Introduction
As pointed out by Lance Roberts in an excellent article entitled Exuberance – Investors Have Rarely Been So Optimistic (and from which much of the content in this article has been quoted) “Nobel Prize-winning economist Robert Shiller famously coined “irrational exuberance” to describe situations where speculative behavior pushes asset prices far above intrinsic values. Shiller’s research shows that emotional narratives and herd behavior dominate in bull markets, fueling market increases that eventually revert under the weight of reality. He warned that “markets can stay irrational longer than you can stay solvent,” reflecting how unpredictable and dangerous excessive optimism can become.
Similarly, Jeremy Grantham, a seasoned investor known for identifying bubbles, recently described the post-2009 bull market as an “epic bubble” driven by speculative behavior and extreme overvaluation. Unsurprisingly, as market prices increase, exuberance builds, and investors rationalize overvaluation by believing that “this time is different.”
Valuations Are A Terrible Market Timing Tool
However, with that said, valuations are a terrible market timing tool. Valuations only measure when prices are moving faster or slower than earnings. In other words, valuations are a measure of psychology in the short term. To wit: Valuation metrics are just that – a measure of current valuation. More importantly, when valuation metrics are excessive, it is a better measure of ‘investor psychology’ and the manifestation of the ‘greater fool theory.’ As shown, there is a high correlation between our composite consumer confidence index and trailing 1-year S&P 500 valuations.
Investors repeatedly make the mistake of dismissing valuations in the short term because there is no immediate impact on price returns. However, as noted above, while valuations are HORRIBLE predictors of 12-month returns, they indicate “exuberance,” which impacts markets in the near term.
High Levels of Investor Exuberance Increase Correction Risk
High levels of Investor exuberance increase correction risks because markets are more fragile when built on sentiment rather than fundamentals. As the enthusiasm fades, a small negative event, like disappointing earnings, geopolitical tensions, or concerning economic reports, can trigger a reversal between buyers and sellers.
When markets are propped up by speculative exuberance, corrections tend to be more severe...creating a feedback loop that accelerates the decline. Historical data confirms that pattern, where market exuberance, fueled by liquidity and investor mania, typically ends in rapid, painful corrections…..
Predicting the Exact Timing Of A Correction is Difficult
While investor exuberance sets the stage for corrections, predicting the exact timing is difficult. Alan Greenspan’s famous “irrational exuberance” speech in 1996 came three years before the dot-com peak. Markets can remain euphoric longer than expected, but corrections are inevitable as valuations eventually revert to more sustainable levels, as shown in the chart below.
However, as noted, timing is critical. Investors always make two primary mistakes when investing in an exuberant market.
- The first is overreacting to signals, believing a more severe correction is coming.
- The second is taking action too soon.
Therefore, we must continue to navigate the market within the context of the current bullish trend.
Sentiment and momentum are often in direct opposition. Just when things are looking best for trend-following momentum chasers, it looks the most at-risk for contrarian-minded investors. We’re reaching one of those times now, as momentum is impressive and compelling. There is little to no evidence that the gas has run out, as breadth remains robust and sector performance is supremely healthy.
Extremes in sentiment tend to work better when there is less buying interest underlying the indexes. If we saw more divergences with breadth metrics, the extreme disparity in stock-bond sentiment would have more meaning. As it stands, it’s probably most useful as an early heads-up that conditions are ripe for disappointment, and we should be on guard for any signs of a buying strike in the weeks ahead.
Practical Takeaways for Investors
Given the signs of elevated exuberance today, investors should consider the following strategies to manage risk:
- Rebalance Portfolios: Shift allocations toward defensive sectors or cash to reduce exposure to speculative assets.
- Limit Leverage: Avoid excessive use of margin to minimize forced selling risks.
- Monitor Indicators: Pay attention to the technicals, positioning changes, and fund flows for early warning signs.
- Consider Bonds: If bonds are out of favor as stock demand increases, a rotational “safety trade” is likely when volatility arises.”
In Summary
Roberts concludes his enlightening article by saying “While optimism plays a role in market growth, unchecked exuberance often leads to corrections as markets adjust to reality. By recognizing the signs of market excess and managing risks proactively, investors can better navigate these uncertain periods and protect their portfolios from excessive drawdowns.”
