Alan Greenspan Revisits Irrational Exuberance

The meteoric rise in the stock price of GameStop seems to have brought up the question of irrational exuberance in the markets. Irrational exuberance is a state of investor psychology, when the pendulum between fear and euphoria has swung too far towards the latter. In other words, stock prices are the aggregation of the myriad expectations held by market participants and can at times reflect what seems an unjustifiably optimistic view of future economic conditions. Though prices may appear excessive during periods of irrational exuberance (i.e., priced for perfection) they are nonetheless rooted in some concrete view of an uncertain future that can be articulated in terms of expectations of future cash flows, interest rates, etc.

While the first leg of the GameStop rally can be attributed to pockets of irrational exuberance, the latter part of its parabolic rise is almost certainly more a case of market structure rather than investor psychology. In this view, the latter part of the rally is a simple case of supply and demand, with several historical precedents, compounded somewhat by technology and features of the present-day financial system.

In 1869, when Jay Gould (an American railroad magnate, financial speculator, and one of the Robber barons of the Gilded Age) sought to drive up the price of gold, he turned to the basic economic principle of limiting the supply. He and his associates attempted to convince President Grant to limit the amount of gold the Treasury was selling into the market. Their ploy was successful until Grant deduced their intentions and ordered the Treasury to release $4 million worth of gold into the market. Like the price of gold in 1869, the price of GameStop continued to rally beyond the point of irrational exuberance because buyers were faced with a limited supply, not because of overly optimistic expectations.

Another historical parallel occurred in 1901 as E.H. Harriman battled James J. Hill over control of the Northern Pacific Railway. As the two parties amassed shares (controlling over 94% of outstanding shares by May 1901), unknowing third parties were shorting the stock as it rose. When it became apparent neither party was willing to sell, the shorts tried frantically to cover their positions with the limited shares available. The ensuing short squeeze caused heavy selling in the rest of the market as other holdings were liquidated to raise cash to cover. The resulting selloff precipitated the Panic of 1901. The buyers that ultimately drove Northern Pacific Railway shares higher were not
driven by irrational exuberance, they were driven by panic from having to cover their shorts at ever-higher prices. This recalls reports of hedge funds that were short GameStop taking substantial losses in the final throes of the rally as they were forced to cover their positions. Their buying was spurred not by irrational exuberance, but rather capitulation.

While sharing characteristics with these examples from the past, modern innovations in technology and the financial system also contributed to the dramatic speed with which shares in GameStop morphed from irrational exuberance to market structure-induced bubble. Online platforms, most notably Reddit (the social news aggregation, web content rating, and discussion website) in the case of GameStop, allow individual investors to communicate more quickly and broadly than ever before. Meanwhile, established brokerages have followed the pioneering Robinhood (a financial services firm known for offering commission-free trades) in reducing commission fees on trading to $0, making trading more appealing to individual investors as a result. Wider adoption of options trading allowed the individual investor herd to leverage each dollar invested, greatly enhancing their influence on markets relative to the past.

As I mentioned in a previous article, history shows us that investors should invest for the long-term. Earnings per share essentially rise with increased productivity, and therefore gross domestic product. Going back about a century and a half, we see that a buy-and-hold strategy would undoubtedly pay off over the long run. But as recent weeks have reminded us, fear and euphoria are factors which we must always consider when discussing gyrations in the markets, because they may unduly influence otherwise rational people. Though technical factors like those witnessed in past manias can account for the heights GameStop shares ultimately reached, a degree of irrational exuberance likely kindled the flame.