5 Signs of Irrational Exuberance You Can’t Ignore

The U.S. economy continues to show tangible signs of recovery. In April, businesses created new jobs at the fastest rate for five years.

But all may not be hunky dory in the world’s biggest economy. writer Alex Dumortier explains.

In October 2009 and again last November, I highlighted 5 signs of irrational exuberance.

Sure, U.S. corporate earnings growth has been impressive, and the stock market is riding relatively high, but that doesn’t stop me from worrying that investors aren’t displaying the proper restraint in an environment that remains exceptionally uncertain.

Here we are in 2011, and I’ve spotted five more signs that investors are abusing the laughing gas:

1. Gold and silver at new highs. In early May, the volume in the iShares Silver Trust reached five times its average daily volume in the first quarter, as the metal hit a 31-year high.

Gold also achieved an all-time nominal high above $US1,500 recently, and the SPDR Gold Shares has become one of the largest exchange-traded funds.

Part of this phenomenon is the product of investors who are resolutely bearish about the prospect for shares and the U.S. dollar, but there is also evidence that purely speculative buyers are piling into these markets. Let me be clear: Both gold and silver are at bubble levels.

2. Small-cap stocks hit new highs. The Russell 2000 small-cap index recently achieved a new all-time high. Small caps have handsomely outperformed large caps in the massive rally that began in March 2009. That has produced some eyebrow-raising valuations, particularly in e-commerce related companies.

Small caps have greater exposure to the U.S. economy than large caps, which generate substantial revenues and profits in higher-growth economies; despite this, small caps are now historically pricey with regard to large caps.

3. The smart money is cashing out. The Wall Street Journal recently reported private equity behemoth Carlyle Group is preparing an IPO.

When successful financiers who make their living buying and selling companies decide to sell their own company, which is more likely: That they feel they will receive less than a fair price for it, or that they believe the market is buoyant enough to support a rich valuation?

When Carlyle’s rival, the Blackstone Group, went public in June 2007, it proved to be a superb indicator of the top of the credit bubble — and a contrary indicator for the share market.

Blackstone’s shares have performed disastrously since the flotation, underperforming the S&P 500 by more than 25%.

4. The VIX is cheap. The VIX index is known as the market’s “fear gauge” because it relates to the price investors are willing to pay for protection with options on the S&P 500. Lower VIX values mean investors are paying less for options, i.e., they are less concerned about stock market declines.

The VIX recently closed at 14.75, well below its historical average of 20.36. Yes, we are heading into the northern hemisphere’s summer months, which are typically less volatile than the autumn and spring. Yes, the VIX is based on options that are maturing in a month, so it doesn’t look out very far. And yes, the VIX curve is upward sloping, indicating that the market expects the VIX to rise.

However, the current VIX value smacks of stunning complacency in an environment as uncertain as the one we now occupy. For example, the Fed will end its second round of money-printing next month (QE2, as the program is known). Investors who say they know how this will affect markets and the economy are liars or small-fools — it’s a genuine wild card.

5. The art market is booming. New York auction houses recently tried to sell $US1 billion worth of art and antiquities, with a dozen works priced near $US20 million.

Michael Plummer, a principal at Artvest, told The Wall Street Journal:

The speed of the art market’s recovery is astonishing, but it’s a differently revived market. The lesson of the crash was to do your homework. Collectors feel wiser for the experience.

In other words, Michael, it’s different this time?

Value: More relevant than ever

I’m neither the boy who cried wolf, nor a prophet of doom — I’m optimistic regarding the U.S. over the long-term, despite the significant challenges ahead.

However, in the current context, I see no reason to deviate from the counsel I have been repeating for nearly two years: Maintain a keen focus on the valuation of the shares you own.

If you’re tempted to put your money into gold or silver — assets with zero yield, you may instead want to think about increasing your cash allocation at least until real asset valuations become more compelling. Unlike in the U.S., in Australia you can earn a juicy and safe 5%+ in a savings account.

This article, written by Alex Dumortier, was originally published on Bruce Jackson has updated it.

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