Howard Marks takes the market’s Temperature
Legendary Value investor, Howard Marks of Oaktree Capital has just released his latest memo to investors overnight. His observation that “overly generous capital markets ultimately lead to unwise financing, and thus to danger for participants” is worth noting with respect to Australia’s recent property boom…
It’s also worth appreciating the latest September memo is the second time recently that Marks has quoted the same paragraphs from his 2007 Memo The Race to the Bottom, namely;
“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 (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. . .
“This memo can be recapped simply: there’s a race to the bottom going on, reflecting a widespread reduction in the level of prudence on the part of investors and capital providers. No one can prove at this point that those who participate will be punished, or that their long-run performance won’t exceed that of the naysayers. But that is the usual pattern.”
And here are a few further excerpts;
“What are the implications of these events? I think they’re these:
- Enough time has passed for the trauma of the Crisis to have worn off; memories of those terrible times to have grown dim; and the reasons for stringent credit standards to have receded into the past. My friend Arthur Segel was head of TA Associates Realty and now teaches real estate at Harvard Business School. Here’s how he recently put it: “I tell my students real estate has ten-year cycles, but luckily bankers have five-year memories”
- Investors have had plenty of time to get used to monetary stimulus and reliance on the Fed to inject liquidity to support economic activity.
- While there certainly is no hard-and-fast rule that limits economic recoveries to ten years, it seems reasonable to assume based on history that the odds are against a ten-year-old recovery continuing much longer. (On the other hand, since the current recovery has been the slowest since World War II, it’s reasonable to believe there haven’t been the usual excesses that require correcting, bringing the recovery to an end. And some observers feel that in the period ahead, a proactive or politicized Fed might well return to cutting interest rates – or at least stop raising them – if weakness materializes in the economy or the stock market.)
- (Editors Note: It’s worth noting the economist Rudi Dornbusch, who in 1997 said; ‘none of the U.S. expansions of the past 40 years died in bed of old age; every one was murdered by the Federal Reserve.’ Roger M)
- Finally, nobody who entered the market in nearly ten years has experienced a bear market or even a really bad year, or seen dips that didn’t correct quickly. Thus newly minted investment managers haven’t had a chance to learn first hand about the importance of risk aversion, and they haven’t been tested in times of economic slowness, prolonged market declines, rising defaults or scarce capital.
“For the reasons described above, I feel the requirements have been fulfilled for a frothy market as set forth in the citation from my new book on this memo’s first page.
- Investors may not feel optimistic, but because the returns available on low-risk investments are so low, they’ve been forced to undertake optimistic-type actions.
- Likewise, in order to achieve acceptable results in the low-return world described above, many investors have had to abandon their usual risk aversion and move out the risk curve.
- As a result of the above two factors, capital markets have become very accommodating.”
“In memos and presentations over the last 14 months, I’ve made reference to some specific aspects of the investment environment. These have included:
- The FAANG companies (Facebook, Amazon, Apple, Netflix and Google/Alphabet), whose stock prices incorporated lofty expectations for future growth;
- Corporate credit, where the amounts outstanding were increasing, debt ratios were rising, covenants were disappearing, and yield spreads were shrinking;
- Emerging market debt, where yields were below those on U.S. high yield bonds for only the third time in history;
- SoftBank, which was organizing a $100 billion fund for technology investment;
- Private equity, which was able to raise more capital than at any other time in history; and
- Cryptocurrencies led by Bitcoin, which appreciated by 1,400 per cent in in 2017.
“I didn’t cite these things to criticize them or to blow the whistle on something amiss. Rather I did so because phenomena like these tell me the market is being driven by:
- Optimism,
- Trust in the future,
- Faith in investments and investment managers,
- A low level of skepticism, and
- Risk tolerance, not risk aversion
“In short, attributes like these don’t make for a positive climate for returns and safety.
Assuming you have the requisite capital and nerve, the big and relatively easy money in investing is made when prices are low, pessimism is widespread and investors are fleeing from risk. The above factors tell me this is not such a time.
“Being alert for the ability of others to issue flimsy securities and execute fly-by-night schemes is a big part of what I call “taking the temperature of the market.” By also incorporating awareness of historically high valuations and euphoric investor attitudes, taking the temperature can give us a sense for whether a market is elevated in its cycle and it’s time for increased defensiveness.
“This process can give you a sense that the stage is being set for losses, although certainly not when or to what extent a downturn will occur. Remember that The Race to the Bottom, which in retrospect seems to have been correct and timely, was written in February 2007, whereas the real pain of the Global Financial Crisis didn’t set in until September 2008. Thus there were 19 months when, according to the old saying, “being too far ahead of one’s time was indistinguishable from being wrong.” In investing we may have a sense for what’s going to happen, but we never know when.
“Thus the best we can do is turn cautious when the situation becomes precarious. We never know for sure when – or even whether – “precarious” is going to turn into “collapse.”
“I’m absolutely not saying people shouldn’t invest today, or shouldn’t invest in debt. Oaktree’s mantra recently has been, and continues to be, “move forward, but with caution.” The outlook is not so bad, and asset prices are not so high, that one should be in cash or near-cash. The penalty in terms of likely opportunity cost is just too great to justify being out of the markets.
“But for me, the import of all the above is that investors should favor strategies, managers and approaches that emphasize limiting losses in declines above ensuring full participation in gains. You simply can’t have it both ways.
“Just about everything in the investment world can be done either aggressively or defensively. In my view, market conditions make this a time for caution.
You can download the full memo here.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
