We’ve just been reading through Howard Marks’ latest memo – Latest Thinking. He makes a number of great points on current market conditions, possible future catalysts, and defensive versus aggressive investing. But the one take-away that stuck out for us is that regardless of current market conditions one should always invest on the basis of value and its relationship to price.
Here’s an excerpt from that memo:
It appears many investment decisions are being made today on the basis of relative return, the unacceptability of the returns on cash and Treasurys, the belief that the overpriced market may have further to go, and FOMO. That is, they’re not being based on absolute returns or the fairness of price relative to intrinsic value. Thus, as my colleague Julio Herrera said the other day, “valuation is a lost art; today it’s all about momentum.”
The potential catalysts for decline that we have to worry about most may be the unknown ones. And although I read recently that bull markets don’t die of old age or collapse of their own weight, I think sometimes they do (a dollar for anyone who can identify the catalyst for the collapse of the bull market and tech bubble in 2000 – it’s not easy).
The bottom line of the above is that some people are excited about the fundamentals, and others are wary of asset prices. Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily.
As I wrote in September, most people (and certainly the media) want definite answers: in or out? buy or sell? risk-on or risk-off? But it’s rare for answers that simple to be correct. There’s a wide range of possible stances that investors might adopt. At one end of the spectrum there’s maximum aggressiveness (100% invested in high-beta, high-risk assets, or maybe more than 100% through the use of leverage), and at the other there’s maximum defensiveness (100% cash, or perhaps being net short). Most investors are never either of those.
And I certainly wouldn’t be either of them today; I’d be someplace in between. That’s easy to say. But where? Closer to the bullish end of the spectrum or the bearish end? Or balancing the two equally? My answer today, as readers know, is that I would favor the defensive or cautious part of the spectrum. In my view, the macro uncertainties, high valuations and risky investor behavior rule out aggressiveness and render defensiveness more sensible.
For one thing, I’m convinced the easy money has been made. For example, the S&P 500 has roughly quadrupled, including income, from its low in 2009. It was certainly easier for the p/e ratio to go from the low teens in 2011-12 to 25 today than it would be for it to double again from here. Thus the one thing we can say for sure is that the current prospects for making money in U.S. equities aren’t what they were half a dozen years ago. And if that’s the case, isn’t it appropriate to take less risk in equities than one took six years ago?
Prospective returns are well below normal for virtually every asset class. Thus I don’t see a reason to be aggressive. Some investors may adopt an aggressive stance to be in the riskiest (and thus hopefully the highest-returning) assets; to squeeze out the last drop of return as the markets continue to rise (under the assumption they’ll be able to get out at the top, something that’s present in every strongly rising market); or to achieve a high return in this low-return world. I don’t view any of those as good ideas.
For years my description of the factors characterizing the markets has been essentially unchanged:
- a large number of big-picture uncertainties,
- sub-par prospective returns,
- above average valuations, and
- pro-risk investor behavior.
For as long as I have been discussing this view, no one has ever taken issue with any of these observations. Do you? That’s the key question. And if not, what will you do about it?
You could have made the above four points a year ago, and two years ago, and three years ago, etc. And in general I did. Thus it was possible to argue for raising some cash at a variety of times over the last few years. However, going meaningfully to cash would have been a big mistake – certainly based on how markets performed, but also on the merits – and I think it still would be wrong today.
When I came up with the mantra that has governed at Oaktree over the last several years – “move forward, but with caution” – I described my position as follows:
the outlook is not so bad, and prices are not so high, that it’s time for maximum defensiveness (and if you turn to maximum defense today, your return will be near zero, something most people can’t stomach), but
the outlook is not so good, and prices are not so low, that it’s right to be aggressive. In fact, the only thing I was sure of was that there was no place for aggressiveness.
So I didn’t say, “Get out now,” and I still wouldn’t. But I think this continues to be a time to incorporate a good helping of defensiveness in portfolio management. Being fully invested in a cautious portfolio has been an appropriate stance over the last few years. It gave Oaktree performance that in general was respectable or better.
Aggressiveness would have produced higher returns, of course, but I don’t think it could have been justified a priori. (Is an incorrect decision one that didn’t work out well, or one that was wrong at the time it was made? I insist it’s the latter, as you know.)
And today? What has changed? To the four descriptors of the investment environment listed above, I would add three more:
the economy is strengthening, not slowing, and Washington is supporting its progress, prices are even higher and valuation metrics have moved up, and, as I said, the easy money has been made.
Thus the current environment is still mixed – better fundamentally and worse price-wise. The positive near-term economic outlook, lowness of interest rates, need of most investors for return and moderate psychology all seem to suggest it would be a mistake to get out. On the other hand, the extremely high asset prices, macro-fragility and risky behavior going on all around us argue for considerable caution.
At times when the economy does well, risk doesn’t rear its head, risk-takers prosper and the returns on low-risk alternatives are unattractive, investors tend to drop their prudence and conclude that high prices aren’t a problem in and of themselves. This usually turns out to be a mistake, but it can take years.
For authority, I’ll cite a passage that seconds that view:
The market seems extremely comfortable with the proposition that as long as the macro-environment remains benign, stocks prices can continue to appreciate at rates that far outstrip the growth of their issuers’ profits, and thus the growth of their intrinsic value. Few market participants seem concerned about appropriate valuation levels – the relationship between assets and their prices – and this is a condition that we think must eventually have negative consequences. . . .
Today’s combination of a stable economy, low interest rates, enormous cash flows and strong investor optimism has created a climate in which capital is available for both good investments and bad, and in which risk is rarely seen as something to be shunned.
I wrote that in 1997, in a clients-only memo entitled “Are You an Investor or a Speculator?” I was cautionary then, like I am now. And it took almost three years for that to turn out to be correct. That doesn’t mean it wasn’t correct when it was written . . . just early.
Today there’s beginning to be talk of a possible late-bull-market melt-up, making investors more money but perhaps fulfilling the requirements for a full-fledged bubble. (This may be part of the usual pattern of capitulation that occurs when those who haven’t fully participated lose the will to keep abstaining after years of market gains.) The basic themes supporting the “melt-up” theory include (a) the existence of the fundamental positives listed above and (b) the arrival of euphoric psychology, which has been absent to date.
For me the key points regarding the general market outlook are as follows:
- The absence of widespread euphoria certainly is an important flaw in any near-term bearish view.
- Thus there’s no reason for confidence in the existence of a soon-to-burst bubble.
- Investor psychology continues to grow more confident, however.
- Asset prices are already unusually high.
- Future events remain unpredictable, but today’s high prices mean the odds are against a significant long-term upward move from here.
- No one can say what’s going to happen in the short term.
Asset prices and valuation metrics are certainly worrisome, but psychology and its implications – as well as timing – are unpredictable. I think that’s about all we can know.
Thus Oaktree will continue to invest on the basis of value and its relationship to price, and to refrain from trying to time markets based on predictions regarding economies, markets or psychology. The “melt-up” school says securities that already are highly priced may become more so. We’d never bet on whether they will or won’t.
Our post-2011 mantra remains in force: we’re investing when we find reasonable propositions, albeit with caution. We’re investing, and with the exception of the distressed debt fund specifically raised to await an upsurge in opportunities, we aren’t intentionally uninvested. If we find things with decent return prospects, structure and risk, we don’t pass them by because we think they’ll be cheaper a year from now. And we’re making our views clear to clients so that, especially in our open-end strategies, they can make their own choice between aggressiveness and defensiveness.
You can read the latest Howard Marks memo here – Latest Thinking.
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