Irrational exuberance is a state of mania. In the stock market, it's when investors are so confident that the price of an asset will keep going up, they lose sight of its underlying value. The phrase was coined by former Federal Reserve Chairman Alan Greenspan in 1996. It's also a book by Robert Shiller describing the 2000 stock market bubble.

The Dangers of Irrational Exuberance

Investors egg each other into a state of irrational exuberance. They become so greedy for profits that they overlook deteriorating economic fundamentals. They get into a bidding war and send prices up even higher.

Irrational exuberance can only occur during the later expansion phase of the business cycle. That's when the economy has been running at full capacity for a while. There is not a lot of undiscovered opportunities. If investors strictly followed the fundamentals, they would reject these poor investments and remain in cash.

But investors still try to outperform the market. They desperately search for any overlooked profit. As a result, they sink more money into investments with ever-deteriorating returns.

As a result, a herd mentality develops. Investors follow each other into whatever asset is rising. They create an asset bubble. It usually occurs in stocks but has also happened in housing, gold, or even Bitcoin.

It may even look like prices are rising for valid reasons. But anything can burst the bubble. As a result, the frenzy of greed turns to panic when asset prices return to their real-world values.

Investors sell at any cost, sending prices below their real value. The collapse then spreads to other asset classes. An economic contraction follows, usually leading to a recession. Irrational exuberance is usually how a stock market crash causes a recession.

Alan Greenspan Quote

Fed Chair Alan Greenspan first coined the phrase in a 1996 speech to the American Enterprise Institute. In "The Challenge of Central Banking in a Democratic Society," Greenspan asked how central bankers could tell whether asset values were overpriced.

"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?"

Greenspan noted that low-interest rates had created steady earnings. It led to complacency on the part of investors. They ignored risks as they sought ever-higher returns.

He then asked whether central banks should address irrational exuberance with monetary policy. At the time, the Fed didn't concern itself with the stock market or even real estate prices. He did note though, that central bankers must get involved when they sense that speculative frenzy is driving a dangerous bubble. He concluded that when the stock market or any asset class affects the economy, then central bankers must get involved.

Greenspan's use of the phrase "irrational exuberance" sent stock markets plummeting the next day. Investors were afraid that the Fed would raise interest rates to slow down the economy.

Robert Shiller Book

In 2000, Yale professor and behavioral economist Robert J. Shiller wrote a book titled "Irrational Exuberance." The book became famous because it explained the herd mentality that created the tech stock bubble in 2000. He also predicted the subsequent stock market crash that led to the 2001 recession.

He released a second edition in 2005. It predicted the housing bubble and subsequent crash. Shiller also pointed out how the 2001 recession created the financial crisis. As investors lost confidence in the falling stock market, they invested in real estate. This ended up creating a bubble there.

Examples

The latest boom-bust cycle happened with oil prices in 2014. After reaching $100.14 in June, West Texas Intermediate crude oil prices plummeted 15% to $53.45 on December 26, 2014. It was the last trading day of 2014. It then fell to $38.22 on August 28, 2015, the lowest for the year. These low prices started affecting the economy in 2015. In particular, U.S. oil companies in the shale oil industry laid off workers. Later in 2015, many started defaulting on junk bonds.

The bursting of the oil price bubble was in part in response to irrational exuberance in the U.S. dollar. Investors increased the dollar's strength by 25% in 2014 and 2015. It affected manufacturers' exports by giving an artificial boost to their prices. Gross domestic product slumped in the third quarter.

The strong dollar also drove up the value of the Chinese yuan, which was pegged to the dollar. In response, the People's Bank of China lowered the yuan's value by 3% in August 2015. That triggered a Chinese stock market crash and raised concerns of currency wars.

Irrational exuberance also happened with gold prices in 2011. Fortunately, it didn't spread to the rest of the economy.

It happened with Treasury notes as well. Prices reached a peak in 2012, creating the lowest yields in 200 years. Demand for Treasurys didn't fall until the Fed began raising rates in 2015.

Asset bubbles occurred with stocks in 2013. Prices rose 30%, outpacing underlying fundamentals.