Irrational exuberance is a killer. But it’s a silent killer. It can bring on an ocean of human misery with hardly anyone noticing until it’s too late. And even then most do not blame irrational exuberance for what it has done. When prices crash and the economy collapses, the cry that goes out from the Buy-and-Holders is that it’s the bad economy that caused it all. Yak!
We all need to take a step back and think through what it means that Robert Shiller published Nobel-prize-winning research showing that irrational exuberance is a real thing. That’s a scary finding. It means that we cannot count on the numbers on our portfolio statement being real. What if we learned that the traffic lights on our roads don’t work and that a car might be heading at us at full speed from the other direction when the green light tells us that it is safe to roll on through the intersection?
Those lights need to work. If the traffic lights are not working, it’s not safe to get on the road. I am sure. Driving without traffic lights makes no sense.
Having one’s retirement money in stocks at a time when the CAPE value is 37 (where it stands today) is akin to driving at a time when the traffic lights aren’t working. I don’t believe that investors should get out of stocks entirely even at times like today. The CAPE value hit 37 in the late 1990s and then continued all the way up to 44. There’s no way to know what is going to happen. Sometimes large amounts of irrationality cause even more irrationality because it convinces investors that putting one’s trust in irrationality has no negative consequences. So keeping something in stocks even at times of insanely high valuations makes sense.
But I strongly believe that one should take risk into consideration when choosing one’s stock allocation. If the traffic lights go out unexpectedly, you still need to find your way home. To drive in the same manner that you were driving when there were working traffic lights to protect you makes zero sense. You would drive at a slower speed and would exercise lots of extra caution when going through intersections in hopes that your efforts could bring the risk associated with driving at such times down to reasonable levels.
The way to reduce risk when investing in stocks is to lower one’s stock allocation. That’s the reduced-speed approach. Unfortunately, the need to tap on the brakes a bit when conditions become crazy dangerous has not caught on just yet. With stocks, we don’t get to see other cars get into accidents as warnings re what will happen to us if we ignore the problem of added risk. With stocks, all of the crashes happen at the same time. So irrational exuberance can grow into a monster problem without much attention being paid to it.
I believe that the answer is to pay more attention to it. The first order of business at every investing site should be to warn people of what has happened in the past when investors have permitted the CAPE value to rise this high. If investors elect to invest heavily in stocks all the same, more power to them. As noted above, we might not see a price crash this month or this year or even within the next two years. Some believe (despite a lot of historical evidence showing the danger of their position, in my assessment) that market timing is not required or doesn’t work when it is employed. Those people are part of the investing community and their voices should be heard. But 10 percent of the investing population has been persuaded by Shiller’s amazing research findings and the voices of those people should be heard as well.
When the voices of caution are heard at every investing site, irrational exuberance will not be such a silent killer. Its presence will be known. I believe that the more frequently we are all reminded of the dangers of irrational exuberance, the less capacity it will have to do us harm. It’s because we are driving as if the traffic lights are functional at a time when they are not that driving conditions have become so risky. Irrational exuberance brought to light is irrational exuberance overcome.
