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Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
The writer is co-founder and co-chairman of Oaktree Capital Management and author of the book “Mastering the Market Cycle: Getting the Odds on Your Side”
Many investors are on high alert these days because of the asset price bubble, worried about a repeat of past highs and lows.
So I’m often asked if there’s a bubble around the handful of stocks leading the S&P 500, the so-called “magnificent seven” tech companies that have dominated the index in recent years and are responsible for a highly disproportionate share of its gains.
You can look at valuation parameters to spot a bubble, but I’ve long believed that psychological diagnosis is more effective. I look for grossly irrational exuberance — open worship of a group of companies or assets resulting in an overwhelming fear of being left behind if one fails to participate in the bubble based on the belief that, for those stocks, “the price is not too high.” In particular, when I hear the latter, I consider it a sure sign that a bubble is brewing. In short, bubbles are characterized by bubble thinking.
If bubble thinking is irrational, what is it that allows investors to escape rational thinking? There is a simple answer: novelty. This phenomenon relies on another famous investment phrase, “this time it’s different.” Bubbles are always associated with new developments, from the craze in the 1630s in Holland for the newly introduced tulips, to the Internet and telecommunications stocks in the late 1990s. Since there is no historical indication of what the appropriate valuation for the new thing might be, there is therefore nothing to tie it to terra firma.
All the bubbles I’ve lived through involved innovation, many of which were either overrated or not fully understood. The appeal of a new product or way of doing business is usually obvious, but the loopholes and pitfalls are often hidden. A new company can completely outperform its predecessors, but investors often fail to realize that even a great newcomer can be replaced. Disruptors can be disrupted, either by skilled competitors or even newer technologies.
In the 1990s, investors were sure that “the Internet will change the world.” It certainly seemed that way, and that assumption fueled a huge demand for everything connected to the Internet. The e-commerce stock went public at seemingly high prices, then tripled on its first day. There is usually a grain of truth behind every mania and bubble. It simply goes too far. The Internet absolutely changed the world, but the vast majority of dotcom companies that bubbled up in the late 1990s ended up worthless.
Too much optimism about a new thing leads to pricing errors. Because participants in the bubble cannot imagine that there is a shortage, they often assign evaluations that assume success. In reality, only a few newcomers can thrive or even survive.
The stock is selling at a multiple of next year’s earnings, reflecting the expectation that it will continue to earn for many years. When you buy a stock, you buy a share of the company’s profits every year in the future. When they buy stocks at above-average price-to-earnings multiples, investors pay the company’s earnings — even after giving them credit for significant growth — for many decades into the future.
Today’s leading companies in the S&P 500 are, in many ways, much better than the best companies of the past. They enjoy enormous technological advantages and enormous scale. But persistence is not easy to achieve, especially in high-tech fields that are susceptible to disruption. In bubbles, investors treat leading companies as if they are certain to maintain their leadership for decades. Some yes, some no, but change seems to be the rule more than persistence.
Is the US stock market too high? It’s very rare for the S&P 500 to return 20 percent or more two years in a row. It it happened over the past two years, with the S&P 500 up 24.2 percent in 2023 and 23.3 percent in 2024, bringing us to 2025. What’s in store?
Today’s warning signs include the optimism prevailing in the markets since late 2022, the enthusiasm applied to the new thing of artificial intelligence and the widespread assumption that the top seven companies will continue to be successful. On the other hand, the forward p/e ratio on the S&P 500 is high, but not crazy, at 23.6 times. I also don’t hear people saying, “The price isn’t too high,” and the markets, while expensive and maybe frothy, don’t seem crazy to me.
