Behind The Memo: On Bubble Watch

Hello and welcome to Behind the Memo with Howard Marks. I'm Harry Whitelaw and I'm delighted to welcome Howard to explore a recent memo that has received great reader interest. Perhaps because it addresses something that is both enduring and topical, on Bubble Watch. So Howard, when most of us conceptualize a market bubble, we probably picture a line on a chart displaying some kind of financial metric and rocketing upwards. But you argue that a bubble isn't best defined by numbers, but instead by investor psychology.

Well, I think that's right, Harry. The line rocketing upward on the chart does indicate a bubble, but it doesn't give a sense for a bubble. And I think that you have to have both. I think that a bubble is both a time when prices for one asset or one asset class or a whole market are elevated. But to really understand it and be able to work with it, I think you have to grasp the emotional or psychological aspects. And a bubble is really a temporary mania. It is the excessiveness of the psychology that creates the phenomenon and characterizes the phenomenon and then, of course, creates its vulne

You incorporate one aspect of investor psychology into this definition, which is FOMO. And, again, a quote by Kindleberger in the memo that I think probably made a lot of us chuckle is, there's nothing so disturbing to one's well-being as to see a friend get rich.

Right. I think that if a bubble is a period when investors become unhinged, I think more than anything else, it is the fact that some people have been watching others get fabulously rich that unhinges them. And the element that keeps markets safe and sane is risk aversion. People don't like to lose money. And in particular, money lost counts more heavily for most people than money gained. Most people are ho about making a hundred dollars, but really pained to lose a hundred dollars. So that makes people biased toward risk aversion. Because they are risk averse, however, they perform a function

And sometimes that excitement is around something that's previously unknown, a new product, a new service, a new idea. You write how that can whip existing positive broad sentiment into a real frenzy. Most things move in a historical range, but for something totally new, we have no map, nothing to chart the course of a new technology, for example.

And it follows then that it's very easy to get off course, isn't it, Harry? Bubbles are usually around something new, something that captures and fires the imagination. And as you say, there's no historical precedent to indicate when people are behaving irrationally about it. So we have, let's see, the tulip craze in Holland, Sixteen Thirty, I believe. The South Sea Bubble in England, Seventeen Twenty. We had several in the meantime. But, of course, the one I remember best is the nifty fifty bubble of the sixties, in which growth stock investing was just invented in the early sixties. So you h

poor old Simplicity pattern, Howard, which you often pick out.

My favorite. When stocks are highly valued, you pay a high multiple of their current profitability in the expectation that the profitability will continue and perhaps even grow. Thus, the high price is predicated on something I call persistence. And when you look at something called simplicity pattern, which everybody thought was a great idea at the time, there was an implicit assumption that Americans would continue to make their own clothes. And how did that work out? Did it really make sense to buy the earnings of that company decades into the future, which is what people were doing anyway?

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