10 Questions: About The Stock Market

Last week was a roller coaster ride for the stock market—and nervous investors. Buy? Sell? Sit tight? Panic? (The last, of course, seemed the most popular.)

On Thursday, the Federal Reserve injected $24 billion into the financial system; the very next day, it injected $38 billion. That was the Fed's largest intervention in the economy since the days when the market reopened after 9/11.

But to everyone's surprise, despite the Dow's scary 387 point plunge on Thursday, the market actually closed UP for the week. Not by much, .4%, but up.

(Yale University)
To make sense of all this, we called Robert Shiller, an economist at Yale University, who wrote the best-selling "Irrational Exuberance," about the stock market boom of the 1980s and `90s. He's more-than-capable of talking markets, models, valuation ratios, international risk sharing -— but he's also been married for 31 years to a psychologist. We thought he'd have an interesting take on the market, and some insight into what we might expect as a new week of trading begins.
1. So what was going on last week?

Markets do this. They go through sudden drops and get people rattled. Since 1950, we`ve had more than 50 such drops. It happens every year or so.

Markets all over the world have been booming. Countries are setting new records for the first time since 2000, and even depressed countries like Japan have been booming.

Now some investors are starting to wonder if it`s coming to an end. It`s very simple. Some people start saying, I`m getting out.

But because it`s coming at the end of a real estate boom, and at the end of spectacular growth in the stock market, there is the sense that something might be wrong, and that it could develop into something worse.

2. Are we seeing a replay of the 1990s' irrational exuberance, followed by the bubble`s burst?

The stock market never got as exuberant in recent years as it did in the 1990s. But I would say we`ve had irrational exuberance in the real estate market.

In the 1990s we had money-investment magazines and TV shows about investing. (And let`s face it, some of those are really boring, unless you get excited by investment prospects.) After the stock markets peaked, people lost interest, and then we got new investment clubs for homes and TV shows like "Property Ladder." That term refers to when you buy a house, it appreciates, you flip it and buy another.

3. Last Thursday, the US stock market began dropping after BNP Paribas, a bank based in France, halted investors` ability to withdraw their money from funds with investments in American home mortgage securities. This sounds like a run on the banks, like the opening of a Frank Capra movie from the 1930s.

It does sound similar to a run on the bank; some things never change. It makes it sound as if this is a big crisis happening in Europe and the U.S. It can have a tremendous psychological effect on all sorts of people.

4. And what was the connection between home mortgages in the U.S. and the French bank?

When you say "French bank," you have to remember that barriers across nations are falling, that we have multinationals everywhere, that this "French bank" may have an office three blocks from where you live, and that you could walk in and not hear any French being spoken.

Several funds at Paribas had invested in subprime mortgages, which is a very risky investment. Those are mortgages issued to a borrower who would only marginally qualify, who doesn`t have a good credit history. Many were made during a bad time in the real estate boom, and now often their homes aren`t worth what they`ve paid for them, and they default.

Paribas had several investment funds that had invested in subprime mortgages. People started withdrawing their money, but the price of the mortgage securities was dropping so fast that Paribas didn`t know what they were worth. So Paribas froze them and said, You can`t take your money out.

5. We hear a lot about hedge funds recently? What exactly is a hedge fund?

It`s not a technical or a legal term. It`s basically an investment company that doesn`t market to the general public but to wealthy investors. Because they don`t advertise to the general public, hedge funds are not subject to the usual federal restrictions—and federal protections. (The thinking behind that is that wealthy people know what they`re doing when it comes to investments.)

Hedge funds take high-risk, sophisticated strategies, and they charge high fees, often 20% of capital gains. There`s been a boom in hedge funds in the last 10 years, and there's this envy because people think that hedge fund managers are the best and the brightest, and that the average Joe can`t get in. There are few women managers. It`s high-testosterone, macho, for the super rich. It`s the Wild West.

In order to justify these tremendous management fees, the managers have to do something dramatic. And one thing they`ve been doing is investing in subprime mortgages. Prices start dropping when hedge funds start to dump them, and it affects other financial institutions. Once confidence starts to fall, everyone tries to sell. It can be like a bank run.

6. Fill us in briefly on what`s been happening in the U.S. housing market, which as you've said is now feeling the aftereffects of "irrational exuberance"?

This has been the biggest boom in the housing market ever. It`s been going on since 1997. It reflects a new thought on home prices-that they`ll go up forever. People didn`t always think this way.

The last eight or nine years have seen a speculative boom in housing. By that I mean, people have been looking at homes, and they might find one they don`t really like but end up buying anyway because they think the price will go up. That`s an unstable situation.

I suspect the boom may be over and we`ll see years of decline. Some of that has to do with the fact that a lot of people lose interest, that only a minority are really interested in investing in real estate or the stock market to begin with. For most people, it`s only interesting because it`s going up.

The biggest worry is for people who have overinvested in real estate. They`ve taken out big mortgages, they don`t need this big house. That can lead to a lot of stress on families, a lot of unhappiness and if the market drops, to recession and unemployment.

Construction was at near record levels in 2006, and now it`s pulling back. There`s a lot of supply on the market, and the market has to absorb that.

7. Whenever talk turns to the economy, China always comes up. Should we be worrying about China's effect on our economy?

China`s been growing at 9% a year. We`re all spooked by China, there are a billion people and they`re getting rich fast. Good for them, but it`s not irrational for people here to be concerned. The Chinese central bank is investing in U.S. government bonds,and that`s supporting our currency and our government deficit. If they were to pull out, that would contribute to a credit crunch and push interest rates up.

We`re more self-sustaining than a lot of people realize. Our toys and knick-knacks come from China, but we really don`t buy that many. When you buy your gardening supplies, when you have your house fixed, when you send your kids to school, China doesn`t play a role.

8. We`ve heard the phrase "liquidity is drying up" a lot recently. What exactly does this refer to?

Liquidity is the ability to sell something quickly. There`s been a lot of concern recently that we`re ``awash with liquidity.`` People thought the central banks were too loose and lending too freely. But it`s not clear that was the case.

Liquidity is more of psychological thing. This has been a theme of mine, that psychology matters a lot in the markets. I wrote a paper about this in 1981 and was attacked by a good part of the finance establishment then. But I`ve stuck by it, and no one`s proven me wrong. –

9. Do you invest in the stock market?

Yes, but less than most people. I did sell off some of my stock in the last few weeks and put money in short-term treasuries, where you get around 5 1/4%. I`m in that mood.

10. With all the volatility of last week, what might we expect to happen in markets this week?

The market is vulnerable right now. This year the market has seen some big quakes.

I think the market is too highly priced, but the stock market is very hard to forecast. Anyone who`s said it can be forecasted has usually been proven wrong.

Paradoxically, this recent drop could yet bring the market to new highs. All these noisy moves create the exciting story of the day, it brings people in, gets people thinking about it, and they just might be big buyers. It`s a crazy game.

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