Not all stock gains are real. When price increases push the CAPE value above its fair-value level (17), those price increases are irrational exuberance, not the true and lasting gains that are generated by increases in economic productivity.
That’s the point of Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns. Long-term returns are largely predictable because the fair-value CAPE level exerts a magnetic pull on stock prices until they return to fair-value levels.
Reputed short-seller Spruce Point Capital Management released its latest short report this week. The firm is shorting Canadian dairy and grocery manufacturer Saputo. Spruce Point chief Ben Axler believes the company is entering a phase of declining growth and highlights the financial stress and growing challenges he sees it facing, not only in Canada but Read More
That reality exerts a powerful influence on our entire economy, does it not?
It sure seems so to me. Shiller is the most important investing analyst alive, in my assessment. But he is not a professor of stock investing, he is a professor of economics. Shiller changed our understanding of how the economy works in a profound way. His research points us to the most important cause of economic crises.
Too much irrational exuberance causes economic crises!
The Nature Of Irrational Exuberance
Investors create irrational exuberance because there is something in the human heart that craves getting something for nothing. When investors push stock prices up far beyond their proper level, they are essentially voting themselves raises.
It is in the nature of irrational exuberance that it disappears in time. Stock gains which have no economic productivity behind them eventually disappear into thin air.
That hurts the investors who were counting on those gains to finance their retirements. Obviously. Most people who comment on Shiller’s work make an effort to warn investors of the dangers of investing in overpriced stocks.
That makes sense. But I rarely see even the most ardent Shiller supporters make the obvious (to my mind) follow-up point. The inevitable disappearance of irrational exuberance (in a price crash) sinks the economy.
Investors lose many trillions of dollars in a price crash. That affects their ability to spend on goods and services. The fellow who has seen his retirement account cut in half does not feel as free as he did before to buy a bigger house or a new car or to go on a second vacation.
When irrational exuberance meets its inevitable demise, hundreds of thousands of businesses go under. Which of course means that millions of workers lose their jobs. Which of course means that political frictions are exacerbated.
Both the Occupy Wall Street movement and the Tea Party movement enjoyed a big push forward via the price crash of 2012.
But you never hear economists talking about this reality.
A Bigger Economic Factor
They talk about everything else under the sun. Economists talk about inflation all the time. They talk about gas prices. They talk about interest rates. They talk about saving rates. They talk about trends in consumer psychology.
All of those things are worth talking about. But at times when stock prices are where they reside today, irrational exuberance is the far bigger economic factor. Today’s scary CAPE value casts a dark cloud on all economic activity taking place in our country today.
I think that the adjective that I used in that last sentence offers the best explanation of this otherwise inexplicable phenomenon. Irrational exuberance is scary. It’s not one or two or three foolish investors who permit a bull market to get out of control.
We all play a part in that nasty game. It’s not even just all stock investors who do that. People who do not own stocks generally keep their mouths shut about the dangers of high stock prices during a bull market because they do not want to offend their fellow humans.
Humans are social creatures. Most stock investors come to depend on the gains added to their accounts during bull markets to finance their retirement dreams. Point out to them that there is research showing that those gains are not real and it hurts their feelings. So most of us keep it zipped.
People who cheer on bull markets are not dumb. They know. On some level of consciousness, they appreciate that stock gains created out of thin air are sooner or later going to return to thin air.
So they are highly sensitive to mentions of the far-reaching implications of Shiller’s amazing research findings. It’s not only the big numbers on their portfolio statements that depend on us all keeping the realities on the hush-hush. It is the continued health of our entire economic system.
The economists should be talking about this stuff. That’s the job. Yes, irrational exuberance is a scary subject. But you know what? It’s a liberating subject to consider as well.
If irrational exuberance causes as much human misery as I am suggesting it does, getting irrational exuberance under control would diminish human misery to a great extent.
In a world in which economists talked about irrational exuberance and its horrible effects and taught us all practices aimed at keeping irrational exuberance under tight control at all times, we would all live far better and richer and fuller lives than we are able to live today. I could go for that.
Hey! You over there! Mr. and Ms. Economist, hiding in the corner! Come out! Get with it! Do your job!
Rob’s bio is here.