U.S. stocks recovered from the 1987 crash and kept climbing after a 1996 warning about valuations, showing how high prices gave little indication of when the next reversal would arrive.
In December 1996, economists John Campbell and Robert Shiller presented research to the Federal Reserve arguing that stocks were overvalued, according to a later account by then-Federal Reserve Governor Ben Bernanke. Federal Reserve Chair Alan Greenspan raised the question of “irrational exuberance” in a Dec. 5 speech that year.
The cyclically adjusted price-to-earnings ratio stood at 27.6 when Greenspan spoke, the Federal Reserve Bank of San Francisco says. The measure divides the inflation-adjusted S&P 500 index by the 10-year average of inflation-adjusted corporate earnings. It later approached 45 during the dot-com boom.
A San Francisco Fed analysis applied a trend line using data available through 1996. At the 27.6 reading, the model implied a decline of roughly 4% over the following 10 years. Real equity prices instead rose about 4% annually over that period. The reading pointed to the possibility of weaker returns but did not establish when prices would turn.
The longer advance began while inflation was falling. Annual-average U.S. consumer price inflation declined from 13.5% in 1980 to 3.2% in 1983, Bureau of Labor Statistics data show. As the Fed pursued policies to curb inflation, unemployment rose from roughly 7% to more than 10%, according to Federal Reserve History.
In an Oct. 3 In My Tribe essay, author Arnold Kling argued that lower inflation helped drive the stock market’s advance. He also viewed rising valuations as a warning of weaker future returns.
The Dow Jones Industrial Average climbed from 776 in August 1982 to 2,722 in August 1987, according to the U.S. Government Accountability Office. It fell 22.6% on Oct. 19, 1987, Federal Reserve History says. U.S. stocks exceeded their pre-crash highs less than two years later.
Federal Reserve History identifies portfolio-insurance strategies as an accelerant of selling during the crash. Exchanges later introduced trading pauses for steep declines, while the Fed signaled its readiness to provide liquidity to the financial system.
The dot-com reversal came years after the 1996 valuation warning. By March 2001, the Nasdaq was nearly 59% below its March 2000 level, according to the San Francisco Fed.
