The musings of famed investor and market watcher Howard Marks are always worth reading. Marks, co-founder of a Los Angeles-based investment firm Oaktree Capital, has a pithy way of discussing investing and investors. (See SMI's April 2024 article, What Risk Is — and Isn’t, excerpted from Marks's book, The Most Important Thing.)
In an early February interview (i.e., before the recent selloff), the Swiss website The Market asked Marks about high stock valuations and giddy investor optimism that seems mostly driven by enthusiasm regarding recent strides forward in artificial intelligence. Although optimism has surely taken a hit over the past couple of weeks, Marks's comments on investor psychology remain spot on.
Here's a snippet.
The title of your latest [market] memo is "On Bubble Watch." How do you define a bubble, and where do you think investors should be wary of one?
A bubble, much like a crash, is more a state of mind than a quantitative calculation. While some may define it as a period of extraordinary high prices, I believe that's insufficient. A real bubble is more than just a financial miscalculation, where people make the mistake of overpaying for something.
It goes beyond that to a psychological extreme. It's a mania where people's psyche gets engaged, their interest in something becomes excessive, and they lose their reason.
How is it even possible for such excesses to happen?
A bubble usually surrounds something new. The newness is very important because it gets people excited, and it defies precedent... I learned this lesson early. When I came into the investment business in 1969, it was during the Nifty Fifty bubble, which centered on the stocks of the best and fastest-growing companies in America....
The Nifty Fifty companies benefited from their involvement with areas of innovation such as computers, drugs, and consumer products. They were considered to be so good that nothing bad could ever happen, and people thought there was no price too high for these stocks. But...they were so many times overpriced that, five years later, you would have suffered a 95% loss on your investment.
In other words, a good company is not necessarily a good investment?
That's the key lesson. Investing is not about buying good things but about buying things well — and if you don't understand the difference, you shouldn't be an investor.... [T]here is nothing so good that it can't become overpriced and dangerous. Conversely, there's almost nothing so bad that it can't be a good buy at a low enough price.
But here's the problem: Bubbles are glaringly obvious in hindsight but rarely so when they're unfolding. In efficient markets, they shouldn't even exist. The idea that the market is always right is crazy....
Consider this: The day I started work, Xerox was trading at, let's say, $100. Five years later, it had plummeted to $5. It's hard for me to accept that those prices were both right. And yet, I am very comfortable with the concept of market efficiency.
How come?
In its essence, the efficient-market hypothesis says that the other people in the market are intelligent, highly motivated, and hard-working. So why should they leave bargains around for you to pick up? The point is, the market does a good job of instantly incorporating all the available information. That's what today's price is: It's an accurate, efficient reflection of the consensus opinion.
But that opinion can be wrong — and that's what bubbles are: profound mistakes, driven by psychological extremes, allowing prices to depart from sanity.... Unanimity of opinion is what drives markets to extremes. When there's a diversity of views, prices tend to hover within a reasonable range. But when people are unanimous, that's when things get crazy.
So how crazy is the current situation?
In my view, [market] psychology is optimistic but not insane.... [P]rices are lofty, but they're not crazy. And when prices are merely high, that doesn't mean the market is going to go down....
In short, this is not the time to get out?
No, this isn't one of those situations. The U.S. economy is doing well, and most companies, driven by a combination of economic growth and skilled management, tend to increase their profits over time. Hence, if you bet against the market, you're betting against these powerful forces. Historically, stocks go up roughly eight years out of 10, sometimes even nine or 10 years in a row.
So if you're going to bet that the market is going down, you're taking a big chance, and you have to have the odds on your side. Today, the odds are not sufficiently on your side to make that call.
Don't overreact
One of my formative investment experiences, in the late 1990s, was rushing for the exit too soon — perhaps influenced by Fed Chairman Alan Greenspan's concern about the market being "irrationally exuberant."
I could have used Howard Marks's advice: Be wary but don't overreact. His view aligns well with SMI's view. Yes, there are reasonable concerns about market valuations, higher interest rates, and geopolitical matters. However, we're content to take a wait-and-see approach regarding market direction while also acting strategically to implement new ways to temper volatility and expand our range of asset options.
No one knows whether the current market pullback is a temporary blip or the start of a significant downturn. It's wise to be wary, but don't overreact. Come what may, SMI's momentum-based mechanical process will help us chart a steady course.
(If you'd like to listen to Howard Marks discuss bubbles and investor psychology, check out his most recent podcast here.)
