Howard Marks: «The easy money has been made.»
Few investors get paid such deep respect as Howard Marks. The Co-founder and Co-Chairman of the Los Angeles based investment boutique Oaktree Capital not only stuns Wall Street with his exceptional track record, but he’s also highly regarded for his sober-minded notes on the ever-changing moods of the global financial markets. The essence of his investment philosophy is unveiled in his new book, entitled «Mastering the Market Cycle: Getting the Odds on Your Side». It was released earlier this month, is well written and belongs in the library of every prudent investor. During our conversation, the legendary value investor addresses the recent turmoil in stocks and bonds, explains why conditions demand a defensively calibrated portfolio, and reveals how investors can successfully position themselves in the market cycle.
Mr. Marks, when you speak, investors around the globe listen up. What’s the key to your investment strategy?
I believe that everything an investor can try to do to improve performance falls under one of two headings: Asset selection and cycle positioning. Asset selection consists of owning more of the things that will do better and less of the things that will do worse. Cycle positioning consists of having more investments and more aggressive investments when the market is poised to do well and fewer investments and more protective investments when the market is poised to do poorly.
That sounds quite simple. But how does cycle positioning really work?
Let’s assume your goal is to have defense at the right time and offense at the right time. There are two possibilities to achieve that: Number one, have a forecast of what’s going to happen. You can do this by predicting psychology and guessing at how people are going to feel about things a year from now: How they will feel about the market, the economy, company performance, the administration in Washington and so forth. But I do not think that this can be done successfully.
Because our world is too uncertain to permit certainty. We don’t know what’s going to happen and we don’t know how the market is going to react to it. Let’s go back two years to October of 2016. There were two things most investors were certain of: Hillary Clinton would win the presidency and, if by some fluke Trump won, the market would crash. But what happened was Trump won, and the market went up. If that’s not enough to convince you that forecasts don’t work I don’t know what will.
Many investors were also taken by surprise by the recent setback in the stock market. What are your thoughts on the latest financial markets turbulences?
Just a month ago, everything was «cool». Everybody said, «the economy is good, companies are doing well, the tax cuts make everybody rich, and we’re settled with the North Koreans». But then the market had a few very bad days and the main explanation was because long-term interest rates picked up. But how could this have come as a surprise? The Federal Reserve said three or four years ago that interest rates should go up. They have been raising rates on the short end and it shouldn’t be a surprise that the rates on the long end finally woke up and started going up. And yet, if it’s expectable as it should have been, how can it be the source of so much volatility? To me, that just shows you how nutty the market is.
What can investors do to make better investment decisions?
As I make the case in my new book, you have to have a sense for where the market stands in its cycle. That’s what’s determines the odds. When the market is attractively positioned, low in its cycle, then the expected return is above average, and you want to play offense. In contrast to that, when the market is unattractively positioned, high in its cycle, then the expected return is below average, and you want to play defense. When you get this judgment right, then your results will be better than average.
But how exactly do you do that?
The main factors which influence where the market is in its cycle are fundamentals and investor psychology. The market tends to reflect how the economy has been doing and how companies have been doing. But most investors think naively that if good things happen, stocks will go up, and if bad things happen, stocks will go down. But sometimes the opposite is the case. If expectations are too high you can have good things happen, but investors are disappointed, and stocks go down. Or, you can have unpleasant events but if they’re not as bad as expected the market can go up. Every event can be interpreted positively or negatively. For instance, rising interest rates can be a bad thing because it could crush businesses. But it also can be viewed as a good thing because it signals that the economy is strong.
Why is investor psychology so important?
Investors are not good at taking all the factors into account and balancing them. Usually they look only at the positives or only at the negatives. I made this point in my memo from January 2016 entitled «On the Couch»: In real life, things fluctuate between «pretty good» and «not so hot». But in the market, attitudes fluctuate between «all good» and «all bad». That’s what happened a few weeks ago when interest rates on the long end started to rise. So it’s not enough to know what you think is going to happen event-wise. You also have to think about psychology and emotion, because where the market stands and what the market does is the result of the interaction of what events occur and how people react to them. If you can understand what expectations are factored into the market and where emotion and psychology stand, then you have a better chance of getting the odds on your side.
How do you get the odds on your side?
Think of a bowl full of lottery tickets. The makeup of the tickets changes as the market moves in its cycle. Let’s say, normally there are 60% winning tickets and 40% losing tickets in the bowl. But when the market is low in its cycle it may be 90% winning tickets and 10% losing tickets. And when the market is high in its cycle it’s 30% winning tickets and 70% losing tickets. So before you decide to buy a lottery ticket, wouldn’t you like to know the composition of the tickets in the bowl? In other words: If you think clearly about the composition of the tickets you can get the odds on your side. However, even when you have the odds on your side it doesn’t tell you what’s going to happen. You can have a bowl with 90% winners and 10% losers and you reach in that bowl and you pull out a loser. All you can do is get the odds on your side, so your probability of success is better than neutral. And if you can do that repeatedly in the long run you will come out ahead.
How do you improve your odds when it comes to cycle positioning?
It’s very hard to make predictions of the future but it’s not so hard to assess the current environment. That’s how you can improve your results, and it comes down to one question: is the market hot or cold? Are investors optimistic, greedy and risk tolerant? Or are they fearful, pessimistic and risk averse? When it’s the latter category, that’s when we want to buy. We want to buy when everybody discounts the positives and overrates the negatives. And if the opposite is the case, then we want to reduce our risk.
What’s the temperature of the market right now?
I believe we are high in the cycle. For instance, P/E ratios on stocks are above average. They are not as crazy as they were in 2000, but they are above average. Also, interest rates on bonds are below average, yield spreads are at historic lows and credit conditions are weak in terms of looser covenants. What’s more, we are in the tenth year of an economic recovery and there has never been a recovery of more than ten years. That doesn’t mean this recovery can’t continue, and frankly, it feels like this one will go more than ten years.
What does this mean for investors?
The longer the cycle has gone up, the closer we probably are to the point when it turns down. We’re in the tenth year of a bull market and the S&P 500 has quadrupled from the low of March 2009. That’s why I would argue that the easy money has been made. The market environment is not as attractive as it was ten years or five years ago, and that means the chances of extreme positive performance are low. So given where we are in the cycle and what has happened, you can’t argue that we should take on more risk today than we did five years ago.
One thing that has changed since the beginning of October is that market volatility has increased. Where do you spot the most dangerous risks today?
First of all, I believe that risk is not volatility. Risk is the probability of losing money. That’s the most important risk. Volatility is academic. The academics use volatility because there is nothing else they can use to measure risk which is quantifiable.
So where are the real risks?
As I explain in my latest memo, entitled «The Seven Worst Words in the World», there is too much money chasing too few deals. People are eager to invest because they can’t stay out of the market. They have a lot of money in their hands and they don’t want to put it in the money market or in Treasuries because the return is so low. So they’re trying to get into aggressive risk asset classes, and that drives up the prices, drives down the returns and drives up the risks. Conditions are probably worse in credit than they are in equities. It’s not like equities are horribly priced. They are a little more expensive than average. But just to be clear: I’m talking about the average stock, not the FAANGs or other high-risk equities whose prices incorporate lofty expectations for future growth.
How dicey could things get in the credit market if the cycle turns down?
When there is a lot of money which wants to go into the market, then people make investment decisions in terms of «I will take less return, I will take less safety» and so forth. There has been a lot of that behavior going on in the world of credit. But it’s important to note that credit is by nature safer than equities. All but the very worst credit investments are not going to collapse and lose money. What they are going to do is to produce subpar returns with more risk than was expected. So I don’t think there is going to be some disastrous crash. But the experience just will not be a good one.
Given this backdrop, what would you advise a Swiss investor to do when it comes to portfolio allocation based on cycle positioning?
Before people start investing at all, the first thing they should do is to ask what the right posture for them is. This depends on your age, your financial situation, the number of dependents, whether you want to retire soon and – very importantly – your psychological makeup: If there’s a decline, can you stand it and hold? Or are you likely to panic and sell? Everybody has to figure out their normal risk posture. Then, based on what has happened and where we stand in the cycle, you have to ask: Is the outlook average, below average or above average? In other words: Should your risk today be above normal, normal or below normal? That’s how you calibrate your positioning. You do it not with absolute precision, but directionally.
And how should your calibration look like today?
In my view, market conditions make this a time for caution, a period more for defense than offense. More defense means more bonds than stocks, high quality stocks rather than low, big companies rather than small ones, value strategies rather than growth strategies, stable companies rather than cyclicals, developed world rather than emerging markets. I believe people can improve their investment results by adjusting risk based on where we are in the cycle, and how other investors are behaving. But it’s important to keep in mind that cycle positioning is not a daily activity. We cannot expect to do this properly every day or every month. In my life, I’ve made four or five major calls correctly in fifty years. If investors do this at market extremes, it’s likely to work. In between the conclusions aren’t compelling, which means people shouldn’t try to adjust portfolios hyper-actively.