Toward Rational Exuberance
The Evolution of the Modern Stock Market
by Mark Smith
reviewed by Ian Bullock

The author writes in his preface that, "The purpose of the book is not to marshal historical evidence to prove that stocks today are either too 'high' or too 'low'; it is instead to help the reader understand that evidence and what it means. Only in this way is it possible to fully understand the modern stock market and the central role it plays in today's economy."

Smith traces the major trends and events since 1901 that have made the market what it is today, but not before giving the reader a prologue of its checkered history in the boom-and-bust cycles in the preceding century. For added color, we also meet some of the rogues and rascals that were active at the exchange during that earlier time.

The year 1901 marks the entry point for the author because the creation of trusts, such as U.S.Steel, and similar events, first gave rise publicly to questions about the true valuation of a public company in that particular New Era. Thereafter followed the ever ongoing clashes between new and traditional methods for valuing stocks. This was also the period of time when Charles Dow wrote his famous series of articles in the Wall Street Journal, later known as the Dow theory, that developed an entirely new way of looking at the stock market, and having nothing to do with the earnings and dividends of individual companies.

Until the end of WW1, Smith notes that venture capital for new and innovative technologies was difficult, or extremely expensive to come by as the investment bankers of Wall Street still clung to the traditional methods of industrial stock valuation based primarily on earnings and (after tax) dividend payout. And the dividend payout had to exceed the bond interest rate by a significant margin to account for the "risk" factor in industrial stocks. Future earnings were still considered to be largely unpredictable. It was during this period that Charles Schwab and other like-minded individuals started to question whether the stock market was misjudging the potential of the American economy and therefore under-valuing industrial stocks. As well, Charles Barron was writing that outsiders could successfully invest in stocks because the longer term price performance would reflect economic trends and the changing fortunes of individual companies, thereby overriding then-prevalent concerns about insider manipulation of the market.

Conventional wisdom has it that the crash of 1929 heralded the onset of the Great Depression of the 1930s; however, Smith devotes a whole chapter to the subject and concludes that the facts indicate otherwise. In fact, his findings show that the crash of 1929 was not much different than many of the crashes during the earlier century and, by contrast, he points out that on October 19,1987, the market dropped twice as much, in percentage terms, as it did on the single worst day of the 1929 crash.

The 1930s saw the introduction of legislation, in the form of the Securities Act of 1933, and the Banking Act of the same year, that were designed to impose statutory guidelines on underwriters of new securities, and strengthen the banking system. Insider trading was curbed with the Securities & Exchange Act of 1934.

The year 1934 also saw the publication of Security Analysis by Ben Graham and David Dodd (considered to be the originators of "value" investing) wherein the authors sought to identify hidden value in the assets of a company whose stock price they considered to be undervalued. A few years later T. Rowe Price introduced the concept of growth stocks investment as a means for investors to protect themselves from the effects of inflation. However, it wasn't until 1952 that Harry Markowitz published a paper entitled Portfolio Selection that introduced the notion of a trade-off between risk and return, then going on to develop the portfolio concept of securities. Smith writes that "Markowitz's ideas, when they finally received the attention they deserved, turned traditional concepts of investment management upside down." Markowitz's work freed up investment managers from the Prudent Man Rule and thereby "made possible the rush to stocks by institutional investors that would characterize the second half of the twentieth century." It was William Sharpe who in 1963 developed a computer model for a diversified Markowitz portfolio, and then followed with identification of the two risk premium factors "alpha" and "beta" in the current parlance, if not use, by most investment managers. Eugene Fama then came along (in 1965) with his theory that in an efficient market, "securities are instantaneously priced to reflect all information available to market participants"; a theory that questioned the very existence of a portfolio manager because nobody could really expect to outperform a truly "efficient" market.

We're not yet in Fama's truly efficient market, although moving in that direction, and Smith warns that "…irrational stock prices pose a potentially dangerous problem for the Federal Reserve. The crash that will presumably occur if and when a speculative bubble bursts may severely test the ability of the central bank to keep the financial system, and the economy, afloat."

Smith concedes that the risk premium investors require has declined, thereby contributing to the rise in stock prices that has already taken place, but cautions that this process cannot go on forever and, "Once the market completes the adjustment to the 'new' risk premium, it will no longer rise faster than the rate of growth in corporate earnings."

Against this background of changing and evolving standards for valuing stocks, the author breaks up the century into discreet segments bounded by major political and economic events. An increasingly regulatory role by government, more often than not brought on by specific events, crises and scandals weaves its way throughout. Smith's research transforms what might otherwise appear to be a dry treatment of historical fact into a fascinating narrative replete with cameo biographies of the colorful personalities that have both brought about, or caused the stock market to evolve from being a primitive insider's game to becoming the economic force that it is at the present time affecting a large proportion of the population, both directly or indirectly.

On all counts Toward Rational Exuberance achieves the objectives set out in the preface, and also makes for highly informative and entertaining reading.

December, 2001

Toward Rational Exuberance
The Evolution of the Modern Stock Market
by Mark Smith
Farrar, Straus and Giroux,
New York, 2001

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