Howard Marks: A Storm is Brewing in the Stock Market (The "AI Bubble")

Every bubble ensues from widespread conviction. People are now convinced AI will change the world. I imagine it will, but you know, if you go back 25 years ago, exactly to, uh, to mid-1999, everybody was sure that the internet would change the world. And it did. 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 not worthless.

Billionaire investor Howard Marks is warning about a $1.15 trillion dollar storm that is brewing in the stock market. Marks is the co-founder of Oaktree Capital Management, one of the most highly respected investment firms in the world. You see, Marks made his career out of being willing to go against the crowd. As legendary investor Warren Buffett puts it, "Be fearful when others are greedy, and be greedy when others are fearful."

Well, as you're about to hear, Howard Marks believes we are likely in one of those periods where it could save you a lot of money and financial pain to be fearful about what is happening in the stock market, particularly with the so-called Magnificent Seven stocks. Listen to him explain.

"Every bubble ensues from widespread conviction. Everybody believes they are the beneficiaries of a up to the Moon. It turns out it's overdone. And, uh, you know, people are now convinced AI will change the world. I may, 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, uh, uh, reflected.

But you know, if you go back 25 years ago, exactly to, uh, to mid-1999, everybody was sure that the internet would change the world, and it did. And can you imagine today living without the internet and e-commerce, and so forth? 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 not worthless.

So, uh, I run through this only to say that this stuff isn't easy, and anybody who thinks it's easy is misleading themselves. And so to say, 'Well, I think that the AI will be very important,' that's the easy part. But knowing how it should be reflected in portfolios, that's the hard part."

Throughout history, bubbles have often formed due to excitement about new technology. The stock market bubble of 1929 saw technology stocks of the day rise dramatically. Back then, an example of that new technology was the Advent of the radio. Oh boy, it's crazy how things change from 1921 to 1929. Radio Corp of America, or RCA for short, saw its stock increase from $1 a share to $573 a share as investors got excited about how radios would transform society. The radio did, in fact, go on to change the lives of people across the world.

However, that did not protect people who bought Radio Corp of America stock from losing a lot of money. RCA stock went on to fall by more than 95% as the bubble finally burst. There was also the dot-com bubble of the late 1990s. Here, investors and speculators were excited about how the internet would become an integral part of people's daily lives. The excitement was so high that even companies with little to no revenue saw their valuations skyrocket into the billions of dollars. Companies like Pets.com, Webvan, and Boo.com saw their stock prices skyrocket.

Companies that were once worth billions on paper, of course, became completely worthless just a few years later. I think you know where I'm about to go with this. Mark Twain famously said, "History doesn't repeat itself, but it often rhymes." Now, in the year 2024, the technology that has been getting investors excited is artificial intelligence. Similar to other technological innovations, artificial intelligence has the potential to fundamentally alter society.

This enthusiasm has been concentrated in a group of companies that have come to be known as The Magnificent 7. The so-called Mag 7 companies are Apple, worth $2.97 trillion; Microsoft, $3.16 trillion; Alphabet, $2.15 trillion; Amazon, $1.94 trillion; Nvidia, $3.01 trillion; Tesla, $546 billion; and Meta, $1.27 trillion, as of the making of this video. These 7 companies have a combined market cap of a staggering over $15 trillion. Yes, that is trillion with a T. Just to put that number into perspective, the combined GDP of the entire European Union was 16.7 trillion in 2022.

The value of these companies is truly mind-boggling. The market caps of these companies have gotten so large because the stocks have skyrocketed. As of late in 2023, the Magnificent 7 generated an average return of over 75%. But that only tells part of the story. As you can see here, companies like Nvidia, Meta, and Tesla generated returns well in excess of 100%.

These returns are shocking when you consider that the S&P 500 generated a 24.2% return in 2023. And if you really want to be surprised, take a guess at what the S&P 500 returned if it were to exclude the Magnificent 7 stocks. Maybe 20%? How about 15%? Okay, maybe 12%? If you want to get really extreme, not even close. If we exclude the Magnificent 7 stocks, the S&P 500 returned just 8% in 2023.

This huge divergence in stock performance relative to the rest of the stock market has some people concerned that the Magnificent 7 stocks are in a massive bubble. One way to get a sense about how optimistic investors are about a stock is to look at what is known as a price-to-earnings ratio, or PE ratio for short. This metric is calculated by taking a company's stock price and dividing it by its earnings per share. So if a stock trades at $20 a share and its earnings per share is $2, the PE ratio is 10 times. Simply take the stock price, in this case $20, and divide it by the EPS of two. This gets us a PE ratio of 10 times.

Conceptually, one way to think about a PE ratio is that it reflects how excited investors are about a company's future growth prospects. To demonstrate what I mean, let's say we have two stocks: Stock A and Stock B. Stock A trades at $20 per share and has $1 in earnings per share; its PE ratio is 20 times. Stock B also trades at $20 per share but has $2 in earnings per share; its PE ratio is 10 times.

Conventional investing wisdom would tell you that Stock B is a better investment because its PE ratio is lower, half the PE ratio of Stock A. However, that only tells part of the story here and is missing something incredibly important. Let's say Stock A is able to grow earnings per share at a 12% annual rate for 10 years. At the end of 10 years, Stock A will have an earnings per share of $31.11. On the other hand, Stock B is not growing earnings as fast. Let's say Stock B is only able to grow earnings per share 3% over the same time period. At the end of 10 years, Stock B's earnings per share will be $26.91, well below that of Stock A.

Assuming both companies now trade at similar PE ratios, Stock A turned out to be the better investment, even though its PE ratio was twice that of Stock B. This was because Stock A was able to significantly grow earnings per share over time. Put another way, Stock A was able to what is known as grow into its higher PE ratio. I tell you this example to provide context as to why the Magnificent 7 stocks trade at such high PE ratios relative to the rest of the market. As you can see here, the seven stocks all traded PE ratios well above that of the S&P 500 of 27 times. And that difference gets even more magnified if you exclude the Magnificent 7 stocks.

According to a report by Capital Group, one of the world's largest investment firms, the S&P 500 has a PE ratio of around 15 times excluding the Mag 7. With these high PE ratios, investors are in essence betting that artificial intelligence will allow these companies to grow earnings at high rates well into the future. However, it is important to understand that if this expected earnings growth fails to materialize, the results could be very painful for investors buying at today's high prices.

With the Magnificent 7 stocks trading at what appear to be sky-high PE ratios, it would be easy to say avoid these stocks and there is an AI bubble. However, as you're about to hear from Howard Marks, that too comes with its own set of challenges. Take a listen.

But first, some quick background on how Howard Marks became a closely followed investor. Marks built his following publishing now-legendary investment memos. These memos have become must-reads for those interested in investing, and they are so good that even Warren Buffett says it makes his day when he gets one of Howard Marks's memos in the mail. If you're interested in checking these memos out, check out the link in the description of this video. I compiled 17 years' worth of Howard Marks memos that you can download completely free as my gift to you. Enjoy.

Here's Marks describing the challenges of not investing in the Magnificent 7. "Well, risk is never easy. Um, the obvious answer is that you invest in the Magnificent Seven because you think their earnings growth will be so rapid, uh, you overweight them, um, and then it isn't.

So, your large holdings suffer because they didn't live up to expectations. But it's really important to look at risks as two-sided. So, the corresponding risk is that you don't overweight them, and you don't have a market weight, and then they perform earnings-wise as expected, and you're left behind. So, 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. When the stock market is hitting all-time highs, it can feel like the safe thing to do is to sell your stocks and pile up cash. Ideally, the goal would be to wait for what would appear to be the inevitable stock market crash once the bubble finally bursts. However, this comes with its own set of risks. As of the making of this video, the Magnificent 7 stocks account for roughly 30% of the weighting of the entire S&P 500.

What this means is that whether you like it or not, you and your family's financial future is heavily tied to the performance of these seven stocks. Let me explain what I mean using some simple math and our friend John here. As I mentioned earlier, the Magnificent 7 accounts for roughly 30% of the weighting of the S&P 500. Due to these companies' massive market caps, obviously, that means that the other roughly 493 stocks in the S&P 500 account for the remaining 70% of the index.

To calculate the total return of the S&P 500, you would have to multiply the weighting of each group of stocks by what that group of stocks generated. So let's say the Mag 7 stocks go on to generate a 25% return while the rest of the stock market generates only a 7% return. We can see here that based on their respective weighting, the total return of the S&P 500 was 12%.

Now, let's see what happens if someone doesn't invest in the Magnificent 7 stocks. For that, let me introduce you to John. John is a smart guy but is naturally pretty skeptical. He sees the strong performance of the Mag 7 stocks and says it's a bubble that is about to burst. He avoids investing in this group of companies; he puts 0% of his portfolio in the Mag 7 and instead chooses to spread out his portfolio among the roughly 493 other companies that comprise the S&P 500.

Unfortunately for John, the Mag 7 generated a 25% return while the rest of the S&P 500 companies generated a 7% return. As we can see here, the return of John's portfolio is just 7%, well below the 12% return the entire S&P 500 generated under this scenario. This 5% return difference may not seem like much; however, over the course of an investing lifetime, it can mean millions of dollars' worth of lost returns.

Of course, these are just rough numbers, and there's more that goes into it than just this. However, this perfectly demonstrates the two-sided risk Howard Marks was talking about. Thinking you are making the "safe" choice by avoiding the Mag 7 stocks can end up costing you a large amount of money.

So what exactly are investors supposed to do? If you made it this far into the video, it is clear and obvious that you're wanting to learn about how you should be investing in the year 2024, am I right? Since I know this is the case, check out this Warren Buffett video here because it covers how Buffett is navigating the balancing act of investing in a potentially overvalued stock market. I'll see you over there.