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Irrational Exuberance Explains Google Jitters

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Shares of Google fell 7% on February 1st this year after the firm reported that its fourth quarter earnings rose by 82% or $1.22 per share rather than the expected rate of $1.50 per share. [BBC ]

Google’s stock has been priced for perfection so any minor perceived downturns extract a large price on the stock. But Google is not the only stock that is “priced for perfection” and hence suffers from catastrophic declines as a result of bare failure to meet sky-high expectations. It seems the whole stock market is besieged by nervous anxiety – ready to pounce upon companies showing any sign of weakness. The phenomenon has a name – “Irrational exuberance”, first coined by ex-Federal Reserve Chairman Alan Greenspan to describe the dot-com bubble of the late 1990s.

Yale economist Dr. Robert Schiller co-opted this term, Irrational Exuberance, for the title of his book that explicates further about the phenomenon. Schiller, through his research on stock price data and earning ratios, puts forth convincing evidence that many of the stocks are absurdly over-valued and hence investors are very sensitive to any signs of weakness in a company. Schiller has also incorporated statistics on the housing prices in his book.

Markets have often been often hailed as being a great barometer to accurately judge the profit potential of a company. Schiller shows that markets are prone to error. He discusses factors like culture and high-profile coverage of Internet in media as reasons that led to the creation of a bubble. On the question of how so many people got it wrong, he uses factors like Asch conformity (named after an experiment done by Dr. Solomon Asch to show influence of peer pressure on people) to explain “how people can listen to others against their own best judgment.”

“Irrational exuberance” and resulting inflated stock prices have created a very nervous market heavily dependent on the nervous cues of analysts and the quarterly results of the companies. The reliance on those factors has made many CEOs reluctant to making any substantial changes that will affect quarterly results until of course the company’s situation is critical and the knowledge of that public. Carly Fiorina, ex-CEO of HP, has publicly lamented that the increased focus on Quarterly results prevented her from initially doing the restructuring that she had envisioned. The other major consequence of the continued stock market and housing bubble is that shareholders have become more active in ensuring the welfare of ‘their’ companies.

Of course the most important possible consequence of “irrational exuberance” is the possibility that it will lead to depression or worse. John Campbell and Robert Shiller in their paper, “Valuation Ratios and the Long-Run Market Outlook: An Update,” posted on Yale University, calculated that share prices divided by a moving average of 10 years worth of earnings reached 28 just prior to the crash of 1929 as compared to 45 on March 2000. [Wall Street, October 1929 ] A major correction to the sustained bull run on the wall-street can have major consequences.

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  • Dave Nalle

    It’s dismaying to me that an 82% increase in profits in a quarter could be viewed by people as a bad sign and cause a drop in stock value of 7%. That’s just bad craziness.

    Dave