Outside the Box

Yet Again?

September 20, 2017

This week’s Outside the Box is from one of my favorite writers and analysts. Howard Marks of Oaktree Capital is simply an investing legend. He writes several “memos” a year on the world of investing, and I put quotes around the word memos because they are typically longer than what you would think of as a memo. This week’s selection is reduced from the full memo, which you can see here.

(And for those who are wondering what I omitted, Howard did a long section on Bitcoin that I had to edit out. If you’re interested, click on the link above, go down about halfway, and you’ll find that section.)

Oaktree Capital, which is a $100 billion hedge fund, runs the largest distressed debt fund in the world, according to its wiki. Distressed-debt hedge funds are among my favorite investment styles. Where others see risk, great distressed investors simply say let’s lower the valuation of the asset until we take out the risk. It’s all about the market finding its own level. And the really good funds can offer some quite pleasurable investments noncorrelated to market returns. The problem is getting access to them. Oh well. More from the wiki:

Oaktree Capital Management is an American global asset management firm specializing in alternative investment strategies. It is the largest distressed investor in the world, and one of the largest credit investors in the world. Oaktree emphasizes an opportunistic, value-oriented, and risk-controlled approach to investments in distressed debt, corporate debt (including high yield debt and senior loans), control investing (including private equity and special situations), convertible securities, real estate and listed equities.

This letter in particular will be useful for investors of all stripes, as Howard shares his views on where we are in the marketplace and how we should go about responding. You might want to read this one a few times.

(As an aside, I have always wanted to meet Howard Marks and have never had the opportunity. If somebody could arrange to make that happen, even if just on the phone, I would be grateful.)

I am home alone for a few days, and Shane is up in New Jersey visiting her son. She seemed all worried about how I was going to feed myself, but I assured her that I somehow or other managed to do that for well over 10 years. Maybe not as nicely nor nearly as healthily as she does, but I am able to keep fuel in the body.

Have a great week, and maybe take a friend or two out to dinner. And remember, next Wednesday I should be on CNBC with Rick Santelli around the 9:35 slot. That should be fun.

Your thinking about risk a lot analyst,

John Mauldin, Editor
Outside the Box

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Yet Again?

By Howard Marks
September 7, 2017
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:

  1. “The story from Howard Marks is ‘it’s time to get out.’ ”
  1. “He’s right in the concept but wrong to execute right now.” 
  1. “The market is a little expensive, but you should continue to ride it until there are a couple of big down days.”
  1. “There are stocks that are past my sell points, and I’m letting them continue to burble higher.”
  1. “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:

  1. Invest as you always have and expect your historic returns.
  1. Invest as you always have and settle for today’s low returns.
  1. Reduce risk to prepare for a correction and accept still-lower returns.
  1. Go to cash at a near-zero return and wait for a better environment.
  1. Increase risk in pursuit of higher returns.
  1. 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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Comments

jack goldman

Sep. 20, 9:34 p.m.

Always nice to get the generic view. Stay the course, get in or get out. We are obviously in a bubble that could become an even bigger bubble so no one dares call it a bubble just yet. Wait until it’s down fifty per cent, then call it a bubble. We are in a global debt bubble. In silver dollars the Dow index is 1000 silver dollars in 1966 and 1000 silver dollars in 2016, fifty years later, the REAL price. In counterfeit debt notes the Dow is 1000 debt notes in 1966 and 22,000 counterfeit debt notes in 2017. It’s no growth in silver dollars and a bull market in counterfeit debt notes. Take your pick. Fake news is in fake dollars and a massive counterfeit bull market. Real news is in real dollars no growth in fifty years. I prefer real news in real dollars to fake news in fake dollars. CNN really is fake news.