Transcription
If and when we reach a period of pessimism, the potential unraveling in terms of perceived wealth is much greater this time than it will have ever been before. The US is not moderately overpriced. It is shockingly overpriced. I think they'll do pretty well by selling.
Whatever you do, get rid of this fear of missing out. This terrible lust to participate in profit-making that comes along at the end of every one of the great bubbles. It is incredibly seductive, very hard to resist. Been there, done that myself a few decades ago, made a fortune and wiped myself out. Very salutary. And I would wish on most of you that you avoid it.
It's crossed off all the boxes. It's done all the things that a super bubble typically does. And it could uh start its way down any time and perhaps a month ago. It needs a long bull market and we had 11 years, so the longest in history. It needs a lot of crazy behavior and we had some of the great crazy behavior of all time. I think they'll be telling these stories in 20 years. It needs to accelerate at the end of a bubble at something like three times the average rate of the bull market. And it did that from COVID on upwards. The NASDAQ more than doubled and it it went up at well over three times the normal rate. And finally, a thing that is unique to the super bubbles, the two or three that just keep going and going, is that at the end, the speculative stocks start to peel off and even on the upside for the broad market, they start to go down.
So, you're saying we are at the beginning of a crash. I would say it is likely that we are. I think it would be unlikely that the market would not come down by 50% from its peak. The broad market, the S&P, and it would be unusual if the specs did not do worse than that. The problem is, is it slow or is it quick?
The um stimulus program left a lot of money in individual hands for buying the dip and they have been throwing money this year, individuals at the dips. They have probably never invested more rapidly than they have this year, but they have a lot of money. They're pretty well funded. Corporations, many corporations are doing well. The economy isn't too bad. So, this could be turn out to be quite a struggle where slowly but surely the market has to readjust to higher and higher rates and higher inflation. It will not give up, I suspect, too easily, but we'll fight it out.
If you look at the real estate market, all real estate markets pretty well around the world are very, very high. And if you look at the bond market, of course, interest rates are incredibly low and bonds are incredibly high. But when it comes to the stock market, rather like 2000 and the tech bubble, this is more an American affair than anything else. Outside America, the world is merely overpriced. Ho ho. It's often overpriced. It's usually not that dangerous. In the US, however, we have an extreme overpricing, extreme crazy behavior, and I think we're in a rather dangerous equity bubble. So, there is a decent chance that Australia, the UK, Japan, there's some fairly reasonably priced countries. If they come down in sympathy, they'll come down a lot less and probably rally earlier.
This bubble in the US is eerily similar to the 2000 tech bubble. It's led by the NASDAQ. It's led by the specs. 2000, the specs underperformed all year and the S&P continued to climb. It is just possible that the S&P will rally to a new high. I think it is impossible that the specs will. So, I think the game has started and u it will play out perhaps rather like at 2000.
Historically, the stock market has hated inflation. It crushes price earnings ratios. This time uniquely it did not. Inflation started roared through the roof and the PEs continued to rise. Nothing like that had happened before. And we have a model that goes back to 1925. And there are two factors that determine price earnings ratios or the price level of the market. One of them is profit margins. Of course, it loves them. And the other is inflation. Of course, it hates it. And uh they have worked like a charm. And in 2000 you had, for example, at the top of the market world record profit margins and uh very little inflation. And today we have world record profit margins, but we have rather high inflation. The market should have dropped starting in the middle of last year had it been following the normal battle plan. It did not. The market is saying about inflation that it totally ignores it. It completely believes the Fed that it's temporary, ephemeral, etc. And uh it doesn't appear to be and if that seeps into the market in the usual way, it will mercilessly depress the price earnings ratios.
And in the end the Fed doesn't like to get on the bad side of the administration. Politically, inflation is dead. The average person in the street notices it, measures it. If anything exaggerates it, but even with that exaggeration, it's painful and politically very, very tough on the voting pattern. And therefore, the administration really wants to do everything it can to get inflation down. So, it will be discreetly leaning on the Fed to do what it can. There are people who spend their entire lives watching the Fed and going into the nuances of quarter points and half points, and I do not. I am confident that they will move at the stronger end of the range. I am confident they will try very hard to make sure that inflation does not become embedded. I'm also confident that that will be difficult because we're very short of labor. We're running very scarce and wage rates will start to come through the system in the US increasingly for the next few months. That makes it very difficult to control inflation. So, it will be quite a struggle.
If you have to own US stocks, you should own high-quality stocks that are in good financial shape because this can always spiral in to something of a financial crisis. They often do. I would emphasize in general though non-US stocks and uh quite a few countries as I said are not that bad. Emerging markets has some overhang problems. If the US goes and commodities are high-priced, it's a mixed blessing at best for them. But they're very, very cheap and in the end cheapness usually trumps everything else. So emerging markets, some of the cheaper developed countries would be very much better idea than a massive holding of US equities.
I think it is ending. I'm trying to write a paper which is basically the end of the golden era or Goldilocks and three hungry bears. Um everything has been different for the 20 years of the 21st century. The PEs averaged not just a little bit higher, but 50, 60% higher. Profit margins averaged 30, 35% higher than they had in the previous 50, 60 years. Everything seemed to work out. Corporations got a lot of political power. The taxes on capital all dropped. Tax on dividends, tax on interest rates, tax on capital gains all came down. Most of the regulatory bodies were somewhat captured by corporations and uh they have had a golden era. We've never seen bigger profits. The concentration in each industry has increased and the fangs that are remarkable companies are in their own way instant monopolies. So the monopolistic feature of our economy today and somewhat around the world has increased. This is very good for profits. It's not so good for growth and the governments are beginning to twitch a bit.
I don't think they are assets. I think they embed a technology that may turn out rather like the internet to be useful here, there, and everywhere. And when they are useful, and when they're making money in the traditional way, then you value it like any other money-making enterprise. But while they just sit there and they go up in price, uh, because people are persuaded that they will go up in price, it's very much a question of the emperor and his clothes. I think uh Bitcoin in particular, it does nothing for anybody and is superseded by a whole generation of smarter and more effective cryptocurrencies, many of which in their turn do not make money in the traditional way, and a few do. So, I'm sure the idea embedded in cryptocurrency will be around perhaps forever. But I'm equally certain that most of the value today as a store of value is a hoax. It is not a store of value. Everyone can agree that the volatility is massive. It goes up and down with the high-risk stocks. What is the point of a store of value that trades like a hyperspec? I mean, this is not the principle. Gold in comparison with several thousand years of practice has been uh boringly stable throughout the last couple of years. I should know I earn some.
For me, value has always been you pay for what you get. And so I'm not a great believer in price to book, particularly since book as an accounting entry has been incredibly distorted in the last 20 years. It used to be a pretty good proxy back in the '90s, '80s, '70s, but not recently. What I've always felt is the best definition of value is a dividend discount model that projects earnings into the future, discounts them back according to the quality with high-quality companies having a lower discount rate than junky companies. And what we brought to bear on this 40 years ago almost was we studied the regression rate by type of company. We tried to work out on a company-specific basis what regression rate they were liable to have if they behaved in the normal way given their special characteristics. And so we had Microsoft in our value portfolio all the way through the '90s. We didn't phase it out until June of '99. We started to slice it out. We had 12 monthly slices and by June of 2000, really before the crunch came on Microsoft, we had gotten rid of it.
And if you use those models, you do see for example that emerging markets are absolutely cheap. They are relatively as cheap as they have ever been, parallel to one or two other occasions, but if anything a little bit even cheaper relatively. And you see that they are absolutely not bad at all. And um that's the group where the absolute price looks appealing. And I can anticipate because I hear it so often. Of course, emerging markets always has a lot of question marks, a lot of risk questions, a lot of quality questions, a lot of currency questions and so on and so forth. And it's all true. They've always had those things, but they are highly diversified. You've got, you know, 28 countries in the index. 40% of that is China. And heck, China, the biggest economy in the world in inflation-adjusted dollars, considerably bigger than the US, growing much faster. Just this year alone, by the way, they've opened up yet another 10% GDP gap, and they're grinding this out. The IMF, as you know, the rest of the guys think that they're going to have to carry about a third of all the growth on the planet on their shoulders. And then you have India, who until the recent virus was growing even faster than China and on the cusp of becoming a giant economy and interestingly in intellectual capital and consulting and the use of real brain power. And then you have interesting riskier elements, Brazil and so on. It really is the future in a world where the developed world has had a growth rate that frankly is slowly but surely unraveling for 40 years. When I came here, the productivity per person hour was about 3% a year and now it's down to one and it'll be lucky to be one in Europe. So growth is not what it was. And then the increase in the workforce has declined. When I got here it was 1 and a half% a year. This year it will be 0.2. In 10 years the US will go negative. Japan has been negative in the growth rate of the workforce for 15 to 20 years. And Europe is going negative as we sit. We're going to have to get used to a GDP growth which is a whole lot less than we thought and there'll be a premium on growth and emerging will have a lot higher top-line revenue than the developed world.
We are suffering a baby bust without precedent throughout the world in the developed markets. South Korea is a whole lot worse than China at 1.0 fertility rate when 2.1 is replacement. I mean, it's just hard to get one's brain around it. They're losing half the baby cohort every generation, which is to say every 30, 35 years. Italy is 1.4. Japan is 1.4. China is 1.5, 1.55, which is terrible. The US is 1.70. Italy's in the mix and Hungary's the growth rate of Europe in population is going to be very similar to China. It's perhaps a little bit higher, but not enough to count. The US will not have a rising workforce. We were highly unlikely to take immigrants sufficient to block a drop-off in the baby cohort. At 1.7, you're running 15% plus below replacement. We haven't taken that level of immigrants for years. And we don't know going forward how the immigration numbers will hold up, but highly unlikely, I think, to expand enough to even get to zero. But the US will have a slower rate of decline in the workforce over the next 50 years than Europe and China. And of course very much slower than the developed world. That becomes one of the more attractive features of the other 60%. So China will have a falling workforce and the other 60% will have a rising workforce. On average that puts them, even on that issue, way ahead of the developed world.
Stay out of trouble. Make sure you don't buy expensive markets, expensive stocks. Emphasize value, cheapness for what you get. Hunt around for the cheaper countries. Hunt around for the cheaper stocks within those countries. Carry some cash reserves. There'll be perhaps some very nice buying opportunities. And um whatever you do, get rid of this fear of missing out, this terrible lust to participate in profit-making that comes along at the end of every one of the great bubbles. It is incredibly seductive, very hard to resist, and I would wish on most of you that you avoid it.
I think since I said that we could take out the rivaling 1929 and 2000. I think we've gone way past that. There are examples of large-scale craziness and meme investing etc. for which there is simply no parallel in 1929 even or 2000. 2000 had pet.coms and they were kind of glorious but they were scores of millions or a few hundred million. We have crazy things now that are billions and in some cases tens of billions. And uh we were the most impressive speculation. I think there is nothing like that at scale. Even adjusted for current dollars in 1929. The market is a self-correcting mechanism, but it's a little wonky in the time it takes. Sometimes it corrects pretty quickly and sometimes it corrects uh incredibly slowly and that's the problem.
But if you go back to 2000, which is the previous leader in speculation, let's say what happened there is the market peaked in March of 2000 and uh between March and September the uh pet.coms basically went out of business, the internet stocks basically went down 80%. But the whole dot-com, the whole TMT bubble burst and the industry which had been 30% of the market declined by 50%. The S&P was unchanged. And you could have said during that five month, six-month window, oh, isn't that healthy? They're selling the flakiest pet.coms and uh they're buying Coca-Cola. What's not to like about that? That's exactly what happened. And I like to think of them as the kind of pessimism termites. They eat through the craziest first and then the junior growth stocks and then the intermediate growth stocks and then finally Cisco, which was for eight minutes or so the biggest company in the world by market cap, and they were all down collectively 50%. The balance of the market was up 17%. So that looked incredibly healthy, but then the termites reached the broad market and the entire 70% rolled over and fell 50% in 2 years and the NASDAQ was down 82%.
The thing about the underpinnings is they always look terrific. 1929, the market didn't peak when they thought the underpinnings were terrible. They peaked when the market's enthusiasm for the underpinnings was approximately the highest it had ever been in history. In 2000 in March, the world uniformly, including the boss of the Federal Reserve, Alan Greenspan, they all thought the system had never been better. At the top of the housing bubble in '07, Bernanke and the boys thought the US housing market had never declined, unquote. It merely reflected a strong US economy. The underpinnings were great. They have never gotten it right. The Federal Reserve, in particular, has never had a clue about asset bubbles. It doesn't even address it. They act as if they don't exist except on the upside they occasionally take credit for the wealth effect helping the economy along and it does. There is an income effect and it does help the economy along and Greenspan, Bernanke and Yellen all took credit explicitly for helping the economy along. What they never did is they never took discredit for the reverse side.
The market is a mean-reverting mechanism and eventually it goes back to a fair price and when it went back in 2001, 2002, it had a dreadful negative income effect when the housing market collapsed and it took the equity market with it. It had a double-pronged negative effect on the economy. So it had a much bigger impact on the economy than had occurred in 2000. And this time we're really playing with fire because this time, unlike 2000, we have an overpriced bond market. Jim Grant would argue the most overpriced in 4,000 years. We have, in my opinion, and that of many other bubble students, the most overpriced US equity market in history. We have a housing market that three weeks ago reached the same multiple of median family income as it did in 2006 at the peak of the housing bubble. And we have commodities that have recently run a muck. So that the Goldman Sachs index of non-energy, which is food and metals, which are pretty important, have just equaled the peak of 2011, which was said to be one of those super cycle commodity events. So this is the first time we've ever risked three and a half asset classes bubbling at the same time.
If and when we reach a period of pessimism, the potential unraveling in terms of perceived wealth is much greater this time than it will have ever been before. I think the uh interest rate argument is an explanation of how we get there in behavioral terms. It is not by any stretch of the imagination a justification. You don't justify anything by taking the most overpriced asset in the history of man, the bond market, and saying compared to that, we are merely very overpriced and therefore relatively cheaper. That is very cold comfort. Solomon Brothers, an important firm at the time in 1989, sent around a hit squad justifying the Japanese stock market which was approaching 65 times earnings. We were told at the time the data was represented as 65 times earnings. It had never previously sold over 25. So that was to say the least the real McCoy. And this team went around pointing out that the rates in Japan were so low that 100 PE would be fair. Of course, the collapse that followed in land and bonds and and stocks was cosmic, which reminds us of the cardinal rule, and that is the bigger the bubble, the most ingenious the arguments. And the bigger the bubble, the most extended and painful the decline. This is the most broad, as I said, asset bubble of all time with three and a half of the four major asset classes clearly in severe bubble territory. Thinking that you have no alternative but pick between one of the four bubbles is a pretty grim way to view life. I get the argument, so pick a bubble, they'll all go together probably, and you will suffer a lot of pain. And the intellectual content of that argument that they were all bubbles, so we had to pick the least bad one will um resonate in your head as the market unravels.
If you had a dozen to 15 years of flat market with earnings doing okay and rotation within the market, everything would work out fine. And every portfolio manager I almost ever met has felt in market bubbles that that could happen. It just never does. The market abhors long sideways movements. As we all know, it either goes up more than you think or down more than you think. You can always hold out hope for an extended sideways movement but it never seems to arrive.
Let me just say by the way, I have enormous sympathy for participating in a bubble. When I was young in 1968, '69, we had a spectacular mini bubble in tiny stocks and they all quadrupled and made us rich and then they all blew up together and most of them went out of business and I was just out of business school and I made a small fortune, almost enough to think about retiring to England and then in the space of about 9 months I lost everything back to $2,000 and was lucky to cover my leverage and get out without a huge debt. It was thoroughly exciting. Probably the most exciting time I've ever had in investing. So, I completely sympathize. Nobody who is young and investing and making money is going to listen to some old codger tell his war stories about when he got wiped out. I get that. So, there's nothing that I can say that will cause anyone to change their behavior. The power, the psychological power of a bubble to suck everybody in is prodigious. And we've known that since the tulip bubble and it will never stop. It feels as psychologically difficult as reinvesting when terrified. They both catch the spirit of the exercise.
Well, I would look around and ask the question, what is the least bad? And the least bad is emerging markets. It's a little overpriced absolutely, but it is at one of its three points of maximum difference to the S&P 500. Each of the other two examples worked out wonderfully well in favor of emerging markets. Conversely, when emerging markets was at a peak, which it was in '07, it sold at a premium PE to the S&P. You can have very bad things happen, which they did. And since there is no hope of persuading people to actually get out of stocks, that would be the best I could offer. But for those three people out there who have a will of steel, I would say also have a cash reserve of 20 or 30%, as much as you can psychologically bear to take advantage of much cheaper prices sometime in the not too distant future. I would have low growth emerging markets as much as I could stand and a cash reserve as much as I could stand. If you had 70% cheap emerging markets and 30% cash, that would be a pretty resilient portfolio. I have no doubt it's about as far away from overpriced assets as you can get. For the next 10 or 20 years though, I think the S&P of course will underperform, just as it had a tough time from 2000 to 2010 where it had a negative return.
I have only two lessons. One of them is that Homo sapiens is hugely tilted to wanting good news. A desperate preference for good news over bad news. Why not? I get that. And the other is they have no interest at all in the future. They extrapolate today's conditions forever. So if you're sitting there in 1929 and the data looks good and you're growing at 7% annualized GDP, what the hell have you got to worry about? We never anticipate anything. Just step back and look at the data. Does it look good? Does the future look good? And um don't be conned into being super optimistic by the professionals, by the industry that makes money from overconfidence, lots and lots of money. Look around for signs of crazy bubbly behavior, to the moon, to the moon sort of thing, which we have seen as splendidly in this last several years as we have ever seen in history, which is a high hurdle. Just use your own brains and u if you don't want to follow my advice and buy international stocks and keep plenty of