Those of us who were investing during the bubble probably remember Federal Reserve Board Chairman, Alan Greenspan’s “irrational exuberance” speech in December 1996:

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?

Mr. Greenspan’s cautionary words had a short-term effect of slowing down the markets. But pretty soon investors were at it again, bidding up prices to even higher levels. Markets continued to go up into bubblelicious territory until 2000, but they eventually corrected. They always do. You just don’t know when. That’s the trouble with predictions. As physicist Niels Bohr once quipped, “Prediction is very difficult, especially if it’s about the future.”

Bubblelicious! Photo credit: John Loo

But seriously, if you’d heeded Chairman Greenspan’s warning and sold your stocks in December 1996, you would have missed out on significant gains. Between Greenspan’s speech and the actual top of the market in March 2000, the TSP C Fund gained another 98 percent, and the S Fund gained 127 percent. That’s a long time sit on the sidelines, and a lot of gains to miss out on.

That’s one reason why our investment strategy uses a purely systematic approach to determine what asset classes to invest in. Financial pundits come up with all sorts of theories about why they think stock markets are overvalued. Sometimes they’re right, often they’re not. Fund prices by contrast are objective, and trends, relative strength, volatility, and so on, can be measured and used to help manage a portfolio on a more quantitative basis.

Gains during the current bull market

We’ve had an impressive run in stocks since the beginning of the current bull market in March 2009, and TSP stock funds reached their all-time highs this past week. The following table shows the percentage gains in each TSP fund from the bear market bottom in 2009 to today’s close (6/3/2013):

TSP Fund: F Fund G Fund C Fund I Fund S Fund
Gain since March 2009: 27.8% 10.2% 166.0% 117.2% 214.2%

As you can see, the S Fund is up 214% since 2009, followed by 166% gains in the C fund, and 117% in the I fund. Compare this to a modest 10.2% in the G fund, and 27.8% in the F fund. Recent returns are also quite impressive. Large cap stocks like the TSP C Fund are up over 31% over the past year, and small caps like the S Fund have increased more than 35%. Compare this to their long-term average of 10 and 11 percent. I don’t know about you, but to me, it’s starting to feel a little like 1999 again…

It helps to put these raw numbers into a more objective valuation framework. One such model is published by Rob Arnott's Research Affiliates, a comprehensive framework that estimates 10-year expected future returns for various asset classes including U.S. and international stocks. Take a look at some of the "pricier" asset classes in that chart (including U.S. stocks and bonds), and you'll find very modest expected future returns. What Mr. Arnott is trying to tell us: don’t expect the next ten years to be anywhere near as good as recent returns since 2009. Another widely followed model is Robert Shiller's cyclically adjusted price-to-earnings ratio (CAPE). For many countries’ stock markets, CAPEs are getting into expensive or bubble territory. This chart is updated regularly with the current CAPE of the U.S. stock market.

Be fearful when others are greedy

As I’ve become a more experienced investor, I’ve learned to control some of my personal behavioral investing biases. For example, I’ve learned to “be greedy when others are fearful, and fearful when others are greedy” — that’s a quote from Warren Buffett. In the midst of the financial crisis in 2008, Mr. Buffett urged investors to buy American stocks, because “most certainly, fear is now widespread, gripping even seasoned investors”. I can’t help but wonder what Mr. Buffett thinks about the stock market today. To me, it’s clear that there’s currently much more greed than fear. Combined with my earlier observations, this makes me very cautious.

Are markets irrationally exuberant again?

Judging by the criteria above, markets are once again “irrationally exuberant.” But as noted, that doesn’t mean that everyone should go and dump their stocks and go to cash. And certainly don’t bet against rising markets — a mistake that wiped out many short sellers in the late 1990s. As economist John Maynard Keynes once said:

Markets can remain irrational a lot longer than you and I can remain solvent.

What it does mean to me is that, rather than getting caught up in the hype and celebration, this is a time to re-evaluate your portfolio and risk exposure. In particular, if after an honest and thorough analysis you decide that you’re taking on too much risk in stocks, now is a great opportunity to correct that, from a position of strength, while markets are near all-time highs. Here are some specific actions you can take:

  • Review the long-term performance history of the TSP funds, study their historical charts and stats, and remind yourself that they tanked as much as 61% during previous bear markets, as recently as 2009.
  • Remind yourself that while everything looks rosy at the moment, things can get ugly rather quickly. For example, in the past, TSP stock funds have lost as much as 45 percent of their value in 2 months.
  • If you haven’t already done so, determine your risk tolerance: how much you can stand and afford to lose (these are two separate answers). Factor in how many years you have left until retirement. Educate yourself about how long it takes for different asset classes to recover from bear market downturns. Do you have the stomach and enough time to weather a significant downturn?
  • Review your asset allocation, and make sure it’s appropriate for your personal circumstances. You should do this whether you’re following a strategic (buy and hold, passive indexing) allocation or a more tactical approach (such as our strategy).
  • Beware of concentrated stock positions in your TSP account if this is inappropriate for your circumstances. Consider allocating a portion of your account to the G Fund. Yes, it dilutes the return potential of an equity-oriented investment strategy, but it also reduces the magnitude of potential losses.
  • Learn about the common behavioral investing biases, and ask yourself whether any of these have affected your own actions in the markets over the past 5 years. For example, you can determine your personal allocation to stocks right now, and compare it to what you owned during the worst part of the global recession in 2008-2009. If you’re currently holding a larger percentage in stocks, ask yourself why. Make sure it’s for good reasons and not, for example, due to an attraction to rising prices (a known behavioral bias that affects many of us, if left unchecked).

If necessary, take action now, from a position of strength

Am I “doing a Greenspan” here, three years too early in calling “irrational exuberance”? Or is a significant market correction coming sooner? Who knows, and that’s not the point of this post. The main point is that this is a time to be cautious — “fearful” as Buffett would say — and not behave exuberantly or take large investment risks for the wrong reasons.

Remember, there are no tax consequences to exchanging TSP funds (as long as you keep the balance in your account, say in the risk-free G fund). Selling stocks at the top of the market from a position of strength is much better than selling them near a bear market bottom. Too many investors sell in a panic after markets have already tanked. You don’t have to be one of them.