Take the Red Pill
Top 5 januari - Portfolio transaction - Weekly 2 2025
After last Thursday's newsletter, I found myself reflecting on two key questions:
Am I being too cautious?
Has the market fundamentally changed?
The first question has been largely answered after I reexamined and meticulously analyzed the portfolio (prompted by the newsletter from our fund). I don’t believe I’ve played it too safe. The portfolio includes several cyclical stocks with significant potential, but I’ve avoided taking unnecessary risks by investing in growth opportunities that are overly uncertain. This aligns with my role as a value investor—no one expects me to do otherwise.
The second question remains: has something changed in recent years, fundamentally altering how the market operates and rendering the “old” approach less effective? And if so, is this change permanent or temporary?
Let me begin by referencing an excellent presentation by Michael Green from Simplify Asset Management during a CFA (Chartered Financial Analysts) dinner, where he discussed the risks of the growing dominance of passive investing.
The title of his presentation says it all: The Greatest Story Ever Sold.
A snippet from the event organizer’s announcement reads:
“His studies and messaging are somewhat like taking the red pill in The Matrix. Once you’ve listened to his thesis, there is no going back. The world is going to look a little different to you.”
This presentation is definitely worth spending an hour on. It provides valuable insights into current developments in the stock market.
The Passive Investing Effect
According to Michael Green—and I share his view—the overvalued U.S. market, particularly the inflated valuations of the largest stocks, can largely be attributed to passive investing.
As Green puts it, passive investing is the simplest algorithm: you give me money, I buy. The mechanism simply involves “buying the market” without differentiating between overpriced and fairly valued stocks. In other words, no rational or evidence-based decisions are made. As long as money keeps flowing into ETFs, the party in the U.S. continues.
Historically, markets could collapse when they became overpriced. But according to Green’s thesis on passive investing, that likelihood is much smaller today. Passive investors don’t pay attention to valuations and, perhaps more importantly, they don’t sell.
The risk of a crash only arises when passive investors are forced to sell. But when does that happen? Only when money is needed. In other words, a recession in the U.S. alone won’t suffice. A significant number of job losses would be required before passive investors are forced to sell.
Howard Marks: Not Quite a Bubble
Howard Marks of Oaktree recently released a new memo titled On Bubble Watch. Like I’ve done previously, he points to the Nifty-Fifty era as a comparable situation to what we’re seeing today.
Marks defines a bubble as follows:
highly irrational exuberance (to borrow a term from former Federal Reserve Chair Alan Greenspan),
outright adoration of the subject companies or assets, and a belief that they can’t miss,
massive fear of being left behind if one fails to participate (‘‘FOMO’’), and
resulting conviction that, for these stocks, “there’s no price too high.”.
While he observes signs of a bubble, Marks is hesitant to definitively label it as such. He does, however, highlight a few points of concern:
the optimism that has prevailed in the markets since late 2022,
the above average valuation on the S&P 500, and the fact that its stocks in most industrial groups sell at higher multiples than stocks in those industries in the rest of the world,
the enthusiasm that is being applied to the new thing of AI, and perhaps the extension of that positive psychology to other high-tech areas,
the implicit presumption that the top seven companies will continue to be successful, and
the possibility that some of the appreciation of the S&P has stemmed from automated buying of these stocks by index investors, without regard for their intrinsic value..
Interestingly, Marks also highlights the effect of passive investing. However, he concludes that there’s no clear bubble yet, for the following reasons:
the p/e ratio on the S&P 500 is high but not insane,
the Magnificent Seven are incredible companies, so their high p/e ratios could be warranted,
I don’t hear people saying, “there’s no price too high;” and
the markets, while high-priced and perhaps frothy, don’t seem nutty to me.
From both Michael Green’s presentation and Howard Marks’s memo, we can conclude that the U.S. market rally may continue for some time. Considering that Trump is desperate to avoid being seen as a poor economic president and views the stock market as his benchmark, there’s a chance we may see four more years of rising prices—until things ultimately do become irrational.
Man muss immer umkehren
Charlie Munger once said, “Invert, always invert,” borrowing the phrase from mathematician Carl Jacobi, who argued, “Man muss immer umkehren”. When faced with a problem, inverting it can lead to solutions.
If we invert the characteristics Marks describes as signs of a bubble, they fit European markets perfectly:
In Europe, there’s no exuberance but rather deeply rooted pessimism.
There’s no adoration of companies—not even market leaders like ASML. On the contrary, there’s widespread disdain for many companies, such as Tessenderlo.
FOMO is completely absent. No one seems interested in investing in European markets.
No price is low enough to make European stocks attractive.
Moreover, the allocation of European stocks in global indices (and therefore in ETFs held by passive investors) is very low. This suggests that Europe might be experiencing the opposite of a bubble (a void?).
Valuing Dutchman: The Ideal Diversifier
Since I remain confident in my analytical and calculation skills, and because I continue to outperform the S&P 500 over my 20-year investing career (albeit narrowly), I believe I’m still on the right track.
The stocks in our selection provide perfect diversification for anyone already heavily exposed to the U.S. market. This could be via ETFs, funds offered by banks or asset managers (which often operate as closet indexers), retirement savings, or direct investments in the “Magnificent Seven.”
How long the U.S. party will last is impossible to predict. But I do foresee a time when valuations will matter again. And when that happens, we’ll be well-positioned with our companies.
Until then, we must rely on what our companies earn for us in the meantime. That’s why I’ve updated the Top Five stocks of the month (see below). For now, I’m not factoring in any potential revaluation.
Articles and updates this week
For the next two weeks, things will be quiet in terms of company news, so you'll only hear from me twice a week in your inbox.
This past Tuesday, the article “Why earning and managing money are wolds apart” was posted
Planned Transaction: Double Portfolio
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