5 Signs of Irrational Exuberance No One Can Ignore

In October 2009 and again last November, I highlighted 5 signs of irrational exuberance. Sure, corporate earnings growth has been impressive, and the stock market appears unstoppable, but that doesn't stop me from worrying that investors aren't displaying the proper restraint in an environment that remains exceptionally uncertain. Here we are in 2011, and I've spotted five more signs that investors are abusing the laughing gas:

1. Gold and silver at new highs. Last Monday, the volume in the iShares Silver Trust (NYSE: SLV  ) reached five times its average daily volume in the first quarter, as the metal hit a 31-year high. Gold also achieved an all-time nominal high above $1,500 recently, and the SPDR Gold Shares (NYSE: GLD  ) has become one of the largest exchange-traded funds. Part of this phenomenon is the product of investors who are resolutely bearish about the prospect for stocks and the U.S. dollar, but there is also evidence that purely speculative buyers are piling into these markets. Let me be clear: Both gold and silver are at bubble levels.

2. Small-cap stocks hit new highs. Last week, the Russell 2000 small-cap index achieved a new all-time high. Small caps have handsomely outperformed large caps in the massive rally that began in March 2009. That has produced some eyebrow-raising valuations, like that of Ariba (Nasdaq: ARBA  ) at 33 times forward earnings, or Blue Nile (Nasdaq: NILE  ) at 46 times! (Note that the latter is a longtime recommendation of our Motley Fool Rule Breakers service, so they may disagree.)

Small caps have greater exposure to the U.S. economy than large caps, which generate substantial revenues and profits in higher-growth economies; despite this, small caps are now historically pricey with regard to large caps.

3. The smart money is cashing out. On Monday, The Wall Street Journal reported that private equity behemoth Carlyle Group is preparing an IPO. When successful financiers who make their living buying and selling companies decide to sell their own company, which is more likely: That they feel they will receive less than a fair price for it, or that they believe the market is buoyant enough to support a rich valuation? When Carlyle's rival, the Blackstone Group (NYSE: BX  ) , went public in June 2007, it proved to be a superb indicator of the top of the credit bubble -- and a contrary indicator for stocks. Blackstone's shares have performed disastrously since the flotation, underperforming the S&P 500 by more than 25%.

4. The VIX is cheap. The VIX index is known as the market's "fear gauge" because it relates to the price investors are willing to pay for protection with options on the S&P 500. Lower VIX values mean investors are paying less for options, i.e., they are less concerned about stock market declines.

On Friday, the VIX closed at 14.75, well below its historical average of 20.36. Yes, we are heading into the summer months, which are typically less volatile than the autumn and spring. Yes, the VIX is based on options that are maturing in a month, so it doesn't look out very far. And yes, the VIX curve is upward sloping, indicating that the market expects the VIX to rise.

As I explain here, however, the current VIX value smacks of stunning complacency in an environment as uncertain as the one we now occupy. For example, the Fed will end its second round of money-printing next month (QE2, as the program is known). Investors who say they know how this will affect markets and the economy are liars or small-fools -- it's a genuine wild card.

(Investors who think the obvious bet is to go long the iPath S&P 500 VIX Short-term Futures ETN (NYSE: VXX  ) need to make sure that they understand the nuts and bolts of this product and the tracking error it displays with regard to the VIX index.)

5. The art market is booming. This week, New York auction houses will try to sell $1 billion worth of art and antiquities, with a dozen works priced near $20 million.

Michael Plummer, a principal at Artvest, told The Wall Street Journal last week: 

The speed of the art market's recovery is astonishing, but it's a differently revived market. The lesson of the crash was to do your homework. Collectors feel wiser for the experience.

In other words, Michael, it's different this time?

Value: More relevant than ever
I'm neither the boy who cried wolf, nor a prophet of doom -- I'm optimistic regarding the U.S. over the long term, despite the significant challenges ahead. However, in the current context, I see no reason to deviate from the counsel I have been repeating for nearly two years: Be wary of U.S. index funds at present valuations. Favor value-oriented fund managers or, if you pick your own stocks, maintain a keen focus on the valuation of the stocks you own. Finally, I'm no fan of gold or silver. If you want to put your money into an asset with zero yield, I would suggest that increasing your cash allocation is much the superior choice until real asset valuations become more compelling.

Are you being left behind by the bull market in commodities? The Motley Fool's top analysts have identified 3 Stocks for $100 Oil.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Ariba is a Motley Fool Big Short short-sale selection. Blue Nile is a Motley Fool Rule Breakers pick. The Fool has written naked calls on iPath S&P 500 VIX Short-Term Futures ETN. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (41)

Comments from our Foolish Readers

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  • Report this Comment On May 04, 2011, at 4:12 PM, Borbality wrote:

    seems to me like bubbles in gold and other PM would suggest these investors are avoiding stocks. that's a lot of money that might normally go into stocks.

    The S&P 500 p/e is still historically not too bad, and I am of the belief that with more and more money coming from employer 401ks and pension funds and that sort of thing, you might see higher P/Es anyway. Earnings are still pretty good, and isn't that what the market is all about?

    that said, i'm not saying the market is going to be pretty. anything can happen, and I'm holding a lot of cash.

  • Report this Comment On May 04, 2011, at 5:29 PM, TMFKopp wrote:

    #3 Glencore fits here as well...

    Matt

  • Report this Comment On May 06, 2011, at 12:38 PM, TMFAleph1 wrote:

    <<The S&P 500 p/e is still historically not too bad>>

    On the basis of 12-month forward earnings, that's accurate; however, on a cyclically-adjusted basis (average real earnings over the trailing ten years), that statement doesn't hold.

    Alex Dumortier

  • Report this Comment On May 06, 2011, at 4:55 PM, ldkoehler wrote:

    I agree that the Russell 2000 is overvalued.

    I'm looking at a model for the Russell 2K based on the cap-weighted aggregation of models for companies in the index and seeing negative economic earnings, a free cash flow yield of -1.4%, and an ROIC of 8.7%. Not very impressive given that the S&P 500 has positive and rising economic earnings, an FCF yield of 2.4%, and an ROIC of 18.3%.

    The outperformance of small caps stocks looks to be unjustified from here. The S&P 500 is clearly the better option.

    This free roadmap report gives ratings for the S&P 500, Russell 2000, and all sectors. It's pretty useful for finding over- or under-valued areas in the market to start looking for good investments.

    http://www.newconstructs.com/nc/research/report/etf-and-fund...

  • Report this Comment On May 07, 2011, at 12:28 PM, jrj90620 wrote:

    Irrational exuberance is what is happening with the Dollar and Dollar promises(bonds).Why are investors holding short term CD's with yields under .1%?Why hold bonds with 3% yields.Do they actually think we are living in a world where the Dollar is that valuable?There is really no way to put a Dollar price on stocks or commodities,since no one knows how fast the Dollar will devalue over time.You only know that it will happen.The long trend is for the Dollar to decline against real assets and there is no reason to believe this is going to change.In fact,the decline should be accelerating.

  • Report this Comment On May 07, 2011, at 1:59 PM, lowmaple wrote:

    Fro people who may be slow on the mark the market can turn in a day and keep falling for some time so some cash even if it is losing it's value could by comparison be worth more in that scenario. Also summer may be less volitile but stocks often soften over thi period giving oppertunitie t o buy again.

  • Report this Comment On May 07, 2011, at 7:19 PM, ranaxy wrote:

    I disagree that gold is at bubble levels.. Since gold doesnt trade with a P/E attached to it, I dont understand on what basis one can say gold is pricey. Maybe compared to historic norms or other ratios?

    Perhaps I'd say that the US Dollar is and has been at bubble levels for the greater part of a decade or so, and yet people pile into $ based bonds at the sight of a market crash. Inexplicable, right? Maybe there is more money floating around than one can imagine, which only means one thing... gold is going to rule.

  • Report this Comment On May 08, 2011, at 8:19 PM, extremist wrote:

    The VIX indicates complacency, yet gold is at record highs? Something doesn't quite gel there. In any case, the gold and especially the silver bubbles were deflated just a tad last week. This is a very strange market, the likes of which I certainly have never seen in my (too) many decades.

  • Report this Comment On May 09, 2011, at 9:15 AM, congxin140 wrote:

    ddddddddddddddddddddddddddddddddddddddd

  • Report this Comment On May 10, 2011, at 1:31 PM, TheDumbMoney wrote:

    +1

  • Report this Comment On May 13, 2011, at 10:53 AM, rfaramir wrote:

    "Small caps have greater exposure to the U.S. economy than large caps, which generate substantial revenues and profits in higher-growth economies; despite this, small caps are now historically pricey with regard to large caps."

    This is a good point. Normally I prefer small caps, but they do business where the source of inflation rests (the US Federal Reserve), and where unemployment is very high. Whereas large caps have the wherewithal to escape to wherever in the world capital is welcome, labor is cheap and plentiful, and the currencies are inflating more slowly (they're all fiat, after all).

  • Report this Comment On August 10, 2011, at 6:41 PM, joaquingrech wrote:

    you nailed this one Alex

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