How high is the valuation of US stocks? It has reached the level of "irrational exuberance."

U.S. stock valuations are too high, and Greenspan's warning has sounded again.

On January 9th, Thursday, Eastern Time, U.S. stocks were closed for a day in mourning for the late former President Carter. Meanwhile, Bloomberg reporter John Authers calculated that U.S. stock valuations have reached their highest level since 2002, matching the level when former Federal Reserve Chairman Greenspan made his remarks about "irrational exuberance."

U.S. Stock Valuations at a 20-Year High

"Irrational exuberance" is a famous concept mentioned by Greenspan on December 5, 1996. At that time, Bill Clinton had just been re-elected as president, and U.S. stocks were continuously rising. Greenspan warned investors that overly optimistic sentiment could lead to asset values being excessively inflated, and this sentiment might be irrational.

He posed an important question:

"How do we judge whether irrational exuberance has excessively inflated asset values, which may then experience unexpected and prolonged contraction? How should we incorporate this assessment into monetary policy decisions?"

This statement was interpreted by the market as Greenspan believing that U.S. stock valuations were too high and at risk of a bubble, leading to a subsequent decline in the stock market. Three months later, the Federal Reserve indeed raised interest rates by 25 basis points, resulting in a nearly 10% correction in the S&P 500 index. However, the Federal Reserve did not raise rates again in the following 18 months.

Greenspan's indicator measures stock market valuations by comparing the difference between stock yields (the inverse of the price-to-earnings ratio) and bond yields. The higher the stock yield relative to bonds, the cheaper the stock is, and vice versa. Particularly when bond yields rise, it becomes more difficult to justify stock valuations.

Taking the spread between the S&P 500 index yield and the 10-year U.S. Treasury yield as an example, under normal circumstances, stocks, due to their relatively higher risk, tend to have expected yields that are higher than bond yields, so the stock-bond yield spread is usually positive. When the spread decreases or falls below zero, it indicates that stock valuations are high.

Using this simple model (although there are more complex versions, this already reflects Greenspan's core idea), it is calculated that current stock market valuation levels have returned to the highest point since 2002, consistent with the time when Greenspan issued his "irrational exuberance" warning in 1996.

It is worth mentioning that the recent decline in Greenspan's valuation model is not closely related to the stock market but is mainly due to the rise in U.S. bond yields. This is because the market is concerned that inflationary pressures will persist before Trump's second presidential term, leading to a continuous rise in U.S. bond yields.

Additionally, the current level of U.S. stock valuations has raised alarms among some financial analysts and Federal Reserve officials. Federal Reserve Governor Cook stated on Monday that at current price levels, the stock and corporate bond markets "are susceptible to significant declines."

Goldman Sachs Chief Global Equity Strategist Peter Oppenheimer also warned on Thursday that over the past two years, stock price increases have reached the 93rd percentile of the past century. Although earnings are expected to drive U.S. stocks higher, with rising bond yields or economic data and corporate earnings falling short of expectations, the stock market will be more vulnerable to shocks, potentially triggering a market adjustmentLooking back at history, a series of events in the fall of 1998 may provide us with valuable lessons.

Long-Term Capital Management (LTCM) was formed by a group of elite financial professionals, including Nobel Prize winners, who used complex mathematical models and quantitative trading strategies, primarily engaging in fixed income arbitrage and other financial activities, amplifying returns through significant leverage.

In 1998, due to Russia's debt default and the impact of the Asian financial crisis, the large positions held by LTCM faced massive losses in an instant. Due to its high leverage (with leverage ratios reaching dozens of times), the losses were magnified, quickly bringing the company to the brink of bankruptcy, ultimately leading to its collapse. Subsequently, the spread between stock and bond yields briefly turned positive, with stock yields slightly higher than bond yields.

However, corporate debt financing became extremely difficult at that time. Alan Greenspan decided to cut interest rates in an attempt to stabilize market confidence by lowering borrowing costs. Analysis pointed out that this decision also opened the most extreme phase of the internet bubble. The interest rate cuts at that time may have been a mistake, providing cheap funds to the stock market and indirectly exacerbating the market bubble's expansion, laying hidden dangers for the later bursting of the U.S. stock market bubble. Around the year 2000, the bubble began to burst, leading to a series of consequences such as economic recession and prolonged stagnation in the stock market