Top Trading Lessons: A Lesson on Irrational Exuberance and Trader Psychology

You might have heard the aphorism “the market is not the economy” before. The phrase surfaced quite a bit this past year largely owing to COVID-19 and the economic fallout caused by the pandemic. In spite of stark disruptions to consumption and the global supply chain, coupled with lasting structural damage done to the labor market, stocks have seemingly escaped the gravitational pull of economic reality. Although, to be fair, economic activity and the GDP growth outlook have improved considerably since the global economy was paralyzed by government-mandated lockdowns aimed at curbing the spread of COVID-19.

On the other hand, it is difficult to understand the near-vertical rally by stocks in the wake of a pandemic that’s still wreaking havoc. This glaring disconnect between perceived market fundamentals and price brings remembrance of the popular term “irrational exuberance,” which was coined by former Fed Chair Alan Greenspan during the “dot-com” bubble. While market valuations always warrant scrutiny, current conditions have led some investors to draw comparisons to past periods of irrational exuberance. However, central bank intervention throughout 2020 has highlighted the component of liquidity as a critical difference between markets and the economy.

The tsunami of accommodative monetary policies ushered in by the Fed, ECB, et al revealed that liquidity can have a significant impact on investor psychology. This seismic shift in liquidity largely explains relatively higher valuations and helps argue to the point that the market may not be irrationally exuberant. To that end, instead of defaulting to irrational exuberance as an explanation for why the market might be moving higher despite increasingly stretched valuations, perhaps a more prudent approach could be looking at the market through a different lens - particularly in light of its dynamic nature.

In short, the lesson of 2021 is to look beyond well-trodden terms to the real dynamics driving the market.

-- Written by Rich Dvorak, Analyst for DailyFX.com

Connect with @ RichDvorakFX on Twitter for real-time market insight