5 More Signs Irrational Exuberance Is Back

At this stage, the burden of proof must surely lie with those bulls who claim that current market prices are entirely justified by fundamentals. Nearly two weeks ago, I highlighted 5 Signs Irrational Exuberance Is Back. I certainly didn't expect the process to reverse on publication of the article, so I remained vigilant for other signals that sentiment, not rationality, is driving this market. It didn't take long for me to collect five more (bulls -- please leave intelligent counterarguments in the "Comments" section below the article):

1. Stocks are still overpriced. In his latest note to clients, Andrew Smithers -- who literally wrote the book on market valuation -- reckons the U.S. market is now approximately 40% overvalued. That number is based on a comparison between the S&P 500's current cyclically adjusted P/E multiple (the CAPE, which uses average inflation-adjusted earnings in order to smooth out the fluctuations of the business cycle) and its long-term historical average.

The CAPE isn't a lone data point, either. Smithers writes that Tobin's q ratio -- which compares the market value of equities to their net worth at replacement cost -- points to a similar degree of overvaluation in U.S. stocks.

2. The IPO market is back. The third quarter was the strongest for U.S. IPOs since the first quarter of 2008, with 20 offerings for a cumulative value of $5.8 billion. That trend looks set to continue with 34 registrants seeking to raise $10.9 billion at the end of last quarter against 28 aiming to raise $7.6 billion at the end of the second quarter. Notably, technology is the best represented sector -- with six registrants newly filed in August and September.

Successful IPOs depend on positive sentiment. While we're still far from the "glory days" of 2007 (thankfully), this resurgence in the IPO market suggests there is a strong, increasing appetite for risk assets.

3. Asset managers are floating shares. Among the new IPOs, some are more telling than others. English fund manager Gartmore could register plans to float shares this week. Asset management firms earn a percentage of their assets under management (AUM). Rising markets swell existing AUM and encourage new asset inflows; thus, investors reward asset managers with rich valuations when markets are ebullient, not depressed. Gartmore's owners, a shrewd LBO group named Hellman & Friedman, know this; the timing of the IPO -- which they expect to complete by year-end -- is anything but casual.

A legendary LBO group, KKR, went public within the last month by merging with an affiliate listed on Euronext Amsterdam (part of NYSE Euronext (NYSE: NYX  ) ), with shares to trade on the NYSE as early as spring 2010. Successful private equity firms are masters of timing. The June 2007 listing of KKR's fiercest rival, the Blackstone Group (NYSE: BX  ) , rang the bell at the top of the private equity boom: Blackstone shares have lost 57% since their first day of trading.

4. The towering inferno. Less than two weeks ago, Henderson Land, a large Hong Kong property developer, announced that it had sold a high-rise apartment for 439 million Hong Kong dollars (US$56.6 million). At a cost per square foot of useable area equivalent to US$11,350, Henderson affirms it is a record sale for Hong Kong and believes it trumps all transactions anywhere in the world.

This is simply the most blatant example of a Chinese property bubble fueled by cheap money; Hong Kong home prices have risen by 28% so far this year.

5. John Meriwether is launching a hedge fund ... again. Surely you remember Mr. Meriwether: In 1998, he introduced us to the notion of "too interconnected to fail" when the Fed orchestrated a bank-led rescue of his massively leveraged hedge fund, Long-Term Capital Management. (The rescuers included Goldman Sachs (NYSE: GS  ) , Morgan Stanley (NYSE: MS  ) , JPMorgan Chase (NYSE: JPM  ) , Lehman Brothers (now bankrupt), Salomon Smith Barney (part of Morgan Stanley and Citigroup (NYSE: C  ) ), and Merrill Lynch (now part of Bank of America (NYSE: BAC  ) .)

Undeterred by having threatened global financial stability, Meriwether created a new fund soon thereafter, boasting similar strategies with lower leverage. Unfortunately, 10:1 leverage was still too high for last year's jarring volatility, and Meriwether shuttered the fund after inflicting a 44% loss on his investors.

"Third time's a charm," must be Meriwether's new pitch. He's back soliciting assets from well-heeled investors for a fund to launch in 2010 ... following the same strategy as the first two. I propose a new contrarian indicator: When there is enough risk appetite for John Meriwether to start fundraising for a new hedge fund, investors must consider rebalancing their portfolios toward lower-risk assets.

Bubble or not, my recommendations
It may be premature to say that we are already in another full-fledged bubble, but it should be clear that the combination of government-sponsored liquidity and low fixed interest rates is distorting the pricing of risk and stoking bubbles in many areas of the capital markets. U.S. investors should think twice before chasing stock returns; if you must be fully allocated to U.S. equities, my recommendation is to focus on the highest-quality segment of U.S. corporations. Alternatively, you could trade some of your U.S. exposure for international stock exposure (although I'd be wary of red-hot China -- they've got a highly effective bubble machine of their own).

There's more to China than the red-hot coastal regions. Motley Fool Global Gains co-advisor Tim Hanson puts his finger on the next great place to invest.

Quality matters. The team at Motley Fool Inside Value can show you how to build -- and manage -- a portfolio of high-quality company stocks trading at reasonable prices. To find out their 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. NYSE Euronext is a Motley Fool Rule Breakers pick. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (19)

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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 27, 2009, at 7:59 PM, chaztv55 wrote:

    "...my recommendation is to focus on the highest-quality segment of U.S. corporations."

    What would those be? As we have seen, no corporation of whatever historic quality, is capable of protecting their assets in a consumer/worker slaughter-driven market dive.

    Also, how can any small investor get a "fair" return relative to risk with the current situation of trade skimming and who knows what other black box scams?

    Any rational investor opted out months ago and is waiting for the storm to pass and the enforcement of necessary regulations to create a market situation where the odds of success can be determined; where risk can be reasonably determined. The current market is untenable. The only people participating at the moment are ignorant of the current circumstances, blinded by greed or pulling the levels of this the biggest con of all time.

    Believe you can pick good stocks, good companies? Sure. Still, you better time this market because even the best of the best can be crushed without an economy with a stable foundation of work/reward and risk/reward.

  • Report this Comment On October 27, 2009, at 8:05 PM, Dannysea wrote:

    Too many nasty bombshells coming out and going off in our economy right now. Whether a true bubble or a weakened economy or investment capital no longer available (or on sidelines,) am very unsure of any US stock. With the Fed making all the decisions on what to bail out-- no, no, take over-- what sector of the market is safe?

    A few years back I would have doubted the issuance of all new stock in the Worldcom scenario, (private greed,) the all new stock in Freddie Mac and Fannie Mae, (Bureaucrat control,) and so much more.

    But in all this I still believe in investing and finding opportunities. But with the Big Brother telling me it is a great time to invest? And for me to trust the lion that just made how many stock owners poor, I am to trust?

    I think with all this give and take, prices are way too high. Way too much liability, especially with the new legislation holding stock holders responsible. Too many direct-own investments that limit responsibility out there. Sure things can unravel. But that is the nature of life. Just look for limited pressures.

  • Report this Comment On October 27, 2009, at 9:20 PM, sentinelbrit wrote:

    Exuberance occurs at extremes, we are not at extremes yet. We would have to see a lot more IPOs and they would have to do well in the after-market. Stocks are not overvalued if the economy grows at a decent clip. Profits will explode if the economy grows at a decent rate due to the leverage now created as a result of extreme cost cutting. But frankly, who knows if it will.

  • Report this Comment On October 28, 2009, at 12:39 AM, mountain8 wrote:

    Stocks are still overpriced. In his latest note to clients, Andrew Smithers -- who literally wrote the book on market valuation -- reckons the U.S. market is now approximately 40% overvalued

    Am I reading this right? Should the Dow be 6000?

  • Report this Comment On October 28, 2009, at 12:45 AM, mountain8 wrote:

    "The only people participating at the moment are ignorant of the current circumstances, blinded by greed or pulling the levels of this the biggest con of all time."

    You obviously don't read the motley fool. I could say the same thing about the ignorant people who aren't taking advantage of the current circumstances. And we would probably both be right.

  • Report this Comment On October 28, 2009, at 12:47 AM, mountain8 wrote:

    Ignorance and opinion go hand in hand too often.

  • Report this Comment On October 28, 2009, at 5:22 AM, TMFAleph1 wrote:

    chaztv55,

    Thanks for your interest. You wrote: "What would that be?" concerning what I referred to as 'the highest quality segment of U.S. corporations'.

    I have written extensively on this topic in the last few months. Here is an article that will give you a better idea of which stocks belong to the highest quality segment.

    The Easy Bet in Today's Market, August 17, 2009

    http://www.fool.com/investing/value/2009/08/17/the-easy-bet-...

    Best,

    Alex Dumortier

  • Report this Comment On October 28, 2009, at 5:29 AM, TMFAleph1 wrote:

    @mountain8,

    Thanks for your interest. You wrote: "Am I reading this right? Should the Dow be 6000?"

    No, you can't infer that the Dow should be at 6,000 as the 40% overvaluation refers to the S&P 500. The Dow Jones Industrial Average is a mega-cap, blue-chip index, which is a poor proxy for the broad market. On the basis of the CAPE, the Dow appears to be more attractively priced than the S&P 500; see, for example:

    'What's Next For Stocks' (October 5, 2009)

    http://www.fool.com/investing/value/2009/10/05/whats-next-fo...

    Best,

    Alex Dumortier

  • Report this Comment On October 29, 2009, at 9:54 AM, sofpan wrote:

    Folks, whoever didn't buy back in February, March, April or even May of 2009 when the majority of the companies were cheap and bought in June, July, August, September or even October when the prices were no more cheap (actually in the last months the prices are overvalued), why did this and act like that?

    Because they were afraid to buy in lows and they are buying in the last months, just following the trend.

    So, if it will happens something that will scary them, all of them will be the first ones that will sell. The market will confront a big correction or even a crash.

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