Yet Again? (Howard Marks’ Memo)


Howard Marks’ Memo: Yet Again?, September 7, 2017

There They Go Again…Again” of July 26 has generated the most response in the 28 years I’ve been writing memos, with comments coming from Oaktree clients, other readers, the print media and TV.

Media Reaction

  • Some of what they said:
    • “The story from Howard Marks is ‘it’s time to get out.’”
    • “He’s right in the concept but wrong to execute right now.”
    • “The market is a little expensive, but you should continue to ride it until there are a couple of big down days.”
    • “There are stocks that are past my sell points, and I’m letting them continue to burble higher.”
    • “I appreciate Howard Marks’ message but I think now is no more a time to be cautious than at any other time. We should always invest as if the best is yet to come but the worst could be right around the corner. This means durable portfolios, hedges, cash reserves…etc. There is no better or worse time for any of these things that we can foresee in advance.”
  • I would never say when referring to the market: “get out” and “it’s time.” The media like to hear people say “get in” or “get out,” but most of the time the correct action is somewhere in between
  • Investing is not black or white, in or out, risky or safe. The key word is “calibrate.” The amount you have invested, your capital allocation among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive
  • What matters is the level that securities are trading at and the emotion that is embodied in prices. Investors’ actions should be governed by the relationship between each asset’s price and its intrinsic value. It’s not what’s going on; it’s how it’s priced… When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back
  • All I’m saying is that prices are elevated; prospective returns are low; risks are high; people are engaging in risky behavior. Now nobody disagrees with any of the four of those, and if not, then it seems to me that this is a time for increased caution
  • Arguing that it’s too early to sell even if the market is expensive or holdings are past their sell point are interesting. They’re either absolutely illogical or signs of the investor error and lack of discipline that are typical in bull markets
    • These things translate into “I want to think of myself as disciplined and analytical, but even more I want to make sure I don’t miss out on further gains.” In other words, FOMO has taken over from value discipline, a development that is a sure sign of a bull market
  • Things an investor can do to achieve above average performance can be divided into two general categories:
    • Selection: trying to hold more of the things that will do better and less of the things that will do worse
    • Cycle adjustment: trying to have more risk exposure when markets rise and less when they fall
  • Accepting that “there is no better or worse time” simply means giving up on the latter – this commentator seems to be saying we should be equally greedy and equally fearful all the time
  • Up-and-down cycles are usually triggered by changes in fundamentals and pushed to their extremes by swings in emotion. Everyone is exposed to the same fundamental information and emotional influences, and if you respond to them in a typical fashion, your behavior will be typical: pro-cyclical and painfully wrong at the extremes. To do better – to succeed at being contrarian and anti-cyclical – you have to have an understanding of cycles, which can be gained through either experience or studying history, and be able to control your emotions to external stimuli

Passive Investing

  • How would golf be if the course played back: if the efforts of golfers to put their shot in the right place caused the right place to become the wrong place? That’s certainly the case with investing
  • It’s tempting to think of the investment environment as an unchanging backdrop, that is, an independent variable. Then all you have to do is figure out the right course of action and take it. But what if the environment is a dependent variable? Does the behavior of investors alter the environment in which they work? (Of course it does)
  • Roughly 35% of all US equity investing is estimated to be done on a passive basis today, leaving 65% for active management. However, already a substantial majority of daily trading is originated by quantitative and systematic strategies including passive vehicles, quantitative/algorithmic funds and electronic market makers
    • What % of assets has to be actively managed by investors driven by fundamentals and value for stocks to be priced “right,” market weightings to be reasonable and passive investing to be sensible?
  • Passive investing is done in vehicles that make no judgments about soundness of companies and fairness of prices. More than $1Bn is flowing daily to these vehicles that buy regardless of price
    • How comfortable can investors be these days, now that fewer and fewer active decisions are being made?
  • If all equity capital flows into index funds for their dependability and low cost, then the stocks in the indices will be expensive relative to those outside them. That will create widespread opportunities for active managers to find bargains among the latter

The State of the Market

  • In short, I believe the market is “not a nonsensical bubble – just high and therefore risky”
  • Current psychology cannot be described as “euphoric” or “over-the-moon”. Most people seem to be aware of uncertainties that are present and of the fact that the good times won’t roll on forever
  • Since there hasn’t been an economic boom in this recovery, there doesn’t have to be a major bust
  • Leverage at the banks is a fraction of the levels reached in 2007, and it was those levels that gave rise to the meltdowns we witnessed
  • Importantly, sub-prime mortgages and sub-prime-based mortgage backed securities were the key ingredient whose failure directly caused the GFC and I see no analog to them today, either in magnitude or degree of dubiousness
  • It’s time for caution, as I wrote in the memo, not a full-scale exodus
  • There may be a painful correction, or in theory the markets could simply drift down to more reasonable levels over a long period (although most of the time, “the air goes out of the balloon much faster than it went in”)

Investing in a Low-Return World

  • Options are limited:
    • Invest as you always have and expect your historic returns
    • Invest as you always have and settle for today’s low returns
    • Reduce risk to prepare for a correction and accept still-lower returns
    • Go to cash at a near-zero return and wait for a better environment
    • Increase risk in pursuit of higher returns
    • Put more into special niches and special investment managers
  • It would be sheer folly to expect to earn traditional returns today from investing like you’ve done traditionally. Therefore, one of the sensible action is to invest as you did in the past but accept that returns will be lower – sensible but not highly satisfactory
  • If you think a correction is coming, reducing your risk makes sense. But what if it takes years for it to arrive? Since Treasuries currently offer 1-2% and high yield bonds offer 5-6%, fleeing to the safety of Treasuries would cost you about 4%/year
  • Going to cash is the extreme example of risk reduction – are you willing to accept a return of 0 as the price for being assured of avoiding a possible correction? Most investors can’t or won’t voluntarily sign on for 0 returns
  • All the above leads to “increasing risk as the way to earn high returns in a low-return world”: but if presence of elevated risk in the environment truly means a correction lies ahead at some point, risk should be increased only with care. At this juncture, it should be done with great care, if at all
  • “Special niches and special people” if they can be identified, can deliver higher returns without proportionally more risk – that’s what “special” means to me and it seems like the ideal solution (but it’s not easy)
  • What would I do? For me the answer lies in a combination of numbers 2, 3, and 6
    • I would accept that returns will be lower than they traditionally have been (#2), I would increase the caution with which I do it (#3), and I would emphasize “alpha markets” where hard work and skill might add to returns (#6)
  • Since the US economy continues to bump along, growing moderately, there’s no reason to expect a recession anytime soon. As a consequence, it’s appropriate to bet that a correction of high prices and pro-risk behavior will occur in the immediate future

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

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