A few years ago I had the good fortune to interview Robert Shiller of Princeton University (Listen to the audio interview.) His name will probably be familiar to you. Shiller won the Nobel Prize for Economics, along with Eugene Fama and Lars Peter Hansen of the University of Chicago this past week. Shiller is an influential economist whose housing index is a valuable leading indicator of home prices. We spoke about documenting human capital.
He’s also the man who coined the phrase “irrational exuberance” that described the behavior of investors during the dotcom and housing bubbles. The upshot of this is that there are huge variations in the price of an asset compared to its intrinsic value, but that prices will return to an average price over time. In the long run, the markets win, which was the contribution of Shiller’s co-Nobelists, Fama and Hansen.
I’ve been thinking about bubbles. They seem to occur at the outset of every market, a bubble unto itself, in essence, that will make or break a new industry. It is clear a market can be organized around anything, and within any market there is opportunity to profit by jumping aboard. Within those nascent markets, firms act like individual investors (and firms) that drive exaggerated valuations. I think this describes all fad behaviors and the market organized around them. Likewise, as a vet of the trade and financial press, I’ve seen whole industries form around, and that intense activity dissipate, a market as it grows until it reaches maturity. From inception to maturity, markets act erratically. Investors put money into the wrong places, and at the same time more investors enter the market, exacerbating the chaos of early growth. Some bubbles actually die out, like the pet rock of the gasoline automobile, but others become part of the sedimentary history of an economy.
This occurred to me because I read about the explosion of scientific papers published annually, which is resulting in very high degree of findings which cannot be reproduced. Eugene Samuel Reich, writing in Nature this week, quoted Henk Mode of scientific publisher Elsevier:
He notes that some institutional rankings, such as the Academic Ranking of World Universities, compiled by Shanghai Jiao Tong University, give explicit weight to the number of Nature and Science papers an institution has produced — making it likely that some universities would then begin to rank prospective faculty by the same measure. “There is more and more evaluation, and a need for researchers to prove their quality,” Moed says. “Journal reputations play a role, and that role has increased.”
That is the description of what happens in the early stages of growth, too, as intermediary players pile into a new market. Publishers of key data and news fructify around the mass of investors in the market, whether for dotstocks or housing derivatives or, as I see here in Washington State with the nascent marijuana market. All the missed investments will be recaptured by the market aggregator that eventually triumphs. This is why the greatest wealth is almost always from a reorganization of the economy, not simply innovation. The Walton and Gates fortunes, for example, come from aggregating markets in the wake of early broad innovations, which are consolidated and made normal, in the sense the product becomes a commodity.
The chaos at the core of the market, where the most investment exists in the form of capital and labor working in close order, is also analogous to the hot center of a bee colony, where the queen and the genetic investment exist in a perpetual swarming, while the bee colony as a whole maintains an equilibrium. In markets, the rapid early growth will end, consolidation will occur, and prices will settle down to at or near their intrinsic value, so that the only action in the markets come as long options chains.
Shiller’s insight will be discovered to be richer by each generation for millennia to come.