Yet Again?
By Howard Marks
Excerpted from the memo originally published here
“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. I also understand
my comments regarding digital currencies have been the subject of extensive –
and critical – comments on social media, but my primitiveness in this regard
has kept me from seeing them.
The responses and the time that has
elapsed have given me the opportunity to listen, learn and think. Thus I’ve
decided to share some of those reflections here.
Media Reaction
The cable news shows and blogposts
delivered a wide range of reactions – both positive and negative. The best of
the former came from a manager who, when asked on TV what he thought of the
memo, said, “I’d like to photocopy it and sign it and send it out as my
quarterly letter.” Love that guy.
I haven’t spent my time reveling in
the praise, but rather thinking about those who took issue. (My son Andrew
always reminds me about Warren Buffett’s prescription: “praise by name,
criticize by category.” Thus no names.) Here’s 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’s
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 take issue with all these
statements, especially the last, and I want to respond – not just in the sense
of “dispute,” but rather to clarify where I stand. In doing so, I’ll
incorporate some of what I said during my appearances on TV following the
memo’s publication.
Numbers one and two are easy. As I explained on CNBC, there are two things I would never say
when referring to the market: “get out” and “it’s time.” I’m not that smart,
and I’m never that sure. The media like to hear people say “get in” or “get
out,” but most of the time the correct action is somewhere in between.
I told Bloomberg, “Investing is not
black or white, in or out, risky or safe.” The key word is “calibrate.” The amount you have invested,
your allocation of capital 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.
And as I told CNBC, 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.”
Here’s how I summed up on
Bloomberg:
It’s all about
investors’ willingness to take risk as opposed to insisting on safety. And when
people are highly willing to take risk, and not concerned about safety, that’s
when I get worried.
If it’s true, as I believe, that
(a) the easy money in this cycle has been made, (b) the world is a risky place,
and (c) securities are priced high, then people should probably be taking less
risk today than they did three, five or seven years ago. Not “out,” but “less
risk” and “more caution.”
And from my visit to CNBC:
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. . . . It’s maybe “in, but maybe a little less than you used to be in.”
Or maybe “in as much as you used to be in, but with less-risky securities.”
Numbers three and four –
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 (a) absolutely
illogical or (b) signs of the investor error and lack of discipline that are
typical in bull markets.
- If the market is expensive, why
wouldn’t you lighten up?
- Why would you prefer to sell
after a few big down days, rather than today? (What if the big down days
are the start of a slide so big that you can’t get out at anything close
to fair value? What if there’s a big down day followed by a big up day
that gets you right back where you started? Does the process re-set? And
is it three big down days in a row, or four?)
- And if you continue to hold
past your sell points, what does “sell point” mean?
Bottom line: I think 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, fear of missing out has taken over from value discipline, a development
that is a sure sign of a bull market.
The fifth and final comment –
that one should exercise the same degree of care and risk aversion at all times
– gives me a lot to talk about. In working on my
new book, I divided the things an investor can do to achieve above average
performance 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, and
- 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. Whereas Buffett tells us to “be fearful when others are greedy and
greedy when others are fearful” – and he’s got a pretty good track record –
this commentator seems to be saying we should be equally greedy (and equally
fearful) all the time.
I feel strongly that it’s possible
to improve investment results by adjusting your positioning to fit the market,
and Oaktree was able to do so by turning highly cautious in 2005-06 and highly
aggressive in 1990-91, 2001-02 and immediately after the Lehman bankruptcy
filing in 2008. This was done on the basis of reasoned judgments concerning:
- how markets have been acting,
- the level of valuations,
- the ease of executing risky
financings,
- the status of investor psychology
and behavior,
- the presence of greed versus
fear, and
- where the markets stand in
their usual cycle.
Is this effort in conflict with the
tenet of Oaktree’s investment philosophy that says macro-forecasting isn’t key
to our investing? My answer is an emphatic “no.” Importantly, assessing these things only requires
observations regarding the present, not a single forecast.
As I say regularly, “We may
not know where we’re going, but we sure as heck ought to know where we stand.” Observations regarding valuation and investor behavior can’t tell
you what’ll happen tomorrow, but they say a lot about where we stand today, and
thus about the odds that will govern the intermediate term. They can tell you
whether to be more aggressive or more defensive; they just can’t be expected to
always be correct, and certainly not correct right away.
The person who said “there is no
better or worse time” was on TV with me, giving me a chance to push back. What
he meant, he said, was that the vast majority of people lack the ability to
discern where we stand in this regard, so they might as well not try.
I agree that it’s hard. 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 (a) have an
understanding of cycles, which can be gained through either experience or
studying history, and (b) be able to control your emotional reaction to
external stimuli. Clearly this isn’t easy, and if average
investors (i.e., the people who drive cycles to extremes) could do it, the
extremes wouldn’t be as high and low as they are. But investors should still
try. If they can’t be explicitly contrarian – doing the opposite at the
extremes (which admittedly is hard) – how about just refusing to go along with
the herd?
Here’s what I wrote with respect to
the difficulty of doing this in “On the Couch” (January 2016):
I want to make it
abundantly clear that when I call for caution in 2006-07, or active buying in
late 2008, or renewed caution in 2012, or a somewhat more aggressive stance
here in early 2016, I do it with considerable uncertainty. My conclusions are
the result of my reasoning, applied with the benefit of my experience (and
collaboration with my Oaktree colleagues), but I never consider them 100%
likely to be correct, or even 80%. I
think they’re right, of course, but I always make my recommendations with
trepidation.
When widespread euphoria and
optimism cause asset prices to meaningfully exceed intrinsic values and normal
valuation metrics, at some point we must take note and increase caution. And
yet, invariably, the market will continue to march upward for a while to even
greater excesses, making us look wrong. This
is an inescapable consequence of trying to know where we stand
and take appropriate action. But it’s still worthwhile. Even
though no one can ascertain when we’re at the exact top or bottom, a key to
successful investing lies in selling – or lightening up – when we’re closer to
the top, and buying – or, hopefully, loading up – when we’re closer to the
bottom.
FAANGs
There’s been a lot of discussion
regarding my comments on the FAANGs – Facebook, Amazon, Apple, Netflix and
Google – and whether they’re a “sell.” Some of them are trading at p/e ratios
that are just on the high side of average, while others, sporting triple-digit
p/e’s, are clearly being valued more on hoped-for growth than on their current
performance.
But whether these stocks should be
sold, held or bought was never my concern. As I said on Bloomberg:
My point about the FAANGs was not
that they are bad investments individually, or that they are overvalued. It was
that the anointment of one group of super-stocks is indicative of a bull
market. You can’t have a
group treated like the FAANGs have been treated in a cautious, pessimistic,
sober market. So that should not be read as a complaint about
that group, but rather indicative [of the state of the market].
That’s everything I have to say on
the subject.
Passive Investing
Passive investing can be thought of
as a low-risk, low-cost and non-opinionated way to participate in “the market,”
and that view is making it more and more popular. But I continue to think about
the impact of passive investing on the
market.
One of the most important things to
always bear in mind is George Soros’s “theory of reflexivity,” which I
paraphrase as saying that the efforts of investors to master the market affect
the market they’re trying to master. In
other words, 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.
The early foundation for passive or
index investing lay in the belief that the efforts of active investors cause
stocks to be priced fairly, so that they offer a fair risk-adjusted return.
This “efficiency” makes it hard for mispricings to exist and for investors to
identify them. “The average investor does average before fees,” I was taught,
“and thus below average after fees. You might as well throw darts.”
There’s less talk of dart-throwing
these days, but much more money is being invested passively. If you want an index’s performance and
believe active managers can’t deliver it (or beat it) after their high fees,
why not just buy a little of every stock in the index? That way you’ll invest
in the stocks in the index in proportion to their representation, which is
presumed to be “right” since it is set by investors assessing their
fundamentals. (Of course there’s a contradiction in this.
Active managers have been judged to be unable to beat the market but competent
to set appropriate market weightings for the passive investors to rely on. But
why quibble?)
The trend toward passive investing
has made great strides. Roughly 35% of all U.S. equity investing is estimated
to be done on a passive basis today, leaving 65% for active management.
However, Raj Mahajan of Goldman Sachs estimates that already a substantial
majority of daily trading is originated by quantitative and systematic
strategies including passive vehicles, quantitative/algorithmic funds and
electronic market makers. In other words, just a fraction of trades have what
Raj calls “originating decision makers” that are human beings making
fundamental value judgments regarding companies and their stocks, and
performing “price discovery” (that is, implementing their views of what
something’s worth through discretionary purchases and sales).
What percentage 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? I don’t think there’s a way to know, but people say it can be as
little as 20%. If that’s true, active, fundamentally driven investing will
determine stock prices for a long time to come. But what if it takes more?
Passive investing is done in
vehicles that make no judgments about the soundness of companies and the
fairness of prices. More than $1 billion is flowing daily to “passive managers”
(there’s an oxymoron for you) who buy regardless of price. I’ve always viewed
index funds as “freeloaders” who make use of the consensus decisions of active
investors for free. How
comfortable can investors be these days, now that fewer and fewer active
decisions are being made?
Certainly the process described
above can introduce distortions. At the simplest level, 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.
Today, with the
proliferation of ETFs and their emphasis on the scalable market leaders, the
FAANGs are a good example of insiders that are flying high, at least partially
on the strength of non-discretionary buying.
I’m not saying the passive
investing process is faulty, just that it deserves more scrutiny than it’s
getting today.
The State of the Market
There has been a lot of discussion
about how elevated I think the market is. I’ve pushed back strongly against
people who describe me as “super-bearish.” In short, as I wrote in the memo, I believe the market
is “not a nonsensical bubble – just high and therefore risky.”
I wouldn’t use the word “bubble” to
describe today’s general investment environment. It happens that our last two
experiences were bubble-crash (1998-2002) and bubble-crash (2005-09). But that
doesn’t mean every advance will become a bubble, or that by definition it will
be followed by a crash.
- Current psychology cannot be
described as “euphoric” or “over-the-moon.” Most people seem to be aware
of the 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 Global Financial Crisis, 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 is absolutely no reason to expect a crash. There may be a
painful correction, or in theory the markets could simply drift down to more
reasonable levels – or stay flat as earnings increase – over a long period
(although most of the time, as my partner Sheldon Stone says, “the air goes out
of the balloon much faster than it went in”).
Investing in a
Low-Return World
A lot of the questions I’ve gotten
on the memo are one form or another of “So what should I do?” Thus I’ve
realized the memo was diagnostic but not sufficiently prescriptive. I should
have spent more time on the subject of what behavior is right for the
environment I think we’re in.
In the low-return world I described
in the memo, the 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 (#1). With the risk-free rate
of interest near zero and the returns on all other investments scaled based on
that, I dare say few if any asset classes will return in the next few years
what they’ve delivered historically.
Thus one of the sensible courses of
action is to invest
as you did in the past but accept that returns will be lower.
Sensible, but not highly satisfactory. No one wants to make less than they used
to, and the return needs of institutions such as pension funds and endowments
are little changed. Thus #2 is difficult.
If you believe what I said in the
memo about the presence of risk today, you might want to opt for #3. In the
future people may demand higher prospective returns or increased prospective
risk compensation, and the way investments would provide them would be through
a correction that lowers their prices. If
you think a correction is coming, reducing your risk makes sense. But
what if it takes years for it to arrive? Since Treasurys currently offer 1-2%
and high yield bonds offer 5-6%, for example, fleeing to the safety of
Treasurys would cost you about 4% per year. What if it takes years to be proved
right?
Going to cash (#4) is the extreme
example of risk reduction. Are
you willing to accept a return of zero as the price for being assured of
avoiding a possible correction? Most investors can’t or won’t
voluntarily sign on for zero returns.
All the above leads to #5: increasing risk as the way to earn high
returns in a low-return world. But if the presence of elevated
risk in the environment truly means a correction lies ahead at some point, risk
should be increased only with care. As I said in the memo, every investment
decision can be implemented in high-risk or low-risk ways, and in
risk-conscious or risk-oblivious ways. High risk does not assure higher
returns. It means accepting greater uncertainty with the goal of higher returns
and the possibility of substantially lower (or negative) returns. I’m convinced
that at this juncture it should be done with great care, if at all.
And that leaves #6. “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. Pursuing this tack has to be based on the belief that (a)
there are inefficient markets and (b) you or your managers have the exceptional
skill needed to exploit them. Simply put, this can’t be done without risk, as
one’s choice of market or manager can easily backfire.
As I mentioned above, none of
these possibilities is attractive or a sure thing. But there are no others. What would I do? For me the answer lies in a combination of
numbers 2, 3 and 6.
Expecting normal returns from
normal activities (#1) is out in my book, as are settling for zero in cash (#4)
and amping up risk in the hope of draws from the favorable part of the
probability distribution (#5) (our current position in the elevated part of the
cycle decreases the likelihood that outcomes will be favorable).
Thus I would mostly do the things I
always have done and accept that returns will be lower than they traditionally
have been (#2). While doing the usual, I would increase the caution with which
I do it (#3), even at the cost of a reduction in expected return. And I would
emphasize “alpha markets” where hard work and skill might add to returns (#6),
since there are no “beta markets” that offer generous returns today.
These things are all embodied
in our implementation of the mantra that has guided Oaktree in recent years:
“move forward, but with caution.”
Since the U.S. economy continues to
bump along, growing moderately, there’s no reason to expect a recession anytime
soon. As a consequence, it’s inappropriate to bet that a correction of high
prices and pro-risk behavior will occur in the immediate future (but also, of
course, that it won’t).
Thus Oaktree is investing today
wherever good investment opportunities arise, and we’re not afraid to be fully
invested where there are enough of them. But we are employing caution, and
since we’re a firm that thinks of itself as always being cautious, that means
more caution than usual.
This posture has served us
extremely well in recent years. Our underlying conservatism has given us the
confidence needed to be largely fully invested, and this has permitted us to
participate when the markets performed better than expected, as they did in
2016 and several of the last six years. Thus
we’ll continue to follow our mantra, as we think it positions us well for the
uncertain environment that lies ahead.
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