Nobel Laureate in economics Robert Shiller spoke at the AAII investor conference this month where he quoted Keynes on investing: "Most probably, of our
decisions to do something positive, the full consequences of which will
be drawn out over many days to come, can only be taken as a result of
animal spirits—of a spontaneous urge to action rather than inaction."
Keynes thought investors were driven by animal spirits. Shiller has even a lower opinion of investors. He said at
the World Economic Forum held in Davos, Switzerland in 2010 that hecould identify bubbles using the same methods that psychologists use to
diagnose mental illness in patients. His key
points were these:
1. Sharp increase in the price of an asset.
2. Great public excitement about these price increases.
3. An accompanying media frenzy.
4. Stories of people earning a lot of money, causing envy among people who aren’t.
5. Growing interest in the asset class among the general public.
6. New era “theories” to justify unprecedented price increases.
7. A decline in lending standards.
Shiller was one of the founders of the school of
behavioral finance, which was a reaction against the efficient market
hypothesis (EMH). EMH taught that the market is always right because it
is rational and digests new information very
quickly. Shiller believed the market is mostly wrong and driven by
irrational behavior. Shiller battled a straw man version of the EMH.
EMH proponents never said that all investors were right, only that the
professionals who worked full time at investing
would arbitrage away any major swings caused by the ignorant masses.
Both schools share a fatal fallacy: they think
stocks have an objective value - the net present value (NPV) of
future earnings. They fool themselves into thinking they know exactly
what the NPV for each stock should be, which is
a form of what Hayek call the “fatal conceit.” It’s certainly fatal to
investors. Analysts cannot forecast the future stream of earning of a
company more than one quarter out. Neither do they know the interest
rate at which to discount future earnings, more than
one quarter out. And they don’t know the tolerance for risk that
investors will have. Investors advertise their risk tolerance through
the PE ratio.
EMH is
correct in saying that in the long run the prices of stocks return to an estimate of NPV regularly. The behavioral school is right that prices diverge from NPV in the
short run more than not. The limited view of each school is correct, but for the
wrong reasons.
Both schools assume that deviations from NPV for
stock prices provide evidence of irrationality on the part of investors.
In Shiller’s thinking they are insane. Both are wrong because they have
a poor understanding of monetary theory, the
strength of Austrian economics.Sound monetary theory explains investor behavior well and demonstrates that investors are not perfect but are not insane or possessed by the spirits of animals, either.
The truth is that counterfeiting new money by the
Fed to stimulate the economy floods the world with cheap dollars and
reduces interest rates. Ridiculously low rates, like we have seen for
the past five years, encourages risk taking.
Investors take greater risks because money is cheap, bankers are easy,
and the project doesn’t have to leap high hurdles to become profitable.
Savers take greater risks in order to get the yield they need to pay
bills.
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