Market Outlook: Howard Marks emphasizes that asset prices are high relative to earnings, with fundamentals appearing less favorable than earlier in the year, yet prices continue to rise.
Valuation Concerns: Marks discusses the elevated P/E ratios, particularly outside the MAG7 stocks, and questions the sustainability of these valuations given the current economic conditions.
Investment Psychology: The podcast highlights Marks' view on investor optimism, noting that market participants often interpret ambiguous developments positively, which can lead to overvaluation.
AI and Market Impact: There is significant excitement around AI, with predictions of substantial capital spending, but the broader market impact remains uncertain, especially for companies not directly involved in AI.
Fiscal Policy Influence: The discussion touches on the importance of fiscal policy over monetary policy, suggesting that government spending and deficits may have a more substantial impact on market dynamics.
Historical Returns Analysis: Marks references historical data showing that buying the S&P 500 at high P/E ratios typically results in low future returns, reinforcing the importance of valuation discipline.
Investment Strategy: The podcast suggests focusing on individual stock valuations rather than market trends, emphasizing the need for a disciplined approach to avoid overpaying in an expensive market.
Key Takeaway: Investors should critically assess their return expectations and remain cautious of high valuations, considering alternative investments if expected returns from equities are not compelling.
Transcript
Welcome, welcome, welcome. How's everybody doing? Hope you are doing well. My name is Andrew with Focus Compounding on Air Live with Jeff Ganon. Jeff, how's it going today? >> It's going very well, Andrew. How's it going with you? >> It's going great. We hope it's going great with everybody else as well. If this is the first time you're tuning in with us, thank you so much for joining us. Be sure to check out all of our content that we push out into the investing universe. Best way to do that is to follow me on X at Focuscompound. If you want to get access to investment writeups from Jeff going all the way back to 2005, uh, go to focuscompounding.com and you could do that there. And of course, if you're interested in learning about our money management services, you can reach out to me at andrew at focusedcompounding.com. So, in today's podcast, we're going to be talking about a memo that Howard Marx uh penned or at least released on August 14th uh called the calculus of value. >> August 14th. Very good. >> Um, >> you recorded a podcast that day. Yeah, >> we sure did. We sure did. Uh, Jeff's birthday. So, uh, want to go through it. Obviously, Buffett's talked about Howard Marx's memos are >> something that he reads. We've done a lot or we've gone over uh, a group of them on the podcast over the years. So, wanted to bring it up uh, as we recorded here today, the calculus of value. Uh, you know, I went through and I I read it and I highlighted some things and I, you know, kind of realized I'm like, you know, what he puts in bold is kind of like a good uh highlight for us to go over and just kind of go from there. >> Yeah. >> Uh, but I will put the actual post in the description. So, if you want to uh click the about section, you can pull it up yourself. But, I guess, you know, what are your general thoughts on the calculus of value, where his head is at, where we are in the market, just give me your your thoughts on the write up. take us through it. >> So, he makes a few points. One, he's in the camp of things have been expensive for a while, but he wasn't seeing bubble type things for much of it. Um, like others, I think he may have written some things during the COVID period that, you know, you saw things where there was stuff like that. Um, but since then, we haven't seen um a lot of that kind of thing until very recently in which you've had really high prices for some things. and he specifically talks about the non-MAGG7 things. Um, and what he's talking about basically is there's a lot of negative news um with maybe like one exception or something. Almost everything has been negative news for most of this year and um in terms of what might have been expected by the market and what actually happened and yet uh prices have tended to go up especially if you calculate from following those things. So, you know, he talks about like tariffs and things, right? Like from then the news turned out pretty similar to what it was as of that date and the market went up a lot between those two dates, you know, um things like that. We've seen that with the I think the market was up a bit on a expectation of a rate cut all those sorts of things. So, the one that was excluding was the uh um deficit probably bigger than the than the market would have anticipated, right? So like they either anticipated that they didn't think both spending would be as great is as it is and taxes as low as they are. So that one was probably a a surprise to the the upside so to speak for for equities though maybe not for for treasuries, right? But the other things are like not great news. It could what you expected or or worse or the same or whatever but not a lot of news that would have explained why things should go up from high prices and yet they have generally gone up from those dates. So kind of news and especially particularly the non-mag7 ones. Uh it was a lot of what he talked about basically like is there kind of overly optimistic reaction for the non-mag7 things to things that are not necessarily matched by surprisingly good news. You know what >> Yeah. >> So he walks us through how he thinks about value. uh he talks about you know the earnings power of a company um and the sources of value where that comes from. He talks about price um and then the relationship between the two and you know getting up to date is when he starts to talk about you know where we are in the market and the thing that you had just referenced which um was right here. he talks about that um I have a P of 22 times. >> Yeah. And the reason why that's better to look at than the M7 is kind of what he lays out in the beginning, which is if you think about it, what's the return on capital going to be? What's the reinvestment rate? What's the growth going to be? Those three variables. And if you know two of the three, you kind of know everything. But you kind of have to figure out, okay, so how long are they going to grow at above average returns that can justify high prices and because so much of the index is only those seven stocks, um it is possible to have real disagreement about that. Okay, well these might really be above average businesses and they account for so much of the index, but the average of the other 493, it's a lot harder to believe that they'll have above average returns on invested capital and accelerating returns on that in future years to justify the higher PE, right? So even if the P is 33 on the MAG 7, that's more debatable. Maybe the returns will be great, maybe they'll be poor, whatever. But they're investing a lot in trying to grow. And so it's more uncertain what the returns on that capital in the future will be. But the average of everything else is something that should be easier to predict. Um, and yet the PE on that is really elevated compared to what it has been in the past. Um, and that's the thing that I've noticed the most lately. Um, and he has some of the same points, I guess, that that I did. I don't remember where he puts it, but one of his theories is kind of that things that, um, are perceived to be going up all the time are getting rewarded with higher ratios. Um, and so I think that that could be a factor. He talks specifically about like just that there haven't been as many stock market um, drops that have been sustained and everything, but it is noticeable in the uh, prices of stocks that are kind of um uh predictable like high quality sort of of the other 493. But it's not even necessarily high quality. It's like low variability like that they just don't have down years. Um those have gotten really really expensive in some cases. That's the thing that I've noticed the most. um which is a little flavor of the 1990s cuz that earnings management uh you get a higher PE focus kind of thing was happening even in not um the tech the telecom whatever things it was also happening in consumer products things and we're seeing a little bit of that again >> what are your thoughts on he talks about right here what I have highlighted in this orangeest color about like the psychology of market participants currently as he sees it right so investors are by nature optimistic Um, he says, "When they're in an optimistic mood, investors have the ability to interpret ambiguous developments positively and outlook negatives." Um, this one I thought was funny. Um he talks about how you know this acronym taco which stands for Trump always chickens out uh is a suggestion that you know Trump's strongest threats or I guess these horrible situations where people could worry about or the market could worry about it uh they won't be realized because you know Trump kind of comes on hard and then maybe walks it back or whatever but that's what people say uh taco he always figures out. Yeah, which is a good point that Markx makes there because it is a rationalization like take the tariffs. Um the estimated level of what those are is not chickening out. It's uh quite similar to what was expected uh to what was announced. So um the you know there's different estimates. JP Morgan does an estimate. Um I think Yale has a what do they call it the budget lab or something has an estimate. There's some that are kind of somewhat independent of government that do estimates and uh they do they show you by day or by week what based on the news the estimated tariff um across everything should be and across it assuming also people switch between which products because there's tariffs on some things now and it's really high. Um it'll it take it back to levels it was at about well not quite 100 years ago but levels that it was at shortly after tariffs were increased um just under 100 years ago you know 95 years ago. So and then in the 1800s they were that high frequently but for 90 years no one's seen tariffs this high and they're certainly going to be there. Um so there wasn't much of a a taco on those things. Mhm. Talks about FOMO that's going on right now, but basically bottom line, as he bolded right here, fundamentals appear to be less good overall than they were seven months ago, but at the same time, asset prices are high relative to earnings, higher higher than they were at the end of 2024. >> Yeah. >> And at higher valuations relative to history. So, kind of the psychology of going into it, right? the wealth effect resulting from gains in the markets, high-end real estate and crypto, but then also just the excitement around this new AI thing, right? And the capital spending that is >> for the AI, I think what did they say? Nvidia just reported the other day and >> yeah, >> Jensen Swang, what did he say like two to three trillion over the next decade or something like that? >> Yeah, five years it'll be three to four trillion which is interesting. I actually saw an article that did exactly what I did. So I don't I can't cite the article because I don't remember who wrote it, but they did the same calcul calculations I did, which is to go back and say, okay, well, how much was it in.com versus the GDP and how much was it in the railroad boom back in like the 1880s and stuff. Um much smaller than the railroad boom, but bigger than is what that'll be. So um which in both cases it didn't result in a giant recession for the overall economy. It was not great for financial markets and was horrific for companies that were in those industries. They overinvested and had bad outcomes. But although there were recessions immediately after both of those booms um and and kind of couple rec in both cases there were a few recessions within 10 years. Um it wasn't like the worst recessions that that we ever had. Um they were pretty shallow at first and stuff. though cuz there were real productivity gains um more so for railroad railroad had huge productivity gains but there were some productivity gains in the 1990s although by the time the internet t took over those were less the productivity gains were more associated with like um word and excel and things like that that's where you had really big productivity gains is when offices all went to to using um software it was a little bit less when everything went online but still they're productivity gains in both cases >> I guess how do you as a investor or market participant And how do you weigh sort of this transformative technology against timeless investing principles you know like being disciplined in valuation well for the overall market generally will not matter um what those transformer things are. So that's why I said take the mag seven out of it. If we're dealing with 490 companies, most of which have little or nothing to do with AI, it won't matter. Um, the prices shouldn't be more elevated just because of things like AI. Um, you know, that's already captured all the data that we have going back with Schiller PS and things are capturing the giant boom in railroads, the giant boom in internet things. I mean, that's all taken into account. And uh then in terms of could AI change things more for those biggest companies and can they change things more directly in like investing in our lives and stuff? Sure, just like the internet would. But in terms of changing the valuation of the companies, I don't think so. Like for instance, I don't know that AI would have as big an impact on profitability of those 493 companies is like the fact the government's running large deficits, right? like fiscal spending or something and um taxing uh could be as big or bigger a factor. Um yeah, but it could be big if it changes things dramatically for labor, but it's very hard to know what those are. I mean, there's some AI things uh companies saying like, look, there'll be a lot of unemployment and stuff. and possible that that could improve profitability for some companies if you don't serve consumers in the US and you do use a lot of entry- level workers. It's possible that you could make a lot more money because AI will reduce a lot of your labor expense and stuff. So, there's always specific cases where it could help you out a lot. Do you think fiscal just matters more than anything in fiscal spending? >> Um, no. I I >> you know it's like so many people are worried about interest rates and you know Powell now is talking about he's he's setting the table for a rate cut and I'm like at the end of the day I really think the only thing that matters is yes interest rates but just really even more so just fiscal fiscal spending. So yeah, um the the issues are it depends. I think sometimes monetary policy could matter a lot, sometimes fiscal policy could matter a lot. Um the effects that fiscal policy will have are generally going to be pretty big and immediate. Um but they're only because they're, how do I put this? um they're willing to run the the fiscal policy is more extreme and unusual than what's been imagined in monetary policy necessarily. Um so I think like to take an example you know there's different ways of measuring like Fed um uh liabilities and things like that but let's take an example like that sort of the size of their balance sheet or something it might go from 10 to 30% um or something of the size of the economy um from where it's expected to be really small to where it's huge and people are uh saying this is unprecedented you know whatever um fiscal policy has already gone from you know debts of 40 years ago of like 30% or something of GDP to you know expecting it to be 130% and still having a deficit. Uh you know that that's the long-term projections right now. So that's big but yeah like in a war fiscal policy is far more important than monetary policy. It's a question of to what extent do you reign that in over time and and everything and if the expectation is that it continues then the effect it has is really really big but at some point the expectation can be that it continues at some point there's an expectation that you know it has to level off in terms of debt to GDP and deficits won't be run at those levels and everything um I mean he mentions it I think he mentions it in this um but if you well I don't remember actually um in in this if he mentioned it But, you know, when the um expectations change for for um short-term interest rates, they haven't changed uh for the long term. So, in other words, like um right now, I I don't know if we should always expect that uh cuts in the Fed funds rate and stuff over time are going to necessarily change things in the 30-year as much as people expect. That's basically that's basically like every mom and pop, real estate agent, everybody. They think that the Fed just cuts rates on the short end and and the long end just sort of goes down in lock step. I think you're going to get a really steep curve is what my expectation would be. >> Yeah. And we'll we'll we'll see. I mean, if >> or there's two ways to look at it, though, right? So on those remarks that the the long end basically did nothing. So now people are like whoa wait is is the economy actually really falling off a cliff and they are going to cut is that like how is the bond market interpreting that or is it just hasn't happened yet like what is that you know I mean in the past in 2024 when they cut interest rates um before the election not for political reasons um the long end took off right well what happened here nothing happened here so what does that mean it kind of made me think I'm like oh wow is is is the economy actually falling off a cliff here Should you go long bonds? >> It depends on the how efficient the market is in certain ways in looking at things. Like we could look at this theoretically. There's two issues that can happen as to why things would move in lock step and why they wouldn't. So one, it may not matter that much when news comes out. You don't even need to know what the Fed says it's going to do if you think that you know what its ideal policy should be, right? So like if you get news that long term makes you think a certain way about what the the neutral rate of things should be and everything, then that could affect the long end uh uh for yields and everything. And it can affect it even if you don't hear from the Fed right away. The other thing is if you believe or don't believe what the Fed says for the longer term for longerterm bonds. So if you expect them to have a policy that in the short term that they're going to reverse in the long term then it might not be that important to you. Or if you simply don't believe what they're saying that's hasn't historically happened like the Fed it doesn't usually say something that reverse itself quickly. So the reasons would be either you disagree with the Fed in terms of what the longer term rate should be or you think that the Fed is going to do something in the short term and then reverse itself longer out. And we don't have lots of like the prediction stuff is all based on very short-term stuff. So it may not be able to capture very well what that is. So, you could have expectations for that everyone's agreed, oh, there'll be cuts in the next 6 months or something, but then, you know, expectations that rates won't be that much lower in two or three years or something, in which case it wouldn't affect long-term yields. Um, whereas like when you had the financial crisis, you might not have even needed to wait for the Fed. If you thought you were entering a depression, then those rates should have come down a lot fast and you just would have expected the Fed to follow. >> He said something in here which I could try to find really quick. Um, hold on one second. I thought was interesting. Okay, so he talks about where we began in 2025. Yeah, it was this bullet point. He said so at the beginning of the year JP 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 through 2014 uh which is the only period for which there's data on forward-looking PE ratios and resulting 10-year returns. Your average annual return over subsequent 10 years was between plus 2% and minus 2% every time. >> Yeah. Um, so I thought that was a >> Yeah, and I did that going in 2005. I did that for all years for the Dow going back to 1935 and I went out to 15 years instead of 10. It's even worse. I mean, it's even more predictive over 15 than 10. It stops after 15 years basically. So the PE ratio is determines things about the future for about 15 years and then the effect kind of goes away. It's probably stronger effect at 10 than 15, but it's still present. So for that it tends to be that if you buy something today and hold for 15 years um or 10 years uh the the price that you start at is very strong predictor of what's going to happen in the future. It's stronger than most things but that's but a lot of that is because of the extent to which people's expectations or estimates don't matter. Um like they're not able to estimate correctly. So we just talked about interest rates. every investment bank and governments and things all predict what future interest rates will be but there's not evidence that they predict the Fed does it uh that they predict it correctly and like I went back and looked at GDP things and simply predicting that having a poor level of GDP for the last 15 years predicts better than expected for the next 15 and vice versa is a better guess than trying to model it and estimate and that's definitely true with valuations just saying if the market's done well for the last 15 years it'll do poorly for the next 15 also good estimate. If P, you know, if multiples has been expanding for 15 years, expect them to contract for the next 15. If GDP has been overly hot for 15 years, expect to be cool for the next 15. It's a pretty good guess. Um, like in terms of at least the hit rate, it's not always great about the magnitude, but it's nearly perfect in terms of predicting that. Um, like he said, like you will have almost no return. It's almost perfect in doing that. Now, that's over a period that's shorter because it's 87 to 2014. So it does one observation a year every year but it's not a long-term thing but for most that period um you know multiples were expanding. M so >> so I'm going to ask a question and it's you know separating the political view right at what point is it like Trump truly is this straw that you know stirs the drink right not saying like him don't like him right wrong indifferent we're just purely talking as market participants trying to make money right I mean at what point it's like he's going to get interest rates lower probably or he's going to get the Fed to cut who knows what's going to happen with the long end of the curve there right but I mean at what point is it like he cares so much about markets going higher that something like this can continue on and Trump's the type of person as well where he could step down >> or in you know when when his term is up and everything could go to hell and he'll just say well it was great when I finished it's not my fault right like take all the credit put all the blame on other people right so just kind of curious I mean at what point is it like at the end of the day he's the straw that stirs to drink. He wants markets to go higher. He cares a lot about markets and he's going to get his way. I mean, at some point, like you think about like the dip buying, which I think Howard Marks wrote about, so much of the plumbing is passive now, 401ks, the wealth effect. It's almost like it's a think of national security to continue to have equities go higher, right? And what cracks that if anything? >> Oh, we never know what will do it. I mean, it's funny. There's usually something that comes out that's unexpected in almost all cases. >> It's almost every case. >> Trump, somebody gets on TV and he brings the board out and everyone's like, "Oh my gosh." >> Well, so what I mean is you take Japan, you take 1929, you take uh 2000, um some other bubbles that have happened. Uh, usually there's something that's unexpected that no one anticipates. So, obviously a risk that everyone's anticipating wouldn't matter that much unless somehow everyone's wrong about it. Some people do anticipate a housing bubble and then it happens or uh um you know something about fiscal spending and then it does happen in some countries. Um but there are smaller group of people predicting that. So, usually it's something unexpected that happens that usually causes a recession of some kind, maybe not for long or causes unended or intended but overly done tightening in short-term things. So, that short-term credit stuff like seizes up and and becomes a problem. Um, the one exception to that is uh 2000. I'm not sure that anyone knows what happened. That's the one in which normally we think that something pricks a bubble and stuff in in that one we don't know. There's ne I don't think there's any good evidence for what happened. It may have collapsed on its own in which case it's rare because it doesn't seem to ever happen. There wasn't a recession for a really long time. It was extremely shallow and may not have even occurred if it wasn't for things like 9/11 and the bubble popping anyway. So, it just seemed to crash under its own weight, which is almost unprecedented. I mean, usually you have to have a recession or some really unexpected um financial seizure. Um, and it didn't. So, it's usually something out of left field that's not expected, that might not be that big, but does cause problems because you have really high prices except for that one, which is the dot bubble, which I'm still not sure that we understand what happened and why they just started going down. it would, you know, it's known that it was an emperor's new clothes type thing and that for some reason people started to have a change in perception where at earnings started being released and they said, "Oh, but how are they ever going to make money or something?" Whereas it's the same people who weren't caring about that the quarter before, the quarter before. It's not clear why that kind of happened, but it did. Um, and I'm not sure why. In all other cases, usually something happens. And and none of them is just the cause. It's not like, you know, you can explain a complex thing like the great depression crash of that market and stuff and be like, "Oh, it was just tariffs. It was just uh uh interest rates uh changes. It was just, you know, it's a variety of different things that all happened, but the severity of it is determined by the the price. So, the magnitude is because of the price." Yeah. >> Sure. >> So, where are we on that spectrum? Right. So he let he laid out his invest uh sort of tongue and cheek on defcon scale right and he has you know six first one stop buying reduce five reduce aggressive holdings and increase defensive holdings four sell off the remaining aggressive holdings three trim defensive holdings as well two eliminate all holdings one go short um so I think he he said he's at invest five which is reduce aggressive holdings and increase defensive holdings, >> right? And he thinks he would never go to two or one, does he say? Or what does he say? Three, two or one. So he wouldn't ever trim defensive holdings as well. Yeah. >> Yeah. I agree with that scale. >> Do you agree with >> I don't know um how close we are to people's changes and perception stuff. It's hard to say. I haven't seen much of a change in people's perceptions of things. Um, usually you have a more serious going up. Um, that doesn't seem to make much sense, you know, given the news and stuff, which is what he's describing here. And there's been some of that in the last few months and that wasn't present as much in the past. So, you might be later in the stage in that you're getting a more extreme going up. That doesn't make a lot of sense. Um, which is usually what happens before you go down a lot. But it it's hard to tell until you actually start on the other side of going down. So I I don't know. I mean, you can go up a lot higher in terms of pricing and stuff like that. It may be similar to 29 and 2000, but you know, just because of that doesn't mean it can't go up one and a half times, two times more expensive in price before it then goes down. Usually when you have a a really big thing happen, it's bigger than anyone that there's been before. And there's no reason why it can't be bigger now than it's been before. Just cuz you hit the past kind of um most you've ever had in terms of pricing and stuff doesn't mean you can't exceed it this time. Something can be bigger than it's ever been before. Um and um you know and unless something happens usually things don't reverse. Um but I think he's right somewhat about the psychology in that there is more of a disconnect. There's some studies that like surveys and things that show this. There is a little bit more of a disconnect in the past of people saying that they think things are overpriced and don't have positive things to say about them but also expect them to go up, right? And that is usually that that's more of a sign of something that you see at the end of of a bubble where where people do anticipate things will go up even if if um news isn't particularly good or even if they don't think it's cheap or something. Whereas in the early stages of a um recovery, people tend to think things will not go up even though they also say that things are getting better. Like if you ask people, are things getting better for your company? And do you expect your stock to go up? In 1932 or something, they think no, I I think they're getting better and we won't go up and you know in 1929 you think the reverse. You know, you're like h no, what we're seeing isn't that great, but we still expect our stock to go up. You know, that's shifted a bit. I think that people think it's less more to to um results right now. >> I guess the real question is like how can an investor protect themselves uh from overpaying in a market where just everything feels kind of expensive, right? Like we talked about the other 400 and uh whatever 94 stocks. >> Mhm. >> They're still trading at a premium PE. So, how do you protect yourself from that? Right. We did a past podcast where we talked about >> cyclical commodities and you're like, "Yeah, I mean it may look expensive on paper, but relative to the market, it's not." How can investors protect themselves from that perspective? >> Well, I think you should always buy things individually ignoring what the market is doing. And if you think that they will have good returns, you should keep buying them. in terms of if you're trying to have a portfolio versus the you know diversified portfolio or whatever there is one thing that you can do but it won't matter if we say to do it and stuff it just no one will will do it so he points out that your returns are zero it's plus it's zero plus or minus two from here um so you really shouldn't be buying it at all I mean the expected return is worse than it is on probably short-term treasury things three month treasuries it's actually below that and certainly on short-term, you know, lower levels of investment grade and whatever which doesn't have a lot of risk. Um, and so there's no reason to be in the stock market and that's probably true, but that won't stop people. It won't stop us from doing a podcast about stock market things. It won't stop there from being funds focused on investing in stocks, and it won't stop people from allocating similar amounts to stocks, you know. So, I mean, that that's the only answer is that at some price it doesn't make sense, but people won't stop at that price. So people will continue to to allocate there's a fundamental in terms of efficiencies of markets and stuff the a market is complex and then also there's just things that don't even have to do with people's expectations that create what happens in it. So there aren't if you take extreme example like people could dislike a stock but they can't inefficiently price it low enough because not we're not all going to short at the same rate that we go long things. We're not going to have presentations of the same number of analysts giving negative reports on something as positive. Even if they all feel that way, even if we all think we should short something, we won't. Even if all analysts think they should put out a sale, they won't. And obviously people involved in a company put out information every quarter and and present on it and we don't have an alternative viewpoint on that. So if you have problems in a market with inefficiency or things that go a little crazy, they're going to happen as bubbles. They're not going to happen a as um it's not going to be a large number of stocks that are somewhat cheap. It's going to be a smaller number of stocks that are way too expensive. Um, and you know, that's just that's how it works. And so if everyone wants to continue being like mostly all long all the time in stocks, which people do, they want to be buy and hold. I'm in it for stocks for the long run type thing, they'll they'll be bubbles, you know, and you'll sometimes have returns that are nothing for 10 years and stuff >> in overall stocks though. But if you're still buying cheap based on the individual situation, it's sort of like there's always a bull market somewhere. I do believe that. >> And it could be different. It may not be in overall S&P 500 stocks, but it could be different industries, could be different sectors, stuff like that. >> Yeah, >> I think there's always something to do. It's a good book, right? Book title. There's always something to do. >> Yeah. And there are stocks that aren't expensive. There there stocks that are at normal type prices and things versus the future. And there stocks that are uncertain. We just talked about that with the Mag 7 type things. They could be overpriced or not, but they're investing huge amounts of money in AI things that will either turn out to be really right, really wrong, a little bit of a mix or whatever, but it's very hard to predict what their future prices should be. Like there's a great deal of uncertainty if you're spending a hundred billion dollars in capex and you're making a hundred billion, you know, which is kind of what they're doing. So either it'll work out really well for them or it won't or whatever. The ones that are weirder are the 493 that don't reinvest a lot, aren't involved in AI things and stuff. And so there's a much narrower range of outcomes for them. So there could be stocks that look expensive but are great because you can predict the future better and then you should buy them if you know that. And then there are stocks that actually don't look that expensive right now and maybe you should buy those. The ones that are the problem are that a lot of those stocks that he mentioned have a not a wide range of business outcomes and yet have a price that can't be justified on that basis historically. So the returns have to be lower for those businesses in the future than they were in the past. Like you can't get stock market type returns historically from them investing in that kind of thing. >> Yeah. I mean, it's funny. Think about the big the big buys in the stock market that Buff Fit's done over the past >> couple of years, handful of years. It's like Bent Energy accidental. >> Yep. Japan, bought some of the trading company things there. >> Yeah. >> He sold Apple, Bank of America, things like that. Yep. >> Yeah. >> Yeah. So, and that's why like, you know, there was an earnings thing and then Walmart was down or something on the earnings. The earnings were good. But that's what I mean because that's a stock that has a at some point people will realize that's a stock that has a narrow range of outcomes. >> There's not a lot of ways to lose all your money in Walmart. There's not a lot of ways to trip all your money in Walmart. And at some point you start to worry about well at a 50p versus a 30p versus a 20p you have different outcomes for the stock in terms of your investing. And it's kind of easy to calculate that. It >> is not easy to do that with the mag seven things, right? Because they're now reinvesting so much in it. it's not so easy to say, okay, this is what I think will be the future. Um, and there >> I think it's really good to like everyone likes to dunk on DCFS. I think running reverse DCFS and sort of inverting it is like really smart to do, right? I mean, obviously it's not perfect by any stretch of the imagination. There's different inputs, but kind of to get a feel for like, okay, at this valuation, what is being priced in? And you have some of these companies where they're just pricing in just insane growth and are you comfortable with that growth? Is it justified? Is it not? And you kind of handicap it from there. But really just reverse engineering it and looking at it from that perspective. >> Yeah. Because theoretically that's the right way to price it is to figure out what the future cash flows are going to be. The difficulty of that is that things especially some of the most successful businesses have these big changes for them and so they radically change that. So like with the Mag 7, you would never have predicted because you wouldn't have predicted AI things. You would never have predicted that they would switch from having lots of free cash flow to reinvesting all of it, right? And so now their growth in the future could be a lot higher than you predicted, but also your cash flows now are way less than you ever predicted because they've all gone to basically being pretty neutral on on cash. Whereas, you know, Facebook or something would have, you know, Meta would have been a a free cash flow giant with uh not a lot of reinvestment. And now it's gone to being a lot of reinvestment, you know, taking all that cash and putting into that kind of thing. So, but that's what the calculation has to be based on is is what you think that's going to be like. >> What was your biggest lesson or takeaway from this memo? >> Well, he's focused a lot on psychology, right, which I think is important that way. So, not so much what the prices are of things, um, but what that means about the psychology of how people are interpreting things. And that's always the hard one because we talk about narratives of things. And I don't think they're usually that related to what actually is driving things because we were on this podcast for the early years all the time saying that this had so much to do with um, it making sense for multiples to be higher when interest rates are lower. and then interest rates aren't lower. Uh and it makes sense because inflation is low and stable and it's none of those things since then, you know. So it the truth is that like we know what their prices are. We know if they're going up or down. We kind of know people's psychology and what they're doing, how they're acting. It's harder to know if justifications for things are accurate or not accurate. you know, just kind of like what you were saying about um how they talk in AI things. That might be how they feel about it, but what we know more is like what they're actually spending and everything. That part is more easier to be sure of. And then the narrative of what they're saying about that and all their color that they're giving on it, that's harder to tell for sure, right? Like, so we know if stocks are expensive or if they're going up. And then we kind of look at the psychology and say, why do we think that's happening? Um my own feeling on it honestly from being around things for a while is that way more than people think. It's simply a matter of amount of time um that you've been in a certain situation. So it's more of an issue that things don't usually change that rapidly. So take COVID or something um you had this big drop but then you had a recovery that's really fast. That's a lot more possible than a big drop that's followed by not doing well for a long time. Yes. When you look at histories of like 2000, it'll be like the NASDAQ was down 80% or something. People read that and think it's like a crash and whatever. What happened is late in 2000, 2001, 2002. It was the experience of going through several years of every time a stock started to go up, it went down to making even a lower low than it had before. That is much more important in like investor sentiment and why people then became uninterested in the stock market and everything. It's having two or three years in a row where you lose money in stocks is what gets there to be less interest in that. People are actually very excited when it's dropping 20% in a day or something and it and they're hoping it might go back up and everything. They can take a few weeks of that. It might be stressful, but it doesn't get people out of stocks and stuff. It's just like depression. Yeah. So, I mean, it's like it's not panic. It's more like uh being depressed about hopelessness is more what like changes prices a lot. and and you know unwar unwarranted pessimism continuing and unwarranted optimism continuing you know so I don't think that ever there's over I mean there's can be overreactions but I don't think the spikes that people get so excited about is is it justified that a stock went up this much today or dropped this much today that's not as much the issue as it just if it's going up over time um for a long time without really understanding why um and I think usually there has to be something that happened to change it. Um, and absent that, I don't see why people would be completely tethered to some price thing. I don't know that that many people believe that much that the price thing is as strong as, you know, the past record shows that it is. Like, you know, what Marx was talking about with um the JP Morgan thing or anything like that. Um, you know, I they're aware that we're at the highest ever on the Buffett indicator or the Schiller P is near the highest ever or whatever. But if you know, it hasn't been right for a long time, right? It's like, you know, it hasn't gone down. But that's not what those things predict. They don't predict that it's going to go down. They predict it's too high. And people want a signal for it's going to go down. And I have no idea how you'd have a signal that tells you it's going down. You just have a signal that's dangerously high or it's it's safely low, but you don't get a signal of timing. And people actually want a timing signal, not a level signal. >> What's a question that investors should be asking themselves today that maybe they're not? Um well uh I think the biggest issue would be what do they expect future returns to be >> so of the overall market or their >> of their portfolio or the specific stocks. Yeah, it's very most people do not own things where the expectation would be that where it's reasonable to have an expectation that the return would look like stocks did return in the past. That's too high an expectation and that is generally the expectation that like not sophisticated investors do have. And actually there's some surveys that show financial adviserss are using long-term historical things. So, if you're saying, well, stocks return 10% a year from, let's say, when Buffett took over, probably that's right, 1965 to today, it's probably 10% a year. If you're expecting 10% a year on stocks that you own, even if those stocks are quite a bit better than the market, that seems too high. So, I would think that are you buying this because it's you have to buy something and it's better, the better company, lower price, whatever, it's better than the market. Um, which for fund managers and things may be what they have to do, but you don't have to be in those things. Um, so I think there can be a default to thinking that if I pick a stock that's good versus the market, I'll get returns like the market did in the long run. And that's not necessarily the case. But that doesn't mean you shouldn't necessarily buy stocks. It would have to be that it's worse than like bonds and cash and things for there to be other smart things for you to do with the money. But I think without if people don't question their own assumptions about things, they do tend to put in their mind that they're going to get returns similar to what the market had, which is not realistic. >> Got it. Cool. Well, we will leave it with that. I want to thank everybody so much for tuning in with you both of us on the Focus Compounding Podcast. This is the first time you're joining us, be sure to hit the subscribe button wherever you're listening or watching us here today. If you're interested in learning about our money management services, you can reach out to me at andrew focusconomine.com. Um, and of course, if you want to get access to QuickFests, you decide to sign up, there's a link in our description, or you can just go to quickfest, sign up, and tell them about us in the checkout. You should be able to check a box that says focus compounding is how you heard about them. I thank everybody so much for all the support and we will see you in the next podcast. Take care.
Howard Marks’ Memo: The Calculus of Value
Summary
Transcript
Welcome, welcome, welcome. How's everybody doing? Hope you are doing well. My name is Andrew with Focus Compounding on Air Live with Jeff Ganon. Jeff, how's it going today? >> It's going very well, Andrew. How's it going with you? >> It's going great. We hope it's going great with everybody else as well. If this is the first time you're tuning in with us, thank you so much for joining us. Be sure to check out all of our content that we push out into the investing universe. Best way to do that is to follow me on X at Focuscompound. If you want to get access to investment writeups from Jeff going all the way back to 2005, uh, go to focuscompounding.com and you could do that there. And of course, if you're interested in learning about our money management services, you can reach out to me at andrew at focusedcompounding.com. So, in today's podcast, we're going to be talking about a memo that Howard Marx uh penned or at least released on August 14th uh called the calculus of value. >> August 14th. Very good. >> Um, >> you recorded a podcast that day. Yeah, >> we sure did. We sure did. Uh, Jeff's birthday. So, uh, want to go through it. Obviously, Buffett's talked about Howard Marx's memos are >> something that he reads. We've done a lot or we've gone over uh, a group of them on the podcast over the years. So, wanted to bring it up uh, as we recorded here today, the calculus of value. Uh, you know, I went through and I I read it and I highlighted some things and I, you know, kind of realized I'm like, you know, what he puts in bold is kind of like a good uh highlight for us to go over and just kind of go from there. >> Yeah. >> Uh, but I will put the actual post in the description. So, if you want to uh click the about section, you can pull it up yourself. But, I guess, you know, what are your general thoughts on the calculus of value, where his head is at, where we are in the market, just give me your your thoughts on the write up. take us through it. >> So, he makes a few points. One, he's in the camp of things have been expensive for a while, but he wasn't seeing bubble type things for much of it. Um, like others, I think he may have written some things during the COVID period that, you know, you saw things where there was stuff like that. Um, but since then, we haven't seen um a lot of that kind of thing until very recently in which you've had really high prices for some things. and he specifically talks about the non-MAGG7 things. Um, and what he's talking about basically is there's a lot of negative news um with maybe like one exception or something. Almost everything has been negative news for most of this year and um in terms of what might have been expected by the market and what actually happened and yet uh prices have tended to go up especially if you calculate from following those things. So, you know, he talks about like tariffs and things, right? Like from then the news turned out pretty similar to what it was as of that date and the market went up a lot between those two dates, you know, um things like that. We've seen that with the I think the market was up a bit on a expectation of a rate cut all those sorts of things. So, the one that was excluding was the uh um deficit probably bigger than the than the market would have anticipated, right? So like they either anticipated that they didn't think both spending would be as great is as it is and taxes as low as they are. So that one was probably a a surprise to the the upside so to speak for for equities though maybe not for for treasuries, right? But the other things are like not great news. It could what you expected or or worse or the same or whatever but not a lot of news that would have explained why things should go up from high prices and yet they have generally gone up from those dates. So kind of news and especially particularly the non-mag7 ones. Uh it was a lot of what he talked about basically like is there kind of overly optimistic reaction for the non-mag7 things to things that are not necessarily matched by surprisingly good news. You know what >> Yeah. >> So he walks us through how he thinks about value. uh he talks about you know the earnings power of a company um and the sources of value where that comes from. He talks about price um and then the relationship between the two and you know getting up to date is when he starts to talk about you know where we are in the market and the thing that you had just referenced which um was right here. he talks about that um I have a P of 22 times. >> Yeah. And the reason why that's better to look at than the M7 is kind of what he lays out in the beginning, which is if you think about it, what's the return on capital going to be? What's the reinvestment rate? What's the growth going to be? Those three variables. And if you know two of the three, you kind of know everything. But you kind of have to figure out, okay, so how long are they going to grow at above average returns that can justify high prices and because so much of the index is only those seven stocks, um it is possible to have real disagreement about that. Okay, well these might really be above average businesses and they account for so much of the index, but the average of the other 493, it's a lot harder to believe that they'll have above average returns on invested capital and accelerating returns on that in future years to justify the higher PE, right? So even if the P is 33 on the MAG 7, that's more debatable. Maybe the returns will be great, maybe they'll be poor, whatever. But they're investing a lot in trying to grow. And so it's more uncertain what the returns on that capital in the future will be. But the average of everything else is something that should be easier to predict. Um, and yet the PE on that is really elevated compared to what it has been in the past. Um, and that's the thing that I've noticed the most lately. Um, and he has some of the same points, I guess, that that I did. I don't remember where he puts it, but one of his theories is kind of that things that, um, are perceived to be going up all the time are getting rewarded with higher ratios. Um, and so I think that that could be a factor. He talks specifically about like just that there haven't been as many stock market um, drops that have been sustained and everything, but it is noticeable in the uh, prices of stocks that are kind of um uh predictable like high quality sort of of the other 493. But it's not even necessarily high quality. It's like low variability like that they just don't have down years. Um those have gotten really really expensive in some cases. That's the thing that I've noticed the most. um which is a little flavor of the 1990s cuz that earnings management uh you get a higher PE focus kind of thing was happening even in not um the tech the telecom whatever things it was also happening in consumer products things and we're seeing a little bit of that again >> what are your thoughts on he talks about right here what I have highlighted in this orangeest color about like the psychology of market participants currently as he sees it right so investors are by nature optimistic Um, he says, "When they're in an optimistic mood, investors have the ability to interpret ambiguous developments positively and outlook negatives." Um, this one I thought was funny. Um he talks about how you know this acronym taco which stands for Trump always chickens out uh is a suggestion that you know Trump's strongest threats or I guess these horrible situations where people could worry about or the market could worry about it uh they won't be realized because you know Trump kind of comes on hard and then maybe walks it back or whatever but that's what people say uh taco he always figures out. Yeah, which is a good point that Markx makes there because it is a rationalization like take the tariffs. Um the estimated level of what those are is not chickening out. It's uh quite similar to what was expected uh to what was announced. So um the you know there's different estimates. JP Morgan does an estimate. Um I think Yale has a what do they call it the budget lab or something has an estimate. There's some that are kind of somewhat independent of government that do estimates and uh they do they show you by day or by week what based on the news the estimated tariff um across everything should be and across it assuming also people switch between which products because there's tariffs on some things now and it's really high. Um it'll it take it back to levels it was at about well not quite 100 years ago but levels that it was at shortly after tariffs were increased um just under 100 years ago you know 95 years ago. So and then in the 1800s they were that high frequently but for 90 years no one's seen tariffs this high and they're certainly going to be there. Um so there wasn't much of a a taco on those things. Mhm. Talks about FOMO that's going on right now, but basically bottom line, as he bolded right here, fundamentals appear to be less good overall than they were seven months ago, but at the same time, asset prices are high relative to earnings, higher higher than they were at the end of 2024. >> Yeah. >> And at higher valuations relative to history. So, kind of the psychology of going into it, right? the wealth effect resulting from gains in the markets, high-end real estate and crypto, but then also just the excitement around this new AI thing, right? And the capital spending that is >> for the AI, I think what did they say? Nvidia just reported the other day and >> yeah, >> Jensen Swang, what did he say like two to three trillion over the next decade or something like that? >> Yeah, five years it'll be three to four trillion which is interesting. I actually saw an article that did exactly what I did. So I don't I can't cite the article because I don't remember who wrote it, but they did the same calcul calculations I did, which is to go back and say, okay, well, how much was it in.com versus the GDP and how much was it in the railroad boom back in like the 1880s and stuff. Um much smaller than the railroad boom, but bigger than is what that'll be. So um which in both cases it didn't result in a giant recession for the overall economy. It was not great for financial markets and was horrific for companies that were in those industries. They overinvested and had bad outcomes. But although there were recessions immediately after both of those booms um and and kind of couple rec in both cases there were a few recessions within 10 years. Um it wasn't like the worst recessions that that we ever had. Um they were pretty shallow at first and stuff. though cuz there were real productivity gains um more so for railroad railroad had huge productivity gains but there were some productivity gains in the 1990s although by the time the internet t took over those were less the productivity gains were more associated with like um word and excel and things like that that's where you had really big productivity gains is when offices all went to to using um software it was a little bit less when everything went online but still they're productivity gains in both cases >> I guess how do you as a investor or market participant And how do you weigh sort of this transformative technology against timeless investing principles you know like being disciplined in valuation well for the overall market generally will not matter um what those transformer things are. So that's why I said take the mag seven out of it. If we're dealing with 490 companies, most of which have little or nothing to do with AI, it won't matter. Um, the prices shouldn't be more elevated just because of things like AI. Um, you know, that's already captured all the data that we have going back with Schiller PS and things are capturing the giant boom in railroads, the giant boom in internet things. I mean, that's all taken into account. And uh then in terms of could AI change things more for those biggest companies and can they change things more directly in like investing in our lives and stuff? Sure, just like the internet would. But in terms of changing the valuation of the companies, I don't think so. Like for instance, I don't know that AI would have as big an impact on profitability of those 493 companies is like the fact the government's running large deficits, right? like fiscal spending or something and um taxing uh could be as big or bigger a factor. Um yeah, but it could be big if it changes things dramatically for labor, but it's very hard to know what those are. I mean, there's some AI things uh companies saying like, look, there'll be a lot of unemployment and stuff. and possible that that could improve profitability for some companies if you don't serve consumers in the US and you do use a lot of entry- level workers. It's possible that you could make a lot more money because AI will reduce a lot of your labor expense and stuff. So, there's always specific cases where it could help you out a lot. Do you think fiscal just matters more than anything in fiscal spending? >> Um, no. I I >> you know it's like so many people are worried about interest rates and you know Powell now is talking about he's he's setting the table for a rate cut and I'm like at the end of the day I really think the only thing that matters is yes interest rates but just really even more so just fiscal fiscal spending. So yeah, um the the issues are it depends. I think sometimes monetary policy could matter a lot, sometimes fiscal policy could matter a lot. Um the effects that fiscal policy will have are generally going to be pretty big and immediate. Um but they're only because they're, how do I put this? um they're willing to run the the fiscal policy is more extreme and unusual than what's been imagined in monetary policy necessarily. Um so I think like to take an example you know there's different ways of measuring like Fed um uh liabilities and things like that but let's take an example like that sort of the size of their balance sheet or something it might go from 10 to 30% um or something of the size of the economy um from where it's expected to be really small to where it's huge and people are uh saying this is unprecedented you know whatever um fiscal policy has already gone from you know debts of 40 years ago of like 30% or something of GDP to you know expecting it to be 130% and still having a deficit. Uh you know that that's the long-term projections right now. So that's big but yeah like in a war fiscal policy is far more important than monetary policy. It's a question of to what extent do you reign that in over time and and everything and if the expectation is that it continues then the effect it has is really really big but at some point the expectation can be that it continues at some point there's an expectation that you know it has to level off in terms of debt to GDP and deficits won't be run at those levels and everything um I mean he mentions it I think he mentions it in this um but if you well I don't remember actually um in in this if he mentioned it But, you know, when the um expectations change for for um short-term interest rates, they haven't changed uh for the long term. So, in other words, like um right now, I I don't know if we should always expect that uh cuts in the Fed funds rate and stuff over time are going to necessarily change things in the 30-year as much as people expect. That's basically that's basically like every mom and pop, real estate agent, everybody. They think that the Fed just cuts rates on the short end and and the long end just sort of goes down in lock step. I think you're going to get a really steep curve is what my expectation would be. >> Yeah. And we'll we'll we'll see. I mean, if >> or there's two ways to look at it, though, right? So on those remarks that the the long end basically did nothing. So now people are like whoa wait is is the economy actually really falling off a cliff and they are going to cut is that like how is the bond market interpreting that or is it just hasn't happened yet like what is that you know I mean in the past in 2024 when they cut interest rates um before the election not for political reasons um the long end took off right well what happened here nothing happened here so what does that mean it kind of made me think I'm like oh wow is is is the economy actually falling off a cliff here Should you go long bonds? >> It depends on the how efficient the market is in certain ways in looking at things. Like we could look at this theoretically. There's two issues that can happen as to why things would move in lock step and why they wouldn't. So one, it may not matter that much when news comes out. You don't even need to know what the Fed says it's going to do if you think that you know what its ideal policy should be, right? So like if you get news that long term makes you think a certain way about what the the neutral rate of things should be and everything, then that could affect the long end uh uh for yields and everything. And it can affect it even if you don't hear from the Fed right away. The other thing is if you believe or don't believe what the Fed says for the longer term for longerterm bonds. So if you expect them to have a policy that in the short term that they're going to reverse in the long term then it might not be that important to you. Or if you simply don't believe what they're saying that's hasn't historically happened like the Fed it doesn't usually say something that reverse itself quickly. So the reasons would be either you disagree with the Fed in terms of what the longer term rate should be or you think that the Fed is going to do something in the short term and then reverse itself longer out. And we don't have lots of like the prediction stuff is all based on very short-term stuff. So it may not be able to capture very well what that is. So, you could have expectations for that everyone's agreed, oh, there'll be cuts in the next 6 months or something, but then, you know, expectations that rates won't be that much lower in two or three years or something, in which case it wouldn't affect long-term yields. Um, whereas like when you had the financial crisis, you might not have even needed to wait for the Fed. If you thought you were entering a depression, then those rates should have come down a lot fast and you just would have expected the Fed to follow. >> He said something in here which I could try to find really quick. Um, hold on one second. I thought was interesting. Okay, so he talks about where we began in 2025. Yeah, it was this bullet point. He said so at the beginning of the year JP 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 through 2014 uh which is the only period for which there's data on forward-looking PE ratios and resulting 10-year returns. Your average annual return over subsequent 10 years was between plus 2% and minus 2% every time. >> Yeah. Um, so I thought that was a >> Yeah, and I did that going in 2005. I did that for all years for the Dow going back to 1935 and I went out to 15 years instead of 10. It's even worse. I mean, it's even more predictive over 15 than 10. It stops after 15 years basically. So the PE ratio is determines things about the future for about 15 years and then the effect kind of goes away. It's probably stronger effect at 10 than 15, but it's still present. So for that it tends to be that if you buy something today and hold for 15 years um or 10 years uh the the price that you start at is very strong predictor of what's going to happen in the future. It's stronger than most things but that's but a lot of that is because of the extent to which people's expectations or estimates don't matter. Um like they're not able to estimate correctly. So we just talked about interest rates. every investment bank and governments and things all predict what future interest rates will be but there's not evidence that they predict the Fed does it uh that they predict it correctly and like I went back and looked at GDP things and simply predicting that having a poor level of GDP for the last 15 years predicts better than expected for the next 15 and vice versa is a better guess than trying to model it and estimate and that's definitely true with valuations just saying if the market's done well for the last 15 years it'll do poorly for the next 15 also good estimate. If P, you know, if multiples has been expanding for 15 years, expect them to contract for the next 15. If GDP has been overly hot for 15 years, expect to be cool for the next 15. It's a pretty good guess. Um, like in terms of at least the hit rate, it's not always great about the magnitude, but it's nearly perfect in terms of predicting that. Um, like he said, like you will have almost no return. It's almost perfect in doing that. Now, that's over a period that's shorter because it's 87 to 2014. So it does one observation a year every year but it's not a long-term thing but for most that period um you know multiples were expanding. M so >> so I'm going to ask a question and it's you know separating the political view right at what point is it like Trump truly is this straw that you know stirs the drink right not saying like him don't like him right wrong indifferent we're just purely talking as market participants trying to make money right I mean at what point it's like he's going to get interest rates lower probably or he's going to get the Fed to cut who knows what's going to happen with the long end of the curve there right but I mean at what point is it like he cares so much about markets going higher that something like this can continue on and Trump's the type of person as well where he could step down >> or in you know when when his term is up and everything could go to hell and he'll just say well it was great when I finished it's not my fault right like take all the credit put all the blame on other people right so just kind of curious I mean at what point is it like at the end of the day he's the straw that stirs to drink. He wants markets to go higher. He cares a lot about markets and he's going to get his way. I mean, at some point, like you think about like the dip buying, which I think Howard Marks wrote about, so much of the plumbing is passive now, 401ks, the wealth effect. It's almost like it's a think of national security to continue to have equities go higher, right? And what cracks that if anything? >> Oh, we never know what will do it. I mean, it's funny. There's usually something that comes out that's unexpected in almost all cases. >> It's almost every case. >> Trump, somebody gets on TV and he brings the board out and everyone's like, "Oh my gosh." >> Well, so what I mean is you take Japan, you take 1929, you take uh 2000, um some other bubbles that have happened. Uh, usually there's something that's unexpected that no one anticipates. So, obviously a risk that everyone's anticipating wouldn't matter that much unless somehow everyone's wrong about it. Some people do anticipate a housing bubble and then it happens or uh um you know something about fiscal spending and then it does happen in some countries. Um but there are smaller group of people predicting that. So, usually it's something unexpected that happens that usually causes a recession of some kind, maybe not for long or causes unended or intended but overly done tightening in short-term things. So, that short-term credit stuff like seizes up and and becomes a problem. Um, the one exception to that is uh 2000. I'm not sure that anyone knows what happened. That's the one in which normally we think that something pricks a bubble and stuff in in that one we don't know. There's ne I don't think there's any good evidence for what happened. It may have collapsed on its own in which case it's rare because it doesn't seem to ever happen. There wasn't a recession for a really long time. It was extremely shallow and may not have even occurred if it wasn't for things like 9/11 and the bubble popping anyway. So, it just seemed to crash under its own weight, which is almost unprecedented. I mean, usually you have to have a recession or some really unexpected um financial seizure. Um, and it didn't. So, it's usually something out of left field that's not expected, that might not be that big, but does cause problems because you have really high prices except for that one, which is the dot bubble, which I'm still not sure that we understand what happened and why they just started going down. it would, you know, it's known that it was an emperor's new clothes type thing and that for some reason people started to have a change in perception where at earnings started being released and they said, "Oh, but how are they ever going to make money or something?" Whereas it's the same people who weren't caring about that the quarter before, the quarter before. It's not clear why that kind of happened, but it did. Um, and I'm not sure why. In all other cases, usually something happens. And and none of them is just the cause. It's not like, you know, you can explain a complex thing like the great depression crash of that market and stuff and be like, "Oh, it was just tariffs. It was just uh uh interest rates uh changes. It was just, you know, it's a variety of different things that all happened, but the severity of it is determined by the the price. So, the magnitude is because of the price." Yeah. >> Sure. >> So, where are we on that spectrum? Right. So he let he laid out his invest uh sort of tongue and cheek on defcon scale right and he has you know six first one stop buying reduce five reduce aggressive holdings and increase defensive holdings four sell off the remaining aggressive holdings three trim defensive holdings as well two eliminate all holdings one go short um so I think he he said he's at invest five which is reduce aggressive holdings and increase defensive holdings, >> right? And he thinks he would never go to two or one, does he say? Or what does he say? Three, two or one. So he wouldn't ever trim defensive holdings as well. Yeah. >> Yeah. I agree with that scale. >> Do you agree with >> I don't know um how close we are to people's changes and perception stuff. It's hard to say. I haven't seen much of a change in people's perceptions of things. Um, usually you have a more serious going up. Um, that doesn't seem to make much sense, you know, given the news and stuff, which is what he's describing here. And there's been some of that in the last few months and that wasn't present as much in the past. So, you might be later in the stage in that you're getting a more extreme going up. That doesn't make a lot of sense. Um, which is usually what happens before you go down a lot. But it it's hard to tell until you actually start on the other side of going down. So I I don't know. I mean, you can go up a lot higher in terms of pricing and stuff like that. It may be similar to 29 and 2000, but you know, just because of that doesn't mean it can't go up one and a half times, two times more expensive in price before it then goes down. Usually when you have a a really big thing happen, it's bigger than anyone that there's been before. And there's no reason why it can't be bigger now than it's been before. Just cuz you hit the past kind of um most you've ever had in terms of pricing and stuff doesn't mean you can't exceed it this time. Something can be bigger than it's ever been before. Um and um you know and unless something happens usually things don't reverse. Um but I think he's right somewhat about the psychology in that there is more of a disconnect. There's some studies that like surveys and things that show this. There is a little bit more of a disconnect in the past of people saying that they think things are overpriced and don't have positive things to say about them but also expect them to go up, right? And that is usually that that's more of a sign of something that you see at the end of of a bubble where where people do anticipate things will go up even if if um news isn't particularly good or even if they don't think it's cheap or something. Whereas in the early stages of a um recovery, people tend to think things will not go up even though they also say that things are getting better. Like if you ask people, are things getting better for your company? And do you expect your stock to go up? In 1932 or something, they think no, I I think they're getting better and we won't go up and you know in 1929 you think the reverse. You know, you're like h no, what we're seeing isn't that great, but we still expect our stock to go up. You know, that's shifted a bit. I think that people think it's less more to to um results right now. >> I guess the real question is like how can an investor protect themselves uh from overpaying in a market where just everything feels kind of expensive, right? Like we talked about the other 400 and uh whatever 94 stocks. >> Mhm. >> They're still trading at a premium PE. So, how do you protect yourself from that? Right. We did a past podcast where we talked about >> cyclical commodities and you're like, "Yeah, I mean it may look expensive on paper, but relative to the market, it's not." How can investors protect themselves from that perspective? >> Well, I think you should always buy things individually ignoring what the market is doing. And if you think that they will have good returns, you should keep buying them. in terms of if you're trying to have a portfolio versus the you know diversified portfolio or whatever there is one thing that you can do but it won't matter if we say to do it and stuff it just no one will will do it so he points out that your returns are zero it's plus it's zero plus or minus two from here um so you really shouldn't be buying it at all I mean the expected return is worse than it is on probably short-term treasury things three month treasuries it's actually below that and certainly on short-term, you know, lower levels of investment grade and whatever which doesn't have a lot of risk. Um, and so there's no reason to be in the stock market and that's probably true, but that won't stop people. It won't stop us from doing a podcast about stock market things. It won't stop there from being funds focused on investing in stocks, and it won't stop people from allocating similar amounts to stocks, you know. So, I mean, that that's the only answer is that at some price it doesn't make sense, but people won't stop at that price. So people will continue to to allocate there's a fundamental in terms of efficiencies of markets and stuff the a market is complex and then also there's just things that don't even have to do with people's expectations that create what happens in it. So there aren't if you take extreme example like people could dislike a stock but they can't inefficiently price it low enough because not we're not all going to short at the same rate that we go long things. We're not going to have presentations of the same number of analysts giving negative reports on something as positive. Even if they all feel that way, even if we all think we should short something, we won't. Even if all analysts think they should put out a sale, they won't. And obviously people involved in a company put out information every quarter and and present on it and we don't have an alternative viewpoint on that. So if you have problems in a market with inefficiency or things that go a little crazy, they're going to happen as bubbles. They're not going to happen a as um it's not going to be a large number of stocks that are somewhat cheap. It's going to be a smaller number of stocks that are way too expensive. Um, and you know, that's just that's how it works. And so if everyone wants to continue being like mostly all long all the time in stocks, which people do, they want to be buy and hold. I'm in it for stocks for the long run type thing, they'll they'll be bubbles, you know, and you'll sometimes have returns that are nothing for 10 years and stuff >> in overall stocks though. But if you're still buying cheap based on the individual situation, it's sort of like there's always a bull market somewhere. I do believe that. >> And it could be different. It may not be in overall S&P 500 stocks, but it could be different industries, could be different sectors, stuff like that. >> Yeah, >> I think there's always something to do. It's a good book, right? Book title. There's always something to do. >> Yeah. And there are stocks that aren't expensive. There there stocks that are at normal type prices and things versus the future. And there stocks that are uncertain. We just talked about that with the Mag 7 type things. They could be overpriced or not, but they're investing huge amounts of money in AI things that will either turn out to be really right, really wrong, a little bit of a mix or whatever, but it's very hard to predict what their future prices should be. Like there's a great deal of uncertainty if you're spending a hundred billion dollars in capex and you're making a hundred billion, you know, which is kind of what they're doing. So either it'll work out really well for them or it won't or whatever. The ones that are weirder are the 493 that don't reinvest a lot, aren't involved in AI things and stuff. And so there's a much narrower range of outcomes for them. So there could be stocks that look expensive but are great because you can predict the future better and then you should buy them if you know that. And then there are stocks that actually don't look that expensive right now and maybe you should buy those. The ones that are the problem are that a lot of those stocks that he mentioned have a not a wide range of business outcomes and yet have a price that can't be justified on that basis historically. So the returns have to be lower for those businesses in the future than they were in the past. Like you can't get stock market type returns historically from them investing in that kind of thing. >> Yeah. I mean, it's funny. Think about the big the big buys in the stock market that Buff Fit's done over the past >> couple of years, handful of years. It's like Bent Energy accidental. >> Yep. Japan, bought some of the trading company things there. >> Yeah. >> He sold Apple, Bank of America, things like that. Yep. >> Yeah. >> Yeah. So, and that's why like, you know, there was an earnings thing and then Walmart was down or something on the earnings. The earnings were good. But that's what I mean because that's a stock that has a at some point people will realize that's a stock that has a narrow range of outcomes. >> There's not a lot of ways to lose all your money in Walmart. There's not a lot of ways to trip all your money in Walmart. And at some point you start to worry about well at a 50p versus a 30p versus a 20p you have different outcomes for the stock in terms of your investing. And it's kind of easy to calculate that. It >> is not easy to do that with the mag seven things, right? Because they're now reinvesting so much in it. it's not so easy to say, okay, this is what I think will be the future. Um, and there >> I think it's really good to like everyone likes to dunk on DCFS. I think running reverse DCFS and sort of inverting it is like really smart to do, right? I mean, obviously it's not perfect by any stretch of the imagination. There's different inputs, but kind of to get a feel for like, okay, at this valuation, what is being priced in? And you have some of these companies where they're just pricing in just insane growth and are you comfortable with that growth? Is it justified? Is it not? And you kind of handicap it from there. But really just reverse engineering it and looking at it from that perspective. >> Yeah. Because theoretically that's the right way to price it is to figure out what the future cash flows are going to be. The difficulty of that is that things especially some of the most successful businesses have these big changes for them and so they radically change that. So like with the Mag 7, you would never have predicted because you wouldn't have predicted AI things. You would never have predicted that they would switch from having lots of free cash flow to reinvesting all of it, right? And so now their growth in the future could be a lot higher than you predicted, but also your cash flows now are way less than you ever predicted because they've all gone to basically being pretty neutral on on cash. Whereas, you know, Facebook or something would have, you know, Meta would have been a a free cash flow giant with uh not a lot of reinvestment. And now it's gone to being a lot of reinvestment, you know, taking all that cash and putting into that kind of thing. So, but that's what the calculation has to be based on is is what you think that's going to be like. >> What was your biggest lesson or takeaway from this memo? >> Well, he's focused a lot on psychology, right, which I think is important that way. So, not so much what the prices are of things, um, but what that means about the psychology of how people are interpreting things. And that's always the hard one because we talk about narratives of things. And I don't think they're usually that related to what actually is driving things because we were on this podcast for the early years all the time saying that this had so much to do with um, it making sense for multiples to be higher when interest rates are lower. and then interest rates aren't lower. Uh and it makes sense because inflation is low and stable and it's none of those things since then, you know. So it the truth is that like we know what their prices are. We know if they're going up or down. We kind of know people's psychology and what they're doing, how they're acting. It's harder to know if justifications for things are accurate or not accurate. you know, just kind of like what you were saying about um how they talk in AI things. That might be how they feel about it, but what we know more is like what they're actually spending and everything. That part is more easier to be sure of. And then the narrative of what they're saying about that and all their color that they're giving on it, that's harder to tell for sure, right? Like, so we know if stocks are expensive or if they're going up. And then we kind of look at the psychology and say, why do we think that's happening? Um my own feeling on it honestly from being around things for a while is that way more than people think. It's simply a matter of amount of time um that you've been in a certain situation. So it's more of an issue that things don't usually change that rapidly. So take COVID or something um you had this big drop but then you had a recovery that's really fast. That's a lot more possible than a big drop that's followed by not doing well for a long time. Yes. When you look at histories of like 2000, it'll be like the NASDAQ was down 80% or something. People read that and think it's like a crash and whatever. What happened is late in 2000, 2001, 2002. It was the experience of going through several years of every time a stock started to go up, it went down to making even a lower low than it had before. That is much more important in like investor sentiment and why people then became uninterested in the stock market and everything. It's having two or three years in a row where you lose money in stocks is what gets there to be less interest in that. People are actually very excited when it's dropping 20% in a day or something and it and they're hoping it might go back up and everything. They can take a few weeks of that. It might be stressful, but it doesn't get people out of stocks and stuff. It's just like depression. Yeah. So, I mean, it's like it's not panic. It's more like uh being depressed about hopelessness is more what like changes prices a lot. and and you know unwar unwarranted pessimism continuing and unwarranted optimism continuing you know so I don't think that ever there's over I mean there's can be overreactions but I don't think the spikes that people get so excited about is is it justified that a stock went up this much today or dropped this much today that's not as much the issue as it just if it's going up over time um for a long time without really understanding why um and I think usually there has to be something that happened to change it. Um, and absent that, I don't see why people would be completely tethered to some price thing. I don't know that that many people believe that much that the price thing is as strong as, you know, the past record shows that it is. Like, you know, what Marx was talking about with um the JP Morgan thing or anything like that. Um, you know, I they're aware that we're at the highest ever on the Buffett indicator or the Schiller P is near the highest ever or whatever. But if you know, it hasn't been right for a long time, right? It's like, you know, it hasn't gone down. But that's not what those things predict. They don't predict that it's going to go down. They predict it's too high. And people want a signal for it's going to go down. And I have no idea how you'd have a signal that tells you it's going down. You just have a signal that's dangerously high or it's it's safely low, but you don't get a signal of timing. And people actually want a timing signal, not a level signal. >> What's a question that investors should be asking themselves today that maybe they're not? Um well uh I think the biggest issue would be what do they expect future returns to be >> so of the overall market or their >> of their portfolio or the specific stocks. Yeah, it's very most people do not own things where the expectation would be that where it's reasonable to have an expectation that the return would look like stocks did return in the past. That's too high an expectation and that is generally the expectation that like not sophisticated investors do have. And actually there's some surveys that show financial adviserss are using long-term historical things. So, if you're saying, well, stocks return 10% a year from, let's say, when Buffett took over, probably that's right, 1965 to today, it's probably 10% a year. If you're expecting 10% a year on stocks that you own, even if those stocks are quite a bit better than the market, that seems too high. So, I would think that are you buying this because it's you have to buy something and it's better, the better company, lower price, whatever, it's better than the market. Um, which for fund managers and things may be what they have to do, but you don't have to be in those things. Um, so I think there can be a default to thinking that if I pick a stock that's good versus the market, I'll get returns like the market did in the long run. And that's not necessarily the case. But that doesn't mean you shouldn't necessarily buy stocks. It would have to be that it's worse than like bonds and cash and things for there to be other smart things for you to do with the money. But I think without if people don't question their own assumptions about things, they do tend to put in their mind that they're going to get returns similar to what the market had, which is not realistic. >> Got it. Cool. Well, we will leave it with that. I want to thank everybody so much for tuning in with you both of us on the Focus Compounding Podcast. This is the first time you're joining us, be sure to hit the subscribe button wherever you're listening or watching us here today. If you're interested in learning about our money management services, you can reach out to me at andrew focusconomine.com. Um, and of course, if you want to get access to QuickFests, you decide to sign up, there's a link in our description, or you can just go to quickfest, sign up, and tell them about us in the checkout. You should be able to check a box that says focus compounding is how you heard about them. I thank everybody so much for all the support and we will see you in the next podcast. Take care.