Our window on the world of investment
Selwyn Parker writes…..
You’ve probably heard of irrational exuberance, the famous expression coined by Alan Greenspan, the great former head of the US Federal Reserve. It remains one of the best-ever descriptions of the how people behave in the middle of an investment bubble. The expression is so relevant today that it’s worth recording exactly what Greenspan said and when.
The precise date was December 5, 1996, and the occasion was the annual black-tie dinner of the American Enterprise Institute. Greenspan was giving the keynote address and he wanted to make a statement about silly prices for shares and related instruments. The Dow had just roared through the 6,000 barrier and looked to be heading for the stratosphere.
“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions…..?” Greenspan said in his intellectual way. “The chairman”, as the head of the fed is always called, was worried the American economy was overheating.
Next day, as Greenspan’s memoir The Age of Turbulence, recalls, the phrase hit the headlines. “Irrational Exuberance Denounced”, bannered the Philadelphia Enquirer. The expression was on its way into history.
But why is the term relevant now, in the middle of a prolonged slump when doomsters are even predicting another Great Depression-like event?* Simply because the opposite -- namely, irrational depression - is just as true.
Although most investors like to think of themselves as objective and rational, and that market prices embody all the important information, they aren’t and they don’t. Investors are as prone to mood swings about the state of the markets as they are to the fortunes of their favourite football team. And right now, investors are in a serious state of the dumps.
You can hardly blame them after such a run of scary headlines. Banks toppling or being rescued by governments, the Madoff scandal (although it’s highly unlikely the fraud will reach the $50bn mooted to date), RBS posting a £25bn loss, house prices collapsing…. There’s nothing irrational about any of these. They’re facts.
But let’s look at why these truly cataclysmic events happened in the first place. Without exception, the reason for all of the above is absurdly high levels of leverage. Put simply, mountains of debt piled on a mound of principal. If there’s one historical reason for why bubbles burst, it’s an excess of debt. That’s as true of the South Sea Bubble and the Louisiana Purchase as it is of the dot.com implosion of 2001 and the present financial meltdown.
Yet many reputable, professional fund managers stayed well out of all this irrational exuberance. They did careful due diligence on their counterparties, they stayed liquid, they didn’t borrow wildly, and they waited for the proverbial to hit the fan. As a result they thrived through the meltdown and they’re thriving now. As the head of a global exchange-traded fund observed the other day: “This period of market dislocation is a fertile time for [us].”
Despite the dire headlines, there’s a lot of other good investment news out there. Gold, the classic hedge in turbulent times, is heading for the $1000 barrier. Although gold bugs might be suffering a bout of irrational exuberance because most professionals believe gold should not account for more than 1-2 per cent of the total value of an investment portfolio, there’s no doubt they’re doing well.
Gilts and certain bonds are thriving along with many other instruments offering excellent returns in this dark hour.
There’s even one sector of banking that’s taking off, as many readers will know. Credit unions, which don’t do leverage at all, are signing up thousands of new members. Many of them took their money out of the bigger high-street banks and went down the street where they knew they would find true, relationship-style banking rather than being just numbers. Credit unions aside, there are many solid financial institutions out there that kept well away from the irrational exuberance.
There’s even a lot of good news in the “real economy” in the hard-hit industrial estates. Lately I’ve been talking with companies of all kinds that are increasing or even doubling sales.
It is very sad that so many investors, both individual and professional, lost so much money in such a short time to a handful of big but incompetent operators. They’re understandably licking their wounds. But there are many professionals in the investment industry who kept their feet on the ground and continued to invest wisely. As a result their clients will today be richer and duly grateful.
Meantime history teaches us other useful lessons about the aftermath of episodes of irrational exuberance. Namely, that the markets reconsolidate and bounce back. Those who are invested at that point will increase their wealth more quickly because of it.
And when the markets do recover, the whole investment environment will be a better place. Right now, for instance, regulators are tightening up loopholes that Bernard Madoff allegedly walked straight through and the financial sector in general have been put under notice that they put their clients first, not their bonuses.
There are great opportunities out there for those who are neither too exuberant nor too depressed.
Selwyn Parker’s latest book, The Great Crash on the Depression of the thirties, was published in October.