Saturday, February 28, 2009

Irrational Exuberance Revisited

We're back to the level of irrational exuberance. On Friday, Feb. 27, 2009, the S&P 500 closed at 735.09. That was the 9 points lower than the S&P 500's close of 744.38 on Dec. 5, 1995, when then Federal Reserve Chairman Alan Greenspan suggested that the stock market was affected by irrational exuberance. In the two weeks following Greenspan's remark, the stock market dipped lower, partly due to fear that the Fed might take action to discourage irrationality. But Chairman Greenspan decided that the world had changed, that a higher level of economic growth could be sustained, and that the Fed's policies should be accommodating. The S&P 500 index rose to double the irrational exuberance level, not once but twice (first in 2000 and, after the tech stock crash and the stock market resurgence that came with the real estate boom, again in 2007). Then, things got complicated and the market came back down to the level of irrationality.

Another pop by the S&P 500 above 1500 will be a ways off. The index's price-earnings ratio in Dec. 1995 was in the very high 20s, close to 30, and well above the historical average of 15. It might be logical to think that a high p/e ratio would signal a fall in the market. Maybe so in the days of yore, but not when the world has changed. In modern times, a high p/e ratio indicates confidence, indeed exuberance. Investors were willing to pay high prices because they expected even higher prices in the future. That's why the market kept rising in the late 1990s.

Today's S&P 500 has a p/e ratio of approximately 13.6. For the first time in close to two decades, the ratio has dipped below its historical average, which shows that investors have become discouraged. They're no longer willing to pay high prices because they don't expect prices to do a lot of rising in the foreseeable future. This lack of confidence is one reason why the market keeps falling (although the major reasons are the continued banking crisis and the slowing worldwide economy).

Irrationality is going out of style as an investment strategy. Economically speaking, we are in autumn rolling into winter. Rational strategies would include saving more cash, paying down debt, investing conservatively in a diversified portfolio, and ensuring good health insurance coverage. If you can't do all of the foregoing, do as many as possible. Thrifty squirrels have the best chance of surviving winter. And the forecast is for a very cold winter.

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