Irrational Exuberance: Stock Market Exuberance Not So Irrational After All
by Dr. Mark Skousen, Chairman, Investment U
Tuesday, December 12, 2006: Issue #617
Last week, I had lunch with Jeremy Siegel, "The Wizard of Wharton" and premier financial economist who has written two best-sellers, Stocks for the Long Run and The Future for Investors. Both highly recommended.
The last half of our luncheon was spent discussing his controversial December 6th Wall Street Journal op-ed piece, "Irrational Exuberance, Reconsidered." It has now been 10 years since former Fed chairman Alan Greenspan shocked the financial world by suggesting the stock market was entering a period of "irrational exuberance."
Now, says Professor Siegel, it appears investors weren't that irrational after all
Amazingly, at the time, the Dow Jones Industrial Average stood at only 6,437. It continued to climb over 11,000 by 2000. The rise in the tech-laden Nasdaq was more dramatic - doubling, and then doubling again. The collapse came in 2000-2003, with the Dow falling 30% and the Nasdaq 70%.
Looking Back at Irrational Exuberance
Ten years later, what can we say about this boom-bust cycle? Siegel is upbeat
Was there an "irrational exuberance" on Wall Street in 1996? Even though the market had more than doubled from its level of four years earlier, he concludes, "The answer is decidedly no."
As his chart below demonstrates, the market performed reasonably well if you look at the level of the Dow now (12,300), a compounded rate of return of nearly 9%. This 10-year period includes the 2000-03 bear market.
Irrational Exuberance and the Fed Greenspan's Little Secret
Greenspan & Co. cannot go blameless for this fiasco. Despite Greenspan's rhetoric, the Fed encouraged the asset bubble on Wall Street by injecting excessive liquidity as a result of a series of crises: The Asian currency crisis in 1997, the Russian economic crisis in 1998, and the Y2K crisis in 1999. Most of the new money went into Internet stocks.
What about the tech bubble? Professor Siegel declares boldly that the "irrational exuberance" was only detectable in the tech sector, and the non-tech stocks "were never in a bubble." He claims that the Fed was right in not trying to stop the tech bubble before it got out of hand, implying that the damage to the economy was minimal. He concludes, "History has exonerated Alan Greenspan's policies during the late 1990s." Or has it?
On this point, I demur from the Wizard of Wharton. The tech bubble caused severe, if not permanent, damage to the U.S. economy in two ways:
1. It gave us the dreaded Sarbanes-Oxley legislation, which has handcuffed Wall Street's vaulted global competitive advantage in capital formation. As The Economist cover story, "Wall Street, What Went Wrong," declared: "No longer can America take for granted its global superiority as a market for capital."
Today foreign markets are growing much faster than the U.S., and hardly any foreign IPOs are going public in the U.S.
2. Hundreds of thousands, if not millions, of investors lost their shirts and have yet to recover from this debacle. They over-invested in tech stocks, and they saw their pension values decline by 50% or more. I've met many of them at investment conferences. (Fortunately, a few advisors such as Jeremy Siegel warned investors repeatedly that the Nasdaq was deeply overvalued. Unfortunately, few paid attention.)
If the Fed had chartered a steady course throughout the 1990s, and engaged in a stable non-inflationary policy, rather than an "easy money" policy, the boom-bust cycle in technology stocks would have been far less volatile. I doubt if the tech boom could have been averted, but it could have been cushioned.
In short, the Fed is culpable.
Long-Term Investors: Hang In There
The last 10-year stock market cycle reminds me of the wise words of Lord Keynes, made in the 1920s: "Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again."
It's easy to say "stay the course and invest for the long term" during a bull market. Looking back over the past 10 years, investors would have been wise to stay fully invested the entire time, avoiding the tech mania all along, because they would have earned 9% compounded annual returns on their money by investing in non-tech stocks.
But let's face it: Few of us could have remained on the sidelines during the thrilling boom markets of the late 1990s, earning a mere 10% or 15%, when we could be making 50% to 100% a year. Equally, few of us had the stomach to stay fully invested in non-tech stocks during the gut wrenching bear markets in 2000-03.
Everyone is a disciplined, long-term investor until the market goes down!
Good trading, AEIOU,
Today's Investment U Crib Sheet
- In an exclusive Investment U interview in September, Professor Siegel warned readers about the "Growth Trap" - paying too much for technology and other "new economy" stocks. Read the interview here: Part one. Part two.
- In December of 1996, the PE ratio of the S&P 500 companies checked in at a relatively expensive 27.5. Right now, the estimate for year-end 2006 is 18.8 - a much more attractive valuation for the broad market.