On Bubble Watch

[Music] this is the memo by Howard marks on Bubble [Music] Watch exactly 25 years ago today I published the first memo that brought a response from readers after having written for almost 10 years without receiving any the memo was called bubble.com and the subject was the irrational Behavior I thought was taking place with respect to Tech internet and e-commerce stocks the memo had two things going for it it was right and it was right fast one of the first great investment adages I learned in the early 1970s is that being too far ahead of your

time is indistinguishable from being wrong in this case however I wasn't too far ahead this Milestone anniversary gives me an occasion to write again about bubbles a subject that's very much of Interest today some of what I write here will be familiar to anyone who read my December memo about the macro picture but that memo only went to Oak Tree clients so I'm going to recycle here the part of its content that relates to the subject of bubbles since I'm a credit investor having stopped analyzing stocks nearly five decades ago and since I've never ventured

far into the world of technology I I'm certainly not going to say much about today's hot companies and their stocks all of my observations will be generalities but I'm hopeful they'll be relevant nonetheless in this Century's first decade investors had the opportunity to participate in and lose money due to two spectacular bubbles the first was the tech media Telecom TMT bubble of the late 90s which began to burst in mid 2000 and the second was the housing bubble of the mids which gave rise to a extending mortgages to subprime borrowers who couldn't or wouldn't document

income or assets B the structuring of those loans into levered tranched mortgage banked Securities and consequently see massive losses for investors in those Securities especially the financial institutions that had created them and retained some as a result of those experiences many people these days are on heightened alert for bubbles and I'm often asked whether there's a bubble surrounding the standard and pors 500 and the handful of stocks that have been leading it the seven top stocks in the S&P 500 the so-called magnificent 7 are Apple Microsoft alphabet Google's parent amazon.com Nvidia meta on Facebook WhatsApp

and Instagram and Tesla I'm sure I don't have to go into detail regarding the performance of these stocks everyone's aware of the phenomenon suffice it to say that a small number of stocks have dominated the S&P 500 in recent years and have been responsible for a highly disproportionate share of its gains a chart from Michael semolist Chief strategist at JP Morgan Asset Management shows that the market capitalization of the seven largest components of the S&P 500 represented 32 to 33% of the index's total capitalization at the end of October that percentage is roughly double the

leader share 5 years ago and prior to the emergence of The Magnificent 7 the highest share for the top seven stocks in the last 28 years was roughly 22% in 2000 at the height of the TMT bubble it's also important to note that at the end of November US stocks represented over 70% of the msci world index the highest percentage since 1970 according to another symbolist chart thus it's clear that a US companies are worth a lot compared to the companies in other regions and B the top seven US stocks are worth a heightened amount

relative to the rest of us stocks but is it a bubble what is a bubble [Music] investment lingo comes and goes my Young Oak Tree colleagues use a lot of terms these days for which I have to request translation but bubble and crash have been in the financial lexicon for as long as I've been in the investment business and I imagine they'll remain there for generations to come today the mainstream media uses them broadly and people seem to consider them to be subject to objective definition but for me a bubble or crash is more a

state of mind than a quantitative calculation in my view a bubble not only reflects a rapid rise in stock prices but it is a temporary Mania characterized by or perhaps better resulting from the following highly irrational exuberance to borrow a term from former Federal Reserve chair Alan Greenspan outright Adoration of the subject companies or assets and a belief that they can't miss massive fear of being left behind if one fails to participate fomo and resulting conviction that for these stocks there's no price too high no price too high stands out to me in particular when

you can't imagine any flaws in the argument and are terrified that your officemate golf partner brother-in-law competitor will own the asset in question and you won't it's hard to conclude there's a price at which you shouldn't buy as Charles kindleberger and Robert Alber observed in the fifth edition of Manas panics and crashes a history of financial crisis there is nothing so disturbing to one's well-being and judgment as to see a friend get rich so to discern a bubble you can look at valuation parameters but I've long believed a psychological diagnosis is more effective whenever I

hear there's no price too high or one of its variants a more disciplined investor might say of course there's a price that's too high but we're not there yet I consider it a sure sign that a bubble is brewing roughly 50 years ago an elder gave me the gift of one of my favorite maxims I've written about it several times in my memos but in my opinion I can't do so often enough it's the three stages of the bull market the first stage usually comes on the heels of a market decline or crash that has

left most most investors licking their wounds and highly dispirited at this point only a few unusually insightful people are capable of imagining that there could be Improvement ahead in the second stage the economy companies and markets are doing well and most people accept that Improvement is actually taking place in the third stage after a period in which the economic news has been great companies have reported soaring earnings and stocks have appreciated Wild L everyone concludes that things can only get better forever the important inferences aren't with regard to economic or corporate events they involve investor

psychology it's not a matter of what's happening in the macro world it's how people view the developments when few people think there can be Improvement security prices by definition don't incorporate much optimism but when everyone believes things can only get better forever it can be hard to find anything that's reasonably priced bubbles are marked by Bubble thinking perhaps for working purposes we should say that bubbles and crashes are times when extreme events cause people to lose their objectivity and view the world through highly skewed psychology either too positive or too negative here's how kindleberger put

it in the first edition of Manas panics and crashes as firms or households see others making profits from speculative purchases and resales they tend to follow when the number of firms and households indulging in these practices grows larger bringing in segments of the population that are normally aloof from such Ventures speculation for profit leads away from normal rational Behavior to what have been described as Manas or bubbles the word Mania emphasizes the irrationality bubble for Shadows the bursting for me it's psychological extremeness that marks a bubble often as kindleberger indicates it can be inferred from

widespread participation in the investment fad of the moment especially among non-financial types Legend has it that JP Morgan knew there was a problem when the person shining his shoes started giving him stock tips my partner John Frank says he saw it in 2000 when he heard the dad at his son's soccer game bragging about the tech stocks they owned and again in 2006 when a Las Vegas cab driver told him about the three condos he'd purchased when Mark Twain purportedly said history doesn't repeat itself but it often Rhymes it's this kind of thing he was

talking about the new new thing if bubble thinking is irrational what is it that permits investors to get away from rational thinking like the thrust of a rocket ship that breaks free of the limits imposed by gravity and attains escape velocity there's a simple answer newness this phenomenon relies on another time honored investment phrase this time is different bubbles are invariably associated with new developments there were bubbles in the nifty50 stocks in the 1960s more on them later disc drive companies in the 1980s TMT interet stocks in the late 1990s and subprime mortgage-backed securities in

2004 to 06 these relatively recent Manas followed in the tradition of ones like a 1630s craze in Holland over recently introduced tulips and B the south sea bubble in 1720 England concerning the riches that were sure to ensue from a trading Monopoly that the crown had awarded to the south sea company in normal circumstances if an industry's or a country's Securities are attracting unusually high valuations investment historians are able to point out that in the past those stocks had never sold at more than an x% premium over the average or some similar metric in this

way attention to history can serve as a tether keeping a favored group grounded on terrafirma but if something's new meaning there is no history then there's nothing to temper enthusiasm after all it's owned by the brightest people the ones who are showing up in the headlines and on TV and they've made a fortune who's willing to throw a wet blanket over that party or sit out that dance the explanation often lies in Hans Christian Anderson's story The Emperor's New Clothes Khan men sell the emperor an allegedly gorgeous suit of clothes that only intelligent people can

see but in actuality there is no suit when the emperor parades around town naked the citizens are afraid to say they don't see a suit since that would mark them as unintelligent this goes on unchecked until a young boy steps out of the crowd and in his naive Tay points out that the emperor has no clothes most people would rather go along with a shared delusion that's making investors buckets of money then say something to the contrary and appear to be dummy when a whole Market or a group of Securities is blasting off and a

specious idea is making its adherence Rich few people will risk calling it out my baptism Under Fire they say experience is what you got when you didn't get what you wanted and I got my most formative experience at the very beginning of my career as many of my memo readers know I joined the equity research department at First National City Bank now City in September 1969 as was the case with most of the so-called Money Center Banks City invested mainly in the nifty50 stocks of the best and fastest growing companies in America these companies were

considered to be so good that a nothing bad could ever happen and B there was no price too high for their stocks literally three factors contributed to investors fascination with these stocks first the US economy grew strongly in the post World War II period second these companies benefited from their involvement with areas of innovation such as computers drugs and consumer products and third they represented the first wave of growth stocks a new investment style that separately became a fad in itself the nifty50 were the object of the first big bubble in ru 40 years and

since there hadn't been one for so long investors had forgotten what a bubble looks like as a result of the popularity that was conferred on them if you bought these stocks on the day I started work and held them tenaciously for 5 years you lost well over 90% of your money in the best companies in America what happened the nifty50 had been put on a pedestal and investors get hurt when something Falls from it the stock market as a whole declined by about half in 1973 to 74 and it turned out these stocks had been

selling at prices that actually were too high in many cases their price to earnings ratios fell from the range of 60 to 90 to the range of 6 to9 that's the easy way to lose 90% further bad things actually did happen to several of the companies in fundamental terms my early brush with a genuine bubble caused me to formulate some guiding principles that carried me through the next 50 odd years it's not what you buy it's what you pay that counts good investing doesn't come from buying good things but from buying things well there's no

asset so good that it can't become overpriced and thus dangerous and there are few assets so bad that they can't get cheap enough to be a bargain things can only get better [Music] the bubbles I've lived through have all involved Innovations as I noted previously and many of those were either overestimated or not fully understood the attractions of a new product or way of doing business are usually obvious but the potholes and pitfalls are often hidden and only discovered in trying times a new company May completely outclass its predecessors but investors who by definition lack

experience in this new field often fail to grasp that even a bright newcomer can be supplanted the disruptors can be disrupted whether by skillful competitors or even newer Technologies in my early decades in business technology seemed to evolve gradually computers drugs and other Innovative products improved a little at a time but in the 1990s Innovation came in a big rush when oak tree was founded in 1995 I insisted that I could get by with just word perfect for word processing and loadest 123 for spreadsheets but when we moved to our current office in 1998 I

threw in the towel and let our it team install email and the internet and of course Word Perfect gave way to word and Lotus 123 to excel at the time investors were sure the internet will change the world it certainly looked that way and that assumption prompted tremendous demand for everything internet related e-commerce stocks went public at seemingly high prices and then tripled the first day there was a real gold rush there's usually a grain of truth that underlies every Mania and bubble it just gets taken too far it's clear that the internet absolutely did

change the world in fact we can't imagine a world without it but the vast majority of internet and e-commerce companies that soared in the late '90s bubble ended up worthless when a bubble burst in my early investing days The Wall Street Journal would run a box on the front page listing stocks that were down by 90% in the aftermath of the TMT bubble they'd lost 99% when something is on the pedestal of popularity the risk of a decline is high when people assume and price in an expectation that things can only get better the Damage

Done by negative surprises is profound when something is new the competitors and disruptive technologies have yet to arrive the Merit may be there but if it's overestimated it can be overpriced only to evaporate when reality sets in in the real world trees don't grow to the sky the forgoing discussion centered on the risk of overestimating fundamental strength but optimism surrounding the power and potential of the new thing often causes the error to be compounded through the assignment of too high a stock price as mentioned previously for something new there by definition is no historical indicator

of what an appropriate valuation might be further the company's potential hasn't yet been turned into steady state profits meaning the thing that's being valued is conjectural in the TMT bubble the companies didn't have earnings so PE ratios were out and as startups they often didn't have revenues to Value as a result new metrics were invented and trusting investors ended up paying a multiple of clicks or eyeballs regardless of whether these measurables could be turned into revenues and profits since bubble participants can't imagine there being any downside they tend to award valuations that assume success in

fact it's not infrequent for investors to treat all contenders in a new field as likely to succeed whereas in reality only a few May Thrive or perhaps even survive ultimately the really hot new thing investors can adopt what I call a lottery ticket mentality if a successful startup in a hot field can return 200x it's mathematically worth investing in even if it's only 1% likely to succeed Ed and what doesn't have a 1% likelihood of success when investors think this way there are few limits on what they'll support or the prices they'll pay obviously investors

can get caught up in the race to buy the new new thing that's where the bubble comes in what's the appropriate price to pay for a bright future if there's a company for sale that will make $1 million next year and then shut down how much would you pay for it the right answer is a little less than $1 million so that you'll have a positive return on your money but stocks are priced at PE multiples that is multiples of next year's earnings why because presumably they won't earn profits for just one year they'll go

on making money from any more when you buy a stock you buy a share of the company's earnings every year into the future the price of the s P 500 has averaged roughly 16 times earnings in the post World War II period this is typically described as meaning you're paying for 16 years of earnings it's actually more than that though because the process of discounting makes $1 of profit in the future worth less than $1 today the current value of a company is the discounted present value of its future earnings so a PE ratio of

16 means you're paying for more than 20 years of earnings depending on the interest rate at which future earnings are discounted in bubbles hot stocks sell for considerably more than 16 times earnings remember the 60 to 90 times for the nifty50 investors in 1969 were paying for company's earnings even after giving them credit for significant earnings growth many decades into the future did they do so consciously and analytically not that I recall investors thought of a PE ratio as just a number if they thought about it at all today's SNP leading companies are in many

ways much better than the best companies of the past they enjoy massive technological advantages they have vast scale dominant market shares and thus above average profit margins and since their products are based on ideas more than metal the marginal cost of producing an additional unit is low meaning their marginal profitability is unusually high the further good news is that today's leaders don't trade at the PE ratios investors applied to the nifty50 perhaps the sexiest of the seven is NVIDIA the leading designer of chips for artificial intelligence it's current multiple of future earnings is in the

low3s depending on which earnings estimate you believe while double the average post-war PE on the S&P 500 that's cheap compared to the nifty50 but what does a multiple in the 30s imply first that investors think Nvidia will be in business for decades to come second that its profits will grow throughout those decades and third that it won't be supplanted by competitors in other words investors are assuming Nvidia will demonstrate persistence but persistence isn't easily achieved especially in Hightech Fields where new technologies can arise and new competitors can leap frog incumbents it's worth noting for example

that only about half the nifty50 as enumerated by Wikipedia there is no agreed on list are in the S&P 500 today that figure undoubtedly looks worse than the reality since mergers and Acquisitions cause caused some of the old names to disappear not failures leading lights of 1969 that are missing from the S&P 500 today include Xerox Kodak Polaroid Avon burrow digital equipment and my favorite Simplicity pattern how many people make their own clothing these days another indication of how hard it is to persist can be seen in the names of the top 20 S&P 500

companies at the beginning of 2000 according to fin hacker. CZ these 20 companies were the most heavily represented in the index Microsoft General Electric Cisco Systems Walmart Exxon Mobile Intel City Group IBM Oracle Home Depot Merc cocacola Proctor and Gamble AIG Johnson and Johnson Qualcomm Bristol Meers squib fizer AT&T Verizon at the beginning of 2024 however only six of them were still in the top 20 Microsoft Walmart Exxon Mobile Johnson and Johnson Proctor and Gamble Home Depot importantly of today's magnificent 7 only Microsoft was in the top 20 24 years ago in bubbles investors treat

the leading companies and pay for their stocks as though the firms are sure to remain main leaders for decades some do and some don't but change seems to be more the rule than persistence whole [Music] markets the greatest bubbles usually originate in connection with Innovations mostly technological or financial and they initially affect a small group of stocks but sometimes they extend to whole markets as the fervor for a bubble group spreads to everything in the 1990s the S&P 500 was borne aoft by a the continuing decline of interest rates from their inflation fighting peak in

the early 1980s and B the return of investor enthusiasm for stocks that had been lost in the traumatic 70s technological innovation and the rapid earnings growth of the high-tech companies added to the excitement and an upswing in the popularity of stocks was reinforced by new academic research showing there had never been a long period in which the S&P 500 failed to outperform bonds cash and inflation the combination of these positive factors caused the annual return on the index to average more than 20% for the decade I've never seen another period like it I always say

the riskiest thing in the world is the belief that there's no risk in a similar vein heated buying spurred by the observation that stocks had never performed poorly for a long period caused stock prices to rise to a point from which they were destined to do just that in my view that's George soros's investment reflexivity at work stocks were tarred in the bursting of the TMT bubble and the SNP 500 declined in 2000 2001 and 2002 for the first three-year decline since 1939 during the Great Depression as a consequence of this poor performance investors deserted

stocks on mass causing the S&P 500 to have a cumulative return of zero for the more than 11 years from the bubble peak in mid 2000 until December 2011 lately I've been repeating a quote I attribute to Warren Buffett when investors forget that corporate profits grow about 7% per year they tend to get into trouble what this means is that if corporate profits grow at 7% a year and stock stocks which represent a share in corporate profits appreciate at 20% a year for a while eventually stocks will be so highly priced relative to their earnings

that they'll be risky I recently asked Warren for a source on the quote and he told me he never said it but I think it's great so I keep using it the point is that when stocks rise too fast out of proportion to the growth in the underlying company's earnings they're unlikely to keep on appreciating by symbolist has another chart that makes this point it shows that prior to two years ago there were only four times in the history of the S&P 500 when it returned 20% or more for 2 years in a row in

three of those four instances a small sample mind you the index declined in the subsequent 2-year period the exception was 1995 to 98 when the powerful TMT bubble caused the decline to be delayed until 2000 but then the index lost almost 40% in 3 years in the last 2 years it's happened for the fifth time the S&P 500 was up 26% in 2023 and 25% in 2024 for the best 2-year stretch since 1997 to '98 that brings us to 2025 what lies ahead the cautionary signs today include these the optimism that has prevailed in the

markets since late 2020 2 the above average valuation on the SNP 500 and the fact that its stocks in most industrial groups sell at higher multiples than stocks in those Industries in the rest of the world the enthusiasm that is being applied to the new thing of AI and perhaps the extension of that positive psychology to other high-tech areas the implicit presumption that the top seven companies will continue to be successful and the possibility that some of of the appreciation of the S&P has stemmed from automated buying of these stocks by index investors without regard

for their intrinsic value finally while I'm at it although it's not directly related to stocks I have to mention Bitcoin regardless of its Merit the fact that its price Rose 465 in the last 2 years doesn't suggest an overabundance of caution I often find that just as I'm about to release a memo for publication something comes along that demands inclusion and it has happened again on the last day of 20124 I received something from two sources that fits that description the graph from JP Morgan Asset Management has a square for each month from 1988 through

late 2024 meaning there are just short of 324 monthly observations 27 years time 12 each Square shows the forward PE ratio on the S&P 500 at the time and the annualized return over the subsequent 10 years the graph gives rise to some important observations there's a strong relationship between starting valuations and subsequent annualized 10-year returns higher starting valuations consistently lead to lower returns and vice versa there are minor variations in the observ ations but no serious exceptions today's PE ratio is clearly well into the top desile of observations in that 27-year period when people bought

the S&P at price to earnings ratios in line with today's multiple of 22 they always earned 10year returns between plus 2% and minus 2% in November a couple of leading Banks came out with projected 10-year returns for the S&P 500 in the low to mid single digits the just mentioned relationship is the reason it shouldn't come as a surprise that the return on an investment is significantly a function of the price paid for it for that reason investors clearly shouldn't be indifferent to today's market valuation you might say making plus or minus 2% wouldn't be

the worst thing in the world and that's certainly true if stocks were to sit still for the next 10 years as the company earnings Rose bringing the multiples back to Earth but another possibility is that the multiple correction is compressed into a year or two implying a big decline in stock prices such as we saw in 1973 to 74 and 20202 the result in that case wouldn't be benign these are the things to worry about here are the counterarguments the PE ratio on the S&P 500 is high but not insane the Magnificent 7 are incredible

companies so their high PE ratios could be warranted I don't hear people saying there's no price too high and the markets while high pric and perhaps frothy don't seem nutty to me as I said at the start of this memo I'm not an equity investor and I'm certainly no expert on technology thus I can't speak authorit ly about whether we're in a bubble I just want to lay out the facts as I see them and suggest how you might think about them just as I did 25 years ago I hope you'll keep listening for the

next 25 January 7th [Music] 2025 thank you for listening to the memo by Howard marks to hear more episodes be sure to subscribe wherever you listen to podcast [Music] CS this podcast expresses the views of the author as of the date indicated and such views are subject to change without notice oak tree has no Duty or obligation to update the information contained herein further oak tree makes no representation and it should not be assumed that past investment performance is an indication of future results moreover wherever there is a potential for profit there is also the

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