The Stock Market is One Giant Bubble. (Howard Marks Explains)

People are now convinced AI will change the world; I imagine it will. Every bubble uses widespread conviction. Everybody believes they bid the beneficiaries of a up to the Moon. It turns out it's overdone. There's Howard Marks, the founder of Oak Tree Capital. Honestly, I love following what Howard has to say because, as you heard in that clip, he has an amazing ability of being rather frank and telling it how it is. Kind of similar to the late Charlie Munger in that respect.

Over the years, he's used this super rational approach to financial markets to take advantage of times where they're anything but rational. In fact, his snowball is worth over $2.2 billion. Howard is a very well-respected investor in the field, and because of his ultra-rational approach, my ears definitely perked up when I saw that recently he sat down to talk about a very frothy subset of stocks, that being the Magnificent 7, and how that's affecting the stock market more broadly at this point.

Long story short, he is noticing some similarities between the market of today and bubble markets of yesteryear. This stuff isn't easy, and anybody thinks it's easy is misleading. So, what on Earth is going on? Well, the Magnificent 7 are a group of U.S. tech giants that are responsible for an unusually large percentage of the stock market's overall gains across the last few years. The companies in question are Apple, Google, Amazon, Meta, Microsoft, Nvidia, and Tesla.

If you want a crazy stat, this selection of seven businesses returned more than 106% into 2023, doubling the NASDAQ 100's 54% gain and significantly outperforming the S&P 500's 24% gain. This is the long-term stock chart for each of the seven businesses we're talking about, and you can notice one thing in common, right? They’re all up and to the right, but particularly across the last few years, with the one exception being Tesla.

This is because, ever since the profound unveiling of OpenAI’s ChatGPT, these seven behemoths have all been scrambling to invest heavily in AI technology and have each announced significant plans to build out their own various artificial intelligence infrastructures to capitalize on this new technology. Now, that's great, but the problem for investors globally is this: with any new technology, AI is at such an early stage that none of these businesses besides Nvidia are currently recognizing notable profits from their AI efforts.

But the general consensus is that artificial intelligence will indeed be a profound technology of the future. So, what this has led to is a situation where a lot of investors and speculators have bought shares in these businesses on the hopes that eventually this technology that they're all working on will bear fruit. This is what's meant when market commentators say the market is pricing it in. It means investors are agreeing to pay higher prices for these shares now when the current profits don't suggest that's a wise idea, in the hope that someday down the track, once these companies have generated their polished AI products and services, their profits will then play catch up.

The earnings of the business will grow to a point where the high price all of a sudden becomes more fair. Take a business like Nvidia, for example. Across the last 12 months, they generated $1.93 in earnings for each one of their shares, yet each share costs $898. That's a price-to-earnings ratio of 75. AKA you pay 75 times the company's earnings per share as a price. Now, the average PE ratio for the S&P 500 over history has been about 16; it currently sits at around 27, meaning investors are willing to fork out 27 times the earnings of the S&P 500 just to own it.

So, it doesn't take a genius to see that right now, investors are having to pay up to own Nvidia. The share price is very high relative to what the actual business earns currently, and that opens up investors to a big risk. Well, risk is never easy. The obvious answer is that you invest in the Magnificent 7 because you think their earnings growth will be so rapid you overweight them, and then it isn't, so your large holdings suffer because they didn't live up to expectations, and that's the argument from a large contingent of the value investing crowd right now.

These stocks have skyrocketed over the last few years to some very eye-watering valuations, and it's changed the typical investment philosophy. It's gone from a few years ago, where you'd be paying a fair or slightly expensive price for these high-quality businesses, with any future profits that came from AI investment being a bonus, to now investing at very high valuations for where the business is currently, and then crossing your fingers the AI will indeed become a game-changer, which will cause the earnings of these companies to rise above and beyond what's needed to justify their current valuations.

So, that's why the Magnificent 7 looks very bubbly right now to value-style investors: the fact that if you want in, you have to pay a very high price now. So, that's the first side of the story. Just before I show you what Howard Marks' opinion of The Magnificent 7 is, I quickly wanted to talk about something that's honestly not the easiest thing to discuss, particularly for us men. My channel analytics say that nine out of ten of you guys are dudes, and that topic is mental health.

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As we discussed before, the Magnificent 7 from a value investor's perspective look very expensive, but of course, not everyone is of the opinion that these stocks are bubbly. In fact, that's shown every day by the fact that there are still plenty of shares being bought in fast quantities at these current prices. So, why is that? Well, it's because there is another investment philosophy that actually supports the purchase of these shares, and that is the field of growth investing.

So, growth investors have the opinion that sometimes it is worth paying up for a business if they have ample long-term growth runways ahead of them. An example here might have been, say, Tesla back in 2014 or 15 or 16. The shares were undeniably expensive for what the business was showing at the time. In fact, the company wasn't even profitable back then, but investors could see the runway of the upcoming Model 3, the plans to build out the new factories, the plans to make their own battery sales, and they thought that had potential to lead to future profits, which would more than make up for the business's pricey valuation at that time.

Now, fast forward to 2024, and that turned out to be a very good buy, even as the stock sits down 58% from its all-time highs a few years ago. It's this clash of investment philosophy when it comes to the Magnificent 7 which is what causes this to be such a controversial topic in the media. So, there's always two sides to it. As Howard is about to explain, it's really important to look at risks two-sided.

The corresponding risk is that you don't overweight them, and then they perform earnings-wise as expected, and you're left behind. It's not just what will you do about the risk of a shortfall in anything; it's also what will you do about the corresponding risk that there is no shortfall. And there's no easy answer. This is why I really like Howard Marks as an investor. He always looks at both sides of the equation. That's what makes him so effective, and it's something we can definitely learn from him.

It's the same thing that Charlie Munger always used to do. He always looked to invert, come up with the thesis, then come up with the antithesis to ask, "Why am I right?" and then ask, "Well, why am I wrong?" So, I hope that shows that there are definitely two sides of The Magnificent Seven debate. There's the debate that the valuations are too high for what the businesses are currently putting out, but there's also the debate that if you don't get in now, you're going to miss the AI boat, which is something you really don't want to do.

I just think that in our business in general, there is no room for certainty, as Twain would say, and that extends to the Magnificent 7 as well. So, with that said and with that in mind, what is Howard's opinion on the Magnificent 7? Well, even considering his very balanced approach, he does take the time to just warn investors of some striking similarities between the Magnificent 7 now and prior stock market bubbles, notably the bubble which, as you are all very well aware, ended in disaster.

Now, he of course is not in the game of predicting things, but he did make the comparison in this interview, which is actually quite striking, because a lot of the ingredients that were there last time are also present this time around. Every bubble ensues from widespread conviction. Everybody believes they bid the beneficiaries of a up to the Moon. It turns out it's overdone. That's what we saw happen in 1999 with the internet stocks, and that's what we're seeing again with the Magnificent 7 and AI.

Despite the small pocket of value investors in the world right now, there is widespread conviction in AI, which has caused investors to bid these stocks up to eye-watering valuations. While there's a possibility that that turns out to be justified, we are a long way from that, and market behavior is getting increasingly speculative. People are now convinced AI will change the world; I imagine it will. I don't know how to invest in it. I don't know if the future of AI is adequately reflected in the price of the beneficiaries or over-reflected.

If you go back 25 years ago exactly to mid-1999, everybody was sure that the internet would change the world, and it did. Can you imagine today living without the internet and e-commerce and so forth? And yet the internet and e-commerce stocks that were the beneficiaries of that thinking in the TMT bubble of the late 90s— the vast majority are now worthless.

Howard raises a really interesting point here that, in fact, because we're so early in the AI revolution, while billions of dollars are flowing into these seven large tech companies, the truth of the matter is who knows if these will even be the companies that will make the most successful AI products and services in say 5 to 10 years from now? I actually asked ChatGPT just now what the high-flying internet stocks were during the dot bubble that were rising like the Magnificent 7 is today. Now, do you see any of these companies thriving today?

Howard's point here is that you have to be careful with tech in its infancy. Warren Buffett noted in the 2021 Berkshire shareholder meeting that back during the early 1900s, with the rise of the automobile, there were hundreds of auto manufacturers in America. Across those few decades, then, in 2009, there were three left, and two went bankrupt. So there is perhaps more risk than investors think betting on the Magnificent 7 purely for a bet on the future of AI.

Firstly, we don't know the future of AI. As we sit here in 2024, I'm sure it will be a big technology of the future, but we don't know what it will predominantly be used for in say 10 to 20 years. Then, secondly, we also don't know whether these seven stocks will be the AI Behemoth stocks that will collect the lion's share of the revenue in the future. Nvidia seems to be in the box seat for revenue generation, but that's because they're selling the hardware for this to all happen, as opposed to the other companies that are trying to build the AI services of the future.

I run through this only to say that this stuff isn't easy, and anybody thinks it's easy is misleading themselves. So to say, "Well, I think that AI will be very important," that's the easy part, but knowing how it should be reflected in portfolios, that's the hard. I think this is sage wisdom for a lot of investors right now. It's probably true that AI will be a very dominant technology of the future, but we should really be thinking critically about how we bet.

If we bet on that as investors, yes, there's a risk of missing out on being early, but there's also risks that the tech is in its infancy, and who knows what the future products, services, or winning companies will be. Remember Ben Graham's definition of an investment: an investment operation is one which, upon thorough analysis, promises safety of principle and a satisfactory return.

Is investing in AI now a well-calculated investment, or is it too speculative to make sense? Definitely let me know what you think down in the comments below. Guys, thanks very much for watching. Leave a like if you did enjoy, and if you want to learn how to properly value stocks through three different valuation methods, please check out Introduction to Stock Analysis over on New Money Education. The link will be in the description, but with that said, I'll see you guys in the next video.

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