Semi-Rational Exuberance

In 1996, Yale economist Robert Shiller looked around, considered the historical record, and concluded that the American stock market was overvalued. In the past, whenever price-earnings ratios were high, future long-run stock returns were low. But now prices on the broad index of the S&P 500 stood at 29 times the average of the past decade's earnings.

On the basis of econometric regression analyses carried out by Shiller and Harvard’s John Campbell, Shiller predicted in 1996 that the S&P 500 would be a bad investment over the next decade. In the decade up to January 2006, he argued, the real value of the S&P 500 would fall. Even including dividends, his estimate of the likely inflation-adjusted returns to investors holding the S&P 500 was zero – far below the roughly 6% annual real return that we have come to think of as typical for the American stock market.

Shiller’s arguments were compelling. They persuaded Alan Greenspan to give his famous “irrational exuberance” speech at the American Enterprise Institute in December 1996. They certainly convinced me, too.

But Shiller was wrong. Unless the American stock market collapses before the end of January, the past decade will have seen it offer returns that are slightly higher than the historical averages – and much, much greater than zero. Those who invested and reinvested their money in America’s stock market over the past decade have nearly doubled it, even after taking account of inflation.