Market Insights : Comparing Greenspan's 'Irrational Exuberance' to Today

Market Insights: Comparing Greenspan's 'Irrational Exuberance' to Today 

On December 5, 1996, Federal Reserve Chairman Alan Greenspan hinted that stock prices might be overvalued, suggesting the risk of a market correction that could negatively impact the economy. He famously questioned if the market had entered a phase of "irrational exuberance."

In recent months, the term "irrational exuberance" has been frequently used to describe the current stock market situation. To understand potential future trends, let's compare the market conditions that led to Greenspan's remarks with today's scenario.

Irrational Exuberance

Sustained low inflation generally leads to less uncertainty about the future and lower risk premiums, which in turn results in higher stock prices and other earning assets. Historically, there's been an inverse relationship between price/earnings ratios and inflation rates. But how do we recognize when irrational exuberance has inflated asset values to unsustainable levels, potentially leading to unexpected and prolonged market downturns, as seen in Japan over the past decade? And how should this be factored into monetary policy? Central bankers shouldn't be overly concerned about a financial asset bubble burst unless it threatens the real economy—its production, jobs, and price stability. The 1987 stock market crash, for instance, had minimal negative effects on the economy. However, we must not underestimate the complex interactions between asset markets and the economy. Therefore, assessing changes in balance sheets and asset prices should be a fundamental part of monetary policy development. —Alan Greenspan, December 1996

Simply put, Greenspan was wary of high stock valuations, fearing a market correction could harm the economy. He emphasized not being complacent about the intricate interactions between asset markets and the economy.

Between 1994 and the day Greenspan mentioned irrational exuberance, the S&P 500 surged by nearly 60%. From the low point of the 1990 recession to his speech, the S&P climbed almost 250%.

The economic recovery from the 1990 recession initiated a bull market, fueled further by optimistic projections about the emerging internet, computers, and modern technology, promising substantial corporate profits and economic growth. Sound familiar?

Such high expectations led to significant speculation. Investors were willing to pay more for corporate sales and earnings due to promising growth prospects, driving up valuations.

One graph shows the Shiller CAPE10 valuation reaching levels last seen in 1929, slightly higher than at the peak of the Nifty Fifty Bubble. For more on the Nifty Fifty, see our article "Are The Magnificent Seven In A Bubble? Ask The Nifty Fifty."

Another valuation metric, Tobin's Q ratio, compares a company's market value to its asset replacement value. A ratio above one indicates the market values the company more than its assets, implying high expectations for above-average earnings growth. In 1996, this ratio was slightly higher than the Nifty Fifty Bubble peak but below the 1929 peak.

Was Greenspan Prescient?

Greenspan had good reasons for concern with stock prices and valuations near the peaks of previous market booms. His warning caused a temporary market pause before it continued climbing. Between December 5, 1996, and the bull market peak in 2000, the S&P more than doubled, with valuations far exceeding the 1996 levels.

Despite his concerns, Greenspan cut rates by 75 basis points in late 1998 due to worries about the Long Term Capital Hedge Fund collapse, further boosting the market.

From the peak in August 2000 to its low in 2003, the S&P 500 erased a significant portion of the gains post-"irrational exuberance." Those highs weren't seen again until 2013.

Today's Exuberance

The recent performance of the S&P 500 resembles that of the mid-to-late 1990s. Current valuation metrics are at or above the levels Greenspan warned about in 1996.

Today's enthusiasm for AI mirrors the excitement for the internet and technology in the late 1990s. Investors believe AI will significantly boost productivity, leading to booming corporate profits and economic growth. Companies central to AI, like Nvidia, Google, and Microsoft, are expected to outgrow the market. Or so we're told.

While the AI narrative is compelling, reality often diverges from such narratives. Despite the tech boom of the late 1990s, economic and corporate earnings growth rates did not increase significantly. From 1975 to 1999, the economy grew at nearly 3% annually on average; since then, it has been closer to 2%.

Corporate earnings have followed a similar trend, despite the internet's advantages.

Lessons From An Irrational Market

The market is likely to correct eventually, normalizing valuations. This time is not different.

However, predicting the timing of a correction is uncertain. The market can defy expectations, with high valuations potentially rising even further.

As John Maynard Keynes said, "The market can stay irrational longer than you can stay solvent."

Some bearish analysts suggest withdrawing investments to avoid trying to time the market peak. This may be wise but could also be premature, as with Greenspan's irrational exuberance warning.

Balancing between irrational exuberance and reality is complex. Thus, recognizing the market for what it is and actively managing investments using technical and fundamental analysis along with macroeconomic forecasting is crucial to navigating potential risks and rewards.

Summary

Consider a contrarian view: what if we are experiencing rational exuberance, and AI is a genuine economic game changer? What if current valuations correctly reflect enhanced economic growth? Such profits and wealth formation might improve our ability to manage unproductive debts, potentially resolving today's economic challenges.

No one can predict the future with certainty. However, using tools to maximize potential gains and limit downside risks is prudent. Given the potential for significant returns and drawdowns ahead, active management may be the best approach to managing your investments.