Transcription
We were talking earlier that outside it's a P super. You can't even see the next building. And that's a pretty good analogy with the market. From my perspective, it's seldom easy to see what's coming. You only get a little kind of glimpse through what they used to call the fog of war. And now you don't even get that glimpse.
All the old ratios don't seem to work for a variety of reasons, but you start with CO. CO rattled the world to its bones. And then the co stimulus was an order of magnitude bigger than anything we had ever seen. And it ended up with trillions of dollars in very weird hands. People who were bored and forced to be at home with nothing to do but speculate on stocks. And they did. And it stayed that way. So even in the recent decline, the selling was by institutions, the buying was by individuals. This is incredibly new. So that's influence number one.
The second great difference here that's also changed all the traditional responses is the introduction of AI which really came to be recognized with chat GBT in October 22 and we were having what you might call a traditional bare market and it kind of ended overnight with half a dozen MAG 7 roaring upwards and eventually dragging the market with it. That cut right across all the traditional reflexes. And then finally, we have tariff war.
So if anyone can unravel that series of abnormal influences, we're still unpredictable because of COVID response. We're certainly still unpredictable because of AI. No one knows what AI is going to do. It's going to change the world, but no one knows when and how. And on top of all that, no one has a clue what the tariff war is going to do and how quickly it will do it. Are we going to have a major recession, a small recession, none at all? The economists are completely at sea, in case you hadn't noticed that you can find an economist with any view today on a huge spectrum. And since the stock market in a way takes its lead from the economy, and no one knows what's happening to the economy. So they're the three levels of abnormal responses that have completely scrambled the market and makes it very very hard to know what's going on.
Well, the single thing all three have in common is that they should increase your respect for risk, volatility, uncertainty, be more careful than normal. That's kind of round one. And then round two, you back down to looking at more traditional views of the market. And the ones I respect the most, the ones that have provably the best predictable record over 7, 8, 9, 10 years, they all say that the market is about as high in December recently as it has ever been in history. Higher than 1929 and at least as high as 2000 and as high as the recent peak in December 21.
But the most predictable ones are variants of the total market cap versus the GDP which is said to be Warren Buffett's favorite. And there are fairly elegant serious variants of that. And Husman does a very well-worked out variant which he believes is the single most predictive. And I have no reason to doubt it since we have a very similar model at GMO. And that suggests that the market could easily go down by 50% and be well within its historical boundary. That would not be a colossal low. A colossal low, I've been through a couple, 1982, 1974. They sold at seven times depressed earnings. The market, by the way, loves double counting. When it has peak profit margins, it has peak PEs. And when it has terrible profit margins, like 74, it has terrible PEs. So, seven times terrible earnings goes up to 35 times wonderful earnings in 2000, guaranteeing that 74 to 2000 was one hell of a good trip.
The quote attributed to Keynes is that the market can stay irrational longer than the investor can stay solvent. And that's really true. If you're in the institutional business, as we have been, you run the risk of getting forced out of your positions, even if you're right. And in 2000, we were right. The PE went to a new all-time high in January 98. It overtook the previous high of 1929 at the top of the legendary bull market and then it just kept going and at 35 times earnings in March of 2000, it finally quit. And how were you to know once you were in new high territory like that and earnings continued to rise? So you not only went from 21 to 35, which is kind of a 50% hit, but you had earnings go up 20% as well. And all you know is that in the end it doesn't change the outcome. It just meant that the break from 35 times earnings was spectacular and the NASDAQ that led the charge upwards went down pretty much 80%.
And the same in Japan, although Japan is even worse. Japan had never sold over 25 times earnings and then it did. And for some miraculous reason, we stayed invested until about 45 times and then we got out. We said, "This is ridiculous. We're out of it 100% out." It was the biggest part of foreign portfolios, the EPHA index, and we went to zero and then we watched as it went from 45 to 50 to 55 to you must be kidding me to 60 to 65 times earnings by which time we had underperformed by 10 points a year. It came back all the way only instead of taking five years, it took 20 years. And now Japan finally is an ordinary country selling a little bit cheaply from the highest price of any major market ever by a lot. So you have a wonderful ride on the way up. It changes nothing. Eventually they come down. But getting the timing right is just about impossible. And in each case of the great ones we got right, we suffered a lot.
And the one we got fairly right was the so-called great financial crash because we focused on the housing market and we saw how much overpriced it was. So we knew it was coming down. Housing market was unbelievably well-behaved. It went up to in statistical terms a three sigma event which would occur every hundred years or so and then it came all the way back down again. It was beautifully symmetrical. It took three years going up, three years coming down. Sucked in a lot of poor people into the housing market who should never have been there. Gave an opportunity for the rent seekers, as we call them, to design crazy bits of sliced and diced subprime mortgage paper to sell to idiot European banks and so on. And then the shock nearly destroyed the banking system. Queen Elizabeth said, "Why did no one see it coming?" which was particularly irritating since we were describing it quarter by quarter from 2007 spring from there onwards. In 2007 the Federal Reserve boss and secretary of the Treasury both used the same word describing it and saying it was contained. I took the opportunity to be very cute and said if it was contained in this case it was likely to be Pandora.
The problem we have, you can't predict any outcome except one. There will come a time when you will be happy to have been out of the market is my definition of success. So when I say let the wild rumpus begin at the end of 21, every condition of a crazy bubble was in place. I expect that there will be a time in the not too distant future when you will be happy to have been out of the market from December 21 until then. And the market will be considerably cheaper than it is now. But it was always difficult to get the timing right without the three major changes I described at the beginning. That makes it absolutely impossible to know what the heck is happening. It's actually quite interesting.
In Japan, which was our biggest failure, we lost nothing because Japan was so obviously crazy and we were here and they were there and we could all see how crazy they were. The tech bubble was our second biggest. We lost six and a half points for two and a half years versus 10 each for three years in Japan. But the difference there was that was here. So our clients didn't see that at all. They saw Japan as crazy. But when it came to America, they bought into the golden new era that Greenspan was selling. It's much harder to stay cool when it's your market. And so we lost a ton of business, maybe almost half our asset allocation business in two years and a quarter. There used to be a kind of saying that if you have a decent track record, which we had a very good track record in 97, they will hang tough for three years. Well, forget it. They won't.
The other thing is people think you get fired by underperforming in a bare market. Absolutely not. You get fired by underperforming in a bull market. And the reason is in a bare market everyone freezes and they postpone moves until they've recovered from the shock. In a bull market, they're out there talking to their neighbor on the golf course and he's making tons of money because somewhere Fred is leveraged the market and there's always a Fred and he's always killing you and they go crazy. They can't stand the shock of being outperformed and listening to all these wonderful stories of other people getting rich and so they shoot you, and much more lethal, much quicker than in a bare market.
I think the speculation after COVID stimulus was more impressive than anything we have seen. Right? All that speculative money from the COVID stimulus where they were hopping around saying AMC let's take it to the moon to the moon and the thing was going up 40 times in 2 weeks becoming billions of dollars and forcing the poor hedge fund guys into jumping out of the window. There's no way you can calculate things like that. It was on such a scale and there were so many of them, each one more ridiculous than the next. I think that was a good candidate for beating 1929.
The market itself never corrected. It was beginning to in 22, of course, that was a major 25% wipeout. And in that the growth stocks came down 50% in a hurry. But then they rallied so much with AI that they got it all back in the following year, stabilized the whole market again which went to new highs. So there is no precedent for this kind of bubble within a bubble. We had all the frenzy, all the speculation. We had the thing bust. We had a lot of the flakes go to nothing. We had the growth stocks come down 50%. And then they rewrite the novel with AI. And AI of course is the real McCoy in the sense it's a major, major development. And people say well then it's not a bubble. And I say it's quite the reverse. The great inventions like railroads and I'm told the canals even before then internet, the more you could see that they were brilliant ideas, the more they would change the world, the more effective it was of sucking in your money, of course, why would it not be so? They designed six railroads between Manchester and Leeds which is not a great idea. It changed the world, it brought down the cost of transportation, everyone's GDP was helped, but the people who invested in the railroads had a terrible bust and out of the wreckage, the world advanced.
Internet was identical. Amazon and the boys, the little flags like Pet.com, they all went to nothing in 9 months or so. But Amazon, believe it or not, went down 92% in 2000 and 2001. To the low of that market move. It fell 92%. And out of the wreckage, the internet was a terrific life-changing idea. And it's precisely those wonderful ideas that actually work that suck in the money and give you upfront the biggest bubbles. And you would have to think that AI is right up there in the general significance potential. It's hard to imagine that that will not be a bubble. And out of which wreckage I really count on the fact that AI will change everything. Some for the good, some for the bad. It's going to be the biggest destroyer of jobs that you have even thought about.
What should you do now? The stock market is gloriously overpriced in the US, but foreign stocks are perfectly reasonable. And when you have a major bubble, you also have incredible stretching of traditional relationships. So the gap between value and growth is as big as it gets. It's in the, you know, top few percentile of history. And the gap between foreign and the US is at or close to an all-time record. So these are the things you have to do. Emphasize value, emphasize non-US. And if you're in the US, and you have to be, the thing to do is concentrate on risk. One way to do that is high quality. High quality has less debt. If the economy goes into the tank, and it may well do just that because of the tariff war and other problems, record debt and so on. You do not want to have debt, and high-quality companies have very little. And you want to have high profit margins so they can be squeezed without sending you out of business.
Climate and resources have been utterly crushed. Even if they are American securities, a lot of them are not. And resources not only unprecedentedly cheap, but they are the only group that tends to be uncorrelated to the broad market. As in on a 10-year basis, they have no positive correlation at all. That is the only group. Do what you should do when you invest. Kind of lock them up for 10 years and throw the key away. You will make a decent amount of money. But if you do that in the S&P, I think 50/50 you won't make any money at all.