Problem With Irrational Exuberance: It Can Make You Rich

Eighteen years ago today, Alan Greenspan asked a rhetorical question that was as relevant then as it is now. It was probably relevant even to the guys in the top hats under the buttonwood tree on Wall Street in 1792.

“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?” the Maestro asked a dinner at the American Enterprise Institute in Washington on Dec. 5, 1996.

Here’s what the exuberance in the stock market looked like then: The Nasdaq 100 Index of its biggest stocks was up 45 percent for the year and trading near a record. The larger Nasdaq Composite Index had risen 24 percent year-to-date and the Standard & Poor’s 500 Index was up 21 percent.

Among the various measures that could be viewed as ratios of exuberance-to-rationality, the Nasdaq Composite was at 1.22 times sales, near its record of 1.28 earlier in the year and almost triple its level at the end of 1992. The index hadn’t suffered a bear market in six years.

3,300 Words

Greenspan wasn’t exactly pounding the table about irrational exuberance on this day in 1996, and in hindsight many blame him for not doing so at some point during the dot-com bubble. And they blame him for cutting rates too low to clean up the mess afterward, thereby causing another bubble in housing.

The now famous “irrational exuberance” question came about 3,300 words into a 4,300 word speech, much of it discussing the history of an “end-the-Fed” mentality that is older than the Fed itself.

Still, if you had used the remarks as a cue to cash out completely from the stock market after you finished your rubber chicken (or whatever the AEI served that night), it was the wrong time. The Nasdaq almost quadrupled from that level before it peaked in 2000 and the S&P 500 more than doubled.

Today, the price-to-sales ratio of the Nasdaq Composite Index is at 2.28, almost double its 1996 level. The index hasn’t suffered a bear market in almost six years.

The economy had just posted 3.7 percent growth in 1996, compared with 3.9 percent now. The consumer price index was 3.3 percent then, versus 1.7 percent now. The Fed funds rate was 5.25 percent then, versus almost zero now.

‘Don't Stop’

Bill Clinton’s theme song back then was the Fleetwood Mac classic “Don’t Stop,” as in “thinking about tomorrow.” Today, Hillary Clinton’s appears to be the country croon “Stand With Hillary,” which will likely go down as a classic for entirely different reasons.

And again, we ask ourselves: “How do we know when irrational exuberance has unduly escalated asset values?”

Exuberance is pretty easy to spot. And maybe irrationality is too, though it’s much more subjective. But there’s a lot of money to be made from both. Spotting the tipping point between rationality and irrationality is the tricky part.

Birinyi Associates examined the “exuberance phase” of the last five long bull markets, which have ranged in size from 80 percent to 302 percent. The firm concluded that there is “little in the way of clear-cut signals regarding the end of a bull market.”

“Every market is different and an infinite number of events can ‘lead to’ or ‘cause’ the end of a bull market: fundamentals, the economy, the Fed, interest rates, currency issues, financial blowups, wars, bubbles, foreign concerns, etc.,” Birinyi analyst Kevin Pleines wrote in a note to clients today. “But, these crises appear at different stages of bull markets and with varying severities.”

Today also offers another anniversary of note: In 1933, Utah became the final state needed to ratify the 21st Amendment, thereby ending Prohibition. Much exuberance followed, and there was nothing irrational about it.

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