Anything For You All: CHART OF THE DAY: Here's What Stocks Did After Alan Greenspan Warned About 'Irrational Exuberance'

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Chart of the Day

CHART OF THE DAY: Here's What Stocks Did After Alan Greenspan Warned About 'Irrational Exuberance'

This morning, Janet Yellen warned that valuations of certain assets, especially small firms, social media stocks and biotech companies, are "substantially stretched."

Although she was more sanguine about the broader stock market, it got some people thinking about the most famous instance of an explicit warning about market overheating: Alan Greenspan's "irrational exuberance" speech.

Delivered on December 5, 1996, Greenspan's full remarks, often misremembered, were actually rhetorical questions about the economy's ability absorb a collapse in asset prices caused by everyone realizing their exuberance had grown irrational.

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? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

The thing is, it took more than four years for that collapse to come: From the date of the speech through the year 2000, the Dow climbed 81%, and the NASDAQ gained 200%. While his warnings proved useful, everyone had forgotten them by the time time the 2001-2002 recession rolled around.

Let's see how long it takes for a correction to come this time. Read »