Is there a bubble risk in Huaxia Max’s latest memorandum due to excessive P/E ratio and AI optimism?

Investment guru Howard Marks discusses the issue of market bubbles in his latest memo titled “On Bubble Watch”. He specifically addresses concerns about the seven giant stocks and the high price-to-earnings ratio in the US market, questioning 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 contributed disproportionately to its gains. According to data from J.P. Morgan Asset Management:

At the end of October, the market capitalization of the seven major constituents of the S&P 500 accounted for 32-33% of the total market capitalization of the index.
This proportion is approximately twice the share of the previous leaders in the index five years ago.
Prior to the emergence of the seven giants, the highest share of the top seven stocks in the past 28 years was approximately 22% during the peak of the dot-com bubble in 2000.
By the end of November, the US stock market accounted for over 70% of the MSCI World Index, the highest proportion since 1970. It is clear that:

Compared to companies in other regions, US companies are highly valued.
The value of the top seven US stocks is higher relative to other US stocks.
Does this form a bubble?

Characteristics and signals of bubbles

“Bubble” and “collapse” have always been present in the financial lexicon, but for Howard Marks, bubbles or crashes are more of a mindset than a quantitative calculation. Bubbles not only reflect rapid price increases but also represent a temporary frenzy characterized by:

Highly irrational prosperity.
Thorough adoration of target companies or assets and a belief that one cannot afford to miss out (FOMO).
The resulting belief is that these stocks are “not overpriced.”
Marks believes that the most important factor in identifying a bubble is the belief that “no price is too high.” While valuation parameters can be observed, he believes that psychological diagnosis is more effective. If you hear statements like “prices are not too high” or “of course, prices are a bit high, but not at 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 very frustrated. At this point, only a few insightful people can imagine that things may improve in the future.
In the second stage, the economy, companies, and the market perform well, and most people acknowledge that improvements are indeed occurring.
In the third stage, after a period of positive economic news, soaring corporate profits, and significant stock price increases, everyone concludes that things can 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, like the thrust of a rocket breaking through the limits of gravity and achieving 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, nothing to restrain 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, initially impacting a small number of stocks. However, sometimes they expand to the entire market as the enthusiasm for bubbles spreads to all sectors.

Is it a bubble now?

Marks lists the warning signs in the current market, including:

The prevailing optimism in the market since the end of 2022.
The higher valuation of the S&P 500 index compared to average levels, with the price-to-earnings ratios of most industrial groups higher than those in other regions.
The enthusiasm for artificial intelligence as a new phenomenon, and perhaps the positive psychology extending to other high-tech sectors.
The implicit assumption that the top seven companies will continue to be successful.
The partial appreciation of the S&P index may stem from 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. Each square represents a month, and 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 higher than over 90% of the data. In these 27 years, when people bought the S&P 500 index at a price-to-earnings ratio of 22 times today, their ten-year return was always between +2% and -2%.

Arguments against worrying about bubbles

Marks observes many early signs of bubbles, but he also presents 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.
There haven’t been any statements like “prices are not too high” or “of course, prices are a bit high, but not at 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 advises investors on how to think. Additionally, he mentions Bitcoin in the memo.

Marks mentions Bitcoin

In 2017, Marks described cryptocurrencies as a Ponzi scheme, comparing them to tulip mania and the dot-com bubble. However, in 2021, when he mentioned cryptocurrencies again, he stated that he is open-minded and trying to learn, and he expressed gratitude for his son holding a significant amount of Bitcoin.

(Remarks in 2017 called it a Ponzi scheme, Howard Marks’ latest memo: Thankful for my son holding a substantial amount of Bitcoin)

In the 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 that one should be overly cautious.

Risk Warning

Cryptocurrency investments are highly risky, and prices can fluctuate dramatically. You may lose all of your capital. Please evaluate the risks carefully.