Irrational Exuberance?
S&P 500
"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 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? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy."Â
Alan Greenspan, December 1996Â
As we enter a new period of prosperity, Alan Greenspan's comments almost 23 years ago are starting to resonate again. The stock market continues to climb to new highs. How much higher can the market go? Is everyone talking about their stock investments at cocktail parties? Should I be worried when my 18 year old opens up a RobinHood account for day trading? Have we reached a state of irrational exuberance? Should we be worried and put some cash on the sidelines or stay should we stay fully invested in the stock market? Here's a look at both sides of the story.
The Bull Case:
Historically low interest rates are likely to continue for some time (see chart below), keeping cost of borrowing low and favoring leverage and higher-yielding investments (i.e., margin accounts invested in stocks)
Recent tax cuts have largely run their course, but have materially enhanced corporate income statements, fueling stock buybacks and dividend increases; the lower corporate tax rate tailwind effect is likely to continue
Low and declining unemployment rate more likely than not to continue as economy chugs along
Record corporate earnings - Q4 2018 67% of Companies reporting beat their earnings projections
Fear and Greed Index showing Greed - if you're a momentum investor, that's good and you go with the flow
Banks are in good shape and real estate lending is relatively conservative these days
Federal Funds Rate
The Bear Case:
Companies going public that don't make money, at least not yet (i.e., Uber, Lyft, etc.) - a sure sign of irrational exuberance, right?
Oil price spikes, which are pretty reliable predictors of recessions and stock market corrections
China trade war and economy concerns
Europe slowdown concerns and threat of new trade war front
Weekly ETF / Mutual Funds Flows show a lot of movement into bonds from stocks recently, indicating investors are taking a more defensive stance
Unemployment may be worse than reported (see chart below with alternative stats)
Fear and Greed Index shows Greed - if you're a contrarian that's bad and means it's time to head for the hills
Estimated Fund Flows Millions of dollars
4/17/20194/10/20194/3/20193/27/20193/20/2019Equity4,5425,811-7,496-11,085-2,145Domestic3,9936,210-7,465-10,8961,474World549-400-31-190-3,619Hybrid-976-122-3,575-199-636Bond8,8097,81311,2757,88410,552Taxable7,5596,6759,7835,5288,660Municipal1,2501,1381,4922,3561,892Commodity-101-286-983141393Total12,27313,216-778-3,2598,163
Unemployment may actually be a lot worse than reported, since the official measure has changed over the years:
Ultimately you need to decide how much risk you can tolerate in your portfolio and your investment strategy should follow suit. Following a broad diversification strategy, especially when markets are volatile, is a good approach. The goal should be to make money in any market environment and most importantly, to sleep well at night knowing your strategy matches up with your risk tolerance.
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