Irrational Exuberance & Market Timing

“The markets can stay irrational longer than you can remain solvent” – John Maynard Keynes

Source: JP Morgan Guide to the Markets

Investors often try to use valuation metrics like the ones above as market-timing tools and are surprised when they don’t work.

For example, at the end of 1996, Alan Greenspan gave a speech where he posed the following question:

How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions … ? And how do we factor that assessment into monetary policy?”

In the 24 months leading up to the speech, the S&P 500 was up more than 50%. Price-to-earnings ratios were hitting levels not seen since the eve of the Great Depression in 1929, and now the Chairman of the Federal Reserve was openly insinuating that stock market prices were too high.

This screaming sell signal was followed by a momentary decline, followed by a massive three-year rally. The S&P continued to go up 31% in 1997, 26% in 1998, and 19% in 1999. When the dot-com bubble eventually burst, the S&P index declined roughly 50% and returned to the level it was when Greenspan first gave his speech.

For active traders, being three years early was indistinguishable from being wrong. And this type of thing happens all the time.

For example, here is a CNBC article from October 2017, The stock market’s valuation is back to the point where Greenspan warned of ‘irrational exuberance’:

The Shiller CAPE ratio, which compares stock prices to their earnings over a 10-year period, is at 31.43, about where it was when then-Fed Chairman Alan Greenspan gave his widely cited “irrational exuberance” speech in December 1996, according to calculations by Nomura.

The only time valuations were higher was around the time of the stock market crash and beginning of the Great Depression in 1929 and during the dot-com boom in the late 1990s, according to the model formulated by Nobel Prize-winning economist Robert Shiller.

But once again, the market timing didn’t work. The S&P finished 2017 higher by 19%, declined by 6% in 2018, and then moved higher by 28%, 16%, and 26% over the next three years.

Keep this in mind the next time someone cites a valuation metric from the Great Depression or Dot-Com Bubble as the reason you need to sell. The world rarely ends, and market timing is consistently easier said than done.

*Annual S&P Returns from MacroTrends

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Because this is a note to remind us that valuation isn’t always the best indicator of expected returns, I’d be remiss not to point out that the CNBC article linked above finishes with the following advice:

While [Shiller] believes the U.S. market is expensive, he wouldn’t encourage investors to sell aggressively. Instead, he believes they should diversify into global markets, particularly Russia.

Since this suggestion was published by CNBC roughly seven years ago, a broad international ETF like Vanguard’s Total International Stock Fund (VXUS) has been up roughly 1.2% versus 113% for the S&P 500. And Russia was a particularly bad place to be.

It turns out that relative valuation isn’t the only thing that matters.

*Return comparison for VXUS from Yahoo Finance.

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On a personal note, here are a few pictures from Christmas.

Wishing you and yours a healthy and prosperous 2025.