Joe: Everyone thinks the stock market is driven by brilliant analysts and complex algorithms. What if the real drivers are the same forces that make a cat video go viral? A mix of herd behavior, wild stories, and pure, unadulterated FOMO. That's the rabbit hole we're jumping into today. Lewis: I love that. Because it feels true. You see a stock ticker on a news channel, and it feels like this serious, impenetrable fortress of logic. But then you remember GameStop, and you realize, oh, it’s just a bunch of people on the internet getting excited about the same thing at the same time. Joe: That is precisely the territory we are exploring. And this idea comes from a book that's become legendary for its timing. We're talking about Irrational Exuberance by Robert J. Shiller. Lewis: The Nobel laureate, right? I heard the first edition came out in March 2000, almost to the day the dot-com bubble peaked and then spectacularly imploded. That’s not just good timing; that’s a mic drop. Joe: It's an all-time publishing moment. Shiller wasn't just observing; he was standing on the rooftops, shouting a warning. He saw the psychological fever building and he gave it a name. So let's start there, with the anatomy of that fever.

Joe: To really get this, we have to go back to the late 1990s. It was a wild time. The internet was new and exciting, and companies with a ".com" at the end of their name were being valued in the billions, even if they'd never made a single dollar of profit. Lewis: I remember the stories. Companies that were basically just a good idea and a website were having these massive IPOs. It felt like a gold rush. Joe: It was. And in the middle of all this, on December 5, 1996, the most powerful economist in the world, Federal Reserve Chairman Alan Greenspan, gives a speech at a black-tie dinner in Washington D.C. The markets are hanging on his every word. And in the middle of this very formal, televised speech, he poses a question. He asks, "But how do we know when irrational exuberance has unduly escalated asset values?" Lewis: Wow. "Irrational exuberance." That’s the phrase. What happened? Joe: The moment he uttered those two words, markets around the world went into a nosedive. Tokyo, Hong Kong, Frankfurt, London, and then Wall Street. They all dropped, and sharply. It was a global, instantaneous reaction. Lewis: Hold on, so the market dropped just because one guy used two specific words? That sounds insane. Were people just hanging on his every syllable, waiting for a secret code? Joe: It does sound insane, but that's the whole point Shiller makes. It wasn't just the words themselves. It was that Greenspan, the high priest of the economy, had given a name to a feeling that millions of investors secretly had. The feeling that, "This is amazing, but it doesn't quite make sense. This can't last forever, can it?" He punctured the collective fantasy for a moment. Lewis: He basically held up a mirror to the market and the market flinched. So, how did Shiller know it was a bubble before it burst? Did he have some secret metric that no one else was looking at? Joe: He had a very powerful one, and it’s one of his most famous contributions. It’s called the Cyclically Adjusted Price-to-Earnings ratio, or CAPE. Lewis: Okay, that sounds complicated. Break that down for me. Joe: It’s actually pretty simple in concept. Think about buying a house. You could look at its price today and the rent you could get for it this year. That’s a simple price-to-earnings ratio. But what if rents were unusually high this year because of a temporary event? That ratio would be misleading. Lewis: Right, it would make the house seem like a better deal than it really is. Joe: Exactly. So what Shiller did was brilliant. For the stock market, instead of just looking at one year of corporate earnings, which can be volatile, he averaged them out over the previous ten years and adjusted for inflation. This gives you a much smoother, more stable picture of the market's real earning power. The CAPE ratio is the current stock price divided by that ten-year average of earnings. Lewis: So it’s like a long-term reality check. What was the CAPE ratio telling him in the late 90s? Joe: It was screaming red alert. In 2000, the CAPE ratio hit 44. To put that in perspective, its historical average is around 16 or 17. The only other times it had gotten anywhere near that high were right before major crashes, like in 1929 and 1966. Shiller looked at that number and said, "History suggests this will not end well." And he was right. Lewis: That’s incredible. It’s like he had a fever thermometer for the market, and it was reading off the charts. Joe: And that’s the core of irrational exuberance. It’s a speculative bubble driven by a psychological feedback loop, where rising prices fuel investor enthusiasm, which attracts more investors, which pushes prices even higher, all while the underlying value, measured by things like the CAPE ratio, gets left further and further behind.

Lewis: Okay, so we have a psychological fever and a thermometer to measure it. But what's actually stoking the fire? What causes this 'exuberance' in the first place? It can't just be greed, right? Joe: Right. Shiller argues that bubbles don't just appear out of nowhere. They are ignited by what he calls "precipitating factors"—a perfect storm of structural and cultural changes that, together, create the fuel for the fire. And some of them are incredibly surprising. Lewis: Give me some examples. Are we talking about big economic shifts? Joe: Some are, but many are things you wouldn't normally connect to the stock market. For instance, he points to the rise of the 401(k) and other defined contribution pension plans. Lewis: A 401(k) causing a bubble? That sounds like blaming a salad for weight gain. How does something so mundane contribute to market madness? Joe: Think about it. Before the 80s, most people had pensions managed by professionals. They never had to think about stocks. Suddenly, with 401(k)s, millions of ordinary people were forced to become amateur investors. They had to choose: stocks, bonds, or money market funds. This created a massive new wave of public attention and demand for stocks. Lewis: Huh. So it democratized investing, but also maybe democratized getting swept up in the hype. What else? Joe: The explosion of financial media. In the 80s and 90s, you suddenly had 24-hour news channels and entire sections of newspapers dedicated to business news. The stock market wasn't just a financial mechanism anymore; it became a spectator sport, a national drama with daily winners and losers. This constant coverage acted like a massive, free advertising campaign for the market. Lewis: It turns investing into a story, a narrative. And people love stories. Joe: Precisely. And one of the most powerful stories of the 90s was the internet. Shiller points out that the arrival of the World Wide Web in the mid-90s happened to coincide with a period of really strong corporate earnings growth. Now, that growth was mostly due to a recovery from the earlier recession and other boring economic factors. The fledgling internet companies weren't making any money yet. Lewis: But it didn't matter, did it? People saw two things happening at once—this amazing new technology and booming profits—and their brains just drew a line connecting them. Joe: Exactly. The public perception was that the internet was creating a "New Economy" where the old rules didn't apply. This narrative was incredibly contagious. And this is where Shiller introduces a fascinating and slightly terrifying analogy. He says that these factors combine to create what is essentially a "naturally occurring Ponzi scheme." Lewis: Whoa, okay. A Ponzi scheme is an intentional fraud. How can a market be a Ponzi scheme? Joe: In a classic Ponzi scheme, a con artist pays early investors with money from new investors, creating the illusion of high returns. The success of the early investors is the advertisement that recruits the next wave. Shiller argues a bubble works the same way, but without a central con artist. The initial price increases, sparked by the precipitating factors, create profits for the early investors. Lewis: And their success stories—"My neighbor just made a fortune on this dot-com stock!"—become the word-of-mouth advertising that pulls everyone else in. Joe: You got it. The rising price becomes the advertisement for itself. The feedback loop takes over. Price increases lead to positive stories, which lead to more investors, which lead to more price increases. It's a self-fulfilling prophecy. Lewis: Right, so it's not a con artist in a back room; the market itself becomes the con artist. That’s a chilling thought. The system itself is designed to fool us.

Joe: And that brings us to the deepest level of Shiller's analysis. It's not just about market structures or cultural stories. It's about our own minds. Why are we, as individuals, so easily drawn into these feedback loops? Lewis: This is the big question. Why do we fall for it every time? It can't just be that people are unintelligent. Joe: It has almost nothing to do with intelligence. It's about how our brains are wired to make decisions under uncertainty. Shiller talks about the power of "psychological anchors." Our minds are constantly looking for a reference point, an anchor, to make sense of the world. Lewis: Like a starting point for a negotiation or something? Joe: Exactly. And he points to this classic, mind-bending experiment by the psychologists Amos Tversky and Daniel Kahneman. They brought people into a lab and had them spin a wheel of fortune, which was rigged to land on either 10 or 65. Then they asked them a totally unrelated question, like, "What percentage of African nations are in the UN?" Lewis: Okay, that's a weird setup. The wheel is completely random. It shouldn't have any effect on their answer. Joe: It shouldn't. But it did, dramatically. The people who saw the wheel land on 10 guessed, on average, that the answer was 25%. The people who saw it land on 65 guessed, on average, 45%. The random, meaningless number served as an anchor that dragged their estimates along with it. Lewis: That is terrifying. So how does this apply to investing? Joe: Think about a stock price. What is a company like Apple really worth? Nobody knows the exact number. It's an ambiguous question. So what do we anchor on? We anchor on the price we saw yesterday. Or the 52-week high. If a stock hit $200 last month, our brain uses that as a reference point. We start thinking, "Well, it was $200, so $180 must be a bargain," without ever asking if the fundamental value is actually closer to $50. Lewis: Oh, I've totally done that. You see a house sell for a million dollars on your street, and suddenly you think your much smaller house must be worth $800,000. The first number just sticks in your head and becomes the new reality. Joe: It becomes the anchor. And this leads directly to the next phenomenon: herd behavior and what are called "information cascades." Shiller uses a simple but perfect analogy: choosing a restaurant. Lewis: Okay, I'm with you. Joe: Imagine you're in a new town and you see two restaurants side-by-side. They look identical, but one is packed with people and the other is completely empty. Which one do you choose? Lewis: The busy one, of course. You assume all those people must know something you don't. Maybe the food is better, or the empty one has a health code violation. Joe: Right. You ignore your own private information (which is nothing) and you follow the herd, assuming they have better information. That's an information cascade. The first few people might have chosen randomly, but once a small crowd forms, everyone else just follows, and the other restaurant stays empty, even if it's actually better. Lewis: And that’s the stock market. A few people start buying a stock, the price goes up, other people see the rising price and the crowd forming, and they jump in, assuming the first group knew what they were doing. Joe: Exactly. It becomes rational for each individual to ignore their own doubts and follow the group. The problem is, the group as a whole can be running in a completely irrational direction, all based on a tiny bit of initial information, or maybe no information at all. We are wired to seek safety in the consensus.

Lewis: So, if we know all this—that markets are fundamentally psychological, that they run on these feedback loops, and that our own brains are wired with these biases to follow the herd—what's the takeaway? Are we just doomed to repeat these bubbles forever? Joe: That's the billion-dollar question, isn't it? And I think Shiller's ultimate point isn't that we can perfectly predict or stop bubbles. He's a Nobel laureate, but he's not a fortune teller. The point is that we need to change the conversation. We need to stop treating the market like it's a math problem that can be solved with enough data. Lewis: And start treating it like what it is: a human story. Joe: A human story, exactly. A story full of emotion, misinterpretation, and collective belief. Shiller argues the real risk in a bubble isn't just losing money; it's the risk of getting swept up in a collective delusion. It's the risk of outsourcing your thinking to the crowd. Lewis: So the most powerful tool we have is just a healthy dose of skepticism? The ability to step back from the hype and ask, "Wait a minute, does this story really make sense?" Joe: It’s the ability to ask, "Is this story really true, or does it just feel good right now?" Because the narratives during a bubble are always incredibly seductive. The "New Economy," the "Ownership Society"—they promise a future where everyone wins. Lewis: And it feels good to believe in that. It’s much harder to be the person in the corner saying, "I'm not so sure about this." Joe: It is. So maybe the most practical takeaway from Shiller's work is a simple mental check. Before you make a big financial decision, whether it's buying a stock or a house, ask yourself one question. Lewis: What's the question? Joe: "Am I buying this because I've looked at the fundamentals and I believe in its long-term value, or am I buying this because the price is going up, everyone else is doing it, and I have a terrible case of FOMO?" Lewis: That’s a tough question to answer honestly. It requires a level of self-awareness that's hard to muster when you're seeing dollar signs. Joe: It is. But being aware of the irrational forces at play is the first and most important step toward not becoming their victim. It's about recognizing the ghost in the machine. Lewis: It’s a fascinating and humbling perspective on something we think of as so rational. Joe: It really is. And we’d love to hear your own stories of getting caught up in the hype—or successfully resisting it. Find us on our socials and share your experience. We all have a story about a time we almost, or did, get swept away. Joe: This is Aibrary, signing off.