5 Signs Irrational Exuberance Is Back

At a time when many pundits or "investors" are grasping at straws to justify the market's run, I'm seeing an increasing number of buds of "irrational exuberance" (in the words of the maestro bubble-blower Alan Greenspan). It's as if the crisis was a sharp but fleeting pain that investors wish to relegate to the status of a bad memory. To give a jolt to our market nervous system, here are my top five signs that exuberance is returning to the market at an alarming rate:

1. Stocks are overpriced. This is the most direct observation of exuberance. At 19 times cyclically adjusted earnings (average inflation-adjusted earnings over the prior 10 years) against a long-term historical average of 16.3, there is simply no getting around the fact that the S&P 500 is overvalued. At a 17% premium, we aren't in bubble territory yet, but any premium looks inconsistent with an environment of high (and growing) unemployment, spare productive capacity, low wage growth, and lower consumption in favor of saving.

2. Junk has run. Bond markets have rallied to pre-Lehman levels, with the riskiest segment -- high-yield ("junk") bonds -- up 49% in the year through September. Junk-bond yields globally are near their 52-week lows (remember that bond prices and yields are inversely related).

Is that any cause for concern? When he was asked in an interview last week to name the best trade in the bond markets, Mohamed El-Erian, the CEO of bond giant PIMCO, replied: "The best trade now is to reduce risk, keep your ammunition dry [and] wait for a better time. A lot of people are chasing risk assets at this point for all sorts of reasons, but I think the long-term investor can be patient because the economy is likely to face headwinds in 2010."

3. The VIX is cheap. Labeled Wall Street's "fear gauge," the VIX is derived from the prices of options on the S&P 500 index. During periods of financial turmoil, investors are willing to pay up for protection against price declines, pushing the VIX up. Conversely, as investor fear recedes, option prices, and, hence, the VIX, tend to decline. Yesterday, the VIX closed at its lowest value since Sept. 8, 2008 -- one week before the failure of Lehman Brothers.

4. The carry trade is back. A favorite of hedge funds, here's how it works: You borrow money in a low-interest-rate currency (the yen is always popular) and invest the funds in higher-yielding assets in a different currency (the Brazilian real, for example). It might sound like free money, but it is a risk-seeking trade, the ultimate success of which depends on a low-volatility environment in interest and currency rates. When the carry trade gains in popularity, it suggests that traders believe there is smooth sailing ahead.

5. A smart guy said so. Last week, Nobel prize-winning economist Joseph Stiglitz told Bloomberg Television: "There's a lot of risk going ahead of some big bumps ... There's a very big risk that markets have been irrationally exuberant." Academic brilliance doesn't always translate into practical judgment, but this ivory-tower denizen was warning as early as 2006 that the U.S. housing bubble would end in a credit crisis and recession.

Put these clues together and we have a case for a market that is at the very least complacent, if not exuberant. What is the proper course of action when all about you appear to be losing their heads? Although El-Erian was referring specifically to the bond market, I can think of no better advice for equity investors than to adopt a long-term outlook and "keep your ammunition dry" for better prices.

"... focus on high-grade companies"
In the same interview, El-Erian recommended another action that applies to bond and equity investors: "I would focus on high-grade companies, companies that have their financials and operating leverage under control." Not only are such companies better positioned in case the recovery stutters, they're also relatively underpriced right now. All but one of the stocks in the blue-chip Dow Jones Industrial Average are valued at a cyclically adjusted price-to-earnings ratio below that of the S&P 500 (the exception being Coca-Cola (NYSE:KO)). That includes some extraordinary companies:

*At Oct. 13, 2009.

Source: Author's calculation based on data from Capital IQ, a division of Standard & Poor's.

Final recommendations
Now is not the time for investors to be complacent. We are still dealing with a balance-sheet recession and should thus expect (or at least be prepared for) multiple false starts and subsequent declines in the market. If your portfolio is fully or broadly weighted in U.S. equities, I suggest you consider either reducing your exposure or tilting it toward higher-quality names.

Looking for more stock ideas? Morgan Housel has identified three high-quality companies that are still cheap.