On December 5th, 1996, Alan Greenspan, as he accepted the American Enterprise Institute’s Francis Boyer Award said “…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?” (you can see that snippet of the speech, captured by C-SPAN here https://www.c-span.org/video/?c4673470/user-clip-alan-greenspan-irrational-exuberance )
Greenspan’s phrase “irrational exuberance”, is arguably the most famous of any uttered by a central banker before or since. Although the dot.com bull market still had several more years ahead, at the time it was taken as a suggestion that stocks were overvalued. Ironically I would argue that these words were among the least important in a lengthy presentation where Chairman Greenspan made many points so worth remembering that I’ve posted a link to the speech – which I strongly encourage everyone to read – here… FRB: Speech, Greenspan — Central banking in a democratic society — December 5, 1996 (federalreserve.gov)
I didn’t read the book of the same name published a few years later by Yale professor Robert Shiller, but Wikipedia offered this excerpt where he attempts to define it:
Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases, and bringing in a larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly by envy of others’ successes and partly through a gamblers’ excitement.
I cannot count the number of times I’ve recently heard folks say versions of the following…
“Bond yields are so low. The bond market, particularly treasuries, is in a bubble.” (10yr yield chart below source: Bloomberg)
or…
“Stock market valuations are as high as they were in the tech bubble, the stock market is in a bubble.” (S&P 500 P/E Ratio below source: Bloomberg)
or…
“Housing prices to median incomes are as high as they were in the housing bubble. This must be another one, right?” (chart below source: Longtermtrends.com)
Of course, the irony is, these same folks speaking of the “irrational exuberance” they perceive, will almost immediately then go on to blame “the Fed”, the organization Chairman Greenspan led at the time he “coined” the phrase (Secretary Rubin might argue that was his territory). Well, Fed policy may drive us crazy, but is it actually making a world of irrational investors?
Let’s start with treasuries. The Fed itself is the marginal buyer, and the Fed can’t lose; it merely created the money to buy the bonds. The Fed has an agenda, and the easy monetary policy it’s been practicing, if anything, reflects irrational pessimism, not exuberance. So perhaps irrational, but not exuberant.
What about equity investors? An investor, whether a hedge fund manager, a pension or trust or a self-directed individual with money to invest might rationally conclude that if inflation is rising, and demand-deposits pay zero interest one shouldn’t keep money in cash only to be diluted. Those same investors might conclude that the risk-reward of bonds is miserable. With 10-year treasury yields below the rate of inflation, that results in negative real-rates of return. These investors are likely unhappy that they’re paying multiples last seen in the tech bubble, but the earnings yield is still higher than that of bonds, and earnings should (hopefully) grow at a rate greater than inflation as well. These investors are making a rational choice.
What about homebuyers? Should home prices be 7x the median income when the long-term average is closer to 5x? Lower yields = lower mortgage payments, so other than a down payment, buyers may not feel as if they’re spending so much more. Besides if inflation lurks, better bite the bullet and buy now before prices rise further. Here too the homebuyer’s actions, even if a bit simplistic, isn’t entirely irrational. The homebuyers today “paying up” is not quite the same as folks using liar’s loans to speculate on several houses at once.
Of course, the issue we have is that just because these participants are behaving rationally, doesn’t mean they aren’t taking significant risks.
For what it’s worth, European equities are cheaper than those in the US. While this is admittedly their usual condition, I believe they pose less risk than US equities. For one thing, the net % change in fiscal spending in the US is greater than in many European countries, as has been the change in US valuations. Compare the P/E of the MSCI Germany Index to the S&P 500 for example, the premium for US equities by that metric is close to all-time highs. In much the same way that the US equity market valuations are more attractive than US bonds, and yesterday I said the risk/reward for Chinese equities over US equities might indicate an entry point, I also believe that European equities are more attractive than US equities right now, and if one favors German equities, the example I provided here, EWG is the ETF that tracks it.
Still, all of these rationales involve some risk, including the rationale of the Fed which is at the bottom of this precarious pyramid we’re building; and to better understand the Fed – and what it should be, and should be doing – I encourage you once again to read the speech Alan Greenspan gave almost 25 years ago, so I’ll paste the link here again too. FRB: Speech, Greenspan — Central banking in a democratic society — December 5, 1996 (federalreserve.gov)
