Introduction

Last week, Howard Marks released his latest memo, "The Calculus of Value," which I believe is essential reading for anyone trying to understand the current environment. The following does not reflect my personal opinion, but rather represents a "know thy enemy" examination of the derisking arguments currently core to many short theses. 

As co-chairman of Oaktree Capital, which oversees ~$200 billion+ in assets, Marks has built his reputation on market calls and rigorous fundamental analysis. His quarterly memos to clients and the broader investment community have achieved legendary status on Wall Street. When Marks speaks about market valuations and risk, people listen - not because he's infallible, but because his framework has consistently identified major inflection points (alongside the occasional false start!).

The Calculus of Derisking

At the heart of Marks' thesis lies a distinction that sophisticated allocators use to justify defensive positioning: value represents what an asset is genuinely worth based on its earning power and fundamentals, while price reflects the collective psychology and sentiment of market participants at any given moment.

He articulates the bear case with the following points:

Core Valuation Concerns

• S&P 500 forward P/E trades around 23x - way richer than historical averages, with stocks trading at 3.3x sales (an all-time high) 
• Market cap-to-GDP is hitting record levels while underlying fundamentals have actually deteriorated 
• Sixteen years since the last sustained bear market means no one under 35 has experienced prolonged losses 
• The real concern isn't the Magnificent Seven's valuations (averaging 33x P/E), but the other 493 companies averaging 22x earnings when historical norms sit in the mid-teens

Additional Market Warning Signs

• Historical data shows buying the S&P 500 at 23x forward P/E between 1987-2014 resulted in average annual returns of just +2% to -2% over the subsequent ten years 
• Barclays' "equity-euphoria indicator" has surged to twice its normal level, into territory associated with asset bubbles 
• Warren Buffett's favorite indicator (market cap-to-GDP ratio) is at an all-time high 
• Treasury-to-dividend yield spreads shows stocks are expensive in historical terms 
• Credit yield spreads approaching all-time lows, indicating elevated risk tolerance among investors
• "Meme stocks" attracting heightened attention with buyers potentially not understanding precarious fundamentals 
• The ‘Mag7’ now represent a startling one-third of the total S&P 500 market value, with over half the index's 58% two-year return attributable to just these seven stocks

Using these points, Marks makes his case for moving to what he calls "INVESTCON 5" - reducing aggressive holdings and increasing defensive positions within portfolios. Whether this fits a personal view, in my opinion - is irrelevant, as understanding the ‘flip side’ of the coin is only positive for navigating the current environment. I'm sharing the full memo here, along with yesterday's Bloomberg Talk in audio format, both of which are worth consuming!