In the think of market conditions like the one we are in, few investors are able to think clearly and fewer so articulate the same. Howard Marks is one of those who can do both. In this memo of his, he gives us a primer of value, price and the interaction between the two and then apply the primer to the current context to help us decide our likely course of action in our portfolios. As usual, we recommend reading Marks’ memos in its entirety. Here’s him summarizing the primer:
“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.”
He then asks the question: “What conditions might give rise to the superior risk-adjusted returns active investors crave?”
And goes on to answer such:
And goes on to answer such:
- “The consensus of investors doesn’t fully comprehend the asset’s current value.
- The market price is too low for the current value of the asset.
- The asset’s value increases more than investors anticipated, usually because of an unforeseen increase in its earning power.
- The asset becomes more popular with investors, resulting in an increase in its price that is unrelated to changes in value.”
In practice however, this isn’t as easy, despite sounding simple:
“Like many things that are made up of a large number of ingredients both qualitative and quantitative, a company’s attributes can’t be summed up through an algorithm or reduced to a single number. Evaluating them requires judgment. And if the value of a company, for example, is multivariate and confusingly unquantifiable, it obviously can be very hard to assess the fairness of its price at a point in time.”
So where do we stand today in the context of the US market?
“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.”
What should one 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… 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 short
…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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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
