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Are We in the Midst of Irrational Exuberance Version 2.0?

By Sean Williams - Mar 16, 2014 at 12:10PM

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It's been 17 years since former Fed chief Alan Greenspan coined the term irrational exuberance, but frothy valuations are once again making the market look top-heavy.

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
– Alan Greenspan, The Challenge of Central Banking in a Democratic Society, December 1996. 

Alan Greenspan testifying, Source: Wikimedia Commons.

It's been more than 17 years since former Federal Reserve Chairman Alan Greenspan delivered a speech at the American Enterprise Institute cautioning that a low inflation environment had allowed stock market valuations to explode well beyond reality. The phrase "irrational exuberance" became instant gold among Wall Street analysts and investors, yet the market continued to motor higher for years even after this speech.

Eventually, though, Greenspan's cautious commentary proved accurate as the dot-com bubble did burst, leading the technology-heavy Nasdaq Composite down by close to 80% from peak to trough.

The dot-com bubble was built upon the as-of-then unrealized potential of the Internet. Simply mentioning the word "Internet" and assigning lofty sales expectations three to five years down the road got companies with practically no proven platform to multibillion-dollar valuations. The problem was that few companies really understood how to monetize the Internet for their benefit, and even fewer companies were able to turn a profit from their operations. Within years, heavy competition and a dearth of venture capital sucked the life out of dot-com sector and caused quite a few previous highfliers, such as WebVan and Commerce One, to go belly-up.

But are we doomed to repeat a similar lesson once again? I'd contend that it's a distinct possibility.

The new irrational exuberance
This new round of "irrational exuberance" comes from a number of sectors, not just the tech sector, and points to a very real possibility that current asset values have outpaced reality once again.

Source: Kewl, Pixabay.

Within the tech sector, it's not the Internet itself, but the emergence of cloud-computing and big data that have caused valuations to soar. The potential for cloud-computing and big data is enormous. The ability to access data anywhere on any device could revolutionize the office setting. Plus, the need for the infrastructure required to store tons of data, as well as access that data could fuel components supplier for years if not longer. But there's one huge problem with big data: No one really understand how to harness it yet.

The majority of cloud-based companies are seeing revenue grow like mad and are adding customers left and right, but they're still not profitable. We saw a number of dot-com companies sacrificing profitability in favor of growth in the late 1990s, but it clearly doesn't always work.

Take cloud-based application provider Workday ( WDAY 0.12% ) as the perfect example. Workday's share price has doubled over the past two years, with revenue growing from $134 million in 2012 to an expected $1.1 billion by 2016. Despite this rapid growth, profits are considered to be a long way off for Workday. In fact, Workday's S-1 filing before going public warned that losses were going to "continue for the foreseeable future." Yet its ongoing losses still haven't stopped Workday's valuation from topping $17.6 billion.

It's not just tech
But as I said, this isn't just confined to the tech sector. The health-care sector, particularly biotech stocks, are demonstrating their own version of irrational exuberance based on valuations being assigned to generally early-stage development programs.

Source: Bayer Healthcare.

In 2013, there were 38 biotechs IPOs, an already huge number, with the collective group of those new debuts rising by 43%! Many are being fueled by new cancer-fighting possibilities, such as cancer immunotherapies, which use a therapy to retrain the body's immune system to recognize cancer which is currently undetected within the body. Once retained, the body's own defenses can fight back and kill cancer cells, which is expected to improve overall survival.

It's a novel idea, and one that's proved to work with the approval of Dendreon's late-stage prostate cancer vaccine Provenge in 2010. But that vast majority of biotech valuations simply don't make a lot of sense right now.

Tesaro (NASDAQ: TSRO), for instance, just last week entered into a collaboration with privately held AnaptysBio to license its immuno-oncology platform targeting PD-1, TIM-3 and LAG-3. Investors took this as their cue to shoot shares of Tesaro to a value of $1.2 billion despite its lack of a single FDA-approved product, and given that AnaptysBio's immunotherapy platform is preclinical in nature.

Need I also remind investors that the biotechnology sector was one of the last sectors to soar right before the rug was pulled out from under the market in March 2000?

Reaching for growth
To add, we've also seen an inordinate number of bad buyouts, where it's clear that companies are reaching for growth.

Perhaps none stands out more to me than the mid-February announcement that Actavis ( AGN ) would be purchasing global pharmaceutical company Forest Laboratories (NYSE: FRX) for $25 billion in a mixed cash and stock deal. While Wall Street cheered the deal, I scratched my head as Forest Labs' key drug, Namenda, an Alzheimer's disease drug that accounted for close to half of Forest Labs' total sales last quarter, is set to lose patent exclusivity next year. This seems like an awfully risky bet for Actavis to make for a pipeline that's struggled for years and is about to lose its most prized possession to generic competition.

The signs are there
Plenty of people have tried to call a top in this market, but we all know that's practically impossible. What we should recognize, though, is that many of the clear-cut signs of irrational exuberance and market unsustainability are present -- they just look a bit differently than they did in March 2000. Just looking at sectors as a whole based on current P/E valuations, I wouldn't personally be surprised one bit to see the stock market undergo a potentially large correction or protracted downtrend in the coming years.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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