5 ideas
Divide the real stock price index by the average of real earnings over the prior ten years instead of the latest year's earnings. Averaging over a decade removes business-cycle swings in profits, so the ratio shows whether prices are high relative to sustainable earning power. Historically, high CAPE readings have preceded low real returns over the following ten to twenty years.
Rising prices draw attention and enthusiasm, which bring in new buyers, whose purchases push prices higher still. The loop needs no fraudster: past price gains act like the promised returns of a Ponzi scheme and pull in later investors. It keeps going until the flow of new buyers dries up, and then it can run in reverse.
Stock prices swing much more than the later-realized present value of dividends could justify. Most price volatility therefore comes from changes in sentiment, not from new information about future cash flows. This contradicts the efficient-markets view that prices are optimal forecasts of fundamentals.
At every major peak, stories circulate claiming that the old valuation rules no longer apply, citing new technology, a demographic shift, or better policy. Treat the popularity of such a story as evidence of speculative excess, not as a justification for high prices. The narrative spreads by contagion and gives investors a rationalization for prices they are already inclined to accept.
Explain a bubble in layers. First, identify the structural precipitating factors, such as the internet, baby-boomer saving, 401(k) plans, and expanded media coverage. Second, identify the feedback amplification those factors trigger. Third, identify the psychological anchors that set what price seems reasonable, including quantitative anchors like recent price levels and moral anchors like the story people tell about their wealth.