At the recent meeting, a client said that it is time for new valuation theories as old theories are dead. This coming from someone who made it to the Top 300 rich list of Romanians indicated what smart money was thinking. It also illustrated how much time it took for a mainstream thought to be challenged.
Shiller’s theory
It was about 30 years ago, Robert Shiller - the award winning economist, author of Irrational Exuberance, a bestseller that challenged the Efficient Market Hypothesis (EMH) in an article published in the American Economic Review in 1981. 30 years, yes that is what it took. This is how outdated we are in our thought.
This was my second reading of the book. I read the first edition in 2000. Unlike Beyond Greed and Fear by Hersh Shefrin, Irrational Exuberance was more focussed and had more objective criticism of conventional research thought. Despite the incredible timing of the book which shuts up comments like “who knew it?” The author calls himself plain “lucky” and makes no claim of having a forecasting ability. He also talks about the role of opinion leaders to stabilise markets even if in a minor way.
In a follow-up discussion paper titled From Efficient Market Theory to Behavioural Finance, Shiller explains how in the 1970’s it would have been wishful thinking that models which describe the world around us could be true.
Anomalies in the EMH were discovered in 1970’s and it was the excess volatility of the stock markets which was too large an aberration to remain unexplained. In simple terms, changes in prices occur for no fundamental reason and is primarily driven by mass psychology. He does mention other drivers like “sun spots”, albeit casually.
On to behavioural finance
To validate his case he takes present value (PV) of dividends paid on S&P composite stock price index discounted by a constant real discount rate for the period (1871-2002). He demonstrates that PV behaves remarkably like a stable trend. In contrast, stock price index gyrates, wildly up and down around this trend. This proved that there is excess volatility in the aggregate stock market relative to the PV implied by the EMH.
You cannot defend the EMH. Markets are crazy, even if not totally. There has been no effective study linking fluctuations with fundamentals till date.
This is where Shiller moves to another explanation, behavioural finance feedback model which is the academic form of a feedback theory first written by Charles Mackay in 1841 in his book Memoirs of Extraordinary Popular Delusions. The book described the famous tulip mania of 1630’s, a speculative bubble in tulip flower bulbs, with words that suggest feedback and the ultimate results of the feedback.
A price to price feedback theory causes word-of-mouth enthusiasm giving birth to new era theories and popular models that justify price increases. The feedback that propelled the bubble carries the seeds of its own destruction. Smith, Suchanek and Williams (1988) were able to create experimental feedback trading.
All in feedback loops?
Shiller is unequivocal regarding the feedback loops as the explanation for excessive volatility or bubbles. He supports his case by research in cognitive psychology, which shows that people try to predict by seeking the closest match to past patterns leading to feedback dynamics. Such human interactions, he says, are the essential cause of speculative bubbles (positive and negative), which appear to recur across centuries and across countries. Recurring ponzi schemes is an example.
We have some questions and observations on Shiller’s case. Is the model Shiller working on for 30 years an all-encompassing one? What he mentions as appearing to recur not cyclicality in time? Is he not just replacing cognitive psychology patterns with another pattern which seems consistent with some combination of feedback effects driving the stock markets? Why even after 30 years of challenging and a Nobel Prize for behavioural finance is fundamental stories so engraved in human psyche? Is behavioural finance a capable alternative to conventional research? Is psychology really driving the markets? Or are something like “sun spots” more significant than what Shiller thinks.
Role of proportion
What about proportion? Everything is ruled by proportion, why is psychology so special? Why there is repetitive mention of 30 years, 10 years in Shiller’s work? Why does he not mention about all the work done on time cyclicality which is as old as the dividend data he charts? Is it too much for him to admit that the basic tenet of behavioural finance “what goes up comes down and what goes down comes up”, is nothing but a cycle? Why does he never mention Edward R Dewey, chief economist of President Hoover who said depression was a cyclical reality? Why in his now famous comparison of dividend PV and stock prices he does not observe the 30 year cycle? From a time perspective, all the talk about excessive volatility may have disproved the EMH, but it does not prove that feedback loop is the final explanation. Bubbles are a cyclical phenomenon caused in time and both amplification and time are mathematical aspects.
The question of “when” which 83 per cent of Shiller survey respondents including Shiller himself admit being an illusion and an opportunity too good to be true might be a thought 30 years behind its time.
The author is CEO, Orpheus CAPITALS, a global alternative research firm
