From Oaktree Capital, January 7:
Exactly 25 years ago today, I published the first memo that brought a response from readers (after having written for almost ten 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 Oaktree 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’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 mid-aughts, which gave rise to (a) extending mortgages to sub-prime borrowers who couldn’t or wouldn’t document income or assets, (b) the structuring of those loans into levered, tranched mortgage-backed securities, and consequently (c) 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 & Poor’s 500 and the handful of stocks that have been leading it.
The seven top stocks in the S&P 500 – the so-called “Magnificent Seven” – are Apple, Microsoft, Alphabet (Google’s parent), Amazon.com, Nvidia, Meta (owner of 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 Cembalest, chief strategist at J.P. Morgan Asset Management, shows that:
the market capitalization of the seven largest components of the S&P 500 represented 32-33% of the index’s total capitalization at the end of October;
that percentage is roughly double the leaders’ share five years ago; and
prior to the emergence of the “Magnificent Seven,” 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, U.S. stocks represented over 70% of the MSCI World Index, the highest percentage since 1970 according to another Cembalest chart. Thus, it’s clear that (a) U.S. companies are worth a lot compared to the companies in other regions and (b) the top seven U.S. stocks are worth a heightened amount relative to the rest of U.S. stocks. But is it a bubble?
What Is a Bubble?
Investment lingo comes and goes. My young Oaktree 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 Aliber observed in the fifth edition of Manias, Panics, and Crashes: A History of Financial Crises, “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....
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