Are we in a stock market bubble?

For intermediaries only

One of the questions I have gotten a lot lately is: “Is the stock market in a speculative bubble?”

Well, let me try to answer that question based on my own experience. I entered the financial services industry in late 1995, a bright-eyed and eager runaway from the practice of law. Not soon afterward, I listened intently to a historic speech by then-Federal Reserve Chair Alan Greenspan, who suggested that the stock market was exhibiting “irrational exuberance.” More specifically, he asked the question, “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” While Greenspan’s timing wasn’t perfect – the stock market continued to rise for several more years – it did suffer a major drop when the “tech bubble” burst in March 2000.

Optimism and pessimism

Robert Shiller expanded on this concept in his 2000 book Irrational Exuberance, in which he treated irrational exuberance as a critical part of a speculative bubble – the psychological basis of it, in fact. He defined it as “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process of amplifying stories that might justify the price increases, and bringing in a larger and larger class of investors who despite doubts about the real value of an investment, are drawn to it partly by envy of others’ successes and partly through a gambler’s excitement.”

Well, that might not be a definition that works for many investors. After all, we know that there are really only two emotions that we encounter in the investing world: fear and greed – or, to put it more politely, optimism and pessimism. And I would argue that it is difficult to differentiate between optimism/greed and irrational exuberance.

Why are stocks rising?

We know financial conditions are supportive and investors have gotten more enthusiastic; and we know asset prices have risen. But this does not mean the stock market is in a speculative bubble. Stocks might be rising in expectation of a strong period of economic growth as many countries recover from the pandemic and benefit from greater fiscal and monetary stimulus. Stocks might also be rising because investing is all relative, and stocks and other risk assets are more attractive than sovereign debt and cash in a low rate environment (a concept referred to as “TINA” for “there is no alternative”). Stocks might also be rising because discretionary spending has fallen and average household savings have risen in this pandemic, making more cash available for individuals to invest with.

Hindsight is key

The bottom line is that it is inevitable for asset prices to experience cycles, and corrections are a natural part of cycles. But that’s not a reason for investors to abandon stocks; in my view, it is a reason to be well-diversified across and within a variety of asset classes including fixed income and alternatives. And it is a reason to have a long time horizon. I think back to Alan Greenspan’s speech in 1996 – imagine if I had decided to stop investing in stocks because they were exhibiting “irrational exuberance” back then?

For reference, the Dow Jones Industrial Average closed at 6,437.10 and the S&P 500 Index closed at 744.38 on 5 December 1996 right before Fed Chair Greenspan’s famous speech that evening.1

In other words, we don’t know if we are in a sustained rally or a speculative bubble until it is in the rear-view mirror – and it really doesn’t matter for longer-term investors. The reality is that market rallies and corrections occur, but the trend line for stocks over the long run is upward.

1 Source: Bloomberg L.P.


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