What is irrational exuberance? It is a term used to describe an unfounded market optimism that lacks a real foundation of fundamental valuation. The appreciation of an asset to unrealistic levels is driven predominately by psychological factors. Former Fed chairman Alan Greenspan popularized the term in a 1996 speech addressing the potential for an impending speculative internet bubble in the US stock market. Robert Shiller, Professor of Economics at Yale University, further defines a bubble as a social epidemic that involves extravagant expectations for the future.
Although the Efficient Markets Hypothesis has been a prominent financial market theory for many decades, individual investors are not always rational. It is reasonable to say that markets are not entirely efficient because investors can be irrational, especially during market extremes.
So, can markets ever be rational when humans are not?
Yes! Irrational exuberance may be developing. But is this the top?
Probably not yet!
The COVID-19 pandemic and the global lockdowns led to an unprecedented economic recession and one of the fastest bears in recent memories. However, the extraordinary fiscal and monetary policies from around the world prevented an economic and financial collapse.
Although there remains a financial disconnect between the stock market and the economy, the disconnect could begin to narrow if a sustainable economic recovery materializes. The historically low-interest-rate environment in the US. The negative global yields around the world. The accommodating FED and central bank monetary policies enacted. Continue fiscal stimulus and the approval of COVID-19 vaccines. All the above is conducive to economic recovery and continuation of the current stock market bull rally.
From a technical perspective, there are some data to suggest irrational exuberance may be developing. Popular contrarian indicators such as investor and consumer sentiments (AAII, Wall Street, Investors Intelligence, University of Michigan consumer confidence, etc.) have risen sharply from their respective Mar/Apr 2020 lows. However, there is also a tendency in strong and powerful long-term bull trends for many of these contrarian indicators to remain at heightened levels for far longer and higher than expected before finally peaking. As economist John Maynard Keynes said in the 1930s: "Markets can stay irrational longer than you can stay solvent." Just because there may be something wrong with the market does not necessarily mean you can profit from it. The most challenging aspect of investing remains not when to buy. But when to sell or selling too early.
Also, many of the bears may be overlooking the fact that market tops do not often occur with so many market indexes reporting confirmed V-pattern breakouts. Instead, near pivotal market tops, the market will begin to roll over, with different sectors reaching their respective highs over a relatively long period before finally succumbing to selling pressures. It is not the case today as various market breadth studies show neither a contracting nor narrowing marketplace. Instead, many market internal indicators are broadly expanding. For instance, many more S&P 500 sectors are now accompanying the SPX Index to new all-time highs. Investors are no longer exclusively purchasing growth-related investments as they were during the height of the pandemic. Investors are active in value-related securities as well. Mid-cap, small-cap, and micro-cap are also recording all-time highs along with their larger-cap counterparts. Emerging and developed equities are also participating in the recent rally. Commodities are recovering after their respective brutal bear decline. Fixed-income assets such as high yield, investment-grade corporates, muni-bonds, emerging market fixed income assets are approaching or have surpassed their prior record highs.
Perhaps one of the most fundamental questions one can ask above a bubble and irrational exuberance is not whether it can occur, but what are irrational and unsustainable levels? It is no denying that speculators are participating in today's stock market. But the participation of such irrational traders does not necessarily imply stock prices themselves are irrational. In theory, irrational exuberance is self-correcting. If investors are overly optimistic and they collectively bid up stocks to unrealistic levels, then rational investors and traders should be there to sell shares to bring the stock prices back down to realistic levels. The adjustment process in and of itself can help to contain speculations and prevent bubbles from escalating into blow-off market tops.
As we have alluded to in previous technical reports and blogs, the May 2013 technical breakout above 1,576.09 in the SPX Index ended the 2000-2013 structural bear/trading range market. Most importantly, it confirmed the start of the next structural bull trend. The 7-year-old bull rally may be maturing, but it is unlikely that it has reached its end-stage. Why? The three market setbacks since the crucial May 2013 technical breakout such as the -14.5% deep correction from Nov 2015-Feb 2016, the -20.21% bear decline during Sep 2018-Dec 2018, and the recent -35.41% COVID-19 induced bear sell-off from Feb-Mar 2020 may have prevented speculative behaviors to fully develop. Also, the recent Nov 2020 V-pattern breakout above 3,393.52 renders an SPX technical target to 4,595. One final thought, it is uncanny that each of the three previous market setbacks occurred approximately two years apart. Can the 7-year-old bull trend sustain until at least until 2022 when the next 4-year mid-term election year cycle low occurs?