Signs of animal spirits are also in sight when you look at Wall Street. For instance the yields on ten year treasuries have skyrocketed since the elections. Is this the end of low interest rates?
Interest rates have risen, but historically they’re still low. There isn’t any received wisdom about just exactly why they are so low. It’s natural to put it on to the financial crisis of 2007/08. That’s because it’s a dominant narrative that everything today must be due to the financial crisis. But the downtrend in interest rates has been going on for over thirty years. So it doesn’t look like it’s just because of the financial crisis. That’s why I’m inclined to think that is has something to do with technology. We are living in a time where we are worried about our future because of rising inequality and jobs being replaced by robots. So people want to save but they don’t actually end up saving because they bid up prices of assets like bonds that look safe.
What would it take to change the psychology of the financial markets?
It’s been a surprise that these low interest rates lasted as long as they did. So you might think it’s time – even without Trump – for interest rates to start going up. For instance, in the US the Federal Reserve was already talking about raising rates even before the election. Another thought is that there is more worry about a possible default on US debt. I don’t think that’s very likely but there might be some concern because Donald Trump had bankrupt businesses many times. So he doesn’t look like someone who would go to the wall to defend the integrity of the US debt.
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And what about the stock market? For US equities, the cyclically adjusted price-to-earnings ratio, also known as CAPE or Shiller P/E, is now at around 28. Such rich valuations were only seen before the market plunges in 1929, 2000 and 2008.
Honestly, I don’t know what to make of US stocks right now. President-elect Trump might actually boost the market even further. First of all, he wants to cut the corporate profits tax. That’s an immediate direct feed into the stock market. Secondly, he doesn’t care about the environment or other quality of life things. He just wants corporations to succeed. That’s also bullish for the stock market. And then thirdly, he is an inspiration to many people. So maybe they start spending more and maybe someone will try businesses that were considered too risky before. So I’m tempted to be optimistic for the short run and I can I imagine that US stocks go up from here for a while even though valuations are at a high level.
If emotions like greed and euphoria take over at the stock market, it usually ends ugly for investors. Nevertheless, one can observe such kind of excesses quite regularly. How come?
Well, part of the dynamics is what’s called wishful thinking by psychologists. People believe to some extent what they want to believe in and what justifies their actions. They want to think of themselves as moral and smart. So once they’ve taken a position they start to bias their thinking toward believing in a successful return on their investment.
One of the most stunning market exaggerations happened during the dotcom bubble. Fed chairman Alan Greenspan warned already at the end of 1996 of «irrational exuberance». What exactly happens during such periods?
This could be 1996 again. That would mean we have four more years of stock price increases. That’s a lot of time. But you also have to remember to get out and it’s hard to spot the turning points.
What’s your explanation of what’s going on in the late stages of a bubble like at the end of the nineties?
When Greenspan presented his speech a lot of people already had the internet at home. So it was all the talk and excitement at that time. The stock market was already high but it was going to go higher. Also, we had the new millennium coming which encouraged optimistic thinking. Of course, that’s completely irrational. The year 2000 is just an arbitrary choice somebody made a long time ago as the result of the probably incorrect dating of Jesus’ birth date. Nevertheless, it sounds real and important. So there were a lot of animal spirits growing at that time. But then it gets beyond bounds and it starts to look crazy. That’s why I wrote my book « Irrational Exuberance». For the first edition I called up my publisher and urged to rush this book into print because I was just worried that the market would crash before it came out.
The book was published in March of 2000, right at the peak of the dotcom bubble. But such kind of exaggerations shouldn’t even exist if you believe in efficient markets.
The problem is that the world is too complicated. Part of what drives markets, people believe, is what other investors are doing. So as an investor you end up trying to predict what other investors are going to do. It’s like a game we’re playing. That’s why it’s not going to work out that everything is optimally priced and stable.
Even so, until a few years ago, the efficient market hypothesis was dominating economics. Why?
The arguments for efficient markets are not that everyone is smart but that there is smart money. So if there was a profit opportunity they would cash into it aggressively and that should eliminate this opportunity. Basically, the efficient market theory says that markets are efficient because the smart money has put so much effort into predicting that everything is perfect. But my impression is that there is not a whole lot of really smart money. Also, according to the efficient market theory there is all this smart money putting an effort in trying to figure everything out. But then again, there is no profit to be made. So why would they be doing it? If they’re smart they should be doing things like music, writing poetry, art, microbiology or whatever is meaningful. So it’s not as easy as you might think. If you are smart there is something to be gained by putting effort into investing because not everyone is smart.
So how far should we rely on free markets?
Actually, we’ve never tried 100% free markets because the governments had always some regulatory impact. For instance, if you look at the 20th century versus the 19th century, in the the 20th century people were better off partly because of regulation. For instance, if you go back to the 19th century, most of the patent medicines you could buy in a drug store were fraudulent. In the United States there was a drug called «Swaim’s Panacea» that claimed it cured everything. You have to be skeptical of that, right? People are dying, so are they not taking «Swaims Panacea»? Finally, when they set up the Food and Drug Administration they found out that there was really nothing in those «Swaim’s Panacea». So rather than being essentially benign and always creating the greater good, markets are inherently filled with tricks and traps.
Full interview here