The market goes into alert mode: what is the investor Buffett believes is warning about?

The Pentagon, in assessing the threat to national security, uses a five-step DEFCON (DEFense readiness CONdition) scale, where 5 is peacetime and 1 is the imminent threat of nuclear attack. Legendary investor Howard Marks, in his latest note, "The Mathematics of Value," offers a similar scale for the stock market and concludes that although a nuclear attack is still a long way off, the sky over Wall Street is no longer cloudless.

Howard Marks is co-founder of Oaktree Capital, an investment firm with $5.8 billion in assets at the end of the second quarter of 2025. Marks is known for his "memoranda" (memos) describing his views on the stock market. He attracted investors' attention in 2000 when, in a Bubble.com memo, he predicted the imminent collapse of tech stocks just three months before the dot-com bubble began to deflate. Warren Buffett said he always reads Marks' newsletter and gets something new out of it every time.

In his latest "memorandum," Marks recalls the wisdom of the "father of value investing," Benjamin Graham: in the short term, the market acts as a "voting machine" reflecting the popularity of assets, and in the long term, it acts as a "scale" assessing their real value. "Value is what you get by making an investment, and price is what you pay for it," he writes. A good investment occurs when the price matches the value. But the latter is difficult to assess, so investors often look to the P/E ratio (the ratio of a company's price to earnings) to judge whether an asset is undervalued or overvalued.

By the end of last year, the S&P 500 Index was trading at a forward P/E ratio (which takes into account projected earnings for the next year) of about 23 - well above the historical average. History shows: at these levels, the index's subsequent ten-year returns have ranged from +2% to -2%. According to Marks, these data portend a weak outlook for the stock market.

A key factor in Marks' "alarming" state of affairs is the S&P 500's continued high P/E. Just over half of the S&P 500's impressive growth over 2023-2024 has come from the "Magnificent Seven" tech giants. Their average P/E is about 33 - that's above normal, but doesn't seem excessive, according to Marks, given these companies' exceptional products and strong competitive positions. The real problem, he believes, is with the remaining 493 companies: their average P/E is around 22 - noticeably above the historical norm. This is what makes the overall market valuation overly optimistic and potentially dangerous.

Warren Buffett's indicator - the ratio of total market capitalization of U.S. stocks to U.S. GDP - is also at an all-time high. Marks notes that this is particularly troubling given two circumstances: companies are increasingly going non-public for longer before going public, and many of the established issuers have been bought out and moved to the private sector. As a result, the indicator itself appears understated relative to reality, and the actual overvaluation of the market may be even more profound than it appears at first glance.

After the announcement of new U.S. duties, the S&P 500 index experienced a sharp decline: the market put into prices the acceleration of inflation and a decrease in the investment attractiveness of the United States. However, in a few months, the shares have recovered almost 30%. The question arises: why are the quotes growing if the consensus forecast on the economy remains restrained?

Marks attributes this to the peculiarities of market psychology. "Investors are by nature optimists. Only by being optimistic can you give your money to another person and hope to get more from him later. When investors are in an elevated mood, they are able to interpret ambiguous events in a positive way and simply ignore the negative," he writes.

According to him, the U.S. stock market still has fundamental advantages, but it is already "a little less exclusionary" than before. For many market participants, this difference goes unnoticed, and the habit of interpreting facts in a positive way supports the growth of quotations in spite of objective risks. "It seems to me that fundamentals are generally worse than they were seven months ago. At the same time, asset prices remain strong relative to earnings, exceeding even the end-2024 level, and, from a historical perspective, valuations are very high."

Most bull markets are formed by a "constellation of positive factors" against the backdrop of a normally functioning economy. Now Marks sees three such factors in the market:

- positive psychology and the "wealth effect" driven by the recent rise in markets, luxury real estate and cryptocurrencies,

- the belief that for most investors, there really is no alternative to the US markets,

- hype around a new trend: artificial intelligence.

"These are the very things that have the potential to ignite investor imagination and fuel bull markets, and they are certainly doing so now," Marks writes.

An additional factor remains the psychology of market participants. Market growth is supported by the FOMO effect - the fear of missing out on gains, which encourages investors to enter deals despite high valuations. Another popular rationalization is the belief that the US President's toughest trade threats will never materialize. The market calls this by the acronym TACO - Trump Always Chickens Out.

Investor optimism is also fueled by market memory. The last prolonged correction ended back in early 2009, and more than 16 years have passed since then, during which risk-taking has not been penalized and the "buy on the downturn" strategy has almost always been profitable. An entire generation - those under 35 today - have no experience with a prolonged bear market. Older market participants have experienced downturns, but over such a long period of calm, even they may have lost their caution.

Howard Marks suggests that investors assess market conditions the same way the military assesses threat levels: "In the action movies my wife Nancy and I like to watch, the Pentagon sometimes declares a state of alert, starting at DEFCON 5 and raising it as the danger increases to DEFCON 1, which means a nuclear attack is imminent or has already begun."

By analogy, he formulates his own six-step scale of market readiness - INVESTCON, where 6 can be considered "normal, standard readiness in the absence of threats" and 1 - "maximum anxiety". The system reflects what actions an investor should take depending on the level of risk:

6. Stop buying

5. Reduce risk positions and increase protective positions

4. Sell off the remaining risk positions

3. Cut and defense positions

2. liquidate all assets

1. open short positions

In reality, Marks says, it is virtually impossible to achieve the level of certainty that would allow a 3-1 move to be announced. "Overvaluation does not mean a guaranteed fall," he writes, "and so it is rarely wise to take a strategy to extremes. I have never done so myself."

Nevertheless, the investor believes that the current market situation is worrisome. High valuations, excessive optimism and narrow credit spreads increase the vulnerability of the system. "It's time for INVESTCON 5. And if you lighten your portfolio by getting rid of assets that look historically expensive and switch to those that seem safer, you probably won't lose that much, even if the market continues to rise slowly... At least not enough to be worth worrying about," Marks states.

This article was AI-translated and verified by a human editor