Is Your Portfolio “Irrational Exuberance” Proof?

June 8, 2016

Is Your Portfolio “Irrational Exuberance” Proof?

  • There are a few tools to test if the market is in “irrational exuberance.”
  • There are indications that the current market is irrational, but history shows that 100% returns are still possible.
  • The stock market is still risky, so an appropriate premium should be expected.

Introduction

“Irrational exuberance” is a phrase first used by former FED chairman Alan Greenspan in his December 5, 1996 speech. His intention was to question whether low inflation should imply “higher prices for stocks and other earnings assets,” and to assess the risks of such a market by asking “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?” Let’s not forget here that Japan is still in the same prolonged contraction mentioned by Greenspan in 1996.

His speech came after the market had been rallying for 14 years if we exclude the 1987 dip. The market rallied further for another 3 years and doubled before the dot-com bubble crash, but eventually never returned to the level at the time of Greenspan’s warning in nominal terms.

1 figure 1996 2002 sandp
Figure 1: S&P 500 from December 5, 1996 to the bottom of the dot-com bubble in 2002. Source: Yahoo.

This shows how easy it is to proclaim that the market is overvalued, but also how risky it can be as even an icon like Greenspan largely missed. A more scientific approach to analyze whether the market is in “irrational exuberance” was given by Nobel laureate Robert Shiller in his equally named book.

This article is going to use the tools given by professor Shiller in order to assess whether the current market is in “irrational exuberance.”

Testing for Irrational Exuberance

According to Shiller “irrational exuberance” happens when asset prices increases are not backed by increases in real economic indicators and earnings. From a long term perspective, it is easy to explain earnings as they are influenced by natural economic cycles, and a short term earnings spur or decline should not be considered as a new economic big leap forward. But this is exactly what happens, as earnings grow stock markets get into bull mode and rally on optimism based on hope for the repetition of the past trend. When earnings fall, stock markets get into panic mode and crash precipitously.

2 figure 2 sandp earnings
Figure 2: S&P 500 historical inflation adjusted earnings. Source: Multpl.

In the long term, markets grow in perfect correlation with earnings growth and the straight line we can draw through the above earnings chart shows how normal it is for corporate earnings to be susceptible to cycles. So from the historical earnings perspective presented in the above chart, the market is currently in irrational exuberance as corporate earnings are above historical averages and returning to their mean in the last year and a half.

Apart from earnings falling and being above the historical growth mean, another indicator for irrational exuberance testing is the Shiller PE ratio that uses 10-year average earnings in order to smooth out cyclical influences (CAPE – cyclically adjusted PE ratio).

3 figure CAPE ratio
Figure 3: Shiller S&P 500 CAPE ratio. Source: Multpl.

The CAPE ratio has historically been higher only on three occasions, at the end of the famous 1920s stock boom, at the peak of the dot-com bubble and just before the great recession of 2009. Now as back then, the most common explanation for the high current valuation comes along with the most dangerous words ever used on Wall Street: “the new normal” where seeing that stocks have historically always outperformed other investment types they carry less risk, and therefore a smaller premium should be attached to stocks. With this shift in the fear perspective on stocks based on the assumption that stocks will always outperform no matter the paid price, stock prices—aided by low interest rates—just go up.

The Investor’s Dilemma 

The dilemma facing every investor is if the market is in “irrational exuberance,” how much higher can it go and will I look like a fool if I sell now. One of the biggest irrational markets was the 1980s Japanese stock market that went up almost 8 fold in the period from 1976 to 1992.

4 figure japan nikkei
Figure 4: Japan Nikkei 225 stock market index. Source: Trading Economics.

Imagine how the investors that had sold in 1983 at a CAPE ratio of 25 that thought of it as irrational felt when they saw the increases the market delivered up to 1992 and the CAPE ratio jumping to 90.

5 japan cape
Figure 5: CAPE for Japanese stock market. Source: Telegraph.

Should you sell everything now as the S&P 500 has a CAPE of 26.35 or should you stick to your stocks and hold them because they are just going to go higher? Second question, if the S&P 500 doubles in the next two years, are you then going to sell or you are going to hope for more?

The goal of every investor is to reach the highest possible returns with, and this is a part that is usually disregarded, the lowest amount of risk. On the return side we can expect anything, as the FED keeps interest rates low, the European Central bank continues buying corporate bonds and Japan is printing money like crazy, a return of 100% should not be regarded as impossible.

From a more fundamental earnings perspective, the S&P 500 with an average PE ratio of 25 will deliver 4% returns over the long term. On the risk side, looking from an historical perspective, a PE ratio of 25 is overvalued and a 4% earnings yield from stocks is almost 50% below the historical average yield of 7.42%.

6 figure earnings yield
Figure 6: S&P 500 earnings yield. Source: Multpl.

A return to the average would have the S&P 500 falling to a PE ratio of 13.68 or 46% below the current level.

Conclusion

This is the stock market, amazing returns are possible but so are painful experiences. Years of stable growth make investors more and more greedy and therefore willing to pay for higher valuations as their exuberance makes people quickly forget the stock market pains suffered in the past.

It is impossible to give clear advice on what to do as Alan Greenspan also missed the mark in 1996, but the best thing to do is to rethink your portfolio in relation to potential rewards and risks. The current market has a 50% chance of going higher and 50% chance of going lower, but some investments have much better odds than that.

 

By Sven Carlin Investiv Daily Robert Shiller Share: