Why Today’s Irrational Exuberance?

Financial FAQs

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Fed Chairman Alan Greenspan said in a memorable 1996 speech, “…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?”

He was then talking about the penchant for investors to act irrationally in ignoring very high stock valuations accompanying very low interest rates that could show a stock market, and maybe the overall economy, about to enter a down cycle.

Does that sound familiar? We have today the S&P index of 500 top stocks with a price-to-earning ration above 18—i.e., it’s price is 18 times annual earnings, before expenses (EBITDA—earnings before interest, taxes, depreciation, and amortization) when the historical long-term P/E earnings ratio is 15, according to Nobel economist Robert Shiller in his 2000 best-seller, Irrational Exuberance; and which increases the odds of a recession.

For instance, the irrational behavior that Greenspan was warning about wasn’t manifested until the Dot-com bubble bust of 2000 and following 2001 recession, when the P/E ratio reached 44 times earnings. In other words, stock prices were way out of whack with earnings that had been declining—so much so that stock prices had flattened and corporations were barely issuing any dividends at all—a sign that their earnings were depressed.

And what depresses an economy more than depressed corporate earnings, which then depresses job formation, consumer incomes, and overall economic growth?

Professor Shiller gave the 100-year history of stock market P/Es in his book. The last time it had reached great heights was in 1929, and the beginning of the Great Depression.

So irrational exuberance is something to worry about when looking at stock valuations. We are in similar, but not identical circumstances today. The S&P P/E ratio is 18, according to Forbes Magazine.

“On a cautionary note related to the earnings skid,” says Forbes, “the S&P 500’s price-to-earnings ratio has been on the rise and now stands near 18 times projected earnings over the next 12 months. That’s way above the 14 level where we started the year, and it exceeds the long-term average of around 16. Remember, it’s harder to grow the “P” side of that equation when the “E” side is on the decline.”

Why such irrational exuberance today, after past history tells us what happens when investors act irrationally in the face of reality?

Professor Shiller explains it thusly: “(President) Trump has for decades touted a glamorous narrative of his life by “surrounding himself with apparently adoring beautiful women, and maintaining the appearance of vast influence,” Shiller said in a recent op-ed in Britain’s the Guardian newspaper. “The end of confidence in Trump’s narrative is likely to be associated with a recession,” Shiller warned.

Shiller goes much deeper into human behavior in Irrational Exuberance. Human beings have a natural inclination to listen to hearsay and word-of-mouth stories when they make financial decisions, such as buying a home, or stocks. This is in part because of the complexity of modern financial markets, but also because such research is difficult and requires some expertise.

The busted housing bubble is the best example of such irrational exuberance, when consumers believed that housing prices could never fall, because they hadn’t in modern history—at least since WWII—so they kept elevating housing prices with the aid of so-called liar loans, because interest rates had fallen far below inflation rates at the time.

Inflation was so far above interest rates that there was a zero cost to borrowing mortgages, in particular, since rising inflation devalued loan principal faster than the actual loan payments over a 15 or 30-year mortgage.

This could happen again today, in other words. Although corporate profits are still at record highs, they may have already begun their descent to more historical levels, and maybe even lower, if consumers become disillusioned with the Trump ‘success’ narrative, as Professor Shiller has said.

Harlan Green © 2019

Follow Harlan Green on Twitter: https://twitter.com/HarlanGreen

About populareconomicsblog

Harlan Green is editor/publisher of PopularEconomics.com, and content provider of 3 weekly columns to various blogs--Popular Economics Weekly and The Huffington Post
This entry was posted in Consumers, Economy, Keynesian economics, Weekly Financial News and tagged , , , , , . Bookmark the permalink.

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