What Would Alan Greenspan Say About This Stock Market?

Way back in 1996, when I was a cub reporter for The Wall Street Journal, then-Federal Reserve Chairman Alan Greenspan made a speech in Washington that rocked the financial world.

"But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions," Greenspan famously said.

Investors around the world listened and then sold on the warning. However, the sell-off was brief, and the dot-com bubble continued to inflate for three more years before crashing in early 2000, wiping 78% from the Nasdaq Composite and 49% from the S&P 500 by October 2002.

What might Greenspan, if he were still alive, say about the current stock market?

I think he would point to several valuation metrics and make a similar observation. And in fact, a well-respected former Fed official did just that this week.

Bill Dudley is an economist who served as president of the Federal Reserve Bank of New York for almost a decade. And this week, he wrote a column in Bloomberg claiming the market is in bubble territory, noting these metrics.

The Buffett indicator is the ratio of the entire U.S. market cap to the size of the economy, as measured by gross domestic product (GDP). Warren Buffett proposed the metric and called it "probably the best single measure of where valuations stand at any given moment." That ratio is now at about 238. A ratio over 200 suggests that the stock market is strongly overvalued.

Then there's the famous Shiller cyclically adjusted price-to-earnings (CAPE) ratio. That metric compares the price of S&P 500 stocks to inflation-adjusted earnings from the past 10 years. The ratio now stands at 42.15, the second highest in more than 100 years, and just a hair below the level of 44.19 it hit in November 1999, just months before the internet bubble began to deflate.

Image source: Getty Images.

I think Greenspan would agree with Dudley.

Bubbles can last long after they've become obvious

That said, it's important to keep in mind that speculative bubbles can last for years after observers begin to identify them. And I imagine the current bull market will continue for some time before any significant pullback or correction.

And timing the market -- predicting when it hits a top or a bottom -- is a fool's errand. It can't be done, though some market watchers occasionally get it right.

So, investors should continue to look for sound, promising stocks to add to their portfolios. That includes adding stocks of companies in sectors that have historically weathered crashes better. During the dot-com crash, the sectors that performed well were energy, consumer staples, and utilities. In fact, those three sectors produced gains during the 2000-2002 crash, and they'll probably outperform the market during the next one.

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