Predicting what’s next has been a fool’s game, and it continues to be. The S&P 500 was up 26% in 2023 and 25% in 2024, for the best two-year stretch since 1997-98. That brings us to 2025. What lies ahead?
Rationality, Optimism, exuberance, disappointment, correction, and more frequent and intense volatility—with uncertainty about the timing, extent, and outcome. Is enthusiasm for new technology creating a bubble, and will the bubble burst?
Optimism has prevailed in the markets since late 2022, generating above-average valuations and astonishing returns for some (primarily AI-related) equities. Stocks in most industrial groups sell at high multiples, but enthusiasm for artificial intelligence and the persistence of the Magnificent 7 drive most market expectations.
There is the implicit presumption that the top seven companies will continue to be successful and that the “new thing” (artificial intelligence) will drive valuations even higher.
Really?
The Exuberant Seven
The “Magnificent Seven” – Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla have dominated the S&P 500 in recent years, responsible for a disproportionate share of its gains. Their market capitalization is over 32% of the index’s total (roughly double the share five years ago). The highest share for the top seven stocks in almost 30 years was approximately 22% (in 2000 – yes, that bubble). Extending the exuberance further, U.S. stocks are over 70% of the MSCI World Index.
Is It Irrational?
Investor behavior creates bubbles and crashes. It’s not a simple quantitative calculation. A bubble is not just a rapid rise in stock prices; it morphs into a mania—irrational exuberance, as Alan Greenspan put it. It reflects a fear of missing out and an uncompromising adoration for a company independent of fundamental economics (Can anyone say Tesla?). The result is a conviction that no price is too high.
Very soon, it is.
Reasonable valuation metrics become a sideshow, and fallible human behavior takes over. If you hear, “It’s a great company, and the price is irrelevant,” there’s likely trouble coming.
When emotions are moderate, most securities are likely to be reasonably priced. But when extreme optimism hits, and everyone believes things can only improve, it can be hard to find anything that escapes irrationality.
Losing My Objectivity
Bubbles and crashes are extremely subjective states. The world is too asymmetric—either too optimistic or too pessimistic. Broad-based speculation changes behavior from rational to mania. Examples include the 1929 crash, the 2000 dot.com bubble, the 2008 financial crisis, and…something in our future; we’re just not sure what. Is now the beginning? As Mark Twain (allegedly) said, “History doesn’t repeat itself, but it often rhymes.”
It’s unclear what’s rhyming—an unprecedented opportunity for long-term prosperity, an imminent, or something in between?
The New Thing
Rationality leaves when the “new thing” enters. In other words, “this time, it’s different.” Spoiler alert – it never is.
The “new thing” creates bubbles. There were bubbles in the Nifty Fifty stocks in the 1960s, disc drive companies in the 1980s, internet stocks in the late 1990s, and sub-prime mortgage-backed securities in the mid-2000s.
This is not new. Riches without risk were supposed to be from the 1630s Tulip Craze in Holland, the South Sea Bubble in the 1700s Netherlands and England, railroad stocks in the 1800s England and the United States, and other examples of “rhyming” throughout history. Diverse opportunities that ended badly.
The “new thing” quickly becomes irrational because there is no historical basis for valuations. Even if the present value of all invested capital far exceeds the potential market (as with disc drives in the 1980s), there’s still no basis for a clear-headed analysis of ever-increasing valuations. It’s all based on belief, and there is very little data for counterarguments.
After all, people are making fortunes, and no one sits out that dance (at least, while the music is playing. When it stops, there are no chairs). Intelligence is sidelined. After all, even Isaac Newton lost money in the Tulip Bulb craze. There’s no one as intelligent as Sir Newton today, but he even fell victim to mania. Few will avoid today’s version. Most people would instead go along with a shared delusion that makes investors money today than say something contrary about reasonable long-term reality.
It’s not intelligence that’s driving the market.
Basic Principles
Fundamental investment principles tend to get lost as exuberance builds. But there is no counterargument for a few simple but time-tested principles. First, it’s not what you buy that counts; it’s what you pay. Second, good investing doesn’t come from buying good things but from buying things well.
A successful investment is the combination of what you buy, at what price, and how much. There’s no asset so good that it can’t become overpriced and dangerous, and there are few assets so bad that they can’t get cheap enough to be a bargain.
Innovation and Irrationality
Innovations create bubbles.
These products and markets are typically overestimated and misunderstood. The attractions of a new product or better business are usually obvious, but the pitfalls are often hidden and only discovered in trying times. A new company may completely outclass its predecessors, but investors frequently fail to grasp that even a bright newcomer can be supplanted. The disrupters can be disrupted by skillful competitors or even newer technologies.
Intel, one of the most valuable technology companies and considered unassailable in its competitive position, was sidelined by companies such as TSMC, NVIDIA, and ARM. This is only one of many examples.
There’s substance underlying every bubble. It’s taken too far.
The internet has changed the world, and we can’t imagine a world without it. However, the vast majority of internet and e-commerce companies that soared in the late ’90s bubble ended up worthless. Investors expected that things could only get better, and the damage done by negative surprises was profound. When something is new, competitors and disruptive technologies have yet to arrive. The merit may be there, but if it’s overestimated and overpriced, it evaporates when reality sets in.
Exuberance Becomes Irrational
Optimism compounds valuation into an irrational price.
There is no historical indicator of an appropriate valuation, and the company is being valued by conjecture. The Internet bubble is a prime example, with new metrics invented (“clicks” or “eyeballs”) regardless of whether these could be turned into revenues and profits. Valuations that assume smooth success typically mean overvaluation.
Irrationality assumes “a lottery ticket mentality.” If a successful startup might return 200x, it’s mathematically worth investing in, even if it’s only 1% likely to succeed. When investors think this way, there are few limits on what they’ll support or the prices they’ll pay. The reality is there may be a 200x, but the chances are typically 0%, and your return is likely a wipeout. Markets don’t simply allocate small percentages to many players. This is the fundamental fallacy of a bubble.
Valuations attributed today to artificial intelligence companies that are yet to generate revenue or any reasonable and sustainable profitability are receiving valuations of $50 billion to $100 billion. This seems to be the only most recent example of a lottery ticket mentality.
Persistence
The Magnificent 7 are, in many ways, much better than the best companies of the past. They enjoy massive technological advantages, vast scale, dominant market shares, and above-average profit margins. Their products are mostly software or high-margin hardware with unique intellectual property. Their profitability is unusually high, and they don’t trade at absurd multiples.
For example, Nvidia, the leading designer of chips for artificial intelligence, has an earnings multiple in the low 30s. While almost double the historical average of the S&P 500, that’s not extreme. But what does a multiple in the 30s imply? Investors think Nvidia will be in business for decades and that its profits will grow throughout those decades, and competitors won’t supplant it.
In other words, investors assume Nvidia (and the other members of the Magnificent 7) will demonstrate persistence.
Investors assume that leading firms remain leaders for decades. Most don’t. Persistence isn’t easy, especially in high-tech, where new technologies can emerge quickly, and new competitors can leapfrog incumbents. It’s worth noting, for example, that previous companies the market thought demonstrated persistence include Xerox, Kodak, Polaroid, Burroughs, and Digital Equipment.
None persisted. The market can be spectacularly wrong.
Reality Check
There’s a strong relationship between starting valuations and annualized ten-year returns. Higher starting valuations consistently lead to lower returns – and vice versa. Today’s average p/e ratio is about 22x. Over the last 30 years, if stocks were bought at today’s average multiple, the 10-year return was between 2% and -2%.
It shouldn’t be surprising that the return on investment is a function of its price. For that reason, investors clearly shouldn’t be indifferent to today’s market valuation.
Stocks may sit still for the next 10 years as earnings rise and multiples return to earth. However, another possibility is that the multiple correction is compressed into a year or two, implying a significant decline in stock prices (we’ve seen this movie).
It is a reasonable counterargument to say that multiples are not absurd. The Magnificent 7 continue to be great, highly profitable companies, and the market isn’t completely losing its rationality.
It’s time to understand these factors, expect volatility, and be aware of Mr. Market’s irrational behavior. It’s not going to be a smooth pathway forward; there will be great investment opportunities, as there are in any market, but overall, it’s a high starting point. It’s time to think of market neutrality as a good starting strategy.