know whether the current period of high stock market pricing is
like the other historical periods of high pricing, that is, whether it
will be followed by poor or negative performance in coming years.
We need to know confidently whether the increase that brought
us here is indeed a speculative bubble—an unsustainable increase
in prices brought on by investors’ buying behavior rather than by
genuine, fundamental information about value. In short, we need
to know if the value investors have imputed to the market is not
really there, so that we can readjust our planning and thinking.
A Look at the Data
Figure 1.1 shows, for the United States, the monthly real (corrected for inflation using the Consumer Price Index) Standard and
Poor’s (S&P) Composite Stock Price Index from January 1871
through January 2000 (upper curve), along with the corresponding series of real S&P Composite earnings (lower curve) for the same
years.2 This figure allows us to get a truly long-term perspective
on the U.S. stock market’s recent levels. We can see how differently
the market has behaved recently as compared with the past. We
see that the market has been heading up fairly uniformly ever since
it bottomed out in July 1982. It is clearly the most dramatic bull market in U.S. history. The spiking of prices in the years 1992 through
2000 has been most remarkable: the price index looks like a rocket
6
THE S TOCK M AR KET LEV EL I N HISTORI CA L PERSPECT IV E
Real S&P Composite Stock Price Index
Real S&P Composite earnings
Figure 1.1
Stock Prices and Earnings, 1871–2000
Real (inflation-corrected) S&P Composite Stock Price Index, monthly, January 1871 through January 2000 (upper series), and real S&P Composite earnings (lower series), January 1871 to September 1999. Source: Author’s
calculations using data from S&P Statistical Service; U.S. Bureau of Labor
Statistics; Cowles and associates, Common Stock Indexes; and Warren and Pearson, Gold and Prices. See also note 2.
taking off through the top of the chart! This largest stock market
boom ever may be referred to as the millennium boom.3
Yet this dramatic increase in prices since 1982 is not matched in
real earnings growth. Looking at the figure, no such spike in earnings growth occurs in recent years. Earnings in fact seem to be oscillating around a slow, steady growth path that has persisted for over
a century.
No price action quite like this has ever happened before in U.S.
stock market history. There was of course the famous stock runup of the 1920s, culminating in the 1929 crash. Figure 1.1 reveals
this boom as a cusp-shaped price pattern for those years. If one
TH E STO CK MA RK ET LEV EL IN H ISTO RICA L PERSPECTIV E
7
corrects for the market’s smaller scale then, one recognizes that this
episode in the 1920s does resemble somewhat the recent stock market increase, but it is the only historical episode that comes even
close to being comparable to the present boom.
There was also a dramatic run-up in the late 1950s and early
1960s, culminating in a flat period for half a decade that was followed by the 1973–74 stock market debacle. But the price increase
during this boom was certainly less dramatic than today’s.
8
THE S TOCK M AR KET LEV EL I N HISTORI CA L PERSPECT IV E
Price-earnings ratio
Price Relative to Earnings
Part of the explanation for the remarkable price behavior between
1990 and 2000 may have to do with somewhat unusual earnings.
Many observers have remarked that earnings growth in the fiveyear period ending in 1997 was extraordinary: real S&P Composite earnings more than doubled over this interval, and such
a rapid five-year growth of real earnings has not occurred for
nearly half a century. But 1992 marked the end of a recession during which earnings were temporarily depressed. Similar increases
in earnings growth have happened before following periods of
depressed earnings from recession or depression. In fact, there was
more than a quadrupling of real earnings from 1921 to 1926 as the
economy emerged from the severe recession of 1921 into the prosperous Roaring Twenties. Real earnings doubled during five-year
periods following the depression of the 1890s, the Great Depression of the 1930s, and World War II.
Figure 1.2 shows the price-earnings ratio, that is, the real (inflationcorrected) S&P Composite Index divided by the ten-year moving
average real earnings on the index. The dates shown are monthly,
January 1881 to January 2000. The price-earnings ratio is a measure
of how expensive the market is relative to an objective measure of
the ability of corporations to earn profits. I use the ten-year average of real earnings for the denominator, along lines proposed by
Benjamin Graham and David Dodd in 1934. The ten-year average
smooths out such events as the temporary burst of earnings during World War I, the temporary decline in earnings during World
War II, or the frequent boosts and declines that we see due to the
business cycle.4 Note again that there is an enormous spike after
Figure 1.2
Price-Earnings Ratio, 1881–2000
Price-earnings ratio, monthly, January 1881 to January 2000. Numerator:
real (inflation-corrected) S&P Composite Stock Price Index, January. Denominator: moving average over preceding ten years of real S&P Composite earnings. Years of peaks are indicated. Source: Author’s calculations using data
from sources given in Figure 1.1. See also note 2.
1997, when the ratio rises until it hits 44.3 by January 2000. Priceearnings ratios by this measure have never been so high. The
closest parallel is September 1929, when the ratio hit 32.6.
In the latest data on earnings, earnings are quite high in comparison
with the Graham and Dodd measure of long-run earnings, but nothing here is startlingly out of the ordinary. What is extraordinary today
is the behavior of price (as also seen in Figure 1.1), not earnings.
Other Periods of High Price Relative to Earnings
There have been three other times when the price-earnings ratio as
shown in Figure 1.2 attained high values, though never as high as
TH E STO CK MA RK ET LEV EL IN H ISTO RICA L PERSPECTIV E
9
the 2000 value. The first time was in June 1901, when the priceearnings ratio reached a high of 25.2 (see Figure 1.2). This might
be called the “Twentieth Century Peak,” since it came around the
time of the celebration of this century. (The advent of the twentieth
century was celebrated on January 1, 1901, not January 1, 1900.) 5
This peak occurred as the aftermath of a doubling of real earnings
within five years, following the U.S. economy’s emergence from
the depression of the 1890s.6 The 1901 peak in the price-earnings
ratio occurred after a sudden spike in the price-earnings ratio, which
took place between July 1900 and June 1901, an increase of 43%
within eleven months. A turn-of-the-century optimism, associated with expansion talk about a prosperous and high-tech future,
appeared.
After 1901, there was no pronounced immediate downtrend in
real prices, but for the next decade prices bounced around or just
below the 1901 level and then fell. By June 1920, the stock market
had lost 67% of its June 1901 real value. The average real return
in the stock market (including dividends) was 3.4% a year in the
five years following June 1901, barely above the real interest rate.
The average real return (including dividends) was 4.4% a year in
the ten years following June 1901, 3.1% a year in the fifteen years
following June 1901, and –0.2% a year in the twenty years following
June 1901.7 These are lower returns than we generally expect from
the stock market, though had one held on into the 1920s, returns
would have improved dramatically.
The second instance of a high price-earnings ratio occurred in
September 1929, the high point of the market in the 1920s and the
second-highest ratio of all time. After the spectacular bull market
of the 1920s, the ratio attained a value of 32.6. As we all know, the
market tumbled from this high, with a real drop in the S&P Index
of 80.6% by June 1932. The decline in real value was profound and
long-lasting. The real S&P Composite Index did not return to its
September 1929 value until December 1958. The average real return
in the stock market (including dividends) was –13.1% a year for
the five years following September 1929, –1.4% a year for the next
ten years, –0.5% a year for the next fifteen years, and 0.4% a year
for the next twenty years.8
10
THE S TOCK M AR KET LEV EL I N HISTORI CA L PERSPECT IV E
The third instance of a high price-earnings ratio occurred in January 1966, when the price-earnings ratio as shown in Figure 1.2
reached a local maximum of 24.1. We might call this the “KennedyJohnson Peak,” drawing as it did on the prestige and charisma of
President John Kennedy and the help of his vice-president and
successor Lyndon Johnson. This peak came after a dramatic bull
market and after a five-year price surge, from May 1960, of 46%.
This surge, which took the price-earnings ratio to its local maximum, corresponded to a surge in earnings of 53%. The market
reacted to this earnings growth as if it expected the growth to continue, but of course it did not. Real earnings increased little in the
next decade. Real prices bounced around near their January 1966
peak, surpassing it somewhat in 1968 but then falling back, and real
stock prices were down 56% from their January 1966 value by
December 1974. Real stock prices would not be back up to the January 1966 level until May 1992. The average real return in the stock
market (including dividends) was –2.6% a year for the five years following January 1966, –1.8% a year for the next ten years, –0.5% a year
for the next fifteen years, and 1.9% a year for the next twenty years.
A Historical Relation between Price-Earnings Ratios
and Subsequent Long-Term Returns
Figure 1.3 is a scatter diagram showing, for January of each year
1881 to 1989, on the horizontal axis, the price-earnings ratio for that
month, and, on the vertical axis, the annualized real (inflationcorrected) stock market return over the ten years following that
month. This scatter diagram allows us to see visually how well the
price-earnings ratio forecasts subsequent long-term (ten-year)
returns. Only January data are shown: if all twelve months of
each year were shown there would be so many points that the scatter would be unreadable. The downside of this plotting method,
of course, is that by showing only January data we miss most of
the peaks and troughs of the market. For example, we miss the peak
of the market in 1929 and also miss the negative returns that followed it. The price-earnings ratio shown in Figure 1.3 is the same
as that plotted in Figure 1.2. Each year is indicated by the last two
TH E STO CK MA RK ET LEV EL IN H ISTO RICA L PERSPECTIV E
11
Figure 1.3
Price-Earnings Ratio as Predictor of Ten-Year Returns
Scatter diagram of annualized ten-year returns against price-earnings ratios.
Horizontal axis shows the price-earnings ratio (as plotted in Figure 1.2) for
January of the year indicated, dropping the 19 from twentieth-century years
and dropping the 18 from nineteenth-century years and adding an asterisk
(*). Vertical axis shows the geometric average real annual return per year on
investing in the S&P Composite Index in January of the year shown, reinvesting
dividends, and selling ten years later. Source: Author’s calculations using data
from sources given in Figure 1.1. See also note 2.
digits of the year number; years from the nineteenth century are
indicated by an asterisk (*).
Figure 1.3 shows how the price-earnings ratio has forecast
returns, since each price-earnings ratio shown on the horizontal
axis was known at the beginning of the ten-year period. This scatter diagram was developed by fellow economist John Campbell
and me. Plots like it, for various countries, were the centerpiece of
our testimony before the board of governors of the Federal Reserve
on December 3, 1996.9
12
THE S TOCK M AR KET LEV EL I N HISTORI CA L PERSPECT IV E
The swarm of points in the scatter shows a definite tilt, sloping
down from the upper left to the lower right. The scatter shows that
in some years near the left of the scatter (such as January 1920, January 1949, or January 1982) subsequent long-term returns have been
very high. In some years near the right of the scatter (such as January 1929, January 1937, or January 1966) subsequent returns
have been very low. There are also some important exceptions, such
as January 1899, which still managed to have subsequent tenyear returns as high as 5.5% a year despite a high price-earnings
ratio of 22.9, and January 1922, which managed to have subsequent
ten-year returns of only 8.7% a year despite a low price-earnings
ratio of 7.4. But the point of this scatter diagram is that, as a rule
and on average, years with low price-earnings ratios have been followed by high returns, and years with high price-earnings ratios
have been followed by low or negative returns.
The relation between price-earnings ratios and subsequent
returns appears to be moderately strong, though there are questions about its statistical significance, since there are only about
twelve nonoverlapping ten-year intervals in the 119 years’ worth
of data. There has been substantial academic debate about the statistical significance of relationships like this one, and some difficult questions of statistical methodology are still being addressed.
We believe, however, that the relation should be regarded as
statistically significant.10 Our confidence in the relation derives
partly from the fact that analogous relations appear to hold for other
countries and for individual stocks. Figure 1.3 confirms that longterm investors—investors who can commit their money to an
investment for ten full years—do well when prices were low relative to earnings at the beginning of the ten years and do poorly
when prices were high at the beginning of the ten years. Long-term
investors would be well advised, individually, to stay mostly out
of the market when it is high, as it is today, and get into the market when it is low.11
The recent values of the price-earnings ratio, well over 40, are far
outside the historical range of price-earnings ratios. If one were to
locate such a price-earnings ratio on the horizontal axis, it would
TH E STO CK MA RK ET LEV EL IN H ISTO RICA L PERSPECTIV E
13
be off the chart altogether. It is a matter of judgment to say, from
the data shown in Figure 1.3, what predicted return the relationship suggests over the succeeding ten years; the answer depends
on whether one fits a straight line or a curve to the scatter, and since
the 2000 price-earnings ratio is outside the historical range, the shape
of the curve can matter a lot. Suffice it to say that the diagram suggests substantially negative returns, on average, for the next ten
years.
Part of the reason to suspect that the relation shown in Figure 1.3
is real is that, historically, when price was high relative to earnings
as computed here (using a ten-year moving average of earnings),
the return in terms of dividends has been low, and when price
was low relative to earnings, the return in terms of dividends has
been high.12 The recent record-high price-earnings ratios have been
matched by record-low dividend yields. In January 2000, S&P
dividends were 1.2% of price, far below the 4.7% that is the historical average. It is natural to suppose that when one is getting
so much lower dividends from the shares one owns, one ought to
expect to earn lower investing returns overall. The dividend is, after
all, part of the total return one gets from holding stocks (the other
part being the capital gain), and dividends historically represent
the dominant part of the average return on stocks. The reliable
return attributable to dividends, not the less predictable portion
arising from capital gains, is the main reason why stocks have on
average been such good investments historically.
Returns from holding stocks must therefore be low when dividends are low—unless low dividends themselves are somehow
predictors of stock market price increases, so that one can at times
of low dividends actually expect stock price to rise more than usual
to offset the effects of the low dividends on returns. As a matter
of historical fact, times when dividends have been low relative to
stock prices have not tended to be followed by higher stock price
increases in the subsequent five or ten years. Quite to the contrary:
times of low dividends relative to stock price in the stock market
as a whole tend to be followed by price decreases (or smaller than
usual increases) over long horizons, and so returns tend to take a
14
THE S TOCK M AR KET LEV EL I N HISTORI CA L PERSPECT IV E
double hit at such times, from both low dividend yields and price
decreases. Thus the simple wisdom—that when one is not getting
much in dividends relative to the price one pays for stocks it is not
a good time to buy stocks—turns out to have been right historically.
Worries about Irrational Exuberance
The news media have tired of describing the high levels of the
market, and discussion of it is usually omitted from considerations
of market outlook. And yet, deep down, people know that the market is highly priced, and they are uncomfortable about this fact.
Most people I meet, from all walks of life, are puzzled over the
apparently high levels of the stock market. We are unsure whether
the market levels make any sense, or whether they are indeed the
result of some human tendency that might be called irrational exuberance. We are unsure whether the high levels of the stock market
might reflect unjustified optimism, an optimism that might pervade
our thinking and affect many of our life decisions. We are unsure
what to make of any sudden market correction, wondering if the
previous market psychology will return.
Even Alan Greenspan seems unsure. He made his “irrational exuberance” speech two days after I had testified before him and the
Federal Reserve Board that market levels were irrational, but a mere
seven months later he reportedly took an optimistic “new era” position on the economy and the stock market. In fact, Greenspan
has always been very cautious in his public statements, and he has
not committed himself to either view. A modern version of the
prophets who spoke in riddles, Greenspan likes to pose questions
rather than make pronouncements. In the public exegesis of his
remarks, it is often forgotten that, when it comes to such questions,
even he does not know the answers.
Part One
Structural Factors
Two
Precipitating Factors: The Internet,
the Baby Boom, and Other Events
I
f the growth of the economy
does not in itself justify the
increase in the value of the stock market since 1982, then what has
changed since 1982 to cause the market to climb? What precipitating
factors started this remarkable surge? What, in particular, has
happened since July 1997, when the price-earnings ratio passed
above its former record high, set in September 1929, and then
proceeded to move up by yet another third by the start of 2000?
To answer these questions, it is not enough to say that the markets
in general are vulnerable to irrational exuberance. We must specify
what has changed to cause the market to behave so differently from
other times.
Most historical events, from wars through revolutions, do not
have simple causes. When these events move in extreme directions,
as price-earnings ratios have in the recent stock market, it is usually because of a confluence of factors, none of which is by itself
large enough to explain these events.
Rome wasn’t built in a day, nor was it destroyed by one sudden
bolt of bad fortune. More likely, it owed its fall to a plurality of
factors—some large and some small, some remote and some
17
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STRU CTU RA L FACTO RS
immediate—that conspired together. This ambiguity is unsatisfying
to those of us seeking scientific certitude, especially given that it
is so hard to identify and isolate the precipitating factors to begin
with. But that is the nature of history, and such ambiguity justifies
the constant search for new and better information to expose at least
the overall contours of causation.
Recognizing these limitations, let us look at a list of factors—
twelve of them—that may help explain the present speculative market. These factors make up the skin of the bubble, if you will. I
concentrate here mostly on factors that have had an effect on the market
that is not warranted by rational analysis of economic fundamentals. The
list omits consideration of all the small variations in fundamental
factors (e.g., the growth in earnings, the change in real interest rates)
that should rationally have an impact on financial markets. In more
normal times or in markets for individual stocks, such rational factors would assume relatively greater prominence in any discussion
of changes in prices. Indeed it is thanks to a market’s ability to
respond appropriately to such factors, for a variety of investments, that well-functioning financial markets generally promote,
rather than hinder, economic efficiency.1 The list of factors here was
constructed specifically to help us understand the extraordinary
recent situation in the stock market, and so it concentrates on less
rational influences.
In detailing these twelve factors, I describe the reaction of the
general public, not just of professional investment managers.
Some observers believe that professional investment managers are
more sensible and work to offset the irrational exuberance of the nonprofessional investing public. Therefore these observers might
argue that a sharp distinction should be drawn between the behavior of the professionals and the nonprofessionals.2 Professional
investors, however, are not immune from the effects of the popular investing culture that we observe in individual investors, and
many of the factors described here no doubt influence their thinking as well. There is in fact no clear distinction between professional
institutional investors and individual investors, since the professionals routinely give advice to the individual investors.
PRECI PI TATI NG FAC TORS
19
Some of these factors exist in the background of the market,
including the revolution in information technology, a linking of
patriotic feeling with supposed “victory” over foreign economic
rivals, increased emphasis on business success, the political shift
in support of business, the demographics of the Baby Boom, the
decline of inflation and the economics of money illusion, and the
rise of gambling and pleasure in risk taking in general. Others operate in the foreground and shape the changing culture of investment. These include greatly increased media coverage of business,
the aggressively optimistic forecasts of stock analysts, the rise of
401(k) plans, the mutual funds explosion, and the expanding volume of trade.
Despite their varied origins, these twelve factors have something
in common: they have contributed to the self-fulfilling psychology
of a roaring stock market. It is this self-fulfilling psychology that—
at least for now—binds the bubble.
The Arrival of the Internet at a
Time of Solid Earnings Growth
The Internet and the World Wide Web have invaded our homes
during the second half of the 1990s, making us intimately conscious
of the pace of technological change. The World Wide Web first
appeared in the news in November 1993. The Mosaic Web browser
first became available to the public in February 1994. These dates
mark the very beginning of the World Wide Web, when only a
few people had access to it. Large numbers of users did not discover the Web until 1997 and later, marking the very years when
the NASDAQ stock price index (which is heavily weighted toward
high-tech stocks) soared, tripling to the beginning of 2000, and priceearnings ratios took off into unprecedented territory.
Internet technology is unusual in that it is a source of entertainment and preoccupation for us all, indeed for the whole family. In this sense, it is comparable in importance to the personal
computer or, before that, to television. In fact, the impression it
conveys of a changed future is even more vivid than that produced
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STRU CTU RA L FACTO RS
when televisions or personal computers entered the home. Using
the Internet gives people a sense of mastery of the world. They can
electronically roam the world and accomplish tasks that would have
been impossible before. They can even put up a Web site and
become a factor in the world economy themselves in previously
unimaginable ways. In contrast, the advent of television made them
passive receivers of entertainment, and personal computers were
used by most people before the Internet mainly as typewriters and
high-tech pinball machines.
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. Most of us simply do not hear much about
research in those areas.
Spectacular U.S. corporate earnings growth in 1994, up 36% in
real terms as measured by the S&P Composite real earnings, followed by real earnings growth of 8% in 1995 and 10% in 1996, coincided roughly with the Internet’s birth but in fact had little to do
with the Internet. Instead the earnings growth was attributed by
analysts to a continuation of the slow recovery from the 1990–91
recession, coupled with a weak dollar and strong foreign demand
for U.S. capital and technology exports, as well as cost-cutting initiatives by U.S. companies. 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, and indeed they still are not.
But the occurrence of profit growth coincident with the appearance
of a new technology as dramatic as the Internet can easily create
an impression among the general public that the two events are
somehow connected. Publicity linking these twin factors was
especially strong with the advent of the new millennium—a time
of much optimistic discussion of the future.
The Internet is, of course, an important technological advance
in its own right, and it, as well as other developments in computer
technology and robotics, does promise to have an unpredictable
and powerful impact on our future. But we may question what
PRECI PI TATI NG FAC TORS
21
impact the Internet and the computer revolution should have on
the valuation of existing corporations. New technology will always
have an impact on 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?3 Should the advent
of the Internet raise the valuation of the Dow Jones Industrial
Average—which until very recently contained no Internet stocks?4
The notion that existing companies will benefit from the Internet revolution is belied by the stories of E*Trade.com, Amazon.com,
and other upstarts, who did not even exist just a few years ago. Still
more new companies will appear in the future, in the United
States and abroad, and these will compete with the companies in
which we invest today. Simply put, the effect of new technology
on existing companies could go either way: it could boost or
depress their profits.
What matters for a stock market boom is not, however, the
reality of the Internet revolution, which is hard to discern, but rather
the public impressions that the revolution creates. 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.
Triumphalism and the Decline of Foreign Economic Rivals
Since the end of the cold war most other countries have seemed to
be imitating the Western economic system. Communist China has
been embracing market forces since the late 1970s. Increasing tolerance of free markets within the Soviet Union culminated with the
breakup of that nation in 1991 into smaller, market-oriented states.
The world seems to be swinging our way, and therefore it starts to
seem only natural that confidence in the premier capitalist system
would translate into confidence in the market, and that the U.S. stock
market should be the most highly valued in the world.
These political events have unfolded gradually since the bull market began in 1982. The intervening years have also seen the decline
in the Japanese market after 1989, the prolonged economic slump
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STRU CTU RA L FACTO RS
in Japan, and the Asian financial crisis of 1997–98, which coincided
roughly with the dramatic burst of the U.S. stock market into
uncharted territory at the end of the millennium. These foreign
events might have been viewed as ominous developments for
the U.S. stock market, as the harbinger of what bad things could
happen here, but instead they were seen by many as the weakening
of major rivals. The relation between the United States and its economic rivals is often described in the media as a competition in
which there can only be one winner, as in a sports event. The
weakening of a rival is thus viewed simplistically, as good news.
The triumphalism is associated with patriotic feeling. Of course,
patriotic self-congratulation has long been in evidence in discussions of the stock market. In the 1990s Merrill Lynch used the
slogan “We’re Bullish on America.” In the 1950s, the New York
Stock Exchange used the slogan “Take Stock in America.” Popular slogans during the bull market of the 1920s were “Be a Bull
on America” and “Never Sell the United States Short.” But while
such patriotic associations have long been with us, the associations
assume more prominence after a perceived economic victory.
Extensive public discussion of perennial economic problems,
which we may hear after the country feels humbled by failures,
seems out of bounds after a triumph.
Cultural Changes Favoring Business
Success or the Appearance Thereof
The bull market has been accompanied by a significant rise in materialistic values. A Roper-Starch questionnaire survey in both 1975
and 1994 asked, “When you think of the good life—the life you’d
like to have, which of the things on this list, if any, are part of that
good life, as far as you personally are concerned?” In 1975, 38%
picked “a lot of money,” whereas in 1994 fully 63% did.5
Materialistic values do not by themselves have any logical bearing on the level of the stock market. Whether or not people are materialistic, it is still reasonable to expect them to save for the future
and to seek out the best vehicles for their savings. But it is plausible that such feelings would influence their demand for stocks,
PRECI PI TATI NG FAC TORS
23
which have long held out at least the possibility of amassing substantial and quick riches. Such feelings have transformed our culture into one that reveres the successful businessperson as much
as or even more than the accomplished scientist, artist, or revolutionary. The idea that investing in stocks is a road to quick riches
has a certain appeal to born-again materialists.
In the late 1980s and early 1990s, downsizing (the movement to
release surplus staff and the consequent decline in job security) led
to a change in the way people viewed their lives. The experience
of being laid off, or at least of knowing others who had been, was
often viewed as a violation of an implicit pact of loyalty between
employee and employer. Such an experience encouraged workers
to take control of their own lives and to rely less on employers, to
become in effect economic entities unto themselves, rather than
parts of a larger economic organization.
Labor unions have long been in decline: the fraction of wage and
salary workers who were union members fell to 13.9% in 1998,
down from 20.1% in 1983.6 The reasons for the decline are controversial, but a key factor appears to be an erosion of solidarity
and loyalty among workers, an attitude that has come to be replaced by an individual business-success ethic. By pursuing
speculative investments, people in effect create for themselves a
second job—one where they are, at last, their own boss. And in
many cases it is a job that seems to provide a source of income—
income derived from one’s direct interaction with the world at large,
not as part of an organization.
Firms have tilted their compensation packages for management away from fixed salaries toward participation, as investors,
in the firm. By 1998, employee stock options had reached 6.2% of
the outstanding shares in a sample of 144 of the largest S&P 500
firms.7 With such options—which hold out the promise of substantial wealth if the stock price rises above the exercise price of
the options—management has an incentive to do everything they
can to boost share prices. They have an incentive to maintain an
appearance of corporate success, an image of the company as working toward a brilliant future. They have an incentive to undertake
corporate initiatives whenever they think the market will respond
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STRU CTU RA L FACTO RS
to them, even if they themselves are doubtful of the value of these
initiatives. For example, managers the world over have of late been
scratching their heads to figure out how they can redefine their firms
as Internet companies because of the high market valuation such companies currently enjoy. This headlong rush to achieve dot-com status may lead them to undertake new and costly Internet-related
investments with little concern for their long-run consequences.
Managers holding incentive options also have an unusual incentive to substitute share repurchases for a portion of the dividend
payout, since the direct effect of such a substitution is to increase
the value of the managers’ options. Between 1994 and 1998, the 144
firms mentioned earlier repurchased on average 1.9% of their outstanding shares each year, more than offsetting the 0.9% of shares
issued per year, largely to meet the exercise of employee options.8
This level of substituting share repurchasing for dividends alone
should have boosted share prices by a few percentage points.9
A Republican Congress and Capital Gains Tax Cuts
When Ronald Reagan was elected in 1980, so too was a Republican Senate, the first since 1948. In 1994, the House went to the
Republicans as well. Sensing the changed public attitudes that had
elected them, these lawmakers were much more pro-business
than their Democratic predecessors. This change in Congress has
boosted public confidence in the stock market, because of a variety
of controls that the legislature can exert over corporate profits
and investor returns.
Consider taxation. No sooner had the Republican Congress been
seated in 1995 than proposals to cut the capital gains tax became
prominent. In 1997, the top capital gains tax rate was cut from 28%
to 20%. After this cut had been enacted, Congress talked of cutting
rates further. A 1999 tax bill would have cut capital gains taxes still
further, had President Clinton not vetoed it.
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
PRECI PI TATI NG FAC TORS
25
them, until after the capital gains tax cut. This had a strengthening effect on the market. At the time of the 1997 capital gains tax
cut, there was fear that investors who had been waiting to sell would
do so and bring the market down, as had apparently happened after
capital gains tax cuts in 1978 and 1980. But this did not happen in
1997. Of course, many investors must have thought there could be
an even more favorable capital gains tax rate in their future, and
if so there would have been no reason to sell right after the 1997
cut took effect.
It is likely that the general atmosphere of public talk of future
capital gains tax cuts, of possible indexing of capital gains taxes
to inflation, and of analogous tax cuts such as estate tax cuts has
created among investors a reluctance to sell their appreciated
stocks. If capital gains tax rates may be cut sharply in the future,
why sell when the rates are as high as 20%? Having been advised
by experts to wait and see about capital gains tax cuts, many
investors could be expected to defer sales of appreciated assets until
we are more clearly at a historic low in capital gains tax rates. Such
an atmosphere of holding, not folding, naturally places upward
pressure on stock prices.
The Baby Boom and Its Perceived Effects on the Market
Following World War II, there was a substantial increase in the birth
rate in the United States. Peacetime prosperity encouraged those
who had postponed families because of the depression and the war
to have children. There were also postwar birth rate increases in
the United Kingdom, France, and Japan, but they were not as
protracted or strong as that in the United States, no doubt at least
in part because the economies of those nations were in such disarray after the war. Then, around 1966, the growth of U.S. and world
population showed a dramatic decline, one that continues to this
day. This decline was unusual, if not unique, by historical standards:
it did not occur because of famine or war, but rather because of an
endogenous decline in the fertility rate.10
Advances in birth control technology (the pill was invented in
1959 and became widely available by the mid-1960s in the United
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STRU CTU RA L FACTO RS
States and many other countries) and social changes that accepted
the legality of contraception and abortion were instrumental in lowering the rate of population growth, as were growing urbanization
and advances in education and economic aspiration levels. Now
the Baby Boom and the subsequent Baby Bust have created a
looming social security crisis in many countries of the world:
when the Boomers grow old and finally retire, the number of young
working people available to support the elderly population will
decline worldwide.11
The Baby Boom in the United States was marked by very high
birth rates during the years 1946–66, and so there are in the year
2000 (and will be for some time) an unusually large number of
people between the ages of 35 and 55. Two theories suggest that
the presence of so many middle-aged people ought to boost today’s stock market. One theory justifies the high price-earnings
ratios we see today as the result of those Boomers’ competing
against each other to buy stocks to save for their eventual retirement and bidding share prices up relative to the earnings they generate. According to the other theory, it is spending on current
goods and services that boosts stocks, through a generalized positive effect on the economy: high expenditures mean high profits
for companies.
These simple Baby Boom stories are just a bit too simple. For one
thing, they neglect to consider when the Baby Boom should affect
the stock market. Maybe the effect of the Baby Boom has already
been factored into stock prices by investors. They also neglect such
factors as the emergence of new capitalist economies worldwide
and their demand, in another twenty years, for U.S. stocks. The
theory that the Baby Boom drives the market up owing to Boomers’
demand for goods would seem to imply that the market is high
because earnings are high; it would not explain today’s high priceearnings ratios.
If life-cycle savings patterns (the first effect) alone were to be the
dominant force in the markets for savings vehicles, there would
tend to be strong correlations in price behavior across alternative
asset classes, and strong correlations over time between asset prices
and demographics. When the most numerous generation feels
PRECI PI TATI NG FAC TORS
27
they need to save, they would tend to bid up all savings vehicles:
stocks, bonds, and real estate. When the most numerous generation feels they need to draw down their savings, their selling would
tend to force down the prices of all these vehicles. But when one
looks at long-term data on stocks, bonds, and real estate, one finds
that there has in fact been very little relation between their real values.12 Possibly these differences across asset classes could still be
reconciled with a Baby Boom theory, by postulating that people
in different age groups have different attitudes toward risk because
of age-related differences in risk tolerance, that the stock market is
relatively high now because the numerous people in their forties
today are naturally less risk averse than older people. But such a
theory has never been carefully worked out or shown to explain
relative price movements. It is also noteworthy that the personal
savings rate in the United States has recently been nearly zero, not
significantly positive, as the life-cycle theory might suggest. Of
course, one might argue that were it not for the Baby Boom, the
effect of the high stock market would have been to make savings,
as measured, strongly negative, since the capital gains on stocks
would be considered income not included in the national income,
income that people could normally be expected to spend from.13
Another theory as to why Boomers may be less risk averse is that
the Boomers, who have no memory of the Great Depression of the
1930s or of World War II, have less anxiety about the market and
the world. There is indeed some evidence that shared experiences
in formative years leave a mark forever on a generation’s attitudes.14
Over the course of the bull market since 1982, Boomers have gradually replaced as prime investors those who were teens or young
adults during the depression and the war.
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 are most
responsible for the surge in the market. The impact of the Baby
Boom is one of the most talked-about issues relating to the stock
market, and all this talk in and of itself has the potential to affect
stock market value. People believe that the Baby Boom represents
an important source of strength for the market today, and they do
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not see this strength faltering any time soon. These public perceptions contribute to a feeling that there is a good reason for the
market to be high and a confidence that it will stay that way for
some time to come. Congratulating themselves on their cleverness
in understanding and betting on these population trends in their
stock market investments, many investors fail to appreciate just how
common their thinking really is. Their perceptions fuel the continuing upward spiral in market valuations.
The most prominent exponent of the Baby Boom theory of the
stock market has been Harry S. Dent. He began with a 1992 book
entitled The Great Boom Ahead: Your Comprehensive Guide to Personal
and Business Profit in the New Era of Prosperity, which was so successful that he has written several sequels. His 1998 book, The Roaring 2000s: Building the Wealth & Lifestyle You Desire in the Greatest
Boom in History, was on the New York Times best-seller list for four
weeks in 1998. His 1999 book, The Roaring 2000s Investor: Strategies
for the Life You Want, is as of this writing ranked within the top 100
in sales among all books according to Amazon.com. This book predicts that the stock market will continue to boom until 2009, when
the number of people who are 46 starts to decline, and then the market will drop.
Dent’s success with the Baby Boom theme has predictably
spawned a number of imitators—all extolling the wonderful
opportunities now to get rich in the stock market—with titles like
Boomernomics: The Future of Your Money in the Upcoming Generational
Warfare by William Sterling and Stephen Waite (1998) and Boom, Bust
& Echo: How to Profit from the Coming Demographic Shift by David
K. Foot and Daniel Stoffman (1996). Discussions of the Baby Boom
and its effects on the stock market are everywhere, and their general tone is that the Boom is good for the stock market now and
will be for years to come.
An Expansion in Media Reporting of Business News
The first all-news television station, the Cable News Network
(CNN), appeared in 1980 and gradually grew, with viewership
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29
boosted by such events as the Gulf War in 1991 and the O. J.
Simpson trial in 1995, both stories that fueled great demand for uninterrupted coverage. The public acquired the habit of watching
the news on television throughout the day (and night), not simply
at the dinner hour. CNN was followed by the business networks.
The Financial News Network, founded in 1983, was later absorbed
into CNBC. Then came CNNfn and Bloomberg Television. Together,
these networks produced an uninterrupted stream of financial
news, much of it devoted to the stock market. So pervasive was their
influence that traditional brokerage firms found it necessary to keep
CNBC running in the lower corners of their brokers’ computer
screens. So many clients would call to ask about something they
had just heard on the networks that brokers (who were supposed
to be too busy working to watch television!) began to seem behind
the curve.
Not merely the scope but also the nature of business reporting
has changed in recent years. According to a study by Richard
Parker, a senior fellow at Harvard University’s Shorenstein Center, newspapers in the past twenty years have transformed their
formerly staid business sections into enhanced “Money” sections,
which dispense useful tips about personal investing. Articles
about individual corporations that used to be written as if they
would be of interest only to those involved in the industry or the
corporations themselves now are written with a slant toward profit
opportunities for individual investors. Articles about corporations
regularly include analysts’ opinions of the implications of the
news for investors.15
Such enhanced business reporting leads to increased demand
for stocks, just as advertisements for a consumer product make
people more familiar with the product, remind them of the option
to buy, and ultimately motivate them to buy. Most advertising is
really not the presentation of important facts about the product but
merely a reminder of the product and its image. Given the heightened media coverage of investments, a stock market boom should
come as no greater surprise than increased sales of the latest sports
utility vehicle after a major ad campaign.
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Analysts’ Increasingly Optimistic Forecasts
According to data from Zacks Investment Research about analysts’
recommendations on some 6,000 companies, only 1.0% of recommendations were “sells” in late 1999 (while 69.5% were “buys” and
29.9% were “holds”). This situation stands in striking contrast to
that indicated by previous data. Ten years earlier, the fraction of
sells, at 9.1%, was nine times higher.16
Analysts are now reluctant to recommend that investors sell
anything. One reason often given for this reluctance is that a sell
recommendation might incur the wrath of the company involved.
Companies can retaliate by refusing to talk with analysts whom
they view as submitting negative reports, excluding them from
information sessions, and not offering them access to key executives as they prepare earnings forecasts. This situation represents
a change in the fundamental culture of the investment industry,
and in the tacit understanding that recommendations are as objective as the analyst can make them.
Another reason that many analysts are reluctant to issue sell recommendations is that an increasing number of them are employed
by firms that underwrite securities, and these firms do not want
their analysts to do anything that might jeopardize this lucrative
side of the business. Analysts affiliated with investment banks give
significantly more favorable recommendations on firms for which
their employer is the co- or lead underwriter than do unaffiliated
analysts, even though their earnings forecasts are not usually
stronger.17
Those who know the ropes realize that today’s hold recommendation is more like the sell recommendation of yesteryear. According to James Grant, a well-known market commentator, “Honesty
was never a profit center on Wall Street, but the brokers used to
keep up appearances. Now they have stopped pretending. More
than ever, securities research, as it is called, is a branch of sales.
Investor, beware.”18
Analysts’ recommendations have been transformed by something
analogous to grade inflation in our schools: C used to be an average grade, yet now it is considered as bordering on failure. Many
PRECI PI TATI NG FAC TORS
31
of us know that such inflation happens, and we try to correct for
it in interpreting our children’s grades. Similarly, in the market we
factor inflation into analysts’ recommendations. But not everyone
is going to make adequate corrections for analysts’ newly hyperbolic language, and so the general effect of their changed standards
will be to encourage the higher valuation of stocks.
Moreover, it is not just a change in the units of measurement that
infects analysts’ reports. Even their quantitative forecasts of earnings growth show an upward bias. According to a study by
Steven Sharpe of the Federal Reserve Board, analysts’ expectations
of growth in the S&P 500 earnings per share exceeded actual growth
in sixteen of the eighteen years between 1979 and 1996. The average difference between the projected and actual growth rate of
earnings was 9 percentage points. The analysts breezed through
both the steep recession of 1980–81 and the recession of 1990–91
making forecasts of earnings growth in the 10% range.19
This bias in analysts’ forecasts is a characteristic of their one-year
forecasts; they are usually more sober in predicting the next earnings announcement just before it is released. Analysts tend to
comply with firms’ wishes to see positive earnings surprises each
quarter, by issuing estimates that fall slightly short of the actual
number. Firms may, just before making earnings announcements,
talk with analysts whose forecasts are on the high side, urging them
down, while neglecting to talk with analysts whose forecasts are
on the low side, thereby creating a downward bias in the average
earnings forecast without being blatantly untruthful.20 Casual
evaluation of analysts’ forecasts by clients would most naturally
take the form of comparing the latest earnings announcement with
the latest forecast, and therefore analysts do not sharply overestimate earnings just before they are announced, which would be
an obvious embarrassment to them.
Analysts’ upward bias comes to the fore in predicting the vague,
undifferentiated future, not immediate quarterly or yearly outcomes.
And it is expectations for the vague, undifferentiated future, even
far beyond one-year forecasts, that lie behind the high market
valuations we see. Analysts have few worries about being uniformly
optimistic regarding the distant future; they have concluded that
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such generalized optimism is simply good for business. Certainly
they perceive that their fellow analysts are demonstrating such longrun optimism, and there is, after all, safety in numbers. Glibly and
routinely offering “great-outlook-for-the-U.S.” patter to the investing public, they perhaps give little thought to its accuracy.
The Expansion of Defined Contribution Pension Plans
Changes over time in the nature of employee pension plans have
encouraged people to learn about, and eventually accept, stocks
as investments. Although these changes do not technically favor
stocks over other investments for retirement, they have—by forcing people to make explicit choices among their retirement investments, choices that previously were made for them—worked in
the direction of encouraging investment in stocks. Making such
choices teaches people about stocks and increases their level of
familiarity with them.
The most revolutionary change in these institutions in the
United States has been the expansion of defined contribution pension plans at the expense of defined benefit plans. An important
milestone came in 1981, when the first 401(k) plan was created; it
was soon ratified by a landmark ruling by the Internal Revenue
Service.21 Prior to that date, employer pension plans had usually
been of the defined benefit type, in which the employer merely
promised a fixed pension to its employees when they retired.
Reserves to pay the defined benefit were managed by the employer.
With 401(k) plans (as well as such analogues as 403(b) plans),
employees are offered the opportunity to have contributions to a
tax-deferred retirement account deducted from their paychecks.
They then own the investments in their 401(k) accounts and must
allocate them among stocks, bonds, and money market accounts.
The tax law encourages employers to make matching contributions
to their employees’ 401(k) accounts, so there is a powerful incentive for employees to participate.
Various factors have also encouraged the growth of defined contribution pension plans since the bottom of the market in 1982. Labor
unions have traditionally sought defined benefit plans for their
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33
members as a way of ensuring their welfare in retirement, and the
decline of unions has meant diminishing support for these plans.
The importance of the manufacturing sector, long a stronghold of
labor unions and defined benefit pensions, has shrunk. Defined
benefit plans have also become less popular with management,
because so-called overfunded plans sometimes make companies
vulnerable to takeovers. Defined contribution plans are seen as less
costly to administer than defined benefit plans. Moreover, defined
contribution plans have become more popular with those employees who like to monitor their investments, and therefore companies have tended to offer the plans to all employees.
Through these tax incentives for participation in plans offering
choices between stocks and bonds, the government has forced working people to learn about the advantages of stocks versus bonds
or money market investments. Any incentive to learn about an
investment vehicle is likely to boost demand for it. In 1954, when
the New York Stock Exchange carried out a marketing study to
understand how to promote public interest in the stock market, it
concluded that most people did not know very much about stocks:
only 23% of the public even knew enough to define what a share
is. Moreover, the survey revealed a vague public distrust of the stock
market.22 So the exchange held a series of public information
seminars to try to remedy this lack of knowledge and this prejudice against stocks as an investment. But no set of seminars that
the exchange could ever afford could compare with the learningby-doing effects of the defined contribution plan in encouraging
public knowledge about and interest in stocks.
If one’s attention to the stock market is filtered through the lens
of a pension plan, it may encourage longer-term thinking. The stated
purpose of a 401(k) plan is to prepare for retirement, which is, for
most workers, many years away. A 401(k) plan sponsor does not
call participants with tips about short-run investment opportunities, and statements about portfolio value are mailed out only
infrequently. The participant cannot check his or her portfolio value
every day in the newspaper. This longer-term thinking may boost
stock market valuations by diverting investors from preoccupation with short-term fluctuations.
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Encouraging longer-term thinking among investors is probably,
all in all, a good thing. But an additional effect of 401(k) plans as
they are structured today may be to boost demand for stocks further through another psychological mechanism. By offering multiple stock market investment categories for employees to choose
among, employers can create demand for stocks. An effect of
categories on ultimate investment choices was demonstrated by
economists Shlomo Benartzi and Richard Thaler. They found,
using both experimental data and data on actual pension fund allocations, that people tend to spread their allocations evenly over the
available options, without regard to the contents of the options. For
example, if a 401(k) plan offers a choice of a stock fund and a bond
fund, many people will put 50% of their contributions into each.
If the plan instead offers a choice between a stock fund and a balanced fund (with, say, 50% stocks and 50% bonds in it) then
people will still tend to put 50% into each, even though they are
now really putting 75% of their portfolio into stocks.23
The options offered as part of 401(k) plans tend to be heavily
weighted in favor of stocks. In contrast, most 401(k) plans do not
have any real estate options; only one plan, that offered by TIAACREF, has an option for genuine, direct investment in real estate.
In this way the growth of 401(k) plans has encouraged the growth
of public interest in the stock market relative to the real estate
market. Indeed the typical 401(k) plan today offers choices among
a stock fund, a balanced fund (typically 60% stocks and 40% bonds),
company stock (investments in the employer itself), possibly a
specialized stock fund such as a growth fund, a bond fund, and a
money market fund, as well as fixed-income guaranteed investment
contracts. It is not surprising, from the findings of the Benartzi and
Thaler study, that people put proportionately more into the stock
funds, given that so many stock-related choices are laid out before
them. Moreover, since there are more interesting “flavors” of
stocks—just as, in the corner liquor store, there are more varieties
of wine than of vodka—more attention is likely to be drawn to them.
It is in such subtle ways that the interest value or curiosity value
of stocks, not any kind of rational decision-making process, encourages investors to want to buy more of them than they otherwise
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35
would. And this seemingly unconscious interest has helped bid up
the price of the stock market.
The Growth of Mutual Funds
The stock market boom has coincided with a peculiar growth spurt
in the mutual fund industry and a proliferation of advertising for
mutual funds. In 1982, at the beginning of the recent long-term bull
market, there were only 340 equity mutual funds in the United
States. By 1998, there were 3,513—more equity mutual funds than
stocks listed on the New York Stock Exchange. In 1982, there were
6.2 million equity mutual fund shareholder accounts in the United
States, about one for every ten U.S. families. By 1998, there were
119.8 million such shareholder accounts, or nearly two accounts
per family.24
Mutual funds are a new name for an old idea. Investment companies arose in the United States as early as the 1820s, though these
were not called mutual funds.25 The Massachusetts Investors
Trust, generally regarded as the first mutual fund, was created in
1924. It was different from the other investment trusts in that it published its portfolio, promised prudent investment policies, and was
self-liquidating when investors demanded cash for their investments. But this first mutual fund got off to a slow start: investors
were not quick to appreciate its advantages. The 1920s bull market instead saw the proliferation of many other investment trusts:
investment companies without the safeguards we associate with
mutual funds today, many of them dishonest operations and some
of them even, effectively, Ponzi schemes (see Chapter 3).
After the stock market crash of 1929, many of these became even
more worthless than the market as a whole, and the public soured
on investment trusts. In particular, they felt betrayed by the managers of the trusts, who were often pursuing their own interests
in flagrant conflict with those of their investors. The Investment
Company Act of 1940, which established regulations for investment
companies, helped restore a measure of public confidence. But
people needed more than just government regulations; they needed
a new name, one that did not carry the unsavory associations of
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investment trusts. The term mutual fund, with its similarity to the
mutual savings bank and the mutual insurance company—venerable institutions that had survived the stock market crash largely
untouched by scandal—was much more reassuring and attractive
to investors.26
The mutual fund industry was given new impetus by the
Employee Retirement Income Security Act of 1974, which created
Individual Retirement Accounts. But the industry really took off
after the recent bull market began in 1982.
Part of the reason that equity mutual funds proliferated so
rapidly after that date is that they are used as part of 401(k) pension plans. As people invest their plan balances directly in mutual
funds, they develop greater familiarity with the concept; they are
thus more inclined to invest their non-401(k) savings in mutual
funds as well.
Another reason for the funds’ explosive growth is that they have
paid for a great deal of advertising. Television shows, magazines,
and newspapers frequently carry advertisements for them, and
active investors receive unsolicited ads in the mail. Mutual funds
encourage more naïve investors to participate in the market, by leading them to think that the experts managing the funds will steer
them away from pitfalls.
The proliferation of equity mutual funds has therefore focused
public attention on the market, with the effect of encouraging
speculative price movements in stock market aggregates, rather
than in individual stocks.27 The emerging popular concept that
mutual fund investing is sound, convenient, and safe has encouraged many investors who were once afraid of the market to want
to enter it, thereby contributing to an upward thrust in the market. (See Chapter 10 for a further discussion of public attitudes
toward mutual funds.)
The Decline of Inflation and the Effects of Money Illusion
The outlook for U.S. inflation, as measured by the percentage
change in the Consumer Price Index, has gradually improved since
the bull market began. In 1982, even though U.S. inflation was then
PRECI PI TATI NG FAC TORS
37
around 4% a year, there was still considerable uncertainty as to
whether it would return to the high level (nearly 15% for the year)
experienced in 1980. The most dramatic stock price increases of this
bull market occurred once the inflation rate had settled down into
the 2–3% range in the mid-1990s, and it then dropped below 2%.
The general public pays a lot of attention to inflation, as I discovered in my interview studies of public attitudes toward it.28
People widely believe that the inflation rate is a barometer of the
economic and social health of a nation. High inflation is perceived
as a sign of economic disarray, of a loss of basic values, and a disgrace to the nation, an embarrassment before foreigners. Low inflation is viewed as a sign of economic prosperity, social justice, and
good government. It is not surprising, therefore, that a lower inflation rate boosts public confidence, hence stock market valuation.
But from a purely rational standpoint, this stock market reaction to inflation is inappropriate. In 1979 Nobel laureate Franco
Modigliani, with Richard Cohn, published an article arguing that
the stock market reacts inappropriately to inflation because people
do not fully understand the effect of inflation on interest rates.29
When inflation is high—as it was when they wrote, near the bottom of the stock market in 1982—nominal interest rates (the usual
interest rates we see quoted every day) are high because they must
compensate investors for the inflation that is eroding the value of
their dollars. Yet real interest rates (interest rates as corrected for
the effects of inflation) were not high then, and therefore there
should not have been any stock market reaction to the high nominal rates. Modigliani and Cohn suggested that the market tends
to be depressed when nominal rates are high even when real rates
are not high because of a sort of “money illusion,” or public confusion about the effects of a changing monetary standard. When
there is inflation, we are changing the value of the dollar, and therefore changing the yardstick by which we measure values. Faced
with a changing yardstick, it is not surprising that many people
become confused.
Modigliani and Cohn also argued (and this is a more subtle point)
that people fail to take account of a bias in measured corporate profits due to the fact that corporations deduct from their profits the
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total interest paid on their debt, and not just the real (inflationcorrected) interest. In inflationary times, part of this interest paid
may be viewed merely as a prepayment of part of the real debt,
rather than a cost to the company. Few investors realize this and
make corrections for this effect of inflation. Their failure to do so
may be described as another example of money illusion.30
Public misunderstanding about inflation at the present time
encourages high expectations for real (inflation-corrected) returns.
Most data on past long-run stock market returns is reported in
the media in nominal terms, without correction for inflation, and
people might naturally be encouraged to expect that such nominal returns would continue in the future. Inflation today is under
2%, compared with a historical average Consumer Price Index level
of inflation that has averaged 4.4% a year since John Kennedy was
elected president in 1960. Therefore expecting the same nominal
returns we have seen in the stock market since 1960 is expecting
a lot more in real terms.
Plots of historical stock price indexes in the media are almost
invariably shown in nominal terms, not the real inflation-corrected
terms shown in the figures in this book. Consumer prices have
increased six-fold since 1960 and seventeen-fold since 1913. This
inflation imparts an strong upward trend to long-run historical plots
of stock price indexes, if they are not corrected for inflation. Thus
the extraordinary behavior of the real stock market at the turn of
the millennium, the spike up in stock prices that was visible in Figure 1.1, does not stand out in the long historical plots we see in
the media. In fact, viewing these plots encourages us to think that
nothing at all unusual is going on now in the stock market.
The reason news writers generally do not make corrections for
inflation is probably that they think such adjustments are esoteric
and would not be widely appreciated by their readers. And they
are probably right. The general public has not by and large taken
Economics 101, and those who did sit through it have probably forgotten much of what they learned. Thus they have not assimilated
the basic lesson that there is nothing natural about measuring
prices in dollars when the quantity, and value, of those dollars has
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39
been highly unstable. The public at large does not fully appreciate
that the more meaningful measure of the stock market level is in
terms of some broad basket of goods, as the level is measured if
it is corrected for consumer price inflation.31
Expansion of the Volume of Trade: Discount Brokers,
Day Traders, and Twenty-Four-Hour Trading
The turnover rate (the total shares sold in a year divided by the total
number of shares) for New York Stock Exchange stocks nearly
doubled between 1982 and 1999, from 42% to 78%.32 The NASDAQ
market, which emphasizes high-technolgoy stocks, shows an even
greater turnover rate increase, from 88% in 1990 to 221% in 1999.33
The higher turnover rate may be symptomatic of increased interest in the market as a result of other factors mentioned here. But
another reason for the rising turnover rate in the stock market is
the declining cost of making a trade. After competitive brokerage
commissions were mandated by the Securities and Exchange
Commission (SEC) in 1975, there was an immediate drop in commission rates, and discount brokers came into being. Technological and organizational changes were also set in motion. Such
innovations as the Small Order Execution System, introduced by
NASDAQ in 1985, and new order handling rules issued by the SEC
in 1997 have resulted in ever lower trading costs. SEC regulations
encouraging equal access to the markets have now spawned a
growing number of amateur investors who can “day trade,” that
is, try to make profits by rapidly trading stocks using the same order
execution systems used by professionals.
The significant growth of online trading services coincides
roughly with the most spectacular increases in the stock market
since 1997. According to a study by the SEC, there were 3.7 million online accounts in the United States in 1997; by 1999 there were
9.7 million such accounts.34 The growth of online trading, as well
as the associated Internet-based information and communication services, may well encourage minute-by-minute attention to the market. After-hours trading on the exchanges also has the potential to
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increase the level of attention paid to the market, as investors can
track changing prices in their living rooms during their leisure time.
Speculative prices seem to get a volatility nudge whenever
markets are open. The magnitude of price changes tends to be lower
over two-day intervals that include a day when markets are closed
(as, for example, during a time when the New York Stock Exchange
closed on Wednesdays).35 It is therefore plausible to expect that the
expansion of online trading and the opening of markets for longer
hours will raise their volatility. Whether it will raise or lower the
level of prices is less certain.
There is, however, some evidence suggesting that more frequent
exposure to price quotes might in fact diminish demand for stocks.
Economists Shlomo Benartzi and Richard Thaler have shown that
the time pattern of attention to market prices can have important
effects on the demand for stocks. In experimental situations, if
people are shown daily data on stock prices they express much less
interest in investing in stocks than if they are shown only longerrun returns.36 Witnessing the day-to-day noise in stock prices apparently encourages more fear about the inherent risk of investing in
stocks. Thus institutional innovations that encourage viewing the
market price more frequently might tend to depress the price
level of the market.
On the other hand, the increased frequency of reporting of stock
prices caused by recent institutional and technological changes may
have just the opposite effect to that observed in the experimental
situation crafted by Benartzi and Thaler. In a nonexperimental
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.
And changing public attention is a critical factor in the valuation
of investments, a point that will be elaborated in Chapter 8.
The Rise of Gambling Opportunities
There has been a dramatic increase in gambling opportunities in
the United States in recent years. Most forms of gambling and lotteries were outlawed by states in the 1870s after a scandal in the
PRECI PI TATI NG FAC TORS
41
Louisiana lottery, and the Louisiana national lottery itself was
effectively shut down by an 1890 act of Congress prohibiting the
sale of lottery tickets by mail. From then until 1970, opportunities
to gamble legally were confined largely to racetracks, a form of
gambling that has limited public appeal and which at the time
required travel to a racetrack. But by 1975, there were thirteen state
lotteries, and by 1999 there were thirty-seven, offering very convenient and easy means of wagering. Until 1990, legalized casinos
operated only in Nevada and Atlantic City. By 1999 there were
nearly 100 riverboat and dockside casinos and 260 casinos on
Indian reservations. Over the same interval, betting at racetracks
has also expanded dramatically, with the development of off-track
betting, relying on satellite broadcasts of the races. Cable and Internet wagering on races is now possible from home. There has also
been a proliferation of electronic gambling devices, including slot
machines, video poker, video keno, and other stand-alone devices.
In some states these may even be found at truck stops, convenience
stores, and lottery outlets. The ubiquity and convenience of gambling opportunities, and the strength of the marketing campaign
undertaken to promote gambling, are unprecedented in U.S. history. According to the 1999 report of the National Gambling Impact
Study Commission, 125 million Americans gambled in 1998—a
figure that represents most of the adult population.37 Moreover,
7.5 million Americans were estimated to be either problem or
pathological gamblers.
The rise of gambling institutions, and the increased frequency
of actual gambling, have potentially important effects on our culture and on changed attitudes toward risk taking in other areas, such
as investing in the stock market. The legalization of gambling in
the form of state lotteries has sometimes been observed to help the
illegal numbers business, rat...
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