Recently, someone asked me if the US market is in bubble territory, given that stock prices have risen so sharply. She read it from the papers, she said.
My short answer is that it is too presumptuous to assume that we are in bubble territory. Even more so, if you consider your source from a journalist who may or may not be qualified to judge whether we are in a bubble - an assessment which ten thousand other brilliant minds could not conclude on.
Clearly, such an assessment need to be more thorough and well thought through. And thankfully, we have the clairty of thought from Howard Marks, Chairman of Oaktree Capital, to guide us along in this topic.
Note that Howard Marks is merely human and he may be wrong. But on average, he has been more right than wrong.
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Extract from Howard Marks' Nov 26 2013 memo:
No, I don’t think it’s time to bail out of the markets. Prices and valuation parameters are higher than they were a few years ago, and riskier behavior is observed. But what matters is the degree, and I don’t think it has reached the danger zone yet.
First, as mentioned above, the absolute quantum of risk doesn’t seem as high as in 2006-07. The modern miracles of finance aren’t seen as often (or touted as highly), and the use of leverage isn’t as high.
Second, prices and valuations aren’t highly extended (the p/e ratio on the S&P 500 is around 16, the post-war average, while in 2000 it was in the low 30s: now that’s extended).
A rise in risk tolerance is something that should get your attention and focus your concentration. But for it to be highly worrisome, it has to be accompanied by extended valuations. I don’t think we’re there yet. I think most asset classes are priced fully – in many cases on the high side of fair – but not at bubble-type highs. Of course the exception is bonds in general, which the central banks are supporting at yields near all-time lows, meaning prices near all-time highs. But I don’t find them scary (unless their duration is long), since – if the issuers prove to be money-good – they’ll eventually pay off at par, erasing the interim mark-downs that will come when interest rates rise.
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In the 1950s, when I was a kid, I watched old movies on TV when I got home from school. One from the 1940s was called It Happened Tomorrow. In it, a struggling young journalist made a deal with the devil to be given a peek at the next day’s news. His scoops brought him huge success, and everything ran smoothly until he received a newspaper headlined “Reporter Shot Dead at Racetrack.” He tried all he could to avoid it, but as a result of some very clever plot devices, he of course ended up at the track (where he learned that the headline had resulted from a case of mistaken identity).
I go through all of the above to explain that – try as I might to avoid it – my memos on excessive risk bearing and what to do about it invariably end up back at the same place: my favorite Buffettism:
. . . the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.
I repeat Warren’s injunction for the simple reason that you just can’t put it any better. When others are acting imprudently, making the world a riskier place, our caution level should rise in response. (It’s equally true that when others become overly cautious and run from risk, assets get so cheap that we should turn aggressive.)
Over the last 2-3 years, my motto for Oaktree has been consistent: “move forward, but with caution.” I feel the outlook is not so bad, and asset prices are not so high, that it’s time to apply maximum caution (or, as they said in The Godfather, “go to the mattresses”). But by the same token, the outlook is not so good, and asset prices are not so low, that we should be aggressive. That’s the reason for my middling stance.
Having said that, however, there’s no doubt in my mind that the trend is in the direction of increased risk, and I see no reason to think that trend will be arrested anytime soon. Risk is likely to reach extreme levels someday – it always does, eventually – and great caution will be called for. Just not yet.
Here’s my conclusion from The Race to the Bottom. I’ll let it stand – another case of “ditto.”
. . . there’s a race to the bottom going on, reflecting a widespread reduction in the level of prudence on the part of investors and capital providers. No one can prove at this point that those who participate will be punished, or that their long-run performance won’t exceed that of the naysayers. But that is the usual pattern.
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