Howard Marks (Trades, Portfolio) doesn't predict market downturns, but he does use historical valuations as a proxy for whether or not to be invested in the market. As someone who has spent over 50 years investing in the credit markets, Marks understands how to use history to guide his decision-making. In an interview at a Bloomberg Markets forum in 2016, he answered a question about how investors can use investor sentiment and data to help them with their future actions.
Look out for 'bubble thinking'
Marks believes it is possible to know when a market has gotten overvalued based on the kind of investor sentiment that is going around. In particular, he advises capital allocators to be on the lookout for "bubble thinking":
"When there's a demonstrable bubble and when psychology is crazy bullish and when the risks are extremely high and valuations are extremely high…Bubbles are connoted by extremely high valuations and also by 'bubble thinking', which says things like: 'nothing bad can happen', 'there's no price too high,' 'this can't lose.' We've seen bubbles like the 'Nifty Fifty' bubble, in which IBM (IBM, Financial), Xerox (XRX, Financial), Kodak (KODK, Financial), Polaroid, Avon, Merck (MRK, Financial) and Lilly (LLY, Financial) were selling at 80 to 90 times earnings in 1968-1969".
Similarly, at the height of the dotcom bubble, there was a widespread belief that any business that was in any way connected with the internet was destined for great returns, and that therefore any price for shares of these companies was too little. As many investors found out to their chagrin, there's no asset so good that it can't be too expensive.
Look at historical valuations
Another indicator that can be useful is the price-earnings ratio of the overall market. The post-war average price-earnings ratio of the benchmark S&P 500 Index was around 16. In the run up to the dotcom bubble, the ratio was 32. For reference, right now the ratio is at around 26.5, which suggests that stocks are currently overpriced, although they are not quite in bubble territory (by this measure).
Of course, the price-earnings ratio is just a crude indicator and shouldn't be the only yardstick that one uses to price assets. Any value investment must ultimately involve analyzing individual companies, rather than markets in a broad sense. Nonetheless, it is a good starting point for an investor who wants to get a general sense for what the risk appetite of those around them is.
It is a simple principle of any auction-based market system - where the highest bidder takes home the prize - that the buyer typically overpays. The higher the number of bidders, the more the winner overpays. This helps to explain why in bull periods, buyers tend to lose out - they are accepting much lower returns than they would have gotten if they had waited for the assets to become cheaper. You should bear this in mind the next time you see the stock market becoming overheated.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman Explains Why Investors Should Retain Cash
- Jim Chanos Believes Markets Have Gotten Too Speculative
- Bill Ackman Explains the Activist Approach to Investing
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