|Twenty years ago today, former Fed Chief Alan Greenspan gave the now-infamous “irrational exuberance” speech.
Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberancehas unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
Greenspan said he came up with the phrase “irrational exuberance” in the bathtub. And he later said, “I was acutely aware of the fact that that particular phrase was put in that speech to spook the market.”
It did, too. Japan sold off 3% that day. The next day, the Dow Industrials dropped as much as 2.2% during trading.
Of course, the Dow was also trading around 6,400 at the time…
People love to say that Greenspan was basically right, that the stock market was a bubble at the time, and that he was just a little early with his “irrational exuberance” line. Yeah, I guess if you want to call three years and 5,000 points early, you’re welcome to do so. But it’s a pretty lame excuse…
For one, the Dow got creamed when the Asian Tiger economies imploded in late 1997. Between July and September 1997, the Dow fell as much as 16%. That’s a solid correction, enough to temper any irrational exuberance. And if that didn’t do it, the Russian default and subsequent $4.6 billion failure of the Long-Term Capital Management (LTCM) hedge fund in 1998 should have helped. The Dow fell 19.5% in just two months, to around 7,500.
I was just starting to learn about economics and the stock market at that time. And I can tell you, it was a bit scary. I sure wouldn’t describe the action as irrationally exuberant.
A Rational Market?
Here’s the thing I’ve learned about the stock market: it’s pretty much always irrational. I know, you were probably hoping for something better than that. But how else can you explain the way companies will add or lose billion of dollars in valuation every single day the stock market is open?
Rationally, we know that Apple isn’t really worth $17 billion less today than it was on Friday. And we can easily take it a step further and say that Apple’s $584 billion market capitalization isn’t really a rational number, either. And yet we have no problem seeing Apple’s stock trade $0.35 lower and think, “Yeah, that makes sense.”
Or how about the fact that Bank of America (NYSE: BAC) is worth $50 billion more just because Trump won the election? Does that make sense?
The fact is, the stock market is a human construct, and humans are a little nutso sometimes. Personally, I think the craziest thing you can do as an investor is try to pretend that you’re not crazy. The minute you think you have it all figured out, the market will make a fool of you, guaranteed. Just like it did with Greenspan.
My biggest knock on Greenspan is that he always believed his own BS. He always thought he knew. And he still does. That’s why he made some of the biggest mistakes a Fed Chief has ever made. And yes, I firmly believe we can lay the blame for the 2008–9 financial crisis squarely on Greenspan.
After all, it was Greenspan who said that derivatives actually lowered overall economic risk of higher housing prices because of the way derivatives spread risk around the globe. He thought things like credit-default swaps meant no one entity would be left holding the bag if it all went south. He had it completely, absolutely backwards. Derivatives made sure that everyone was a counterparty, so everyone was left holding the bag.
And perhaps worse than that, Fed governors were talking about a housing bubble in 2004, about a year before real estate prices peaked. Transcripts from 2004 meetings show they said things like:
“…buyers freely admitting that they have no intention of occupying the units… but rather are counting on ‘flipping’ the properties—selling them quickly at higher prices.”
“A second concern is that policy accommodation — and the expectation that it will persist — is distorting asset prices.”
“The high price of housing worries many in the region who find that hiring the skilled workers they need in health care, for example, is made even more difficult by high housing costs.”
But the minutes from those meetings, which are released shortly after a meeting concludes, do not mention any of these concerns. All discussion of a housing bubble were stricken from the record and show up only in transcripts, which are released a decade later. In one case, a chart that was viewed by the Fed members was left out of the official record because, as the transcripts show, one member said, “I don’t want to leave the impression that we think there’s a huge housing bubble.”
Personally, I find these revelations shocking. Greenspan’s Fed basically lied about what they were seeing. In the official minutes, they deliberately understate their concerns, concluding that “a slowdown might be likely later in the year.”
If that doesn’t tick you off, maybe this Greenspan quote from March 2004 transcripts will:
We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.
That quote right there tells you all you need to know about Greenspan…
Keep Your Head in the Game
It is absolutely critical that you be on the lookout for know-it-alls like Alan Greenspan. Anybody who says they have it all figured out is lying to you.
I’ve been watching, trading, and learning the markets for nearly 20 years. And every single day, I find more things that I don’t know. I get taken to school every day, and I love it. And I won’t ever tell you I have it all figured out…
But sometimes I do get a few things figured out. Like, I’ve been trading Bank of America a whole lot since the election. And the stock has donated generously to my bottom line.
I hope you took my advice over the last couple of years to buy shares of BofA. If you didn’t, you can probably wait and get them around $19 in the next few months.
Until next time,