Irrational Exuberance 20 Years On

It was 20 years ago today that Alan Greenspan made his famous “irrational exuberance” speech. Here’s the money paragraph from that speech:

Clearly, sustained low inflation implies less uncertainty about the future, and lower-risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

It doesn’t seem that dramatic, but at the time, it was taken very seriously. The next day, the Dow dropped 144 at its open. That may not sound like much today, but it was a loss of 2.2%. That’s equivalent to 430 points today. However, the Dow soon recovered some lost ground, and by the closing bell on December 6, it had shed 55 points (all the way down to 6,381.94).

Greenspan’s famous phrase came from Robert Shiller. I can’t confirm if Shiller was referring to his cyclically adjusted price/earnings ratio, also known as CAPE. Instead of using trailing earnings for one year, CAPE goes back ten years.

I’m not a big fan of CAPE. It’s shown the market to be overpriced for almost all of the last 25 years. I’m also not a big fan of trying to time the market based on any valuation measure. The stock market continued to rally for another three years after Greenspan’s speech. Incidentally, Shiller later came out with a book titled Irrational Exuberance.

I get complaints every time I say this, but I’ll repeat that market bubbles are actually quite rare. A bubble is not when p/e ratios go from 15 to 18. A bubble is when they go to 30 and beyond, and the IPO market goes nuts.

Here’s a look at how the market has done over the last 20 years. This is the Wilshire 5000 Total Return Index, which includes dividends. The red line is the Consumer Price Index:

Since Greenspan’s speech, the total return of the Wilshire 5000 has been 346.5%. That’s 7.77% annualized. I’m reminded of Peter Lynch’s words: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

Posted by Eddy Elfenbein on December 5th, 2016 at 8:25 am

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