I want to start this week by remembering some of Alan Greenspan’s most famous words:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But 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?”

Greenspan was speaking in December 1996. But I believe anytime is a good time to review his famed irrational exuberance speech.

I believe Greenspan was saying that consensus on certainty is correlated with stock market valuations.

If the future looks relatively calm, and everyone agrees the outlook is bullish, then stock prices should be high. Eventually, they will be become too high. That’s because the rational investor will be joined by the irrationally exuberant investor.

Too Much Too Fast?

In the current market environment, we need to be asking if asset values are unduly escalated. Let’s start looking for that answer with a chart.

Below is the Invesco QQQ Trust (Nasdaq: QQQ). I added moving average (MA) bands to identify when the price action is unusually fast.

Last week, I highlighted this ETF and showed that the most recent selloff had been enough to attract buyers. I expected a gain in the ETF, and the gain pushed QQQ back to the level of concern. This week, I want to step back and look at the ETF in a broader context.

The decline that began in February was rapid — and that was clearly driven by fear. There was an unknown virus spreading throughout the world, and estimates of the toll of the virus were horrific. In a way, the fear in the market was rational. To a point.

But fear drove selling too far, which means a bottom was rational. In April, as data indicated the death toll was not as bad as feared in many places, the rally accelerated. It quickly moved above the upper band, an indicator that the move was potentially irrational.

We remain near that upper band, which indicates either traders have unusually clear insight into the future, or the price move is potentially irrational. The next chart helps us address which of these scenarios is most likely.

Source: NY Times

These are charts of coronavirus in the United States. Cases are rising, but deaths are down. This could indicate the economy will remain on track for reopening. Remember, the shutdown was needed to keep hospitals and medical resources from becoming overwhelmed. Less serious cases could mean the medical system can meet all needs and the economy could return to normal.

That’s one interpretation of the charts… One that completely ignores the news. States that took steps to reopen are now reversing course. This is a bearish indicator the economy and the stock market.

What This Means Today

Which brings us back to the lesson Greenspan taught us in 1996. If everyone agrees that the future seems certain, exuberance can last for years. Strong trends in stock market prices rely on consensus about the future.

We don’t have consensus right now. But we do have fundamentals that reflect exuberance.

Below is a chart of the Shiller price-to-earnings (P/E) ratio. This is cyclically adjusted to account for the ups and downs of the economy, as well as for inflation. It was developed by Yale economist Robert Shiller, who believes Greenspan used the words “irrational exuberance” because of a presentation he gave the Fed chair weeks before the speech.

The Shiller P/E is elevated right now. That indicates risks are high unless the economy rows rapidly.

This chart explains why the stock market is vulnerable to additional selling. As Greenspan explained, “Lower risk premiums imply higher prices of stocks and other earning assets.” Traders have priced in a low-risk premium at a time when the risk premium should be high.

In other words, the price-to-earnings (P/E) ratio is high at a time when it should be low. This is a fundamental problem for the stock market that is likely to be resolved by prices falling to match earnings.

Action To Take

However, the timing of the decline can’t be determined. Greenspan was correct that the market was irrational. But he was four years early in his call. I don’t think we have to wait four years this time.

I’m comfortable, for now, saying I believe the stock market will be rational within six months, by the end of the year. Getting there will require volatility and you need to be ready to navigate this environment.

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