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On the stock market last Tuesday the Federal Reserve Board raised short-term interest rates for the first time in two years. That sent shudders through Wall Street, and today the Dow Jones Industrial Average was down again 157 points. Our economics correspondent Paul Solman of WGBH-Boston looks at what makes the market move.

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JIM LEHRER: Still to come on the NewsHour tonight the psychology of the stock market and railroads in America. On the stock market last Tuesday the Federal Reserve Board raised short-term interest rates for the first time in two years. That sent shudders through Wall Street, and today the Dow Jones Industrial Average was down again 157 points. Our economics correspondent Paul Solman of WGBH-Boston looks at what makes the market move.

PAUL SOLMAN: The stock market. Talk of its rapid ten-year rise may be getting as cliched as the footage so often used to depict it, but since some 43 percent of Americans now play the market, one question is on lots of lips these days. Are stocks irrationally high, thus, headed for a fall?

ALAN GREENSPAN, Chairman, Federal Reserve Board: (December 1996) How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?

PAUL SOLMAN: That was Federal Reserve Board Chairman Alan Greenspan last December, worried that if the market was significantly overpriced, it could suddenly drop, depressing both investors and the economy. And more recently in a program called "Betting on the Market," the PBS series "Frontline" documented exuberance that sure looked irrational to us.

DOROTHY FREEH: It's got to go back up. It's got to. It was already up there.

PAUL SOLMAN: This is a neighborhood investment club, one of ten thousand formed in the U.S. last year.

SHARON GORNIE: We could get the "Wall Street Journal" and see what the high was--and the low.

PAUL SOLMAN: Sharon Gornie, a mother of three, who owns a small carpet business with her husband, has put her entire life savings in the stock market, with a big chunk in shares of a tiny high-tech firm.

SHARON GORNIE: To tell you the truth, I don't even know the name of it. (laughing) I know the call letters are AMLN, and it's supposed to double by August.

PAUL SOLMAN: Gornie's mother, Dorothy Freeh, also has all her money in the market, with less than two years till retirement.

DOROTHY FREEH: If the stock market does drop, that's okay. It will go back up again. It has to because the economy grows all the time.

PAUL SOLMAN: Now there's a classic economic debate lurking behind such investment clubs, as well as the usual stock footage. While you, I, and Alan Greenspan may wonder if the market is irrationally exuberant, many economists insist it can't be. Market prices are supposedly the collective best guess of rational investors putting their money where their minds are as to what stocks are actually worth at any given moment, in which case, market prices are never irrational. In fact, we found an experiment in markets that suggests it can be totally rational to pay more than a stock seems worth and still very dangerous. Cal Tech Professor Charles Plott has invented a game showing that rational exuberance can also lead to a crash, and if it can happen in a lab, it could presumably happen in the real stock market any day. That pale blue line is the market price of a make-believe stock. It's a replay of Plott's experiment as run recently with a group of very rational Cal-Tech students.

CHARLES PLOTT, California Institute of Technology: These are not dummies. These people are trained. They understand how this works. They've done this type of thing before, but not this particular one.

PAUL SOLMAN: Since we're showing you a replay, we can re-cue it to the beginning to go over the rules. On the computers in this very room the students were about to make offers, as in any market, to buy and sell a make-believe stock. The better they did in the game, the more money they'd make, up to several hundred dollars. Now to keep things simple--and by the looks of this graphics I might say simple-minded--think of what's being traded as stock in an oil company, with only one well. To give the game an end it's being steadily depleted. And as it pumps, it pays the profits to shareholders in quarterly dividends. That diagonal line is the value of the company as it runs out of oil. So it should also be the average stock price. To make the game a little more like real life, there's a second diagonal showing the most that the company could ever be worth.

CHARLES PLOTT: If the price of the oil was the highest possible, that would be the value of the payoff by the company. Beyond this is impossible, and everyone knows it's impossible.

PAUL SOLMAN: Now, Professor Plott can show us exactly what happens because every move in a market is reported. Those purplish squares down below are orders to buy as low as possible, of course. The green diamonds on top, orders to sell for as much as you can get, and those bluish-white circles in-between?

CHARLES PLOTT: The little blue circle is a trade. So those are actually the contracts that occur in the market.

PAUL SOLMAN: Well, then that makes sense then because the little blue circle is about halfway between the person who wants the most and the person who's willing to pay the least.

PAUL SOLMAN: Oh, one more thing: (music playing)

CHARLES PLOTT: Now we're listening to the market.

PAUL SOLMAN: To get a real feel for the market, Clark has put it to music. You can actually hear the prices, from low to high, as notes on a scale.

CHARLES PLOTT: The high sounds you hear are the "sell" orders.

PAUL SOLMAN: As bee-bee-bee-beep?

CHARLES PLOTT: That's right. The low sounds that you hear are tips to buy.

PAUL SOLMAN: I'll buy at this price. I'll only buy at this price. I'll buy at this price.

PAUL SOLMAN: Okay. Before this explanation and the music drives you to the kitchen, let's rerun the game and see what actually happened. Did investors trade conservatively, gradually lowering the price for the make-believe company as it pumped its oil and lost value? That is, did the price drop along the first diagonal as economic theory would predict? No, not a chance. The price stayed high.

CHARLES PLOTT: Which is a strange phenomena. That means that these buyers are buying at a price that they know and everyone knows is greater than the fundamental value.

PAUL SOLMAN: (music playing) Oh, wait. Here's some skeptics down there.

CHARLES PLOTT: That's a fascinating phenomenon. That's a sign of the market getting nervous. These are people who are basically saying this is crazy; I'm not going to participate; I'm afraid to participate; and they--you can hear them actually sending in the "buy" orders low.

PAUL SOLMAN: But up here, everything's really happening up there? Dee-Dee---

CHARLES PLOTT: These aren't actually trades here. These are just orders that are coming in that would only be seen by somebody who was there at the market. You don't see this.

PAUL SOLMAN: Because all we'd actually see in the daily ticker tape or a chart of this particular stock--

CHARLES PLOTT: Is there.

PAUL SOLMAN: This line coming right across?

CHARLES PLOTT: Just coming across.

PAUL SOLMAN: It was the high prices everyone's seeing these days in the real market and the idea that such exuberance is justified that caused Alan Greenspan to conclude congressional testimony in February with another warning.

ALAN GREENSPAN: (February, 1997) In short, history counsels caution.

PAUL SOLMAN: Other economists, meanwhile, like Martin Feldstein, have remained sanguine throughout.

MARTIN FELDSTEIN, Harvard University: I would say that the long-run record and everything we know about the underpinnings of the stock market tell us that it's going to outperform the alternatives for anybody whose horizon is not a year or two or five years but longer than that.

PAUL SOLMAN: A recent hot seller, "Stocks for the Long Run," [on screen: Stocks for the Long Run by Jeremy J. Siegel] makes the case in rose-colored detail. Over the last two centuries, U.S. stocks as a whole have returned, on average, more than 10 percent a year. Safe bonds, by contrast, have returned less than 5 percent. So stocks do seem better in the long run, and in the short run there are reasons aplenty to justify their high prices: low inflation, high corporate profits, baby boomers saving for retirement, the coming infusion perhaps of Social Security funds. (music in background) Back in the lab, however, there are no such reasons for optimism, yet, as the game marched on, so did the stock price of our make-believe company, staying well above its expected value, making its way toward the maximum price set by the rules of the game.

PAUL SOLMAN: But here's a guy who just asked for more than the stock could possibly be worth.

CHARLES PLOTT: And he listened to the market. It's telling you it's crazy.

PAUL SOLMAN: That is those dark low notes are increasing.

PAUL SOLMAN: But now we've broken through the absolute maximum.

CHARLES PLOTT: Everyone knows that this is higher. But listen to the nervousness.

PAUL SOLMAN: More low notes, more low bids, more nervousness. Now, this is just a game, but why is it much different than you or me putting all our retirement money in mutual funds, even though we keep hearing the stocks are near or above all-time highs? Finance Professor Zvi Bodie is no prophet of doom, but he thinks we investors don't realize the risks we're taking.

ZVI BODIE, Boston University: One of the things you hear is that if you buy shares in a broadly diversified portfolio of stocks, as is offered by a mutual fund company--

PAUL SOLMAN: Lots of different companies?

ZVI BODIE: Lots of different companies' stock--then somehow that eliminates the risk. But even in that broadly diversified stock portfolio there's an awful lot of what we call market risk, that is to say risk associated with the stock market as a whole. And there have been years when the stock--many years--when the stock market has gone down more than 20 percent in one year, the broad stock market.

PAUL SOLMAN: The point, says Bodie, is that 20 percent drop repeated a few years in a row could stagger your savings for the foreseeable future. And as a retiree, you might not have all that much future to foresee. Consider the Japanese stock market for a moment. In 1989 it almost hit 39,000. Today it's around 18,000, an annual decrease of nearly 10 percent a year for most of a decade. Or suppose you'd retired in the U.S. in 1929 at age 65, invested in U.S. stocks? They didn't regain their pre-Depression value until 1954 when you'd have been about 90.

ZVI BODIE: Somebody listening to this is going to say, ah, he's got to rely on the Great Depression to come up with an--well, that's fine. That can happen. But X out the Great Depression; forget that. What about somebody who retired in 1973 when the market collapsed by, what was it, 40 percent in one year, and finds out that he has a heck of a lot less than he thought he was going to have to enjoy a comfortable retirement? Could that happen again? Sure it could happen again.

PAUL SOLMAN: It could happen if stocks today are way over priced, and that, of course, is the whole point of this experiment. Are even the most rational investors liable to overpay? Well, here's the game in fast forward, the stock price holding up after each dividend, those vertical dotted lines, when by all rights it should have been dropping. What on earth was going on?

CHARLES PLOTT: Well, if I think that there are idiots there and I can buy here and sell here for the same price, I get the dividend for nothing.

PAUL SOLMAN: You mean, each time you get that dotted green line, you get some payout.

CHARLES PLOTT: You get some payout, so if I own it overnight I get the payout. So if I can buy here, get the payoff. So I can buy it here, get the payoff overnight, sell it here for the same price, I make money.

PAUL SOLMAN: But these are no dummies. These are Cal-Tech students who know exactly what's going on.

CHARLES PLOTT: No one in this experiment is a fool; they just don't know that no one's a fool.

PAUL SOLMAN: This is sometimes called the "Greater Fool Theory;" that is, you're no fool for paying an astronomical price so long as you have reason to believe there is someone else called the "greater fool" willing to pay even more. In fact, you could say this is turning out to be the punch line of the experiment and moral of this story. It's rational for any given individual to pay too much as long as others will. But that just makes the market as a whole more and more vulnerable to a sudden and massive change of heart. Now, listen for lots of low notes, a sign that opinion is shifting. (music in background) I'll buy. I'll buy. I'll buy. No takers. The green diamonds are sellers dropping their price. The circles are the trades back down to what the company's really worth.

CHARLES PLOTT: The correction is sudden and dramatic. That's it. There's no such thing as getting out of these markets on their way down.

PAUL SOLMAN: So is this the fate that awaits the U.S. stock market in 1997? Well, frankly, who's to say? There is no artificial end point the day the U.S. corporate well runs dry, and even if fundamentals like earnings and inflation were to turn sour, if enough investors continued to believe that they had no good alternative for their money, then prices could stay aloft theoretically forever. On the other hand, its recent drop might suggest the stock market is already singing a different tune. Is real life exuberance, whether rational or irrational, fading as fast as it did in our game? Unfortunately, that's only possible to say long after it's already happened.

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