Tuesday, December 05, 2006

Irrational Exuberance

Exactly ten years ago today, then Federal Reserve Chairman Alan Greenspan spoke before the American Enterprise Institute. Among his comments that day was the market-moving reference to “irrational exuberance” to describe his assessment of stock market conditions.

The speech was broadcast live on C-SPAN and the Asian markets were open at the time. The reaction of investors in those markets was registered almost immediately and both the Tokyo and Hong Kong markets closed sharply down. As the sun rose around the world all other markets followed suit - first Frankfurt and then London. The U.S. market opened down on December 6th.

Greenspan was asking a question as he used the phrase: “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?” Then he added that central bankers “… need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy….” You can appreciate why the Japanese were alarmed and retreated from risky positions even before Greenspan sat down for his dessert.

Greenspan probably did not intend to exert influence over the stock market. Perhaps he was only appealing to his conservative audience. It was a long speech and he delivered a number of messages as he spoke to the tuxedo-clad public policy wonks.

To answer your question Mr. Greenspan, you do not know there is a bubble until it bursts! Greenspan must have been privately horrified four years later when the Internet bubble popped. He may be perplexed today. The stock market has moved on, reaching new highs on new sources of enthusiasm. What Greenspan apparently did not fully appreciate, is that the capital markets are inherently exuberant. The various indices we use to represent the capital markets ebb and flow like the tides, just with less predictability than an economist like Greenspan might hope for.

Greenspan may have been prompted to mention the stock market because the Nasdaq had just hit a new milestone just two days before this speech. On December 3, 1996, the Nasdaq Composite index closed over 1300.00 for the first time. Volume in those days was around 650 million to 700 million shares per day. Compare that level and activity with today when the Nasdaq Composite closed at 2452.38 after trading over 2,061 million shares. Data for the NYSE shown below bears out the same extraordinary increase in value and activity.

_________________12/5/96_____12/6/96______12/5/06

DJ Industrial
Ave ........6,437.10 .........6,381.94 ...........12,839.12
S&P 500 ......................744.38 ............739.60 ............1,414.58
S&P 600 Small Cap ........145.20 ............143.79 ...............406.08
Russell 2000 ................359.05 ............355.50 ..............797.18

NYSE Volume / Mill ........483.3 ..............504.3 ..............2,600.0
NYSE Value / $Mill ...$18,807.1 ........$20,944.6 ...........$70,255.8


The speech and the words have been the subject of much discussion and even inspired a book , Irrational Exuberance, by Yale University professor Robert Shiller. Shiller has done well expounding on the meaning of "irrational exburance" to those who are still trying to figure out whether the remark was inadvertant or a sly way to take a swipe at Wall Street.

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