Irrational Exuberance Indicator

Irrational Exuberance Indicator

Let’s talk about where did irrational exuberance come from before we discuss Irrational Exuberance Indicator.

What is irrational exuberance?

Origin of this term

The term “irrational exuberance” was coined by former Federal Reserve Chairman Alan Greenspan in a speech at the American Enterprise Institute on December 5, 1996 during the dot-com bubble. ‘s discussion.

Also used as a book title

Robert Shiller, a professor at Yale University who shared the 2013 Nobel Prize in Economics with Eugene Fama and Lars Peter Hansen, also used the term “Irrational Exuberance” as the title of his book. The title was inspired by Alan Greenspan’s term. The book was first published in 2000.

Schiller wrote the following in the book:

“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.”

Irrational markets push up asset prices

Greenspan’s discussion points out that asset prices are no longer based on the fundamental factors that determine their value, but are mainly determined by the subjective judgment of market participants, which leads to the phenomenon of continued rise in asset prices.

At that time, Bill Clinton had just been re-elected as president and U.S. stocks continued to rise. Greenspan warned investors that excessive optimism could lead to asset values ​​being pushed up too far, and that such sentiment could be irrational.

Actions taken at the time

Greenspan raises an important question: “How do we judge whether irrational exuberance has overextended asset values ​​that may subsequently experience an unexpected and prolonged contraction? And how do we incorporate this assessment into monetary policy?”

The market interpreted these remarks as Greenspan believing that U.S. stocks are overvalued and at risk of a bubble, and the stock market subsequently fell. Three months later, the Fed did raise interest rates by 25 basis points, causing the S&P 500 to retreat nearly 10%. But the Fed did not raise interest rates again in the 18 months that followed.

This is why many people later believed that the collapse in the Millennium of the U.S. stock market in 2000 was mainly the result of Greenspan’s inaction. The Nasdaq Index of U.S. stocks peaked in 2000, and the bursting of the Nasdaq bubble in 2000 triggered a stock market crash.

Irrational Exuberance Indicator

Definition

Compare the “stock yield” with the “U.S. 10-year Treasury yield” to measure whether the valuation of U.S. stocks is reasonable. The “yield” here is the earnings per share divided by the price per share, which is actually the reciprocal of the commonly used price-to-earnings ratio.

The indicator Greenspan is referring to is to measure the irrational valuation of the stock market by comparing the “difference” between stock yields (the inverse of the price-to-earnings ratio) and bond yields.

Current indicator levels

The results show that the 10-year Treasury yield has soared recently, and the gap with the S&P 500 corporate earnings yield has narrowed significantly. The current valuation of US stocks is the highest level since 2002, which is exactly the level when Alan Greenspan The level of his “Irrational Exuberance” speech on December 5th. This shows that the risk of decline faced by US stocks has increased.

Greenspan’s valuation indicator has fallen sharply recently, mainly due to the surge in U.S. Treasury yields, reflecting investors’ concerns that Trump’s 2.0 tax cuts and tariffs policy may reignite inflation. The U.S. 10-year Treasury bond yield rose for the fourth consecutive trading day on the 8th, rising by 12 basis points.

Note: Bond yields and prices have an inverse relationship.

The theoretical basis is easy to understand

The higher the return on stocks relative to bonds, the cheaper the stocks are, and vice versa. Especially when bond yields rise, it becomes harder to justify stock valuations. Take the spread between the S&P 500 index yield and the 10-year U.S. Treasury bond yield as an example. Under normal circumstances, stocks tend to have higher expected yields than bonds because of their relatively higher risk. The rate difference is usually positive. When the spread falls or drops below zero, it indicates that stocks are valued at a high level.

The main reason bond yields soar

Through this simple model (although there are more complex versions, this model can already reflect Greenspan’s core idea), we found that the current stock market valuation level has returned to the highest point since 2002, which is 1.3 times higher than the level when Greenspan proposed the model in 1996. The warnings about “irrational exuberance” were unanimous. It is worth mentioning that the recent decline in the Greenspan valuation model has little to do with the stock market, but is mainly due to the rise in US bond yields. U.S. bond yields continue to rise as the market worries about continued inflationary pressures before Trump’s second term as president.

In addition, the Fed’s current valuation levels have aroused the vigilance of some financial analysts and Fed officials. Federal Reserve Governor Tim Cook has said that at current price levels, the stock and corporate bond markets are “vulnerable to significant declines.”

Goldman Sachs chief global equity strategist Peter Oppenheimer also warned that over the past two years, stock price increases have reached 93% of the same period over the past century. Although expected earnings have driven U.S. stocks to continue to rise, as bond yields rise or economic data and corporate earnings are worse than expected, the stock market will be more vulnerable, which may trigger a market adjustment.

What about current spread now?

The current P/E ratio of the S&P 500 stocks is 27.87, with a yield of 3.59% (1/27.87). The 10-year U.S. Treasury bond yield is 4.76%. The difference between the two is negative 1.17%!

For your reference: In January 2000, just a few months before the dot-com bubble burst and the stock market crashed, the 10-year Treasury yield was 6% and the S&P 500’s price-to-earnings ratio was 27.37!

The P/E ratios of the S&P 500 stocks in the two periods were very close (27.87 vs. 27.37) , which is why the soaring 10-year Treasury yield scared the market because it awakened investors’ memories before the crash.

Irrational Exuberance Indicator
credit: Ideogram

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