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Generational Dynamics Web Log for 20-Mar-07
Robert Shiller compares stock market to 1929

Web Log - March, 2007

Robert Shiller compares stock market to 1929

He says the recent fall was caused by "market psychology," but is puzzled why.

According to Yale professor of economics Robert J. Shiller, in an article appearing in a Shaighai paper, there was no rational reason for the February 27 worldwide stock market fall.

The author of the 2001 book Irrational Exuberance, a book title that echoed Alan Greenspan's famous 1996 words at the start of the dot-com bubble, said that after the Shanghai market fell 8.8% on that day, there was no reason except "market psychology" for stock markets around the world to fall 2-4%.

Moreover, most of these markets are still down 4-8%, compared to their close on February 26.

Shiller compares this situation to what happened in 1928-29:

"If history is any guide, markets can be severely destabilized by one-day drops, which make powerful stories that have more psychological salience to investors than much larger drops that occur over longer time intervals.

For example, people were really agitated when the Dow dropped 3.8 percent on December 6, 1928.

No news story that day discussed economic fundamentals or gave a clear indication of the cause of the decline, relying instead on sensational prose - "the house that Jack built threatened to topple over" and "traders were quaking in their boots."

But the December 6, 1928, event began a sequence of increasingly severe one-day drops in the Dow over the course of the following year.

Despite a generally rising market, the Dow fell by 3.6 percent on February 7, 1929, 4.1 percent on March 25, 4.2 percent on May 22, 4 percent on May 27 and August 9, 4.2 percent on October 3, and 6.3 percent on October 23, before the infamous "Black Monday" crash.

On each occasion, newspaper accounts further established the 1929 market psychology. The story was always that speculation in the markets had government leaders worried, which is, of course, essentially the same story that we heard from China on February 27.

This is an interesting comparison, and there's validity to it, but he appears to be saying that the February 27 collapse corresponds to December 6, 1928, ten months in advance of the October 1929 crash. The follow on reasoning is that a new stock market crash is still a year off.

But that comparison ignores the LiveDoor scandal that caused an a "Wall Street bloodbath" in January, 2006.

There was another stock market meltdown in May of last year, leading to speculations about a stock market panic and crash.

So if Shiller's date comparison is valid, then we should be very close to a crash right now. And indeed we may be.

Robert Shiller is well-known for having recognized the stock market bubble quite early, and predicting that it would burst and create a financial crisis like the 1930s. His book, Irrational Exuberance, published in 2000, was a bestseller and undoubtedly saved a lot of pain for those who read and heeded it.

But Shiller has always been completely confused about why the stock market bubble occurred at all, and why it occurred when it did. He's always been interested in the concept of a "rational stock market" -- the concept being that investors make rational decisions after evaluating all the available evidence.

So in his book, he tried to come up with "precipitating factors" that caused the new stock market bubble. Frankly, none of them is very convincing, and I don't think even he believes he's doing more than guessing, but he goes ahead with 12 of them:

The arrival of the internet at a time of solid earnings growth (p. 19)

Triumphalism and the decline of foreign economic rivals (p. 21)

Cultural changes favoring business success or the appearance thereof (p. 22)

A Republican congress and capital gains tax cuts (p. 24)

The Baby Boom and its perceived effects on the market (p. 25)

An expansion in media reporting of business news (p. 28)

Analysts' increasingly optimistic forecasts (p. 30)

The expansion of defined contribution pension plans (p. 32)

The growth of mutual funds (p. 35)

The decline of inflation and the effects of money illusion (p. 36)

Expansion of the volume of trade: Discount brokers, day trading, and 24-hour trading (p. 39)

The rise of gambling opportunities (p. 40)

Basically, Shiller believes that there's no rationality to the market at all. This is the same kind of concept for which I've harshly criticized Bernanke for saying, in effect, that Fed jawboning, even misleading statements, are the major drivers for the economy rather than fundamentals. So Shiller's reasons include some that appear to me to be total nonsense -- the Internet, cable news, cultural changes, and even gambling opportunities. This is really just guesswork.

Ironically, Shiller does come close to hitting on the truth, when he talks about the Baby Boomers:

"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. 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 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 pouplation trends in the stock market investments, many investors fail to appreciate just how common their thinking really is. Their perceptions fuel the continuing upward spiral in market values. (pp. 27-28)

He almost begins to be going in the right direction in the first of these paragraphs, but in the second paragraphs he wigs out. Once again, fundamentals don't matter; it's "perceptions" that matter.

Ironically, Shiller is very well aware of the underlying data. In fact, it's Shiller's web site at Yale that I and a lot of other people use to get historical data, dating well back into the 1800s. This data includes stock market graphs and graphs of price/earnings ratios.

So, unlike the vast majority of "experts" that you see on CNBC and other TV stations, Shiller actually understands that the stock market was overpriced by a factor of 250% in 1929, and is similarly overpriced today. But he never makes the generational connection that would connect the dots in his work.

I must say that the essay that I wrote last week on "A conundrum: How increases in 'risk aversion' lead to higher stock prices" has been something of an epiphany to me, and has connected a lot of dots in integrating macroeconomic theory with generational theory.

Last year I wrote the article, "System Dynamics and Macroeconomics." This is the seminal article that explains how to use System Dynamics, invented by MIT's Jay Forrester in the 1960s, can be integrated with mainstream macroeconomic theory to take generational dynamics into account.

Now, having had several day to think over last week's article, I'm really beginning to understand what I've written, and to see everything coming together, and a number of major questions being answered.

I'll be writing a lot more about that article as the occasion requires, but here's a summary.

A Harvard economist named Robert J. Barro has done work on "Rare Events and the Equity Premium," to show why stock markets go up, strangely, just when investors become more risk averse. And the more risk averse they become, the greater the stock market bubble grows. This is a mind-boggling result that can be fully explained by adding generational concepts to Professor Barro's work. Here's an outline:

We define a variable "p" that represents what investors believe is the probability of a "rare event" occurring within the next year. In "normal" times, p=0.5%, but can go up to 1% or 1.5%.

By a "rare event," Barro means a world war or a major stock market crash. For the purposes of this summary, we'll just stick to international stock market crashes.

If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: Tulipomania bubble (1637), South Sea Bubble (1721), French Monarchy bankruptcy (1789), Hamburg Crisis of 1857 (or Panic of 1857), and 1929 Wall Street crash.
Each of these major international crises occurred roughly 70-80 years after the previous one. What you find is that each new "debt bubble" occurs at exactly the time that the generation of people who grew up during the previous financial crisis all disappear (retire or die), all at once. Thus, the length of time between these "generational" financial crises is approximately equal to the length of a maximum human lifetime.

The major driving force of these crashes is not exactly the perception of the probability of a crash, but the widespread willingness of investors to use credit and debt irresponsibly. This is a generational concept: A new debt bubble begins when the generation of people who lived through the last bubble all disappear (retire or die), all at once.

Thus, it's reasonable to say that "p" also represents the willingness of investors to use credit and debt irresponsibly.

From a generational point of view, this means that p drops sharply (close to 0%) just after a crash, and then grows slowly as new generations are born, until it reaches a peak (perhaps around 2%), just before the next crash.

When p increases, and the irresponsible use of credit increases, then the velocity of money increases and liquidity increases.

This big increase in liquidity feeds into BOTH the stock market and the bond market, where by "bonds" we mean super-safe Treasury bonds.

The push of liquidity into bonds increases the demand for bonds, raising the price of bonds, and reducing their yield. Thus, bond yields go DOWN as a crash approaches. (This is the answer to Alan Greenspan's 2005 "conundrum.")

The push of liquidity into stocks increases the stock market bubble.

As investors go increasingly into debt over their heads, they become increasingly desperate for high returns, so they become increasingly risk-seeking. As they take greater risks, risk premiums go DOWN for stocks. That's why the risk premium spread becomes so small. (This stuff is really mindboggling.)

The credit bubble is essentially a pyramid scheme (or Ponzi scheme), and all pyramid schemes must crash.

As investors panic over events like the February 27 mini-crash, investors start to become risk-averse again. This reverses the above process, pulling liquidity out of the market, so that credit becomes less available.

Since credit was supplying the liquidity to keep the bubble growing, investors on the edges start dropping out. As liquidity tightens further, more and more investors are forced to drop out, until a complete generational panic causes a full-scale stock market crash.

I have to tell you, dear reader, putting all this together has been an amazing experience for me.

I'll close with one more quotation from Shiller's book, in the concluding chapter:

"The high recent valuations in the stock market have come about for no good reasons. The market level does not, as so many imagine, represent the consensus judgment of experts who have carefully weighed the long-term evidence. The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and preceptions of conventional wisdom. Their all-too-human behavior is heavily influenced by news media that are interested in attracting viewers or readers, with limited incentive to discipline their readers with the type of quantitative analysis that might give them a correct impression of the aggregate stock market level.

It is a serious mistake for public figures to acquiesce in the stock market valuations we have seen recently, to remain silent about the implications of such high valuations, and to leave all commentary to the market analysts who specialize in the nearly impossible task of forecasting the market over the short term and who share interests with investment banks or brokerage firms. The valuation of the stock market is an important national -- indeed international -- issue. All our plans for the future, as individuals and as a society, hinge on our perceived wealth, and plans can be thrown into disarray if much of that wealth evaporates tomorrow. The tendency for speculative bubbles to grow and then contract can make for very uneven distribution of wealth. It may even cause many of us, at times, to question the very viability of our capitalist and free market institutons. It is for such reasons that we must be clear on the prospect for such contractions and on what should be our individual and national policy regarding this prospect.

Of course in the current political and economic climate one incurs a substantial risk of embarassment if one goes on record saying that stock market returns will be low or negative in coming years. We have seen in this book that, although the market appears to have substantial long-term forecastability when it is very overpriced (as it appears to be, based on recent data) or, alternatively, when it is very underpriced, there is always considerable uncertainty about the outlook. But an observer who remains silent about the unjustifiably high values because he or she could be wrong about the outlook is no better than the doctor who, having diagnosed high blood pressure in a patient, says nothing because the patient might be lucky and show no ill effects." (pp. 203-4)

That certainly represents my feelings. This web site is more than just a pastime for me, more even than an obsession. It's a moral imperative to provide this information if I can. I thank all my readers for coming back all the time and for making this web site increasingly popular. (20-Mar-07) Permanent Link
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Generational Dynamics Web Log for 20-Mar-07 Robert Shiller compares stock market to 1929

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Robert Shiller compares stock market to 1929