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:

Company/ Ticker

Cyclically Adjusted Price-to-Earnings (CAPE) Multiple*

3M (NYSE: MMM  )

12.7

ExxonMobil (NYSE: XOM  )

8.3

IBM (NYSE: IBM  )

14.6

JPMorgan Chase (NYSE: JPM  )

12.8

Merck (NYSE: MRK  )

12.2

Wal-Mart Stores (NYSE: WMT  )

14.0

*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.

Quality matters. The team at Motley Fool Inside Value can show you how to build -- and manage -- a portfolio of high-quality stocks trading at reasonable prices. To find out its top five recommendations for new money now, take advantage of a 30-day free trial today.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Coca-Cola, 3M, and Wal-Mart Stores are Inside Value recommendations. Coca-Cola is an Income Investor pick. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (43)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 14, 2009, at 5:22 PM, thisislabor wrote:

    1 sign irrational exuberance is back,

    Dow hits 10,000 and people throw confetti on the trading floor.

  • Report this Comment On October 14, 2009, at 5:30 PM, ozzfan1317 wrote:

    All of the above. You would do even better if you find some great small companies and hold them. Also even though the index is overpriced many individual bargains still exist if you look hard enough.

  • Report this Comment On October 14, 2009, at 5:30 PM, ozzfan1317 wrote:

    All of the above. You would do even better if you find some great small companies and hold them. Also even though the index is overpriced many individual bargains still exist if you look hard enough.

  • Report this Comment On October 14, 2009, at 6:24 PM, U262554 wrote:

    <<"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:....">>

    So after presenting a case for irrational exuberance isn't this suggesting that the Dow is underpriced at 10,000?

  • Report this Comment On October 14, 2009, at 9:59 PM, thisislabor wrote:

    possibly or that the whole dow jones industrial average still hasn't recovered fully. but then again I dont really know much about that.

  • Report this Comment On October 15, 2009, at 10:01 AM, JakilaTheHun wrote:

    IMO, the market is close to fairly valued, but the level of risk is definitely increasing as it edges higher and higher. I've admittedly become a slight bit more conservative.

  • Report this Comment On October 15, 2009, at 11:30 AM, TMFDeej wrote:

    My favorite sign that irrational exuberance is back is interest rates on corporate bonds. I was big into bonds a number of years ago and found myself buying less and less as we approached the peak of the market in 2007 and 2008...to the point that I wasn't buying any.

    Credit spreads exploded during the height of the credit crunch and I was snapping up corporate debt hand over fist. As someone who is looking for attractive yields, I often peruse the available bond issues and over the past several months the rates are absolutely terrible. Once again I cannot justify buying corporate paper.

    This leads me to believe that people are nor nearly as risk averse in the current environment as they should be.

    Deej

  • Report this Comment On October 15, 2009, at 11:54 AM, TMFAleph1 wrote:

    @Deej,

    Thanks for your interest. You're right, high-yield isn't the only segment of the bond market that has had a good run -- the borrowing cost for U.S. companies is lower now than it has been in approximately 16 months.

    Regards,

    Alex D

    Tracking Bond Benchmarks,

    http://online.wsj.com/mdc/public/page/2_3022-bondbnchmrk.htm...

  • Report this Comment On October 19, 2009, at 1:47 AM, thisislabor wrote:

    deej i dont get it, explain for me please.

    as corporate credit rates rise... people are being less risk advers? please explain. seriously. i'm just trying to understand.

  • Report this Comment On October 19, 2009, at 2:38 AM, Racovius wrote:

    Following the herd is a survival mechanism. If everyone seems to be looking toward the sky, damn right I'll look also. .

  • Report this Comment On October 19, 2009, at 3:28 AM, BDOT071 wrote:

    BEWARE: use of PE averages are mostly unhelpful, and at times, destructive. PE ratios are high before a recovery--with good reason: there is an anticipation of huge revenue and profit increases when the economy heats up. What is more important is where the PE ratio is in relation to WHERE THEY HAVE BEEN historically at the end of recessions. Paying 25x earnings for an industrial company at the bottom of a "once a century" mini-depression looks A LOT cheaper than 8x earnings at then end of a 5 year bull run! The averages indicate otherwise.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1007245, ~/Articles/ArticleHandler.aspx, 10/23/2014 1:29:22 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement