Rational exuberance consists of the massive purchase or sale of financial assets based on rational knowledge of the underlying fundamentals that support them and without taking into account other factors that do not obey reason, but rather emotions.
Actually, it is a concept that seeks to oppose another coined by Alan Greenspan, former Governor of the Federal Reserve System (FED). Thus, he was referring to the stock market boom in the 1990s and indicated a possible overvaluation of the stock market that, moreover, was caused by “irrational exuberance.”
Greenspan used the expression because there was no logical reason for that situation to occur. Over time, the markets seem to have returned to certain excesses between the years 2021 and 2022. But this time, they do have a reason for being or, at least, an argument to base it on, according to many experts.
Rational and irrational exuberance
Various investment fund professionals have made this concept of “rational exuberance” fashionable, as opposed to the one proposed by Greenspan. The difference is that in the irrational one, one does not act with an economic or financial logic and in the rational one, yes.
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In addition, there is also financial knowledge and education. For example, to know the possible evolution of certain values, it is necessary to look at the prices of the liquid markets. These markets are those of highly liquid assets that can be easily converted into money and are a very important indicator for the rest.
These professionals defend that the listed price is formed with market consensus decisions. This includes the financial knowledge of many investors, most of whom are educated and who act on their own account or as intermediaries for others.
Of course, the market can seem too optimistic or pessimistic, as was the case in that Mr. Market devised by Benjamin Graham, but there is almost always an argumentative motivation for this to happen. In the end, as we will see later, the market tends to stabilize and adjust in the long term.
The panic of the markets
One of the issues that most worries economists is the so-called “panic of the markets”. We are facing a situation contrary to that described by the former governor of the FED, but it is also based on irrationality and not on logic, knowledge and rationality.
In this case, investors decide to sell their risk assets such as cryptocurrencies or shares of highly volatile companies. In the end, a panic is generated in the markets that ends up having a downward impact on the price of assets and ends up leading to a burst of the previous bubble. An exuberance but sales.
The dot com bubble
Between 1997 and 2001 there was a bubble of technology companies that skyrocketed the value of their shares on the stock market. This would be a typical example of “irrational exuberance” but for some investment institutions and private investors this is not exactly the case.
In fact, a current of economic thought considers that this was, perhaps, a clear case of “rational exuberance” but done at the wrong time. In other words, investors bought technology shares before, at a time that was too speculative. In this way, they lost money when the markets panicked.
As was later shown, these companies were big business in the years after the bubble burst. In fact, those who stayed (rationally) and did not sell made huge profits. That is, those who took into account the underlying fundamentals, such as real intrinsic value and based on their net worth.
Rational exuberance and the coronavirus
With the paralysis of the economy due to COVID19, an economic recession also ensued, how could it be otherwise. The central banks of the main advanced economies made the decision to carry out economic policies of low interest rates.
For example, between June 2020 and 2021, the European Central Bank (ECB) decided to carry out expansionary monetary policies. This was the way to stop the economic crisis that caused the confinement carried out to prevent the spread of the virus. It seemed that a new speculation could start around this.
However, the good results of companies such as technology companies (remote work), banks (online or card payments) or pharmaceutical companies (masks, pcr or vaccines), created a favorable environment for investors. Rational exuberance occurred, above all, in those more trained in finance and who knew how to take advantage of this upward trend in the price.