There’s No Such Thing as an Irrational Market
In the mid-90s a man called Alan Greenspan was Chairman of the US Federal Reserve. That’s the central bank over there.
Under his watch, American stocks were bubbling along nicely.
In 1990, the NASDAQ was valued at just over 600 points. By 2000 it had rocketed to 5,000 points.
That’s a 733% rise.
But it didn’t last.
The market popped spectacularly at the summit. And over the next three years, the NASDAQ would plunge to 1,000 points.
Unlike most, Greenspan had seen it coming. And he actually tried to warn everyone.
He delivered his now infamous ‘Challenge of Central Banking in a Democratic Society’ speech in December 1996. It was during this talk that he coined the term ‘irrational exuberance’.
‘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?’
To answer his question, most people didn’t know. They were too high on irrational exuberance to see it.
Of course, hindsight reveals that the stock market went completely overboard on the upside, before contracting.
The age of irrational exuberance, as Greenspan termed it, had set in.
But what was it exactly?
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There’s no easy way to describe irrational exuberance.
Partly, that’s because it’s self-explanatory. It describes a baseless giddiness about a rising market. One that acts like a vacuum, sucking investors into its vortex.
But it doesn’t tell you everything about what’s really happening.
When dealing with psychology, many people view human behaviour as unpredictable.
Yet while people are indeed irrational, they’re often rationally irrational.
We all operate through identifiable patterns of behaviour. You can just about guess what someone will do in any given situation knowing very little about them.
In the case of the dotcom mania, investors were at first overjoyed as stock prices boomed to high heaven. Predictably, more capital piled into the market on the back of this.
They then became dismayed as they watched their wealth go up in smoke.
We saw this play out again in the crypto market late last year.
It shouldn’t have been a surprise. This is what people do. They get swept up in the moment. And allow emotions to take over.
Greenspan wasn’t wrong in describing the mood of the day as irrationally exuberant.
But he stopped short of calling it what is really is:
Investors aren’t irrational. They’re just led by emotion. And emotional response is entirely predictable.
You’ll find this to be true no matter what boom or bust you look to in history.
The rational response to an energy crisis
There were two shocks during the 1970s that sent commodity prices, in particular oil, surging.
The first occurred in 1973.
Oil prices rose threefold on the back of an embargo set by OPEC.
Six years later, in 1979, the second oil shock unfolded in the wake of the Iranian Revolution.
How did investors react?
Both times, with predictable widespread panic.
The price of oil doubled within a year. Long lines at petrol stations became a fixture of the nightly news.
Economic growth flatlined around the world. In the US, GDP growth declined 3%. In fact, it marked the end of the 30-year post-Second World War economic boom.
The result of this was high unemployment and rampant inflation, which led to recession.
And yet something didn’t add up.
While oil prices had doubled in the space of the year, actual supply had barely changed.
In fact, global oil supply fell by just 4%.
Did a single-digit drop warrant market panic?
Far from it.
But it happened nonetheless.
Not because markets are irrational. But because they’re rationally irrational.
In fact, you can predict how markets will react to any event with great accuracy.
All that’s needed is a convergence of two factors.
The first is a big macro event. This is something that suddenly and dramatically ramps up demand for certain resources to unusually high levels — think the outbreak of war.
The second is a crisis within a big producing company or resource-rich region that threatens global supply. Think war, civil strife, political upheaval, or what have you.
In the case of the 1970s energy crisis, you had both factors align at once.
The big macro event was the Yom Kippur War. This led to OPEC setting an embargo against nations perceived to be supporting Israel. That included Australia and much of the Western world.
With war in the Middle East, you had a crisis in what is the biggest oil producing region in the world. On top of this, you had Iran, a major oil exporter, going through a revolution.
This was the perfect coming together of a big macro event and crisis.
Not surprisingly, oil prices skyrocketed during the decade. They leapt from US$20 to over a $120 a barrel.
But oil wasn’t the only commodity that skyrocketed. Other commodities saw similar spikes.
Nickel, for example, saw prices rise by over $5,000 a ton during the 1970s.
And copper saw a threefold spike in the early to mid-1970s.
This is simply what happens to commodity prices when those two key factors converge.
Demand rises. Supply contracts. And prices go through the roof.
Why are we telling you this?
Because it’s now appears that these forces may be converging once again.
It’s what Daily Reckoning Australia chief editor Callum Newman calls the ‘C3 Eclipse’.
This eclipse has taken place twice in the past 49 years.
During both eclipses, the resource sector boomed.
Will history repeat?
One way or the other, we’ll be keeping a keen eye on the resources sector.