“When I see memos from Howard Marks in my mail, they’re the first thing I open and read.” – Warren Buffett
Howard Marks always does an excellent job describing key value investing concepts and providing commentary on the current state of the economy and the markets. In his most recent memo, he gives a great overview of what exactly is going on in this 8.5+ year-long bull market and how investors should go about investing when there is constant talk of the market being at a “peak” and of a recession being imminent.
The Good and the Bad of Today’s Markets
Overall, according to Marks, the factors characterizing today’s investment environment have been largely unchanged throughout this bull market:
A large number of big-picture uncertainties
Sub-par prospective returns
Pro-risk investor behavior
More recently, you could add the following characteristics to the list:
The economy is strengthening, not slowing, and Washington is supporting its progress
Prices are even higher and valuation metrics have moved up
The easy money has been made.
Clearly, there is some good and some bad here. Howard Marks expands on that:
Positives – Whereas in my last two memos I talked primarily about reasons to be cautious, I want to make it clear here that I do recognize the positives in the current situation. Most of them have to do with fundamentals – primarily the healthy macro-economic outlook and thus the potential for increasing EPS.
The U.S. economy is chugging along, and the recovery that started in 2009 has become one of the longest in history (103 months old at this point). The rest of the world’s economies are joining in for that rare thing, worldwide growth. Most economies seem to be gaining rather than losing steam, and they don’t appear likely to run out of it anytime soon.
Since the economic recovery hasn’t been marked by excesses to the upside, when a recession eventually does occur, it doesn’t have to be extreme. In short, no boom, no bust.
One of the reasons for the sluggish recovery during the Obama administration was the low level of capital investment (a frequent site of excesses during recoveries). I think that was due to corporate concern over the president’s seeming indifference to business and his tendency to regulate. No one wants to make long-term investments in an inhospitable environment for business. In contrast, it’s very clear that President Trump is committed to being a pro-business president and a deregulator. This change has led to a rise in optimism, confidence and “animal spirits” among corporate executives, things that have great potential to be self-reinforcing. Thus, for example, in the first three quarters of 2017, capital spending rose at an annualized rate of 6.2%.
The recent tax law will put money into the pockets of corporations that pay U.S. taxes by reducing their tax rate, and it will result in the repatriation of large amounts of foreign profits that U.S. companies have been holding abroad. The results will generally be very positive for corporate profits, cash flows and perhaps capital investment (see below).
The unemployment rate is down to 4.1%, nearly the lowest level in 60 years, meaning we’re nearing “full employment” (albeit with an unusually low percentage of adults participating in the workforce). With so little employment slack remaining, it seems reasonable to think near-term GDP growth will translate into wage gains, and thus back into further increases in demand.
Although low, today’s prospective returns are described as being reasonable in the context of low interest rates.
The low levels of inflation worldwide mean central bankers needn’t rush to raise interest rates to restrain it. There’s no obvious reason to predict hyperinflation.
Thus the near-term rise in interest rates – while probable – can be expected to be gradual and limited in scope.
Except in pockets, investor psychology can’t be described as euphoric and imprudent (although it has been strengthening of late). For years the markets have been “climbing a wall of worry,” an old-fashioned phrase used to describe a healthy ascent that’s occurring not because of euphoria and risk-obliviousness, but rather despite a catalog of perceived ills.
The known catalysts for a market downturn – recession, ballooning inflation, much-higher interest rates, major central bank missteps, a governmental breakdown in Washington, and war – can’t be assigned probabilities that are more than modest.
Negatives – As opposed to the positives listed above, most of the negatives surround either (a) positive fundamental factors that have the potential to deteriorate or (b) the high prices being paid for those macro-positives, and the investor behavior creating those prices.
While the outlook isn’t dire, a number of subjects do represent genuine uncertainties and provide basis for concern: the possibility of slow long-term economic growth, the potential for rising interest rates and inflation, the impact of reversing stimulative monetary policy and the Fed switching to being a net seller of securities, the implications for employment as automation increases, the world’s dependence on China’s growth, and political and geopolitical tail risks. As the markets have risen, talk of all these things seems to have gone quiet.
We know interest rates are likely to rise (creating competition for most asset classes and arguing for lower asset prices).We just don’t know by how much.
Some of the elements characterizing the macro-economic environment can be described as “long in the tooth” or “unusually elevated.” For example, the current recovery is one of the longest ever; the GDP growth rate is at the top of the range for the last decade; and profit margins are well above average. Things like these can continue or even get better, but the odds are against it. It feels as if we may get through the next 18 months without a recession, but if we do, that’ll make this the longest recovery since the 1850s. Certainly not impossible, but against the odds.
Most valuation parameters are either the richest ever (Buffett ratio of stock market capitalization to GDP, price-to-sales ratio, the VIX, bond yields, private equity transaction multiples, real estate capitalization ratios) or among the highest in history (p/e ratios, Shiller cycle-adjusted p/e ratio). In the past, levels like these were followed by downturns. Thus a decision to invest today has to rely on the belief that “it’s different this time.”
Prospective returns in the vast majority of asset classes are some of the lowest in history.
The need of investors to wring out good returns in this “low-return world” is causing them to engage in what I call pro-risk behavior. They’re paying high prices for assets and accepting risky and poorly structured propositions.In such a climate, it’s hard for “prudent” investors to insist on traditional levels of safety. Investors who don’t want to sign on for risk (that is, who “refuse to dance”) can be constrained to the sidelines.
As a result, we see a lot of the reaction that greeted my July memo: “the market’s expensive, but I think it has further to go.” How healthy can it be when investors think an asset or market is rich but they’re holding anyway because they think it might go up some more? Fear of missing out (or “FOMO”) is one of the more powerful reasons for investor aggressiveness, and also one of the most dangerous.
Market behavior implies a level of equanimity on investors’ part that could prove unrealistic (and thus subject to reversal). For example, 2017 was the first year in history in which the S&P 500 didn’t decline from high to low by more than 3% at least once. Likewise, in a six-month period late in the year, the VIX (an indicator of the level of volatility implied by investors’ pricing of S&P 500 options) closed below a reading of ten more than 40 days; never before had it done so more than six times in a six-month period (The New York Times, January 14).
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.
What Does This Mean? Should You Be Bearish or Bullish?
So… should you be in the stock market or out? Buy or sell? Up or down? Marks says that you should favor a more defensive portfolio – in his view, the macro uncertainties, high valuations, and risky investor behavior mean being defensive is much more sensible than being aggressive. He supports his defensiveness with two points:
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.
How Should You Invest in 2018?
For Marks, 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.
So if valuations are high, but investor psychology is unpredictable, then how should you invest your money? Marks suggest NOT trying to time markets, and instead simply investing on the basis of value and its relationship to price – the classic value investing approach.
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… 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.