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1-Page Summary of Irrational Exuberance

Remembering the Fundamentals

Financial theory assumes that people are rational and make decisions based on facts. Investors look at financial reports, calculate returns, compare investments, consider fundamental economic values and risk before buying or selling stocks. Because the current economic system is based on this assumption and because the Federal Reserve Board uses models derived from it to manage wealth, it’s important to note that individual investment decisions aren’t rational.

In the 90s, many people invested in stocks due to a belief that they would continue to rise. Even when stock prices were extremely high and out of line with earnings, profits and fundamental values, investors kept buying.

After the crash of 2000, investors focused on real estate as their next big bet. Although prices began to rise in 1997, they really took off after 2000. This was because unhappy buyers lost confidence in stocks and didn’t learn from their mistakes.

While stocks were tripling in price, home prices rose at an even faster rate. This is historically unprecedented and has been called the “real estate bubble.” The rise of real estate prices was so extreme that newspapers, which previously supported rising stock prices, began to call them a “bubble.”

Historical Perspective

In the early 2000s, the stock market tripled in value. During that same period, personal income and gross domestic product rose less than 30 percent. Corporate profits rose only slightly more than that. Home prices increased by 9 percent during that time frame. Given these figures, this increase was unwarranted because earnings did not rise at a comparable rate as the stock price increases had done so dramatically over previous years. In fact, stocks have been rising for decades with no major changes to their growth rates or values despite some fluctuations here and there which were largely due to economic conditions such as inflation or deflation rather than actual company performance of those businesses themselves. The bubble started in the 1980s when investors began buying stocks at unsustainable prices based on irrational expectations about future returns on investment which could never be met given how quickly they inflated beyond any reasonable valuation metrics for stocks like earnings per share or return on equity. This is similar to what happened during the Roaring Twenties before it ended with a crash in 1929 just after Black Tuesday caused by panic selling from speculators who lost money when they tried to sell all their holdings all at once without regard for the underlying fundamentals of companies whose shares they owned which showed signs of trouble even then but were ignored until it was too late.

Real estate prices have been going up at an unprecedented rate. The only other similar increase was just after WWII, which had a fundamental support in the form of returning soldiers who got married and bought homes with government subsidies. However, this recent rise is largely speculative, with no relationship to population growth or interest rates. People seem to be buying homes like they did stocks during the ’90s – convinced that prices can go up indefinitely. Financial history does not support this conviction; house prices increased only 0.4% per year compounded from 1890 through 2004. It’s rational to expect home prices to have a low ceiling as more than 97% of land in the U.S is empty and it’s easy to find a place outside costly metro areas

The Price-Earnings Ratio

Historically, one can see that high returns follow low price-earnings ratios. The opposite is also true, with low or negative returns following high price-earnings ratio years. In January 2000 the P/E ratio hit 44.3. This was a new record for the United States and there are no precedents to predict what would happen next. We do know that in 1901 the P/E ratio reached 25.2 with no immediate reversal of fortune (prices kept going up). By 1920 prices had fallen back down to pre-1901 levels (about 3 times lower than they were before). When we look at 1929, we see another example of a very high P/E ratio of 32.6 just before the crash occurred (-80% drop from peak value). It took until 1958 for prices to return to their September 1929 level which means an average real loss of -13% per year compounded over 20 years! Similar results happened when looking at 1966 when it reached 24.1 as well as 1975 where it fell 56%.