In December 1996, then Fed Chair Alan Greenspan gave a speech entitled ‘The Challenge of Central Banking in a Democratic Society’. As always, it was a thought-provoking speech and one worth re-reading in today’s political environment. However, the speech is best remembered for the phrase ‘irrational exuberance’, which Greenspan used for the first time to describe the ‘dot com’ mania that was engulfing financial markets, before it collapsed spectacularly.

So, was Greenspan prescient with his “irrational exuberance” framing? The answer is a clear no on two fronts. First, despite the excitement created by his speech at the time, his framing was a question about whether markets were irrationally exuberant and, if so, what should the central bank do about it. Second, the U.S. stock market more than doubled thereafter before reaching its peak.

So why I am bothering to rehash ancient history (the fact that I remember this first hand makes me feel ancient)? Well, there are some parallels between the markets in the second half of the 1990s and today. In the 1990s, it was the power of the internet and its revolutionary impact on businesses. Today, it is artificial intelligence (AI) that is dominating conversations. As in the dot com era, AI has driven valuations to dizzy heights and made people worry about whether investing today will be a catastrophic decision in 12 months’ time.

How to view the ongoing exuberance?

Here’s the way I look at this: we are likely in a world of fatter tails. What does this mean? It refers to the likely distribution of returns. Traditional finance is based on the idea that returns are based on a normal distribution. However, this assumes that returns are symmetric around the average return and that most of the values cluster around this average.

The reality can be very different. Indeed, there has been a lot of academic research which suggests that not only are returns skewed from the mean, but the probability of larger moves is higher than that predicted by a normal distribution.

Bringing that back to today, I believe we are likely in an environment that will create larger moves, both positive and negative. There are multiple reasons for taking this view: First, we are living in an incredibly uncertain policy environment. For instance, in the U.S., the decision-making process for policy changes appears to be concentrated in the hands of a few people with little public debate taking place. This means the likelihood of surprises, both positive and negative, are greater than normal.

Meanwhile, these policy decisions have consequences which are difficult to decipher as we have limited historical precedence to lean on. Import duties are expected to be inflationary in the U.S. and disinflationary in the rest of the world, but the quantum and length of impact is unclear. This comes at a time when government finances are stretched in much of the western world, adding another level of complexity.

We are also undergoing a rewiring of the geopolitical order. I wrote in March that the U.S.’s flexing of its power will lead to reduced power in the future as countries seek different alliances and endeavour to become less reliant on the U.S. The epitome of this was the restart of dialogues between China and India, which aim to foster improved relations.

And, of course, the final uncertainty is the power of AI and its impact on the global economy. At the moment, the major focus is on the power of AI to increase productivity, support growth and keep inflation pressures in check. However, the other side of this coin is the concern that many jobs are being made redundant, leading to widespread unemployment. My sense here is that job markets should remain robust as long as companies are making good money, but once the cycle changes then we will likely see more job losses than we would have done without AI.

Implications for the economy and investing

A key question is whether this could push the global economy into a recession. In the U.S., there are already signs that the labour market is cracking. Indeed, recent revisions to 2024 data suggest the strength of the labour market was overplayed. This is worrying the Fed, resulting in a resumption of its rate cutting cycle.

So how should investors think about investing in an apparently risky environment? Of course, when faced with uncertainty, the knee-jerk reaction is to either freeze and do nothing or reduce the level of investments.

We believe this is the wrong approach. Coming back to the 1996 analogy, the U.S. stock market more than doubled in the three years following Greenspan’s “irrational exuberance” speech. Of course, we also must acknowledge that the market, after peaking in early 2000, then declined by almost half in the following two years.

Of course, you could decide either to try to time the market peak or sit this one out and try to pick the low after the collapse. However, we know this is incredibly difficult to do. Let’s say you decide to sit this out. Will you be able to resist investing if the market is up another 25%, or 50%, from here. 

For us, the best approach is to: 1) stay on track with your planned investment journey, and 2) to put as many hedges in your portfolio as you possibly can. The first line of defence is to diversify across as many asset classes and geographies as you can, including cash, equities, bonds, gold, private assets and liquid alternatives. Experienced investors can also consider selectively buying equity index put options that help partially hedge downside equity risk. The challenge here is the cost of these hedges are high, which means only partial hedges, or more complex strategies, will need to be considered.