Robert Shiller, the economist and Nobel laureate, is worried about the boom in the U.S. stock market. Alan Greenspan, the former Federal Reserve chairman, is relaxed, suggesting that the trends are not characteristic of bubble territory.
It's not a duel; Mr. Shiller was quoted in Der Spiegel, the German news magazine, over the weekend expressing his concern about stock values. "Bubbles look like this," he said. Separately, Mr. Greenspan was expounding in a Bloomberg TV interview. The coincidence is noteworthy, however. The former central banker was widely criticized for doubting bubble formation in the late 1990s. Meanwhile, Mr. Shiller is perhaps the world's leading financial bubble analyst, the author and co-founder of the Case Shiller real estate price index. Indeed, the title of Mr. Shiller's book on financial bubbles, Irrational Exuberance, was a jibe at Mr. Greenspan's famous comment in 1996: "how do we know when irrational exuberance has unduly escalated asset values?"
We should not be surprised that two sages disagree about the meaning of the Dow index at 16,000, or the price of prime beachfront property. The global economy is still in very uncertain recovery with most of the euro zone still caught in slow-motion, labouring under high deficits and crippling unemployment. There are bright pockets, notably the U.S. and the U.K. where entirely different economic strategies have been successful in restoring growth. What investors want to know is whether asset values are reflecting real prospects of future income gain or whether they are signs of wishful thinking, hysteria or irrational exuberance (which some of us might call stupidity).
In this regard, statistical analysis of valuations is not terribly helpful. Robert Shiller's own tool, the cyclically adjusted price earnings ratio, suggests that the S&P 500 PER of about 25 is well below the hot ratios of 40 or more seen during the dotcom boom, but that it is still well into a warning zone of 20-29. Some have argued that CAPE is only one metric among many that are not yet showing a bubble, while others see hot money chasing quick returns. However, there may be yet another way of looking at it. Rather than trying to map historical statistical trends, perhaps we should ask ourselves behavioural questions about what investors are thinking when they chase assets at prices which seem relatively high.
Consider real estate in the U.K. capital which has now reached extraordinary valuations, exceeding the pre-crash peak of 1987. The average London home, valued at more than £300,000 ($522,060) is worth twice as much as the national average price, a ratio never before achieved, without a subsequent correction. There is some anecdotal evidence that the prime, multi-million-pound market is peaking, but real estate agents report no general slowdown in transactions. If we ask why the world's hot money is still pumping up London property values, we might as well ask why people bid up the value of tulip bulbs in Holland in the 17th century or why Bitcoin is now worth upwards of $1,000.
In 2003, Shiller co-authored with Karl Case, a paper for the Brookings Institute, in which he used survey evidence from real house buyers to show that peoples' expectations of rising prices, their (often fallacious) theories about why prices won't fall and their fears of being left out of a house price boom, influence their behaviour. One interesting observation made by the authors is that disappointment in the performance of the stock market may have been an additional factor encouraging excessive investment in real estate.
What seems to be excess optimism about stocks or home prices may not be an expression of a sunny outlook but, instead, fear about the financial future and a desperate desire to lock in a gain ahead of a downturn. There is little doubt that prime London real estate has become a home for flight capital from Russia, China and other emerging markets. These are not scarce assets or even good income-producing assets (there is a Thames riverside building boom and rental yields are miniscule) but the illusion is that London property values are safe – or at least, safer than the alternatives. Meanwhile, Bitcoin investors seem to believe that their "independent" currency is a safer home for wealth than fiat money, corrupted by government, politics and the inflationary effect of quantitiative easing. The huge influx of cash into tech stocks could equally well be a desperate flight from government bonds rather than a confident view of the long-term viability of a company, such as Twitter.
Investment decisions by ordinary people have always been guided by volatile emotional responses, from greed to fear. The widespread assumption is that escalating values are a greedy anticipation of imminent recovery. It could also be a fearful response to the prevailing uncertainties.
Carl Mortished