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Memos from Howard Marks – There They Go Again…Again

Memos from Howard Marks – There They Go Again…Again, July 26, 2017

  • Since I’ve written so many cautionary memos, you might conclude I’m just born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time
  • It’s better to turn cautious too soon rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses

Today’s Investment Environment

  • Uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology
  • In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been
  • Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others
  • Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need

Ditto

  • “Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier investments. But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher. This may be exactly the wrong time to add to risk in pursuit of more return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so”
  • “Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate, investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures”

The Seeds for a Boom

  • Elements that typically form the foundation for a bull market, boom or bubble. A few will give us a bull market – all of them will deliver a boom or bubble
    • Benign environment; grain of truth; early success; more money than ideas; willing suspension of disbelief; rejection of valuation norms; pursuit of the new; virtuous cycle; fear of missing out
  • Most people are conscious of the uncertainties listed above, recognize that prospective returns are quite skimpy, and accept that things are unlikely to go well forever – that’s all healthy
  • But on the third hand, most people can’t think of what might cause trouble anytime soon
  • With the negative catalyst so elusive and the return on cash at punitive levels, people worry more about being underinvested or bearing too little risk than they do about losing money

US Equities

  • S&P is selling at 25x LTM earnings, compared to a long-term median of 15x
  • Shiller Cyclicality Adjusted PE ratio stands at almost 30x vs. historic mean of 16x (this multiple was exceeded only in 1929 and 2000)
  • While the “p” in p/e is high, the “e” has probably been inflated by cost cutting, stock buybacks, and M&A activity – thus, today’s reported valuations may actually be understated relative to underlying profits
  • The “Buffett Yardstick” – total US market cap as % of GDP – is immune to company-level accounting issues. It hit a new all-time high last month of around 145, as opposed to a 1970-1995 norm of about 60 and a 1995-2017 median of about 100
  • Even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established
  • Are you happy counting on continued low interest rates for your investment security, especially at a time when the Fed has embarked upon a series of rate increases?

Super-Stocks

  • Bull markets are often marked by the anointment of a single group of stocks as “the greatest”, and the attractive legend surrounding this group is among the factors that support the bull move
  • These attributes are being applied to a small group of tech-based companies, which are typified by the “FAANGs”: Facebook, Amazon, Apple, Netflix, and Google
    • All sport great business models and unchallenged leadership in their markets. They’re viewed as having captured the future and thus as sure to be winners in the years to come
  • Just as it appeared to be true of the Nifty-Fifty in the 1960s, oil stocks in the ‘70s, disk drive companies in the ‘80s, and tech/media/telecom in the late ‘90s. But in each of those cases:
    • Environment changed in unforeseen ways
    • Turned out that the newness of the business model had hidden its flaws
    • Competition arose
    • Excellence in the concept gave rise to weaknesses in execution
    • Shown that even great fundamentals can become overpriced and thus give way to massive losses
  • FAANGs are truly great companies, growing rapidly and trouncing the competition – but some are doing so without much profitability, and for others profits are growing slower than revenues
    • Are they invincible, and is their success truly inevitable?
  • Prices investors are paying for these stocks generally represent 30 or more years of the companies’ current earnings
  • Passage from one company’s 1997 letter to shareholders: “We established long-term relationships with many important strategic partners, including AOL, Yahoo, Excite, Netscape, GeoCities, AltaVista, @Home, and Prodigy”
  • Super-stocks that lead a bull market inevitably become priced for perfection. And in many cases the companies’ perfection turns out eventually to be either illusory or ephemeral (Kodak, Polaroid, Xerox, Sears, and Simplicity Pattern)
  • The powerful multiple expansion that makes a small number of stocks the leaders in a bull market is often reversed in the correction that follows, saddling them with the biggest losses. But when mood is positive and things are going well, the likelihood of such a development is easily overlooked
  • Not saying the FAANGs aren’t great, or that they’ll suffer such a fate. Just that their elevated status today is a sign of the kind of investor optimism for which we must be on the lookout

Passive Investing/ETFs

  • It’s a powerful movement that has expanded to cover 37% of equity fund assets. In the last 10 years, $1.4 trillion has flowed into index mutual funds and ETFs
  • While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming
  • Recent underperformance on the part of active investors may well prove to be cyclical rather than permanent
  • ETF’s promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds
  • Each deviation from the broad indices introduces definitional issues and non-passive, discretionary decisions
    • Organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks
  • In the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced
  • It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual
  • Further Reading: Horizon Kinetics – ETF Distortions

Credit

  • Corporate debt instruments are good candidates for spotting bull-market behavior given that we can readily determine their prospective returns
  • In overpopulated markets, providers of credit compete to make loans and investments that embody low returns, weak structures and slender margins of safety
  • Credit investors of today aren’t gun-shy, leaving investment opportunities to languish at excessive yields and yield spreads – at best, these investments are fairly priced in relative terms and fully priced in absolute terms
  • Investors have grown so confident about the seemingly interminable corporate-debt rally that many are dismissing the likelihood of large swaths of risky companies going bankrupt. After all, these covenants usually don’t matter until there’s a problem
  • Cautious investing produces good performance in a salutary environment which leads to a reduction of caution which leads to bad performance when the environment turns less favorable

Emerging Market Debt

  • Are investors appropriately sensitive to the risks and imposing reasonable discounts, or are they ignoring the risks and happily paying up?
  • Argentina issued $2.75 Bn of bonds in mid-June: maturity was 100 years and the interest rate was 8%
    • Argentina had defaulted on its debts 8 times in its 200-year history, with now fewer than 5 defaults in the past century alone
    • Investors don’t seem to care – there were $9.75Bn of bids
    • Ivory Coast, a nation that underwent another military uprising – in July 2017, sold a 6.25% yield 16-year bonds
  • Essential bottom line in all investing is simple: is the risk premium at least adequate?

Private Equity

  • Private equity firms market double-digit return track records and even their top-of-the-cycle 2005-07 funds now sport respectable gains – they’re attracting capital at all-time-high rates
  • Since PE managers mostly engage in LBOs, these amounts have to be viewed in terms of the levered-up total capital they’ll produce
  • Where will it be invested at a time when few assets can be bought at bargain prices?
  • Its record fundraising is yet one more sign of the willingness of investors to trust in the future

Observations and Implications

  • What do we see?
    • Some of the highest equity valuations in history
    • So-called complacency index at an all-time high
    • Elevation of a can’t-lose group of stocks
    • Movement of more than a trillion dollars into value-agnostic investing
    • Lowest yields in history on low-rated bonds and loans
    • Yields on emerging market debt that are lower still
    • Most fundraising in history for private equity
    • Biggest fund of all time raised for levered tech investing
    • Billions in digital currencies whose value has multiplied dramatically
  • For all the things listed above to simultaneously be gaining in popularity and attracting so much capital, credulousness has to be high and risk aversion has to be low
  • Think of the things that could knock today’s market off kilter, like a surprising spike in inflation, a significant slowdown in growth, central banks losing control, or the big tech stocks running into trouble – the good news is that they all seem unlikely; bad news is that their unlikelihood causes all these concerns to be dismissed, leaving the markets susceptible should any of them actually occur
    • This is a market in which riskiness is being tolerated and perhaps ignored, and one in which most investors are happy to bear risk

What to Do

  • Case for cash that can be built today from all the above could have been made years ago, and doing so would have resulted in huge penalties
  • If one is going to invest at times like this, knowing how to bear risk intelligently, striving for return while keeping an eagle-eye on the potential adverse consequences – is the absolute sine qua non
  • The only reason to be aggressive today is because defensive investing implies low prospective returns – but the question is whether pursuing high expected returns through aggressiveness can be counted on to be rewarded (if the answer is no, this is a time for caution)
  • When the market is rational, low-risk investments will always appear to offer prospective returns lower than those on high-risk ones. But in tough times, the former are less likely to bring losses than the latter. In my opinion that makes them right for today
  • “Investment is the discipline of relative selection”
  • Basic proposition is simple: Investors make the most and the safest money when they do things other people don’t want to do. But when investors are unworried and glad to make risky investments, asset prices will be high, risk premiums will be low, and markets will be risky. That’s what happens when there’s too much money and too little fear

Howard Marks, CFA, is the Co-Chairman of Oaktree Capital, an alternative investment management firm he co-founded in 1995.

Image Source: Oaktree Capital

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