The Return of Irrational Exuberance?

06/14/2007 12:00 am EST

Focus:

Jim Collins

Chairman and CEO, Insight Capital Research & Management, Inc.

Jim Collins, editor of OTC Insight, explains why the recent record highs in the major indexes do not indicate a market top, as they did in 2000.

A little more than a decade ago former Federal Reserve Chairman Alan Greenspan described an “irrational exuberance” that had taken hold of the stock market. It was another four years from this time before stocks endured one of their worst plunges in history. Stock prices outside of the technology sector eventually recovered, and two closely followed indexes, the Dow Jones Industrial Average and Standard & Poor’s 500, [recently traded] at all-time highs.

Once again we find Alan Greenspan mentioning “irrational exuberance.” However, this time he was referring to Chinese stocks. Why isn’t there more concern over US stock prices, and why do we continue to be optimistic about the future?

When stock prices peaked in 2000, the S&P 500’s price-to-earnings ratio (P/E) was approaching 30 times trailing 12-month earnings. This P/E was high on a historical basis and had been climbing for years. Stock prices were able to support these lofty valuations as long as earnings continued to climb.

Unfortunately, earnings failed to climb as expected and instead suffered a sharp decline. Stock prices promptly followed. Over the past few years stock prices have ascended steadily, [but] unlike the rise in the late 1990s, earnings have risen faster than stock prices. Today’s P/E ratio of approximately 17x for the S&P 500 is little more than half its previous peak. This figure is much more in line with historical levels and greatly limits the amount stock prices could fall before being considered severely undervalued.

Another thing the current stock market has going for it now is the economy. In 2000 the economy was preparing to contract, but most economists had expected continued growth, meaning expectations were significantly out of line with reality.

[This time] the slow economic growth of the first quarter of 2007 was widely anticipated. But [economists believe] that the economy has hit a trough and will improve as the year goes on. This makes it likely that corporate earnings will also [grow with the economy, but this time] the downside risk is significantly less than in 2000.

The bottom line is that despite stocks reaching record levels in 2000 and 2007, the background is vastly different. In 2000 there were high expectations and high valuations. In 2007, we have modest expectations and even more modest valuations.

[Our] optimistic outlook does not come without some minor short-term obstacles. June is largely void of earnings reports, which means stocks do not have a specific driving factor behind them, leaving the stock market vulnerable to economic and inflation reports. Those reports that diverge from consensus expectations will move the markets.

[We] continue to recommend that savvy investors “buy the dips.” As our above analysis makes clear, the upside potential easily outweighs any downside risk if you are a long-term investor.

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