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Robert Shiller in Irrational Exuberance explains how investors get caught up in the mass psychology of the markets and abandon rational thinking. We are reminded of this when we examine how investment decisions were made during the technology boom. As Shiller points out, investor’s behavior then was no different than in the early 1920’s before the 1929 market crash.

As we look back at the 1990’s technology boom, it is hard to understand why we paid over 100 times projected earnings per share for companies that had only been in business a year or two. It is also hard to understand why we paid ever-increasing amounts for shares of start-up Internet companies that had no earnings.

Many new technology and Internet companies bragged about how fast they could spend cash. The executives of these companies would report not on profits but on how much they were spending on marketing and promotion. A new term ‘burn rate’ came into being as a measure of how much cash a company was spending. In Internet companies a measure of business success was how many sets of eyeballs a website could attract per day. During this time the belief was that profits did not matter anymore. This was a new era for business, or so we were led to believe as we followed the crowd.

Ken Fisher, an investment manager and author has a favored expression that captures the essence of following the crowd. He says, “When everyone knows or believes something, it generally is not true”. This certainly turned out to be the case during the technology boom. Many of the things that we came to believe about technology companies and the new business era turned out not to be true. We experienced this in March of 2000 when the bubble began to burst.

Ken demonstrates his point about common knowledge and crowd following by reviewing the annual forecasts of investment managers. Each year he gathers data on what

investment professionals around the country think the markets will do in the next year.

If the majority of the investment professionals forecast that the market will go up by 6-8%, Ken believes that there is a likelihood that the market will either go down or go up much higher. Ken looks either at the minority view or at what the experts did not forecast to get the best indication of what the market will do during the next year.

Ken’s track record in using this approach to predict how the market will perform has been quite good. In the majority of the years, the consensus of the professional investors has been wrong. Yet this is what most of us follow. Following the crowd is easy, as everyone is agreeing. Going against the crowd takes courage and there is often little support.

Robert Shiller further explains that as mass hysteria builds, as it did in the early 1920’s, again it the late 1950’s, and in the 1990’s, business writers and analysts try to help us justify our beliefs and keep the momentum going. Do you recall all of the articles and broadcasts about the era of the 1990’s being a new and different time?

During the 1990’s, there was a lot of talk about the impact the baby boom generation would have on the continued growth of the economy. This time we believed we had a new economy and had licked the business cycle. Technology was going to contribute to unprecedented growth in productivity; and our declining interest rates would continue to stimulate both personal and business spending.

We even heard that profits did not matter any more. The technology boom and its benefits were changing forever the economy of the U.S. Anyone that did not invest in it would lose out. Many technology companies were forecasting growth rates of 60, 70, and 80% to continue for many years.

During the technology boom, the number of families investing in the stock market grew from about 40% to about 65%. There was no way we thought that any technology investment was a bad bet. We did not want to miss out so we dove in and drove stock prices even higher.

Reality hit in March of 2000 when the house of cards began to fall.

During this time, most of us abandoned rational thinking as we got caught up in the momentum of the crowd. We were tempted by the rewards of instant gains and feared being left out.

We did not take time to analyze what was happening to the valuations of stocks we were buying.

There were a few investment professionals who were saying in 1998 and 1999 that the market was over priced, the free-for-all spending could not go on forever, companies had to make a profit if they were going to survive, and the market always returns to historical valuations.

A few got out of the market in 1998 and 1999 only to be severely criticized as the market continued to rise. In March of 2000 they became instant geniuses as the market began its decline. The few lone wolves in the crowd were right as rationality began to return to the market.

The lesson learned from this experience is to understand what makes sense, what is rational, and what is not. Even though the market reacts somewhat irrationally every day, means that its valuation may have little to do with reality.

Don’t get caught up in the hysteria of the crowd. Stick with investment fundamentals. Make your own assessment based on your investment principles and your view of the current economic environment.

In the long run the fundamentals of a company and the health of the U.S. economy determine what a fair value is for a company’s stock and for the entire market. When these values get out of touch with reality, as they have for periods of time, they have always returned to fair value and reality.

Chapter 10