A long wait for bursting bubbles

Irrational Exuberance by Robert Shiller (Princeton University Press, £17.50)

As the share prices of dot.coms and high-tech companies fall to earth, you have to wonder whether the bubble is finally bursting. Yet many people still find it hard to shake the gut feeling that nothing should be allowed to spoil the party, even though the rational mind insists stock markets have been wildly overvalued.

Robert Shiller, a highly respected professor of economics at Yale University in the US, offers in this timely book some food for the intellect to chew on. He points out that if the general level of share prices were to fall back to their mid-1990s level - a drop in the S&P 500 from about 1,400 to about 500 - the inflation-adjusted losses would be comparable to the destruction of all the farms, or all the homes in America.

So why have share prices soared so high in the past five years, taking market valuations past all historical records? Professor Shiller's answer, as the title indicates, is not encouraging. His message is - diversify now as much as you can, and batten down the hatches.

He draws on history, giving previous examples of "New Era" optimism or irrational exuberance, to borrow the phrase coined by Alan Greenspan, the Federal Reserve chairman, in December 1996. People in the 1920s felt the same way about household electrification and the radio as we do about the internet.

"Because these innovations had such an impact on everyday lives, affecting people in their homes and in their hours of leisure, the 1920s were a time when massive technological progress was unusually apparent to even the most casualobserver."

Yet the Great Crash of 1929 and the subsequent Great Depression not only put an end to new era-ism but also paved the way for a reaction against capitalism, fuelling communism and fascism.

Professor Shiller also turns to political economy, saying the continuing rise in the share of the economy corporate profits must take to justify anything like current share prices will prove politically unacceptable.

He believes earnings expectations imply that by 2010 the profit share will rise to about double its highest post-war peak so far. The first stirrings of political backlash against globalisation suggest that might be implausible. And it is a backlash not only against corporations but also against specifically American corporate muscle.

The book says it would be a mistake to assume the US government will not respond, as it has before. This could mean a tougher anti-trust policy as in the early years of the century, or a higher tax on corporate profits, recently as steep as 50.75 per cent. It seems off the political scale at present but the public mood can swing fast, and elected governments swing with it.

But the most fascinating section of the book is one where the author gives examples of psychological experiments to argue how flimsy the anchors for the level of the stock market can prove to be. "Psychological anchors for the market hook themselves on the strangest things along the muddy bottom of our consciousness," he says. Over many years, Professor Shiller has sent questionnaires to investors, asking them what they believe and why they make certain investment choices, an obvious technique for a financial economist, but far removed from the abstract theoretical realm many financial experts inhabit.

It is a convincing demonstration that a series of feelgood articles in the media (which have not been too breathless, giving frequent warnings of the danger of a bubble), or word-of-mouth recommendations from friends, or just innate human over-confidence and a tendency to herd-like behaviour, can drive share prices up without a quantitative reason.

He gives the "efficient markets" theory short shrift indeed: stocks can be hugely mis-priced, and clever people really can make more money from investing than not-so-clever ones.

Investors who read Professor Shiller's book and buy his arguments will follow his advice and diversify out of shares.

If enough of them did so, Irrational Exuberance would turn out to be a self-fulfilling prophecy. When Alan Greenspan gave the speech in which he used that phrase, when the S&P500 index stood at a level approaching 700, he did trigger a sharp correction in the US stock market. It was extremely short-lived.

Investors paid no attention to the chairman of the Federal Reserve. (Admittedly, not many private investors know what that is; one Fed survey found the most popular view was that it was a brand of malt whisky.)

And, after all, this book follows numerous warnings about the existence of a stock market bubble. Not only Mr Greenspan has sounded a note of caution. So have the head of the Securities and Exchange Commission, the head of the Financial Services Authority in the UK and now the Chancellor of the Exchequer.

Will one more warning, from however brainy a professor, finally convince us that the bubble is bursting? It doesn't seem very likely. So, carry on partying, dudes! But I'm not going to subscribe for any new dot.com shares after reading this.