Irrational Exuberance Again

In December 1996, Alan Greenspan coined the term irrational exuberance. He did so to describe what he considered to be a grossly overvalued stock market driven by the promise of an internet-driven economic revolution. Directionally, Greenspan’s call turned out to be correct in that in the five years after his call, the inflation-adjusted price gains of the NASDAQ stocks were approximately zero. However, the timing of his call left a lot to be desired. In the three years after his call, the NASDAQ stocks approximately tripled in value before eventually crashing by around 75 percent. Fast forward to today, and the US stock market once again appears to be characterized by irrational exuberance. This time, that exuberance seems to be powered by the promise of an Artificial Intelligence revolution. That has led to a situation in which the stock market appears to be grossly overvalued.  Indeed, the Shiller Cyclically Adjusted Price Earnings (CAPE) ratio currently stands at 41 or more than double its long-run average. Meanwhile, Warren Buffett’s preferred measure of overvaluation—the ratio of total stock market capitalization—to GDP stands at 210 percent, or more than two standard deviations above its long-term average. The experience with the late 1990s dot.com bubble reminds us that gross stock market overvaluation can persist for a long time. Indeed, it took five years from Greenspan’s irrational exuberance warning before the dot.com bubble burst. However, it would seem that there are two dark clouds hanging over today’s stock market that would suggest it will be sooner rather than later that today’s excessive stock market valuations come back to earth. The first of these is the Strait of Hormuz closure. The second is the seeming unfolding of a world bond market crisis. Start with the Strait of Hormuz through which 20 percent of the world’s oil production and 30 percent of world seaborne fertilizer prices pass. Since the end of February, we have already seen a spike not only in energy prices but also in those of fertilizer and helium, which are vital inputs into food and semiconductor production, respectively. International oil prices have increased by more than 60 percent to their present level of over $100 a barrel; fertilizer prices have risen by more than 50 percent; and helium prices have risen by 30 percent. A prolonged closure of the strait must be expected to lead to further increases in those prices as well as to physical shortages once the world’s international oil reserves have been drawn down. That in turn could trigger a US and world economic recession. With the negotiations between the US and Iran stalled and every prospect that the Strait will be closed for another few weeks, the market seems irrationally to be turning a blind eye to such an eventuality. If the stock market seems to be ignoring geopolitical risks, it also seems to be overlooking an unfolding world bond market crisis, which is another reason to fear a world economic recession. This is all the more surprising given the recent spike in bond yields. In the United States, for the first time since 2007, the government has had to pay five percent on its 30-year Treasury bonds. In Japan, 30-year government bond yields have surged to a 1997 high of over four percent on inflation worries, and in the United Kingdom, 30-year gilt yields have surged to a three-decade high of 5.8 percent in reaction to Prime Minister Keir Starmer’s political travails. High government bond yields would not be a matter of great concern if government debt levels were at relatively low levels. Unfortunately, this is far from today’s case. By next year, the United States government’s debt in relation to the size of its economy is now on track to exceed its corresponding end of the Second World War level. Meanwhile, Japan’s public debt to GDP ratio stands at a jaw-dropping 230 percent, while those in France, Italy, and the United Kingdom all stand at over 100 percent. The main reason to fear a future world bond market crisis is that public debt to GDP ratios will all too likely continue increasing for the foreseeable future. They will do so because of the currently high budget deficits, increased defense spending, the risk of recession, and little political will to bring gaping budget deficits under better control. If the stock market is ignoring the risk of a future recession, we have to hope that the policymakers are ready to react to such an eventuality. In particular, we have to hope that incoming Federal Reserve Chair Kevin Warsh stands ready to back down from any idea of trying to shrink the size of the Fed’s balance sheet that would only aggravate an already difficult economic situation. The post Irrational Exuberance Again appeared first on American Enterprise Institute - AEI .