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Has Irrational Exuberance Returned?

Has Irrational Exuberance Returned?

December 07, 2021

Investors tend to put on blinders during times of market froth. After living through the Dot.Com bubble of the late ‘90s, and the real estate bubble of the mid ‘00s, I have watched it firsthand and lived to tell about it.

The funny thing is that even though extreme levels of investor sentiment, focus, and excitement exist in certain asset classes, people tend to think that this time is different, for a variety of reasons. This leads us to the question that Alan Greenspan quipped during a speech to the American Enterprise Institute:

Federal Reserve Chairman Alan Greenspan famously said the following on December 5, 1996:

In hindsight, we know that Chairman Greenspan was right in questioning the decoupling of tech stock prices and their underlying fundamentals. However, his timing was more than slightly off. If you had listened to his concerns and jumped out of your tech stock holdings at that point in time, you would have watched those stocks continue to soar for more than three additional years until the bubble ultimately peaked in March 2000. Most people would not be able to stick with their decision, no matter how good their rationale, for that long a period of time.

This leads us to our second piece of historical economic wisdom of the day, which was credited to economist John Maynard Keynes in the 1930’s: “Markets can stay irrational longer than you can stay solvent." That bit of wisdom remains true today.

So, are there bubble conditions present today? You can generally tell by watching the amount of investor capital and sentiment flowing into certain sectors of the market. Over the last five years, it seems that investor capital is focused primarily on technology, innovation, disruption, cryptocurrencies, electric vehicles, and space travel. 

Let’s look at the chart below provided to us by Catalyst Insights. It shows the long-term trendline for the S&P 500 index, adjusted for inflation, versus current prices going back more than 100 years.

According to Richard Bernstein of RBA, bubbles tend to misallocate capital within the economy. Investors get drawn to the idea that short term returns will continue into the future. Hot sectors typically attract too much capital, while other sectors receive too little capital but could provide better longer-term opportunities.

We know that there is an inverse relationship between the price at which we invest and future rates of return. The higher prices are when you buy, the lower your future returns are likely to be. To illustrate, simply think about what would have happened to the value of your investment had you purchased real estate in Phoenix, Las Vegas, or Fort Myers in 2006, near the top of the real estate bubble. Buying when markets are near all-time highs can lead to long periods of time with little or no return, as seen below.

So, what is an investor to do a today given this information? First of all, stay disciplined in your diversification. By investing into various sectors and asset classes you will be sure of two things. Number one, you will never have all your assets in the best performing sector of the market. And number two, you will never have all your assets in the worst performing part of the market. This is the beauty of this simple strategy. 

Secondly, stay disciplined with your diversification. This is way easier said than done. During the late 90s tech stocks were going up year after year while other asset classes were languishing. I remember being questioned by clients as to why we had money allocated to what they perceived as underperforming parts of the market. After the Dot.Com bubble broke, they were very happy to have had allocations to things that were less expensive and went up in value as tech stocks fell dramatically. There are usually asset classes that are less expensive that can provide diversification options.

Finally, don’t chase the hot sector. Buying after prices have gone up means that somebody else made money. The human brain tends to extrapolate presently observed patterns indefinitely into the future. We know this does not resemble the investment market over long periods of time in any way. At times it is hard not to be taken in by the attractive improbability. The thought that if I buy the right tech stock, Florida condo, or cryptocurrency, I could be set for life. We strongly believe in the less attractive probability. Staying diversified, rebalancing on a regular basis, and creating cash for a future liquidity needs when markets are near all-time highs.

These strategies may not sound nearly as fun or sexy as investing in the future of space travel, but they are far more likely to get you where you want to go. In the end, accomplishing what is most important to you and your family is what drives the team at Impel Wealth Management as we continue “Moving Life Forward”.

© 2021 Jesse Hurst

The views stated are not necessarily the opinion of Cetera Advisors LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein.  Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.  Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.