Investors are mentally ill – Nobel Laureate

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.

So how do good economists identify bubbles? Any time the Fed counterfeits to stimulate a bubble will appear in some or all assets. Just look for the assets with the most rapid growth. Today that would be stocks and bonds.