Will the high P/E ratio and AI's optimistic sentiment form a bubble in the latest memo from Howard Marks?

Investing guru Howard Marks discussed the issue of market bubbles in his latest memo 'On Bubble Watch,' especially whether there is a risk of a bubble in the seven giant stocks that everyone follows and the excessively high price-to-earnings ratio in the United States.

Are the seven giants and the US stock market experiencing a bubble?

The top seven stocks in the S&P 500 index (known as the seven giants) include Apple, Microsoft, Alphabet (Google's parent company), Amazon, Nvidia, Meta (Facebook's parent company), and Tesla. In recent years, these stocks have dominated the S&P 500 index and 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 components of the S&P 500 index accounted for 32-33% of the total market value of the index.

This proportion is approximately double the leading share five years ago.

Before the emergence of the "Big Seven", the highest share of the top seven stocks in the past 28 years was about 22% during the peak of the 2000 Internet bubble.

As of the end of November, the US stock market accounted for over 70% of the MSCI World Index, the highest proportion since 1970. Therefore, it is obvious:

Compared to companies in other regions, the valuation of American companies is very high

The value of the top seven US stocks is relatively higher compared to other US stocks.

Will this create a bubble?

The special micro and signal of the bubble

'Bubble' and 'collapse' have always been present in the financial dictionary, but for Howard Marks, they are more of a mentality than a quantitative calculation.

The bubble not only reflects the rapid rise in stock prices, but also is a temporary frenzy, characterized by:

Highly irrational prosperity

Thorough admiration for the target company or assets, and the belief that they cannot be missed

I am deeply worried that if I don't participate, I will be left behind, that is, the FOMO sentiment.

The resulting belief is that these stocks are not "overpriced".

Howard Marks believes that the most important thing is that there is 'no price too high', so to identify a bubble, one can certainly observe valuation parameters, but he believes that psychological diagnosis is more effective. If you hear 'no price too high' or 'of course the price is a bit high, but it hasn't reached that stage yet', this is a clear signal that a bubble is brewing.

Three stages of a bull market

Howard Marks also mentioned the three stages of a bull market:

The first phase usually occurs after a market downturn or crash, leaving most investors licking their wounds and feeling very discouraged. At this point, only a few insightful individuals can imagine that there might be improvement in the future.

In the second stage, the economy, businesses, and markets are all performing well, and most people acknowledge that improvements are indeed happening.

In the third stage, after a period of positive economic news, soaring corporate profits, and significant stock appreciation, everyone came to the conclusion that things will only get better.

And after the third phase, it often leads to the occurrence of bubbles.

Bubble thinking: This time is different!

If bubble thinking is irrational, then what makes investors break free from rational thinking, just like the thrust of a rocket breaking through the limits of gravity 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, it means there is no history, so there is nothing to suppress enthusiasm. These bubbles involve innovation, many of which are either overvalued or not fully understood. Like the internet bubble, the biggest bubbles usually originate from innovation, mainly technological or financial innovation, initially affecting a small number of stocks. But sometimes they expand to the entire market because enthusiasm for bubbles spreads to all areas.

Is it a bubble now?

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

The general optimism in the market since the end of 2022

The valuation of the S&P 500 index is higher than the average level, and the price-earnings ratio of most industrial stocks is higher than that of other regions in the world.

The enthusiasm of people for this new thing called artificial intelligence, and perhaps the enthusiasm of this positive psychology extending to other high-tech fields.

The top seven companies will continue to succeed on the implicit assumption

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 comes from J.P. Morgan Asset Management. From 1988 to the end of 2014, each month is represented by a square, with each square showing the forward P/E ratio of the S&P 500 index at the time and the subsequent 10-year annualized return.

It can be seen that a higher initial valuation (forward P/E ratio) will lead to lower returns, and vice versa. The current forward P/E ratio is already higher than over 90% of historical data. Over the past 27 years, when people bought the S&P 500 index at today's 22 times earnings ratio, their ten-year return rate was always between +2% and -2%.

The rebuttal of not having to worry about bubbles

Howard Marks observed many pre-bubble phenomena, but he also raised counterarguments:

The price-to-earnings ratio of the S&P 500 index is high, but not crazy.

The seven giants are all incredible companies, so their high P/E ratios are guaranteed

I haven't heard any comments like 'the price is not too high' or 'of course the price is a bit high, but not at that level'.

In conclusion, Howard Marks did not explicitly state whether we are currently in a bubble. He simply elaborated on the facts he sees and suggested how investors should think. In addition, he also mentioned Bitcoin in the memo.

Howard Marks mentioned Bitcoin

In 2017, Howard Marks described cryptocurrencies as a Ponzi scheme and compared them to the tulip and internet bubbles. However, when he mentioned cryptocurrencies again in 2021, he claimed that he was learning about them with an open mind and thanked his son for holding a considerable amount of Bitcoin.

(2017 called it a Ponzi scheme, Howard Marks' latest memo: Thanking my son for holding a substantial amount of Bitcoin)

In the memo, Howard Marks also mentioned Bitcoin, saying:

Regardless of its merits, its price has increased by 465% in the past two years, which does not mean that one should be overly cautious.

This article, Howard Marks' latest memo, will high P/E ratios and AI optimism create a bubble? First appeared in ChainNews ABMedia.