Think about the following excerpts from Howard Marks's latest memo within the context of yesterday's video.
Emphasis (highlights) mine...
“He who knows only his own side of the case knows little of that.”
--John Stuart Mill
"In the long term, the success of an investment will hinge primarily on whether the buyer was right about the asset’s earning power. However, an asset’s current earning power and opinions regarding its future earning power usually don’t change much from month to month or even year to year. Thus, short-term investment performance is likely to stem mostly from changes in the price investors are willing to pay for the asset. That makes price the dominant consideration for anyone whose principal concern is the short run.
Value should be thought of as exerting a “magnetic” influence on price. If price is above value, future price movements are more likely to be downward than upward. And if price is below value, future price movements are more likely to be upward than downward. However, in the short run, price can move in just about any direction relative to value. This is so because an asset’s price at any given point in time is mostly determined by investor psychology, which can be irrational and unpredictable. Thus, while the current relationship of price to underlying value should move in the expected direction, it can only be counted on to do so in the long run at best.
“More likely to be” is the key phrase in the above paragraph. An undervalued asset can remain cheap – or even get cheaper – for a long time, just as an overvalued asset can become more overvalued, and then extremely overvalued, and then crazily overvalued. It’s the ability of price to go to crazy extremes that causes bubbles and crashes. If price always stopped going up when it began to exceed value, we wouldn’t have extended bull markets and bubbles (and the ensuing crashes), and vice versa.
People who bet heavily that price will move in the direction of value – which we call “converging” – can be carried out if they don’t have sufficient staying power. That’s why John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.” It’s intellectually sound to expect price to move toward value rather than diverge further from it, and even to bet that it will happen, but it’s unwise and potentially dangerous to bet heavily that it’ll happen soon.
As Benjamin Graham said, in the short run the market functions like a voting machine, reflecting assets’ popularity. But in the long run, it’s a weighing machine, assessing assets’ value. Thus, we can think in terms of a “calculus of value” that I find entirely logical and almost mathematical . . . except for the fact that it’s applied by people who aren’t:
Value is what you get when you make an investment, and price is what you pay for it.
A good investment is one in which the price is right for what the value turns out to be.
Due to the volatile nature of investor psychology, asset prices fluctuate much more than fundamental value.
Thus, most price changes reflect changes in investor psychology rather than changes in fundamental value.
Because of the key role psychology plays in setting asset prices, in order to have a sense for where price stands relative to value, investors should try to gauge prevailing psychology, not just quantitative valuation parameters.
The relationship of price to value should be expected to strongly influence investment performance, with high valuations presaging low subsequent returns, and vice versa.
But that relationship must not be counted on to have the expected impact in anything but a long-term sense."
"The S&P 500 stock index is the most watched barometer of the U.S. stock market. Toward the end of last year, its forward-looking p/e ratio (the ratio of its price to its estimated earnings over the coming year) was around 23, significantly above its historical average.
At the time, J.P. Morgan published a graph showing that if you bought the S&P 500 index at 23 times the coming year’s earnings per share in the period 1987-2014 (the only period for which there’s data on forward-looking p/e ratios and resulting ten-year returns), your average annual return over the subsequent ten years was between plus 2% and minus 2% every time. To the extent this p/e ratio history is relevant, it bodes pretty poorly for the S&P 500.
I concluded in my January memo that this was troublesome but not threatening, again mostly because the temporary mania or “irrational exuberance” that I believe accompanies – or gives rise to – most bubbles wasn’t present."
" What can we say about the price/value calculus today?
The S&P 500 was highly valued at the end of 2024 and also just before the tariff announcement.
The economic possibilities – and likely multi-year earning power for companies – are probably less positive on balance than they were before the tariff announcement, albeit not as bad as initially feared. Rising inflation is still a concern.
The threat of higher inflation has reduced the likelihood of the early, stimulative interest rate cuts investors had hoped for.
The trade and tariff agreements the administration sought are being extracted, but the U.S. seems to be viewed around the world as a less-dependable ally and partner, and some investors may conclude they should be less heavily weighted toward U.S. assets. Implementation of this view could cause net selling and/or reduce the future demand for these assets.
The U.S. fiscal deficits and national debt show no sign of improvement, and worldwide concern over them seems to be increasing.
Nevertheless, with the outlook possibly diminished on balance, U.S. stock prices are up. While earnings are expected to rise, stock prices are up more. Thus, regardless of where it stood as this year began, the value proposition in U.S. stocks seems to be less appealing today than it was at year-end – and even then, it wasn’t great.
What are the indicators of investor behavior and the resulting price/value relationship?
The elevated p/e ratio on the S&P 500 is the tentpole of the argument that valuations are optimistic.
According to the Financial Times (July 25), “Stocks in the S&P 500 are now valued at more than 3.3 times their [companies’] sales, according to Bloomberg, an all-time high.”
From the same FT article, “A Barclays ‘equity-euphoria indicator,’ a composite of derivative flows, volatility and sentiment, has surged to twice its normal level, into territory associated with asset bubbles.”
Warren Buffett’s favorite indicator – the ratio of the aggregate market capitalization of U.S. stocks to U.S. GDP – is also at an all-time high. It’s especially worth noting that the U.S. market cap has been restrained by companies’ tendency to wait longer these days before going public and by the fact that many companies have been taken private in buyouts. Thus, this elevated indicator could be even more troubling than it appears.
The current relationship between the yield on the 10-year U.S. Treasury note and dividend yield on the S&P 500 shows the latter to be expensive in historical terms.
So-called “meme stocks” – stocks favored by online retail investors, who don’t necessarily think in terms of the value proposition described above – have attracted heightened attention lately. Many sport prices that seem low at first glance, but you have to wonder whether their buyers fully understand the companies’ fundamentals, some of which appear precarious.
Yield spreads – the amount of incremental yield investors demand if they’re going to give up the safety of Treasury securities and buy corporate debt for its higher yields – are approaching all-time lows and are less generous than they were when I wrote the memo Gimme Credit in March. This, too, implies an elevated level of risk tolerance on the part of investors, and thus is another sign of a lofty market.
An aside regarding the valuation of the S&P 500: A bit over half of its jaw-dropping 58% two-year total return in 2023-24 was attributable to the spectacular performance of just seven stocks, those of the so-called “Magnificent Seven” – Apple, Microsoft, Alphabet (parent company of Google), Amazon, Meta Platforms (parent company of Facebook), Nvidia, and Tesla. These are great companies – some are the best companies ever – and these seven stocks have grown to represent a startling one-third of the total market value of the 500-stock index. (Please bear in mind that I don’t claim to be an expert on stocks in general or tech stocks in particular.)
Because of these companies’ greatness, their stocks are highly valued, and there’s a popular perception that their elevated valuations are responsible for the S&P 500’s unusually high average p/e ratio. The fact is their p/e ratios average out to roughly 33. This is certainly an above average figure, but I don’t find it unreasonable when viewed against what I believe to be the companies’ exceptional products, significant market shares, high incremental profit margins, and strong competitive moats. (A lot of the Nifty-Fifty stocks First National City Bank owned when I got there in 1969 were selling at p/e ratios between 60 and 90. Now that’s high!) Rather, I think it’s the average p/e ratio of 22 on the 493 non-Magnificent companies in the index – well above the mid-teens average historical p/e for the S&P 500 – that renders the index’s overall valuation so high and possibly worrisome.
Why are asset prices so strong in the face of what I view as net negative developments? How can the S&P 500 have risen 14% in the four-plus months since April 1, the day before the tariffs were announced, given that most observers believe the tariffs will add to inflation, weigh on economic growth, and reduce the perception of the U.S. as the premiere investment destination? Here’s my explanation:
Investors are by nature optimistic. You must be an optimist to hand over your money to someone else in the hope of getting more back later. This is especially true of equity investors, and I think their optimism dies hard.
When they’re in an optimistic mood, investors have the ability to interpret ambiguous developments positively and overlook negatives.
The last sustained market correction ended in early 2009, meaning it’s been over 16 years since risk bearing was seriously punished and “buying the dips” wasn’t rewarded. That means no one under 35 or so – professional and amateur investors alike – has ever experienced a prolonged bear market. Older investors have experienced one or more, but, with the passage of such a long time, some may have been lulled into a false sense of security.
Although the U.S. probably continues to offer the best investment fundamentals in the world, some investors may not appreciate the possibility that it’s a little “less best.”
Rationalizations often emerge to keep bull markets going. One these days is “TACO,” which stands for “Trump Always Chickens Out.” The suggestion is that his strongest threats – and some of investors’ worst resulting fears – won’t be realized.
Given the long skein of good years in the markets, it seems today’s investors are motivated more by FOMO than by concern about the chance the market is high and likely to produce poor returns or even losses.
Finally, of course, the consensus of investors responsible for today’s asset prices probably view the fundamental outlook as more positive than I do.
What’s the bottom line of the calculus? Fundamentals appear to me to be less good overall than they were seven months ago, but at the same time, asset prices are high relative to earnings, higher than they were at the end of 2024, and at high valuations relative to history. Most bull markets are built through the addition of a “constellation of positives” on top of a well-functioning economy. Today I see elements that include the following:
the positive psychology and “wealth effect” resulting from recent gains in markets, high-end real estate, and crypto,
the belief that, for most investors, there really is no alternative to the U.S. markets, and
the excitement surrounding today’s new, new thing: AI.
These are the kinds of things that have the ability to fire investor imaginations and contribute to bull markets, and they certainly seem to be doing so now."
And lastly:
"The existence of overvaluation can never be proved, and there’s no reason to think the conditions discussed above imply there’ll be a correction anytime soon. But, taken together, they tell me the stock market has moved from “elevated” to “worrisome.”
What should you do about it? I consider tactical actions in terms of the spectrum that runs from aggressiveness to defensiveness, and when valuations are high, I consider becoming more defensive. In the “action shows” my wife, Nancy, and I like to watch, the Pentagon sometimes announces a Defense Readiness Condition, starting at DEFCON 5 and escalating as the danger grows to DEFCON 1, which indicates a nuclear attack is underway or imminent. In a similar vein, I think of progressively applying the following Investment Readiness Conditions, or INVESTCONs, in the face of above average market valuations and optimistic investor behavior:
6. Stop buying
5. Reduce aggressive holdings and increase defensive holdings
4. Sell off the remaining aggressive holdings
3. Trim defensive holdings as well
2. Eliminate all holdings
1. Go shortIn my view, it’s essentially impossible to reasonably reach the degree of certainty needed to implement INVESTCON 3, 2, or 1. Because “overvaluation” is never synonymous with “sure to go down soon,” it’s rarely wise to go to those extremes. I know I never have. But I have no problem thinking it’s time for INVESTCON 5. And if you lighten up on things that appear historically expensive and switch into things that appear safer, there may be relatively little to lose from the market continuing to grind higher for a while . . . or anyway not enough to lose sleep over."
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