What it means
In December 1996 Greenspan asked how a central bank could know when irrational exuberance had unduly escalated asset values, which can later be subject to unexpected and prolonged contractions. Markets took it as a warning, and share prices briefly fell.
The phrase stuck because it captured a feeling that prices were being pushed up by mood instead of by earnings. Shiller took up the idea in a book published in 2000 that examined the technology boom, and he later applied it to housing.
He argued that bubbles are driven by psychology, such as herd behaviour, stories about a new era and the fear of missing out. Feedback also plays a part, since rising prices create excitement, which attracts more buyers, which raises prices further.
For businesses and investors, the phrase works as a warning label. When valuations rest on hopes and not on cash flows, a small disappointment can cause a sharp fall.
Finance teams who value companies, set budgets or judge acquisition prices should ask whether the numbers would still make sense if the market mood turned. There are measures that help.
Analysts compare prices with earnings, for example using a cyclically adjusted price-to-earnings ratio, which divides the price by a ten-year average of inflation-adjusted earnings. A very high reading relative to history suggests that investors are paying a lot for each dollar of profit, but it is a guide and not a timing tool, as markets can stay expensive for years.
The nuance is that nobody can reliably say in the moment that a market is irrationally exuberant. Prices can be high because the outlook has truly improved, and what looks like madness can later seem sensible, or the reverse.
The term is easier to apply with hindsight than during the boom.
In practice
Real-world examples.
Example
During a technology boom, young companies with no profits list on the stock market and their shares double in a few weeks. Commentators say the market shows irrational exuberance as valuations are based on the number of website visitors instead of earnings.
Example
A housing market sees prices rise 20% a year for several years, and buyers take on large mortgages believing prices can only go up. A bank's risk manager questions the assumption and tightens the lending rules before the market turns.
Example
A founder offers to buy a competitor for 40 times its annual revenue after a wave of enthusiasm in its sector. The company's finance director asks the board to test the price against a slower growth scenario, and the deal is renegotiated.
Formula
Calculation
Cyclically adjusted price-to-earnings ratio (CAPE) = index price / average of the last ten years of inflation-adjusted earnings per share
A stock index stands at 4,000. Over the last ten years its earnings per share, adjusted to today's dollars, averaged $160. The ratio is 4,000 / 160 = 25. If the long-run average ratio is 17, the market is priced at 25 / 17 = 1.47 times its historical norm, or about 47% higher. That would suggest enthusiasm, but it does not prove a bubble.Case study
Seen in the real world.
Zenith Gadgets is an illustrative, fictional consumer electronics company whose shares rose from $12 to $60 in eighteen months after it announced a new product. Analysts raised their forecasts and price targets, and retail investors rushed in.
The company's chief financial officer noted that the share price had reached 80 times annual earnings, while the industry average was 20. When she presented the budget, she assumed sales growth would slow to a normal rate and she refused to base the capital plan on the share price staying high.
When the product launch disappointed and the shares fell to $25, the company still had the cash to finish its projects. The illustrative lesson is that excitement in the market is not a reason to change the plan for the business.
Watch out
Common mistakes.
- Assuming a high price always means a bubble, when strong growth can justify a high valuation.
- Trying to time the exact top, when markets can stay expensive for years before they fall.
- Treating the phrase as a scientific measure, when it is a description of mood that cannot be calculated directly.
Questions
People also ask.
Who first used the phrase irrational exuberance?
Alan Greenspan used it in a speech in December 1996, and Robert Shiller later used it as the title of his book about market bubbles.
How can a company protect itself from a bubble?
It can test plans against lower valuations, avoid using inflated share prices to justify large purchases and keep enough cash to survive a downturn.
Does irrational exuberance always end in a crash?
Not always, since some periods of high valuation fade gradually as earnings catch up, though sharp falls are common.
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