Irrational exuberance

The phrase ‘irrational exuberance’ is increasingly applied to the stratospheric performance of some areas of the tech sector. It describes a state of affairs when market optimism gets ahead of more rational profit forecasts. An alternative term would be ‘new era thinking’, when markets predict that the transformational power of a new product or technology will yield exceptional gains. Historical examples include the dotcom boom, the Nifty Fifty, the South Sea Bubble and Tulip Mania. But where does the phrase originate?

The words irrational exuberance were first noted in a speech by Alan Greenspan, then chair of the US Federal Reserve, back in 1996. He was referring to the fact that risk premiums in the equity market, normally higher than those paid by government bond holders, had been falling sharply. This had resulted in soaring equity valuations, as the dotcom bubble gained pace. He posed this question: “How do we know when irrational exuberance has unduly escalated asset values?”

The same question could be asked today, early in the second year of the artificial intelligence (AI) boom. Companies directly involved in AI have seen sharp and repeated upgrades to their earnings forecasts. To the extent that, despite recent jumps in the share price of Nvidia, and after tripling in value last year, forecasts for the speed of the company’s earnings growth have outpaced even this rise.

It is not unreasonable that a company growing strongly should trade at a higher earnings multiple than one showing slower growth. But forward multiples can only be based on forecasts or best estimates of future business prospects. Without the assistance of a crystal ball, the further out those projections are made, logically the less trustworthy they become. Supernormal profits will typically attract competitors to enter the field and might eventually result in tougher regulation. And all this more rapidly than the forecaster might be expecting.

The development of generative AI has been called a ‘singularity’. In other words, an event believed to exceed human intelligence. The same word is used for black holes, which equally have characteristics beyond human comprehension. Whether the AI revolution will result in long years of supernormal profits for the prime movers remains to be seen. As competition and regulation follow hot on their heels, there is a real risk that current forecasts might one day be viewed as the triumph of hope over experience. While the prospects for some areas of the tech sector might point to extensive and strong profit growth, the rational approach would be to hold such investments as part of a diversified portfolio.