“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?”
–Federal Reserve Chairman Alan Greenspan, December 5, 1996
In last month’s article, we explained how true wealth can behave like a river. This month, we celebrate a significant anniversary in the financial history of the United States.
Irrational Exuberance
This month marks a significant anniversary in the modern economic and financial history of the United States, and we could not let it pass without comment. When properly appreciated, it can serve as an important, teachable moment.
A quarter-century ago, on the night of Thursday, December 5th, 1996, Federal Reserve chairman Alan Greenspan, spoke at a dinner of the American Enterprise Institute in Washington, D.C., giving his instantly legendary “Irrational Exuberance” speech.
This is what the oracle said. Or more accurately, this is what he asked:
“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? And how do we factor that assessment into monetary policy?”
At the time of this speech in 1996, the global equity markets had been rising with great energy and endurance since the last Great Bull Market beginning in 1982. At the time, many believed that the fuel for that long and powerful Bull Market was because it was accompanied by a great secular decline in interest rates and easy monetary policy, which had occurred over the same period. Many bearish market observers believed that this “easy money” policy was the only thing supporting the overvalued stock market. The minute the Federal Reserve decided to tighten monetary policy, the party would be over.
Greenspan asked these rhetorical questions because he did not have conclusive answers. And if he didn’t, no one else in the world did either. But coming from him, even this interrogative form of thinking out loud was a financial thunderbolt — a shot heard around the world. Mr. Greenspan was widely known as the most important economic and financial policymaker in the world – and here he was musing publicly about the possibility that equity prices were too overvalued and wondering if it was time for the Fed to do something about it.
He surely understood that, when he so much as broached the question, he had at least suggested an answer. And that answer was unmistakable. “We’re either already there, or will be mighty soon, as this greatest of all bull markets morphs into mania. Before that happens, it might be a good idea for us to do something about it.”
This was really big news in finance and investment management circles and has since become somewhat of a legendary statement.
We thought it might be instructive to cast an eye over the intervening quarter-century. Let’s begin with a key item of baseline data that should inform our inquiry:
The S&P’s 500-Stock Index had closed that Thursday afternoon, in blissful ignorance of what was coming later in the evening, at 744.38. And sure enough — just as Greenspan had darkly suggested it must — the S&P 500 topped out on March 24th, 2000, at 1,527.50.
You read that right: equities more than doubled in the 40 months after Greenspan’s dire warning.
LESSONS LEARNED:
- Markets can stay “Irrational” for a very long time, much longer than most people think. Even when the chairman of the Federal Reserve himself thinks that equities may be overvalued, he suggests that he may use his policy tools to slow things down. It doesn’t matter what talking head is on CNBC today waning investors of an overvalued market; stocks can always keep going higher.
- No one — no central banker, no economist, no market strategist, no hedge fund manager — no one can predict the market, much less tell you where to get out and/or back in. The economy cannot be consistently forecast, nor the market consistently timed by anyone.
Irrational Fearfulness
March 24th, 2000, the equity market peak began a horrible decade for stocks, in which investors suffered the twin bear markets of the “Tech Bubble Collapse” in 2000 through 2002, and then the “Great Financial Crisis” of 2008-2009.
In both of these periods, equities were effectively cut in half, and at the low for the decade, the S&P 500 traveled all the way back to 735 in February of 2009, which was a 52% decline from its March 200 high.
You also read that right: In February of 2009, more than 12 years after Greenspan’s famous “Irrational Exuberance” speech, the S&P 500 stood just a little lower than it was on the night he made those comments.
EQUALLY IMPORTANT LESSONS LEARNED:
- Trees do not grow all the way to the sky, and investors do sometimes become “Irrationally Exuberant.” When the majority of investors no longer fear that their stocks might go down but only fear that their neighbor is making more money in the market than they are, the resulting correction in asset prices can be quite painful.
- Bear market inequities do occur, and they are the price we must pay for being long-term equity investors. This will happen again someday, and a great investor must constantly prepare her emotional temperament to stay calm when it does.
- When the bear strikes, people can also become “Irrationally Fearful,” as they did in response to these horrible twin Bear Markets. When that happens, it is time to prepare for an entirely new Bull Market to be born, which is exactly what happened in 2009. And so, the cycle of investor emotional extremes continues.
The Moral of the Story
After the Great Financial Crisis of 2008 ended, the S&P 500 has experienced a long recovery over the last 12 years. If we take a step back and take a look at the 25 years following Greenspan’s famous speech, we can finally understand “The Moral of the Story.” Here are the relevant factoids:
- On the evening of December 3rd, 2021, the S&P 500 closed at 4,538, up more than six times.
- With dividends reinvested and taxes paid from some other source, $10,000 invested in the S&P 500 on 12/4/96 may have grown to $100,000 by now.
- The earnings of the S&P 500 in 1996 was $40.63. With less than a month to go in the current year, the forecast is around $200, up almost five times.
- The S&P 500’s cash dividend in 1996 was $14.90. The forecast for this year is about $60, up almost four times.
- The Consumer Price Index was 158.6 in December 1996. It will most likely close out this year around 280, up a mere 1.8 times.
All this despite emotions investors have experienced since Alan Greenspan made that famous speech.
What was the single best financial decision you could have made on December 5th, 1996, when the 11 o’clock news breathlessly reported Greenspan’s electrifying remarks? Turning off the TV and going to bed.
Being “Right About the Market”
As I write, at about 4,700 on the S&P 500, the broad equity market is up around 25% so far this year, after rising more than 16% in 2020 in spite of the pandemic.
While this is certainly gratifying, it doesn’t proceed from our having been “right about the market,” other than in the largest, longest-term sense. Our positions in the equity market are a pure function of their being historically best suited to your lifetime financial (and especially retirement) planning. They are never based on a view of the economy and the markets, which we continue to believe can neither be forecast nor timed.
Stated another way, we aren’t “right” because the market is up 25% this year, any more than we’d be “wrong” if it were down 25%. Our investment policy is the same as it’s always been—even (and especially) when the market declined 34% in five weeks in February/March of 2020. Simply stated, that policy is based on two enduring beliefs:
- That the historical long-term premium return of equities over bonds is necessary to the achievement of your most important long-term financial goals.
- That the only way to be reasonably sure of capturing the premium return of equities is to ride out their frequent but historically temporary price declines.
We cherish your kind comments regarding our recent experience. Thank you for them. But in the next breath, be assured that we can claim no credit for anything beyond making an appropriate long-term plan for you and your family and encouraging you to stay invested through thick and thin. This we will continue to do.
Thank you, most sincerely, for being our clients. It is an honor and a privilege to serve you