Are things getting bubbly? I have just finished reading another gem by Howard Marks. As the co-founder of Oaktree Capital Management, established in 1995, he is definitely one of my favorite financial writers out there. You can always count on him for insights that make you think.
Here is a section:
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 aloft 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. 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 have never seen another period like it.
I always say the riskiest thing in the world is the belief that there is 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 is George Soros’s investment “reflexivity” at work.
Stocks were tarred in the bursting of the TMT Bubble, and the S&P 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 en masse, causing the S&P 500 to have a cumulative return of zero for the more than eleven years from the bubble peak in mid-2000 until December 2011.
Lately, I have 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 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 will be risky.