«Nobody knows what will happen»

Howard Marks, Co-Chairman of the US investment firm Oaktree Capital warns that valuations in the financial markets are uncomfortably high and that investors are being too complacent.

Christoph Gisiger and Mark Dittli

When Howard Marks speaks, financial markets listen. The renowned value investor and co-founder of Oaktree Capital looks back at almost fifty years on Wall Street and has seen a thing or two during his successful career. His «Memos from the Chairman», which he sends sporadically to Oaktree’s clients are a must read for investors.

Mr. Marks welcomes the journalists in his corner office on the 34. floor in Midtown Manhattan with a partial view over Central Park: On the wall hangs a huge, gloomy oil painting showing two sailing ships in a severe storm. On the couch table lies a heavy volume with old issues of the «New York Times» from October 1929: the month of the historic stock market crash.

Today, Howard Marks is concerned. He sees growing complacency in the financial markets, high valuations and investors mindlessly shouldering bigger and bigger risks. He warns that central banks have distorted the risk curve and that we have no idea about what’s going to happen next, when they start to unwind their extreme policy measures. But one thing he knows for sure: «As long as people are involved in the process, and given their tendency to take everything to the excess in the upward or the downward direction, there never will be permanent moderation.»

Mr. Marks, you often write in your memos how important it is to know where we are in the cycle. So where are we today?
We are certainly not at the beginning of the game. And we’re not at the midpoint. Now bear in mind that when looking at the cycle, there are several points to consider: valuation, psychology, interest rates and so on. In many regards, I think we’re past the midpoint and already late in the cycle, primarily in terms of valuations and in terms of the capital market deals that can get done.

What kind of deals are you thinking of?
Well, look at deals like Argentina being able to sell 100-year debt at a yield of 8%. Netflix can sell debt at 3,625% and Softbank is raising a private equity fund worth $100 billion. These deals are all indicative of the mindless shouldering of risk that arises when investors are eager to put money to work. They do it because the alternative, cash, is so unattractive. In Switzerland for instance, you have negative interest rates – so investors feel forced to put their money to work. But, you see, it is not necessarily the worst thing to hold cash at negative interest rates. There are things that are worse, like buying securities at prices which are highly inflated and then seeing their prices decline substantially.

When we look at stock market valuations, they are very rich. In the case of the S&P 500 they were only higher in 1929 and in 1999-2000.

Yes, but that does not necessarily mean the valuations can’t go higher. In early 2000, the P/E ratio of the US stock market was significantly higher than today. Also, interest rates are much lower today, which justifies high P/E ratios. Even Warren Buffett says equity valuations are not so high – if you believe interest rates will stay low. The big question of course is whether that will be the case.

What do you think? Will interest rates stay low?
The Fed says it will raise rates. But it seems to have a hard time doing so, because it’s concerned that rate hikes will choke off the little bit of economic growth we have today.

So we have high valuations, deals that shouldn’t get done, and other indications that we’re in the late state of the cycle. Are we even in another bubble?
No. You know, people make sloppy use of terminology. A bubble is not just a highly valued market. A bubble is ridiculously high. Don’t get me wrong, I think the valuation of the U.S. stock market is very high, but it’s not ridiculously high. In a bubble, people say that there is «no price too high,» and they say «only good things can happen.» I don’t see that today. Most of the people I talk to say things like: «We know this thing can’t go on forever, but we just don’t see what could derail the market anytime soon.»  At least they’re conscious that there are limitations.

So it’s the euphoria that’s missing to call this a bubble?
Exactly. People are not euphoric today, nobody is ecstatic. The bullish people acknowledge that stocks are expensive, but they want to let them go a bit higher. In such an environment, prices can go up further, even though they’re expensive. Of course, a value guy would say if stocks are expensive, you should not own them. I would state it like this: You should not own as much of them as you did when they were cheap. But again, I don’t see people coming up with explanations why stocks should be considered cheap because «it’s different this time.» Nobody says valuations don’t matter anymore. Thus the situation today is not as dangerous as it was in past bubbles.

Isn’t it a case of «This time is different» when people say interest rates are going to stay low forever and hence fair valuations should be much higher?
It would be a dangerous bet to say interest rates are going to stay low forever, but I don’t see many people taking that bet. And you see, even if interest rates were to stay where they are, that would argue for P/E ratios to stay where they are. And if they do, then stocks will only appreciate at the same rate as earnings, which is not really fast; there would be no multiple expansion. This market is not built on some euphoric view of the future, but mainly on the unwillingness to accept zero or negative returns on cash and safe instruments. It’s based on the view that there is no alternative: people are afraid to be out of the market. But then again, a perceived lack of alternatives is not a good argument for chasing yield and taking big risks. That’s why I think this is the time to turn cautious.

So people understand that the market is highly valued but they think it will continue to burble up. Isn’t that built on everyone’s assumption that they will be able to get out in time?
Yes, indeed. It’s not smart, but people think that’s what they have to do now. You remember Chuck Prince, the CEO of Citigroup, who in July of 2007 said «when the liquidity dries up, this will end badly, but as long as the music is playing, you have to dance?» What does that even mean? People always say they’ll stay in the market, thinking it has further to go, but if it starts to turn down they will get out. Maybe that’s what people are thinking in today’s stock market: «It will continue to go up, but I will get out in time.» People overestimate their ability to get out in time. Who will be there to buy when everyone wants to sell? That’s wishful thinking.

So you see a lot of complacency today?
Yes. The VIX, the volatility index, is at its all-time low set in 1993. That was a time when Bill Clinton took office, the Cold War had ended and people were expecting a peaceful world. Should investors really be as complacent now as they were then? I don’t think they should. But the VIX does not say what volatility will be in the future. It tells us more about people’s mood today than it does about the events of tomorrow.

What should investors do today?
First, we have to realize that the easy money in this cycle has been made. The returns you will get from elevated valuation levels in a highly uncertain world will be difficult. This is not the time to take on more risk and to reach for yield. Our mantra at Oaktree is «move forward, but with caution.» This is not the time to be completely out of the market, either, because I don’t think we are in a dangerous bubble.

What risks do investors have to consider in this environment?
As an investor, you have to deal with two risks: The risk of losing money, and the risk of missing out on opportunities. It’s the job of a good investor to balance the two: You invest, but with caution. You should certainly have less risk exposure today than you would have had five or seven years ago. I think it’s better to turn cautious too soon rather than too late. Most people can’t think of what might cause trouble anytime soon. It’s precisely when people can’t see what it is that could make things turn down that risk is the highest. It could be an economic slowdown, rising interest rates, the effect of central bank tightening, or geopolitical events. Or it could be «something else.» It’s always the things we don’t know about that really bite us in the end.

From the perspective of a value investor: Do you see any pockets of value left?
Not in our public markets. If you want relative bargains today, you have to go into private investing. In the public markets, yields and expected returns are quite low. In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been. Almost nothing can be bought below its intrinsic value.

You don’t even see bargains in the distressed debt field?
No.  There is little distress today.

Not even in the retail sector, for example?
Look, returns are high when you can buy something for less than its real worth. When distressed debt investors produced high returns, it’s because they bought debt when a company’s problems were exaggerated and the price of its bonds fell too low. In other words, the distress was over-stated. Looking at today’s retail companies, I think the distress we see may not be exaggerated. Our mantra historically has been good company, bad balance sheet. When you look at the retailers that are suffering today, the question is whether they really are good companies. Their future isn’t clearly viable.  Thus there is no thing today that stands out as cheap.

You often write in your memos how important it is to avoid the losers. Do you see anything that stands out as being ridiculously expensive?
Yes, emerging market debt is too expensive today. As I mentioned earlier, if you buy the debt of Argentina at the prices we see today – I mean, this country defaulted five times in the past 100 years. So would you buy Argentina’s debt for the next 100 hundred years? People do, because 8% sounds great in a zero percent world. It all emanates from the low to negative risk-free rates. Central banks have distorted the risk curve; we used to have a world where the risk-free rate was 4%, ten-year Treasuries were 6%, expected returns for the S&P 500 were 9%, high yield bond returns were 12% and so on. Today, the risk-free rate is zero, and the rest emanates from there. That is the whole problem: Pension funds in the US need 7.5%. What should they buy? They don’t even believe they can even get that from the S&P 500 anymore. They have to go further out on the risk curve and reach for return by taking incremental risk.

We can see that in the astonishing demand for European high yield bonds: They yield about the same as US Treasuries. What do you make of that?

That’s because the risk-free alternative in Europe, German Bunds, are only a little above zero. In the US, the risk-free ten-year Treasury at least gets you 2%, so high yield bonds have to be at 5.5%. In Europe, relative to the risk-free rate, high yield bonds look attractive at yields below 3%. This is attractive in relative terms. In the investment world, people always compare one asset relative to the other. European high yield looks attractive relative to European risk-free bonds. But what about the absolute judgment when we realize that they are both overpriced? You can’t eat relative returns. The thing with negative interest rates is provocative, challenging and mysterious. In the old world, if worse came to worst, an investor could always go into cash and make a few percent. Today, that option is not there.

Are there any historical parallels to today’s environment?
I don’t see any. Because that thing of negative or zero interest rates is something we have never seen before. There is no historical parallel. Zero and negative interest rates change everything.

What worries you most?
I see a lot of worries. One example: What’s going to happen when central banks start unwinding their balance sheets? We have no clue. There is no historical precedent for the measures they used to stimulate the economies in the past years, so we don’t know what will happen when they unwind them. If QE was stimulative, won’t the unwinding of it be the opposite of stimulative? I don’t know where the money came from for the QE programs, and I don’t know where the money will go to next. We don’t know what it will mean for interest rates and inflation.

What else worries you?

Another worry is the low economic growth, combined with politics. All these right-wing populist movements – what are the implications of that? This is not imaginary. Where will the person with a low education level get a job in ten or twenty years, when all the cars are self-driving and all the stores have no clerks? I don’t know what the solution is. But I see a lack of political leadership around the world. Another worry concerns our pension systems. In the US and in other countries, defined benefit systems are hundreds of billions of dollars in the red. What’s going to happen to the people who expect to get their promised retirement payments? But today, nobody’s talking about the problems in our pension systems.

In one of your latest memos, you have raised the issue of passive investing and ETF. Could we approach the point where the market gets inefficient if too much money is invested passively?
We could. We don’t know where that threshold is. Today, about two thirds of investment money is estimated to be actively managed. People say markets will still be efficient as long as 20% of the money is actively managed. But the truth is, we simply don’t know. If you take it to the extreme: If active investing was zero, that is, nobody does any analysis, markets would be in chaos because there is no price discovery. So in a sense, passive investors are free-riders on the work of active investors, because they believe the latter make the markets efficient and prices fair. So ETF investors are benefiting from the efficiency of the system without doing anything for it.  But is that relationship sustainable forever?

There are many ETFs where the underlying asset is highly illiquid. Does that worry you?
Yes. There are many things in the investment world that are uncertain, but one thing that is certain is this: No investment vehicle should offer more liquidity than is afforded by the underlying assets. If an ETF is more liquid than the high yield bonds it owns, where did that increment in liquidity come from? The answer is it’s an illusion. Yes, you can sell an ETF at any time, but that is different from saying you can get your money out at the last price. That’s something that will be tested one day. Most investors learn their lessons the hard way.  That may be the case here.

It’s been almost ten years since the financial crisis. When you look back at those years: What were your key learnings?

One lesson is that it’s very hard to stick to your guns when the market is going against you. It required a lot of courage to buy the market in late 2008. The most important surprise for me was that even though everything was very fragile, there were very few bankruptcies. And I thought that given the terrible experiences many people had, it would take years, a decade even, for risk-taking to return. But the low to negative interest rates have fixed that. The lowering of interest rates has mandated the resumption of risk-taking on the part of investors.

So basically, central banks succeeded in re-igniting risk-taking?
Yes. And they also forced open the credit market. Companies were able to refinance their debt easily. When the central banks announced their rate cuts people said that stimulates the economy, and secondly, that this will help the banks and help to recapitalize them. But back in early 2009, you didn’t see many people saying that the rate cuts will re-ignite risk taking and force asset prices up. That’s an important lesson about the power of the government to mandate risk-taking.

Since the financial crisis the Fed has been very reluctant to raise rates. Perhaps out of the fear that markets could revolt?
No, I think that was rather out of the fear that higher interest rates will choke off growth. But yes, there are people who say there is such a thing as the Fed put, consisting of the idea that the Fed will always be able to lower rates to stimulate the stock market. But they can’t lower rates if they are already very low. So from today’s level, I don’t know if the Fed put is really that strong.

Could there be permanent damage after several years of low and negative rates?
We don’t know. This is not physics. In physics, we have the main laws that are in force. They can be applied in any situation at any time. There are no laws that always work in economics and finance. For example, it would be logical that people buy more stocks if their prices are lower. But it rather seems they buy more stocks the higher prices are. We are in unchartered territory with all these central bank policies. We can’t say what will happen. Take the question of central bank balance sheet unwinding. Nobody knows what will happen. You know Edward R. Murrow? He was a highly respected anchorman when I was young. He once said: «Anyone who is not confused doesn’t really understand the situation.» And that’s what I would say about central banks today. Anyone who says «I am completely confident in my understanding of the situation», is really not that smart.

Have you seen anything that would make you change your view on the existence of cycles? Some people say that cycles are a thing of the past because of monetary policy.
They say that all the time. Just before the global financial crisis, they were talking about the Great Moderation. Here’s a quote from Tim Geithners autobiography: «Economists were starting to debate whether that long stretch of stability constituted a new normal, a great moderation, a quasi-permanent situation of resilience to shocks. There was growing confidence that derivatives and other financial innovations designed to hedge and distribute risk, along with the monetary policy, to respond to downturns and the use of technology to smooth out inventory cycles meant that big crises were a thing of the past.» We know how that all ended.

So what’s the most important lesson from that?
I think our ability to cope with these things is not complete. And as long as people are involved in the process, and given their tendency to take everything to the excess in the upward or the downward direction, there never will be permanent moderation. I have quotes from the Nineties about how we never will have recessions again, I have quotes from the Twenties about the fact that we are in an era of permanent prosperity. It’s all wishful thinking. The interesting thing here is: This discussion that current conditions are permanent always increases at high market levels. And when people encourage others to be optimistic, it’s always at high levels. But the people you want to follow in this world are the ones that encourage optimism at low valuation levels; those who say «cool it,» when prices go higher and higher.