Archive for April 17th, 2012

The Rational Exuberance

 

In the age of information, quotes become books and books become religion, almost. Robert Shiller’s Irrational Exuberance was a voice of caution that appeared in March 2000, before the start of a decade long sequence of negative fluctuations. The book itself was written about economic bubbles and investor psychology.

Shiller’s based his work on his 1981 research paper in the American Economic review, where he showed the divergence between fundamentals and market prices. He took the 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 illustrated that PV behaves remarkably like a stable trend. In contrast, stock price index gyrates, wildly up and down around this trend. Shiller’s contention was that the divergence was much larger than what valuation could explain. Price change was driven by psychology not by fundamentals. He suggested feedback dynamics between human interactions as the explanation for excessive volatility or bubbles.

Who owns the truth?

On one side Shiller and other new age experts highlighted the weakness in the assumption of efficiency, but on the other hand was it correct to swing to total irrationality (inefficiency)? Why could we not give benefit of doubt to earlier thoughts on rationality (normality)? After all there were no tera-bytes of data and real computing power. In hindsight the rationalist argument might have gaps, but how do we think tomorrow would judge the “irrationalists”?

A recent award winning paper by David N. Esch in the Journal of Investment Management addresses the…

This article was written for Business Standard

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Mukul Pal, is a Chartered Market Technician, MBA Finance and a member of the reputed Market Technicians Association (MTA). He has more than a decade of Capital Market experience dealing with derivatives and global assets. He has worked for Bombay Stock  Exchange, multinational Banks and brokerage houses in leading research positions before starting on his own in 2005. He is the President of the MTA Central and Eastern European Chapter.