Howard Marks’ latest memo, will excessive earnings ratios and AI optimism form a bubble?

Investment master Howard Marks in his latest memo 《On Bubble Watch》 discussed the issue of market bubbles, especially whether the focus on the seven giant stocks and the high P/E ratio in the US pose bubble risks.

Do the seven giants and US stocks exist in a Bubble?

The top seven stocks in the S&P 500 index (the so-called seven giants), including Apple, Microsoft, Alphabet (Google's parent), Amazon, Nvidia, Meta (Facebook's parent) and Tesla, have dominated the S&P 500 index in recent years and contributed disproportionately to its gains. According to data from JPMorgan Asset Management:

• As of the end of October, the market value of the seven largest components of the S&P 500 accounted for 32-33% of the total market value of the index
• This proportion is about twice the share of the leaders five years ago
• The highest share of the top seven stocks in the past 28 years was around 22% during the peak of the internet Bubble in 2000

As of the end of November, US stocks accounted for more than 70% of the MSCI World Index, the highest level since 1970. Therefore, it is obvious that:

• US companies are valued higher compared to companies in other regions
• The value of the top seven US stocks is higher relative to other US stocks

Does this constitute a Bubble?

Micro-characteristics and signals of Bubbles

For Howard Marks, "Bubble" and "Crash" have always existed in the financial lexicon, but they are more a matter of mentality than quantitative calculation.

Bubbles reflect not only the rapid rise in stock prices, but also a temporary frenzy characterized by:

• Highly irrational exuberance
• Adoration of the target companies or assets, and the belief that they cannot be missed
• Strong fear of being left behind, i.e. FOMO (Fear Of Missing Out)
• The resulting belief that "no price is too high" for these stocks

Marks believes that the most important thing is "no price too high", so to identify Bubbles, one can certainly observe valuation parameters, but he thinks psychological diagnosis is more effective. If you hear "no price is too high" or "prices are a bit high, but not yet at that stage", this is a clear signal that a Bubble is brewing.

Three stages of a Bull Market

Marks also mentioned the three stages of a Bull Market:

The first stage usually occurs after a market decline or crash, when most investors are licking their wounds and feeling very depressed. At this point, only a few highly insightful people can imagine that things may improve in the future.

In the second stage, the economy, companies and the market are performing well, and most people acknowledge that improvement is indeed happening.

In the third stage, after a period of good economic news, soaring corporate profits and sharp stock price increases, everyone concludes that things will just keep getting better forever.

And the third stage is often followed by the occurrence of a Bubble.

Bubble mentality: This time is different!

If the Bubble mentality is irrational, what allows investors to break free of rational thinking, like a rocket's thrust breaking through the gravity limit and reaching escape velocity? There is a simple answer: novelty. This phenomenon relies on another long-standing investment phrase: "This time is different!"

If something is new, meaning there is no history, then there is nothing to dampen the enthusiasm. These Bubbles all involve innovation, many of which are either overestimated or not fully understood. Just like the internet Bubble, the biggest Bubbles usually originate from innovation, mainly technological or financial innovation, which initially affect a small number of stocks. But sometimes they can spread to the entire market, as the enthusiasm for the Bubble spreads to all areas.

Is it a Bubble now?

Howard Marks listed the warning signs in today's market, including:

• The generally optimistic sentiment that has prevailed in the market since the end of 2022
• The valuation of the S&P 500 index is above average, and the price-to-earnings ratios of most industrial groups are higher than in other parts of the world
• The enthusiasm for artificial intelligence, and perhaps the expansion of this positive psychology to other high-tech fields
• The implicit assumption that the top seven companies will continue to succeed
• Some of the appreciation of the S&P index may be due to index investors automatically buying these stocks, without considering their intrinsic value

The following chart is from JPMorgan Asset Management, from 1988 to the end of 2014, with each square representing a month, showing the forward price-to-earnings ratio of the S&P 500 index at the time and the annualized return over the following ten years.

It can be seen that higher initial valuations (forward price-to-earnings ratios) lead to lower returns, and vice versa. The current forward price-to-earnings ratio is already above 90% of the data points. In these 27 years, when people bought the S&P index at a price-to-earnings ratio of 22 today, their 10-year returns were always between positive 2% and negative 2%.

Arguments against the need to worry about a bubble

Howard Marks observed many of the early signs of a bubble, but he also presented counterarguments:

• The price-to-earnings ratio of the S&P 500 index is high, but not crazy
• The seven giants are incredible companies, so their high price-to-earnings ratios are justified
• No one has said "prices are not too high" or "prices are a bit high, but not at that level"

In conclusion, Howard Marks did not explicitly state whether we are currently in a bubble or not. He simply stated the facts he observed and suggested how investors should think about it. Additionally, he also mentioned Bit in his memo.

Howard Marks on Bit

In 2017, Howard Marks described cryptocurrencies as a Ponzi scheme, likening them to the tulip mania and the internet bubble. However, in 2021, when he mentioned cryptocurrencies again, he said he was keeping an open mind and was in the process of learning, and thanked his son for holding a significant amount of Bit.

In this memo, Howard Marks also mentioned Bit, stating: "Regardless of its merits, its price has risen 465% in the past two years, which doesn't mean we should be overly cautious."