Investment guru Howard Marks discusses the issue of market bubbles in his latest memo, “On Bubble Watch,” particularly focusing on the concern surrounding the seven giant stocks and the high price-to-earnings ratio in the US, and whether there is a risk of a bubble.
Are there bubbles in the seven giants and the US stock market?
The seven giant stocks in the S&P 500 index, including Apple, Microsoft, Alphabet (Google’s parent company), Amazon, Nvidia, Meta (Facebook’s parent company), and Tesla, have dominated the index in recent years and have contributed disproportionately to its gains. According to data from J.P. Morgan Asset Management:
As of the end of October, the market value of the seven largest components of the S&P 500 index accounted for 32-33% of the total market value of the index.
This ratio is approximately twice the share of the leaders five years ago.
Before the emergence of the seven giants, the highest share of the top seven stocks in the past 28 years was about 22% during the peak of the dot-com bubble in 2000.
Furthermore, as of the end of November, the US stock market accounted for over 70% of the MSCI World Index, the highest proportion since 1970. Hence, it is evident that:
Compared to companies in other regions, US companies have high valuations.
The value of the top seven US stocks is relatively higher compared to other US stocks.
Does this form a bubble?
The characteristics and signals of bubbles
“Bubble” and “collapse” have always been present in the financial dictionary, but for Howard Marks, a bubble or a crash is more of a mentality rather than a quantitative calculation.
A bubble not only reflects a rapid rise in stock prices but also represents a temporary frenzy, characterized by:
Highly irrational prosperity.
Thorough worship of target companies or assets and a belief that one cannot afford to miss out.
Strong fear of being left behind if not participating, known as FOMO (fear of missing out).
The resulting belief is that these stocks are “not overpriced.”
Marks believes that the most important thing is that “there is no price too high.” Therefore, while valuation parameters can be observed to identify bubbles, he believes that psychological diagnosis is more effective. If you hear phrases like “there is no price too high” or “of course, the price is a bit high, but it hasn’t reached that stage yet,” it is a clear signal that a bubble is brewing.
Three stages of a bull market
Marks also mentions the three stages of a bull market:
The first stage usually occurs after a market decline or crash, leaving most investors licking their wounds and feeling extremely frustrated. At this point, only a few incredibly insightful people can imagine that there might be improvement in the future.
In the second stage, the economy, businesses, and the market perform well, and most people acknowledge that improvement is indeed happening.
In the third stage, after a period of positive economic news, surging corporate profits, and significant stock price increases, everyone concludes that things will only get better.
The occurrence of a bubble often follows the third stage.
Bubble mentality: This time is different!
If bubble mentality is irrational, what makes investors break free from rational thinking, just as the thrust of a rocket breaks through the limits of gravity and reaches 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, it means there is no historical reference, and therefore, there is nothing to temper enthusiasm. These bubbles involve innovation, many of which are either overvalued or not fully understood. Just like the dot-com bubble. The biggest bubbles usually originate from innovation, primarily technological or financial innovation, initially impacting a small number of stocks. However, sometimes they expand to the entire market as the enthusiasm for the bubble spreads to all areas.
Is it a bubble now?
Marks lists the warnings in the current market, including:
The prevalent optimism in the market since the end of 2022.
The valuation of the S&P 500 index is higher than the average, with the price-to-earnings ratio of most industrial groups higher than that of other regions in the world.
The enthusiasm for artificial intelligence as a new phenomenon, and perhaps the positive psychology extends to other high-tech fields.
The implicit assumption that the top seven companies will continue to be successful.
The partial appreciation of the S&P index may be due to index investors automatically buying these stocks without considering their intrinsic value.
The following chart from J.P. Morgan Asset Management shows the forward price-to-earnings ratio of the S&P 500 index and the subsequent ten-year annualized return from 1988 to the end of 2014, with each month represented by a square.
It can be seen that higher starting valuations (forward price-to-earnings ratio) lead to lower returns, and vice versa. The current forward price-to-earnings ratio is higher than over 90% of the data points. Over these 27 years, when people bought the S&P index at a price-to-earnings ratio of 22 times today, their ten-year returns were always between positive 2% and negative 2%.
Rebuttal arguments for not worrying about bubbles
Marks observes many early signs of bubbles, but he also presents rebuttal arguments:
The price-to-earnings ratio of the S&P 500 index is high but not insane.
The seven giants are incredible companies, so their high price-to-earnings ratios are justified.
There haven’t been any remarks like “there is no price too high” or “of course, the price is a bit high, but it hasn’t reached that stage yet.”
In conclusion, Marks does not explicitly state whether we are currently in a bubble. He simply presents the facts he sees and suggests how investors should think. Additionally, he mentions bitcoin in the memo.
Marks mentions bitcoin
In 2017, Marks described cryptocurrencies as a Ponzi scheme and compared them to tulips and the dot-com bubble. However, when he mentioned cryptocurrencies again in 2021, he stated that he is in a learning mode with an open-minded attitude and expressed gratitude for his son holding a significant amount of bitcoin.
(2017 called it a Ponzi scheme, Howard Marks’ latest memo: grateful that my son holds a significant amount of bitcoin)
In this memo, Marks also mentions bitcoin, stating:
Regardless of its merits, its price has risen by 465% in the past two years, which does not mean one should be overly cautious.
Risk Warning
Investing in cryptocurrencies carries a high level of risk, and prices may fluctuate dramatically, resulting in potential loss of the entire principal. Please carefully evaluate the risks.