Irrational Exuberance Part Two?


  • Valuations are elevated, but there is very little relationship between stock valuations and performance in the short term.
  • Consumer confidence breaking out to new post-recession highs confirms the bull market in equities.
  • December has been a very strong month historically for equities and could bode well for continued near-term gains.

Twenty years ago today, Federal Reserve (Fed) Chairman Alan Greenspan gave his now-famous “Irrational Exuberance” speech at a dinner hosted by the American Enterprise Institute.The phrase was meant to be a warning about stretched valuations of equities during the 1990s bull market. Although his warning was three years early, the market factors Greenspan highlighted eventually did contribute to the dot-com bubble bursting, leading to the first 10-year decline (from 1999–2008) in the S&P 500, including dividends, since the 1930s, which was exacerbated by the early-2000s recession.

With equity markets making new highs and the bull market close to turning eight-years old, are we entering another period of irrational exuberance? This week we will examine this question by taking a closer look at the three components of our methodology: valuations, fundamentals, and technicals.


Traditional market cap weighted valuations are high—the current price-to-earnings ratio (PE)* (trailing four quarters) of roughly 17 is above the average of 15 going back to 1950, and the post-1980 average of 16. But it is nowhere near the euphoric levels of the late 1990s, when PE multiples were consistently in the upper 20s. Even then, it was hard to tell when to sell stocks because they can stay overvalued for long periods. At the end of the bubble, the one-year return for the S&P 500 from March 31, 2000 and a PE of 28.2, was -21.7%, so valuations were a good reason to sell then. But the stock market’s PE was high well before that, suggesting that even at extremes, forecasting market direction using valuations can be an inexact science. In fact, the three years after Greenspan’s speech, the S&P 500 gained another 93% in the face of high PEs.

*Price-to-earnings ratio (PE) is for S&P 500 companies.

PEs have not been good indicators of stock market performance over the subsequent one year as shown in Figure 1. If the dots in Figure 1 formed something resembling a straight line, it would suggest lower returns were to be expected at higher PE ratios. The correlation between the S&P 500’s PE and the index’s return over the following year, at -0.3, is relatively low and suggests a fairly weak relationship. We would be more worried about high valuations in a scenario in which the market begins to, or actually does, price in a recession.