The Howard Marks guide to overheated stock markets

Despite record valuations and relatively smooth sailing, there could be a sense of uneasiness creeping into markets.

The dreaded "bubble" word is also rearing its ugly head.

25 years on from his "bubble.com" memo that correctly called the Dot-com crash and put his writing on the map, Howard Marks is stopping short of calling the current market a bubble, but believes it's now moved from “elevated” to “worrisome.”

In a memo late last week titled "The Calculus of Value", Marks lays out, for the first time, his view on where investment value comes from and how he thinks about it (worth reading on its own).

More interestingly, he also sets out his action plan for dealing with extreme valuations.

Inspired by the Pentagon's famous 5-stage DEFCON alert system (where DEFCON 5 means baseline and DEFCON 1 means nuclear war), he's laid out his own 6-stage INVESTCON system.

The stages are as follows:

6. Stop buying
5. Reduce aggressive holdings and increase defensive holdings
4. Sell off the remaining aggressive holdings
3. Trim defensive holdings as well
2. Eliminate all holdings
1. Go short.

While he concedes it's "essentially impossible to reasonably reach the degree of certainty needed to implement INVESTCON 3, 2, or 1," he's still sounding the alarm.

"I have no problem thinking it’s time for INVESTCON 5." - Howard Marks

He identifies several indicators that have helped shape his view - such as the S&P 500's elevated P/E, the relationship between 10-year Treasury bonds and S&P 500 dividend yield, and general investor exuberance.

While he does admit there's not necessarily anything to suggest there'll be a big correction anytime soon, he thinks a bit of prudence could go a long way. 

"If you lighten up on things that appear historically expensive and switch into things that appear safer, there may be relatively little to lose from the market continuing to grind higher for a while...or anyway not enough to lose sleep over," wrote Marks.

What do you think? 

Do you agree with Marks that we're at INVESTCON 5? Or is there nothing to worry about? 

Let us know in the comments below.