Nobel Prize Winner Warns of Stock Market Risk

With the Dow Jones stock index up 115% from March 2009 to an all-time high and the number of bearish investors at the lowest point in 25 years, it should not be surprising that this years' Nobel Prize winning economist, Robert Shiller, would warn over the weekend that greedy investors might be blowing themselves a dangerous bubble that might be about to burst and seriously hurt the economy. As the author of Irrational Exuberance, he predicted the top in the 1990s bull market in stocks, the 2005 top in residential real estate and warned in 2007 of a coming bank crisis less than a year before Lehman Brothers filed for bankruptcy. When Shiller talks; people should listen!

Robert Shiller wasn't always a believer in the ability to call for market tops. He received his Ph.D. from the Massachusetts Institute of Technology in 1972 for his thesis: "Rational expectations and the structure of interest rates". Shiller offered an extension of the "efficient market theory" that argued buyers' and sellers' access to market research meant that even after rising 9 out of the last 10 years, the prices of stocks could not be overvalued. But over the next two years, the stock market suffered a 36% decline, the worst back to back decline since the Depression.

Shiller was so rattled by the 1970s crash, he reversed course and in 1981 published an article in The American Economic Review titled "Do stock prices move too much to be justified by subsequent changes in dividends?" to challenge the efficient-market hypothesis, which was the dominant view in the economics profession at the time. Shiller argued that if the stock market was "rational", then investors would base stock prices on the expected receipt of future dividends, discounted over the time. When Shiller examined U.S. stock market performance since the 1920s, he concluded market volatility was greater than could plausibly be explained by any efficient market. Shiller seemed to prove the obvious;the emotions of fear and greed are not "rational."

Over the weekend Shiller warned in Sunday's Der Spiegel magazine: "I am most worried about the boom in the U.S. stock market... Bubbles look like this. And the world is still very vulnerable to a bubble." He is most concerned that stocks in the financial and technology sectors as so overvalued, they will lead to the downside in a crash.

The Federal Reserve's pushing down interest rates to stimulate the economy undoubtedly forced tens of millions of traditional savers to pull their money out of bank CDs yielding less than 1% in order to speculate in the stock market. I estimate that more than half the equity market performance over the last four years is directly related to the Fed's stimulus. But the Federal Reserve also has the responsibility to make sure that their stimulus does not mutate into destructive inflation. Former Chairman William McChesney Martin once famously said that the job of the Federal Reserve was to "to take away the punch bowl just as the party gets going," -- that is, raise interest rates just when economy reaches peak activity after a recession. If the Fed raises interest rates, the stock market will take a tumble and those savers will panic.

The value of the Standard & Poor's stock market index is up by 115% since the "Great Recession" low of March 2009 and 22% of that gain was just in the last three months. From 2008 to 2011, almost a third of investors were extremely negative on the prospects for stock performance, but the public has recently abandoned all caution and this week only one in seven investors believe stock prices will decline over the next year. Recently Goldman Sachs reassured investors that they believe the stock market has substantial upside. But given the average annualized rate of growth in stock prices since 1871 is only 2.16%, was it Goldman Sachs brokers or customers that have substantial upside?

With the Dow Jones stock index up 115% from March 2009 to an all-time high and the number of bearish investors at the lowest point in 25 years, it should not be surprising that this years' Nobel Prize winning economist, Robert Shiller, would warn over the weekend that greedy investors might be blowing themselves a dangerous bubble that might be about to burst and seriously hurt the economy. As the author of Irrational Exuberance, he predicted the top in the 1990s bull market in stocks, the 2005 top in residential real estate and warned in 2007 of a coming bank crisis less than a year before Lehman Brothers filed for bankruptcy. When Shiller talks; people should listen!

Robert Shiller wasn't always a believer in the ability to call for market tops. He received his Ph.D. from the Massachusetts Institute of Technology in 1972 for his thesis: "Rational expectations and the structure of interest rates". Shiller offered an extension of the "efficient market theory" that argued buyers' and sellers' access to market research meant that even after rising 9 out of the last 10 years, the prices of stocks could not be overvalued. But over the next two years, the stock market suffered a 36% decline, the worst back to back decline since the Depression.

Shiller was so rattled by the 1970s crash, he reversed course and in 1981 published an article in The American Economic Review titled "Do stock prices move too much to be justified by subsequent changes in dividends?" to challenge the efficient-market hypothesis, which was the dominant view in the economics profession at the time. Shiller argued that if the stock market was "rational", then investors would base stock prices on the expected receipt of future dividends, discounted over the time. When Shiller examined U.S. stock market performance since the 1920s, he concluded market volatility was greater than could plausibly be explained by any efficient market. Shiller seemed to prove the obvious;the emotions of fear and greed are not "rational."

Over the weekend Shiller warned in Sunday's Der Spiegel magazine: "I am most worried about the boom in the U.S. stock market... Bubbles look like this. And the world is still very vulnerable to a bubble." He is most concerned that stocks in the financial and technology sectors as so overvalued, they will lead to the downside in a crash.

The Federal Reserve's pushing down interest rates to stimulate the economy undoubtedly forced tens of millions of traditional savers to pull their money out of bank CDs yielding less than 1% in order to speculate in the stock market. I estimate that more than half the equity market performance over the last four years is directly related to the Fed's stimulus. But the Federal Reserve also has the responsibility to make sure that their stimulus does not mutate into destructive inflation. Former Chairman William McChesney Martin once famously said that the job of the Federal Reserve was to "to take away the punch bowl just as the party gets going," -- that is, raise interest rates just when economy reaches peak activity after a recession. If the Fed raises interest rates, the stock market will take a tumble and those savers will panic.

The value of the Standard & Poor's stock market index is up by 115% since the "Great Recession" low of March 2009 and 22% of that gain was just in the last three months. From 2008 to 2011, almost a third of investors were extremely negative on the prospects for stock performance, but the public has recently abandoned all caution and this week only one in seven investors believe stock prices will decline over the next year. Recently Goldman Sachs reassured investors that they believe the stock market has substantial upside. But given the average annualized rate of growth in stock prices since 1871 is only 2.16%, was it Goldman Sachs brokers or customers that have substantial upside?

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