US stock valuations are too high, and Greenspan's warning has resurfaced.

On January 9, Thursday Eastern Time, US stocks paused for one day in memory of the late former president Carter. At the same time, Bloomberg journalist John Authers calculated that US stock valuations have reached their highest level since 2002, matching the levels when former Federal Reserve Chairman Greenspan made his remarks about 'irrational exuberance'.

US stock valuations are at a 20-year high.

'Irrational exuberance' is a famous concept mentioned by Greenspan on December 5, 1996. At that time, Bill Clinton had just been re-elected as president, and US stocks were continuing to rise. Greenspan warned investors that excessive optimism could lead to asset values being overstated, and this sentiment might be irrational.

He raised an important question:

'How do we determine whether irrational exuberance has excessively inflated asset values, which may then experience unexpected and prolonged contractions? How should we incorporate this assessment into monetary policy decisions?'

This statement was interpreted by the market as Greenspan's belief that US stock valuations were too high and at risk of a bubble, leading to a subsequent decline in the stock market. Three months later, the Federal Reserve indeed raised interest rates by 25 basis points, causing the S&P 500 Index to see a nearly 10% correction. However, the Federal Reserve did not raise rates again in the following 18 months.

The Greenspan indicator measures stock market valuation by comparing the difference between stock returns (the inverse of PE) and bond yields. When stock returns are higher relative to bonds, stocks are considered cheaper, and vice versa. Particularly when bond yields rise, it becomes more challenging to justify the valuation of stocks.

Taking the yield spread between the S&P 500 Index and the 10-year US Treasury yield as an example, under normal circumstances, stocks are generally riskier and thus tend to have higher expected returns than bonds, leading to a positive stock-bond yield spread. When the yield spread decreases or falls below zero, it indicates that the valuation of stocks is relatively high.

Using this simple model (although there are more complex versions, this captures the core idea of Greenspan), it is calculated that the current stock market valuation level has returned to its highest point since 2002, consistent with the period when Greenspan issued his warning about 'irrational exuberance' in 1996.

It is worth mentioning that the recent decline in the Greenspan valuation model is not closely related to the stock market but is primarily attributed to the rise in US bond yields. This is because the market is concerned that inflation pressures will persist before Trump's second presidential term, resulting in continuous increases in US bond yields.

Moreover, the current level of US stock valuations has raised alarms among some financial Analysts and Federal Reserve officials. Fed Governor Cook stated on Monday that at current price levels, the stock and corporate bond markets are 'prone to significant declines.'

Goldman Sachs Chief Global Equity Strategist Peter Oppenheimer also warned on Thursday that over the past two years, stock prices have reached the 93rd percentile compared to the same period over the past century. Despite expectations that earnings will drive US stocks higher, with rising bond yields or if economic data and corporate profits fall short of expectations, the stock market may become more susceptible to shocks, potentially triggering a market adjustment.

Looking back at history, a series of events in the fall of 1998 may provide us with valuable lessons.

Long-Term Capital Management (LTCM) was formed by a group of financial elites, including Nobel laureates, who used complex mathematical models and algo trading strategies mainly for fixed income arbitrage and amplified returns through significant leverage.

In 1998, due to Russia's debt default and the impact of the ASIA FINANCIAL crisis, LTCM faced enormous losses on its large positions, and because of its high leverage operation (with leverage ratios reaching several dozen times), the losses were magnified, quickly pushing the company to the brink of bankruptcy, ultimately leading to its collapse. After that, the yield spread between stocks and Bonds briefly turned positive, meaning stock yields were slightly higher than bond yields.

However, at that time, corporate debt financing became very difficult, and Greenspan decided to cut interest rates in an attempt to stabilize confidence in the financial markets by lowering borrowing costs. Analysts pointed out that this decision also marked the beginning of the most extreme phase of the Internet Plus-Related bubble. The interest rate cut may have been a mistake, as it provided cheap funds to the stock market, indirectly exacerbating the market bubble's expansion and laying the groundwork for the later collapse of the USA stock bubble. Around 2000, the bubble began to burst, leading to a series of consequences including economic recession and prolonged stock market sluggishness.