Though it may seem longer, it was just three years ago - on Dec. 5, 1996 - that Alan Greenspan posed his famous question, asking whether "irrational exuberance" was detectable in stock prices.

"Fed Chairman Pops The Big Question" was the headline in the next morning's Wall Street Journal. After a volatile session, the Dow Jones industrial average closed that day at 6,381.94. The blue chip stocks of the Dow average have since gained 69% to hover near the 11,000 mark. But over the same period, bank stocks have considerably outdone blue chips.

The American Banker index of the nation's 225 largest banks is up 115% over the past three years, driven by consolidation in the industry as well as good earnings and a sunny economic climate.

The sustained growth without inflation has led many, even Fed policymakers, to adjust their views on the economy and the stock market, said economist Nicholas S. Perna, who heads an economic consulting firm, Perna Associates, in Ridgefield, Conn.

"Even hard-nosed types like me are willing to concede that something has happened to productivity that is more than cyclical," said Mr. Perna. "One of the things that better productivity gets you is better profits," which are the basis for stock valuations.

On the other hand, if interest rates have not topped out, stocks are very likely overvalued, he asserted. Bank stocks, which have recovered some ground after a rocky summer as investors anticipated, then absorbed, a series of rate hikes, would likely be among the hardest hit again.

Mr. Perna said that in his view, rates may well have peaked, or are at or near their highs. But he cautioned that the "next most likely scenario" is that the economy remains strong enough that the Fed "has to come back with three, four or even more rate hikes." That would make it "very difficult not to have a significant stock market correction."

This would be "a hard landing brought to you by higher interest rates," Mr. Perna said, comparing it with a "soft landing" - a slowing of business conditions that reduces inflationary risks. Such a scenario carries a high risk of recession, a sobering prospect for bank stock investors. The outlook would quickly shift to falling loan demand and higher credit costs, along with the need to bolster loan loss reserves - a threat to bank earnings.

Mr. Greenspan was the target of considerable criticism from both Wall Street and Congress for his Washington speech three years ago. It was the first time he had addressed the issue of stock prices employing the term "bubble" in the process. Typically, the Fed chairman was responding to a question with a question of his own when he made the well known remark.

"How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?" he asked.

The Fed chief also said he would not be concerned about a "collapsing asset bubble" that did not threaten the economy. At the same time, he warned against complacency.

Reaction to Mr. Greenspan's remarks came quickly. That very night financial markets around the globe were wobbling.

In the three years since, Mr. Greenspan has returned to the same theme, though without repeating the famous "irrational exuberance" phrase. The reaction of the investment community has diminished considerably, however. When the Fed raised interest rates on Nov. 16, for the third time since June, the stock market rallied.

Despite the market's roaring gains in recent years, Anthony Chan, chief economist at Banc One Investment Advisors in Columbus, Ohio, thinks the Fed has been successful in "jawboning" the market down.

"My suspicion is that the stock price gains would have been even more dramatic if the Fed had not been jawboning," he said. "The Fed has also been working to keep the banks from lending too much and being irresponsible. And that has, believe it or not, slowed the economy."

Mr. Chan said it is indisputable that business fundamentals have improved, notably productivity, plus "inflationary pressures have been kept down, thanks to globalization. We have a good economy based on solid fundamentals, with the Fed pushing toward a soft landing.

"They have not achieved that, but we are certainly headed in that direction," he said.

Mr. Chan said he felt the Fed actually opened the way for the recent stock price advances. "If the Fed had not been active, the equity market might have risen a lot faster, creating a real bubble in the process and maybe then a bursting of that bubble," he said.

Over the past three years, Mr. Greenspan and his Fed colleagues have seemed more amenable to "new paradigm" arguments that productivity is in a rebound from the lows of the 1970s and 1980s, when inflation was a serious and chronic problem.

In fact, the Fed's forecasters and policymakers, along with many others, have been struggling to understand why the economy has been able to grow so strongly for so long without a rise in inflation or decline in productivity. The current expansion has been under way for over eight-and-a-half years and will soon be the longest in the nation's history, in wartime or in peace.

But Mr. Perna said if inflation reappears, as the Fed regularly warns, "the new arguments will be quickly thrown out." That could trigger higher rates and a less friendly environment for banks and stocks.

Fed Board member Laurence H. Meyer, in a relatively hawkish speech last week at New York University, declined to take on the issue of stock valuations, but said, "the key message is that the old rules still apply to the new limits."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.