Alan Greenspan’s warning came as a shock to investors. It came on a day that the the blue-chip German DAX index hit 2,800 – a far cry from today’s 11,400 – and the Dow Jones reached 6,000 – far from today’s 20,000.
“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” he said.
Mr. Greenspan, then chairman of the U.S. Federal Reserve, gave what was certainly his most famous speech to the American Enterprise Institute in Washington. Share prices promptly declined around the world. The DAX lost 4 percent. Investors interpreted Mr. Greenspan’s words as a warning about excessively high share prices and feared the Fed would raise interest rates to cool down the boom.
Things turned out a little differently. Mr. Greenspan’s words faded and in the following three years, share prices almost doubled on Wall Street and the DAX tripled in value. Only then did the bubble burst: Investors had in fact succumbed to “irrational exuberance.”
Fears of “exuberance” can always be justified, such as with the real estate boom in 2007 as well as now, when share prices have risen on Wall Street for eight years in a row. And yet, anyone who got out of the market completely in 1996 – and stayed out ever since – has missed many opportunities.
Apple’s share price, for example, rose from its lowest value in 1996 by over 20,000 percent. Anyone in Germany who invested 5,000 deutsche mark (€2,556) in Apple 20 years ago would now have €609,182.
Apple is an extreme, of course. And the stock has also seen its share of steep declines: In 2000 it plunged 70 percent; and only two years later, it lost more than 40 percent of its value. Not advisable for anyone with weak nerves.
But the example shows if has always been possible to make money with stocks – and not just Apple’s. Anyone who bought shares across the entire DAX in 1996 would have earned 310 percent so far. Their money would have grown in that time from €5,000 to €20,500.
You might call it a sort of irrational exaggeration.
A thoughtful financial historian once cautioned that despite its market valuation of €598,000,000,000 – no stock in the world is more expensive – Apple basically only embodies hot air. Let’s imagine for a moment that, suddenly, everyone on the planet decides they want hamburgers and nobody wants Apple shares anymore. Then Apple’s market valuation would fall to zero.
The man is of course correct: Every stock reflects only the value that investors currently see in the company – or hope for. In the case of Apple, that is based on annual earnings of most recently €41 billion and liquidity of €238 billion. There’s also the knowledge of 116,000 full-time employees who have developed products like the iPhone and – so many investors think – will continue to succeed in the future.
No one can know whether and how long Apple will actually manage to do so. The Finnish mobile-phone manufacturer Nokia, for example, painfully showed investors how far a firm can fall when it is no longer in sync with the times. Once valued at €300 billion and Europe’s most expensive company, Nokia is worth only €27 billion today. It order to reach its former peak price, the stock would have to climb by 1,000 percent. Even in the long term, that seems unlikely.
We cannot know whether stocks will still have today’s value tomorrow, or whether they will be worth even less the day after tomorrow – simply because more investors tend to sell than buy. That’s a risk every day on the stock markets. But financial history shows that in the long run, investors are quite successful if they hold a continuing stake in companies.
Last year, the DAX rose by 7 percent. It was the stock market’s fifth profitable year in a row. Since 1949 – that is how far back the Deutsches Aktieninstitut calculates the DAX – there was a 70-percent probability of a positive year for the index. From a five-year perspective, the figure rises to almost 90 percent. Only in one of 10 five-year periods did investors make a loss. Anyone who wants to keep wholly on the safe side has to stay invested for at least 15 years, because there has never been a minus over such a long period of time – irrespective of how low the entry level was.
Of course there are exceptions when it comes to individual shares: Commerzbank, Deutsche Bank, E.ON and RWE are famous negative examples of this past year. But the chance of succeeding with shares in an index like the DAX are extraordinarily positive.
DAX investors have enjoyed annual returns of 8 percent, on average, since 1949. That is all the more astounding given that only 7 percent of all Germans own stocks. In no other industrial country is there such reticence – you might call it a sort of irrational exaggeration.
Ulf Sommer writes about companies and markets for Handelsblatt. To contact the author: email@example.com