Yet Again

by Howard Marks of Oaktree Capital Management, 9/8/17

“There They Go Again . . . Again” of July 26 has generated the most response in the 28 years I’ve been writing memos, with comments coming from Oaktree clients, other readers, the print media and TV. I also understand my comments regarding digital currencies have been the subject of extensive – and critical – comments on social media, but my primitiveness in this regard has kept me from seeing them.

The responses and the time that has elapsed have given me the opportunity to listen, learn and think. Thus I’ve decided to share some of those reflections here.

Media Reaction

The cable news shows and blogposts delivered a wide range of reactions – both positive and negative. The best of the former came from a manager who, when asked on TV what he thought of the memo, said, “I’d like to photocopy it and sign it and send it out as my quarterly letter.” Love that guy.

I haven’t spent my time reveling in the praise, but rather thinking about those who took issue. (My son Andrew always reminds me about Warren Buffett’s prescription: “praise by name, criticize by category.” Thus no names.) Here’s some of what they said:

  1. “The story from Howard Marks is ‘it’s time to get out.’ ”
  2. “He’s right in the concept but wrong to execute right now.”
  3. “The market is a little expensive, but you should continue to ride it until there are a couple of big down days.”
  4. “There are stocks that are past my sell points, and I’m letting them continue to burble higher.”
  5. “I appreciate Howard Marks’s message but I think now is no more a time to be cautious than at any other time. We should always invest as if the best is yet to come but the worst could be right around the corner. This means durable portfolios, hedges, cash reserves . . . etc. There is no better or worse time for any of these things that we can foresee in advance.”

I take issue with all these statements, especially the last, and I want to respond – not just in the sense of “dispute,” but rather to clarify where I stand. In doing so, I’ll incorporate some of what I said during my appearances on TV following the memo’s publication.

Numbers one and two are easy. As I explained on CNBC, there are two things I would never say when referring to the market: “get out” and “it’s time.” I’m not that smart, and I’m never that sure. The media like to hear people say “get in” or “get out,” but most of the time the correct action is somewhere in between.

I told Bloomberg, “Investing is not black or white, in or out, risky or safe.” The key word is “calibrate.” The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive.

And as I told CNBC, what matters is “the level that securities are trading at and the emotion that is embodied in prices.” Investors’ actions should be governed by the relationship between each asset’s price and its intrinsic value. “It’s not what’s going on; it’s how it’s priced. . . . When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back.”

Here’s how I summed up on Bloomberg:

It’s all about investors’ willingness to take risk as opposed to insisting on safety. And when people are highly willing to take risk, and not concerned about safety, that’s when I get worried.

If it’s true, as I believe, that (a) the easy money in this cycle has been made, (b) the world is a risky place, and (c ) securities are priced high, then people should probably be taking less risk today than they did three, five or seven years ago. Not “out,” but “less risk” and “more caution.”

And from my visit to CNBC:

All I’m saying is that prices are elevated; prospective returns are low; risks are high; people are engaging in risky behavior. Now nobody disagrees with any of the four of those, and if not, then it seems to me that this is a time for increased caution. . . . It’s maybe “in, but maybe a little less than you used to be in.” Or maybe “in as much as you used to be in, but with less-risky securities.”

Numbers three and four – arguing that it’s too early to sell even if the market is expensive or holdings are past their sell point – are interesting. They’re either (a) absolutely illogical or (b) signs of the investor error and lack of discipline that are typical in bull markets.

  • If the market is expensive, why wouldn’t you lighten up?
  • Why would you prefer to sell after a few big down days, rather than today? (What if the big down days are the start of a slide so big that you can’t get out at anything close to fair value? What if there’s a big down day followed by a big up day that gets you right back where you started? Does the process re-set? And is it three big down days in a row, or four?)
  • And if you continue to hold past your sell points, what does “sell point” mean?

Bottom line: I think these things translate into “I want to think of myself as disciplined and analytical, but even more I want to make sure I don’t miss out on further gains.” In other words, fear of missing out has taken over from value discipline, a development that is a sure sign of a bull market.

The fifth and final comment – that one should exercise the same degree of care and risk aversion at all times – gives me a lot to talk about. In working on my new book, I divided the things an investor can do to achieve above average performance into two general categories:

  • selection: trying to hold more of the things that will do better and less of the things that will do worse, and
  • cycle adjustment: trying to have more risk exposure when markets rise and less when they fall.

Accepting that “there is no better or worse time” simply means giving up on the latter. Whereas Buffett tells us to “be fearful when others are greedy and greedy when others are fearful” – and he’s got a pretty good track record – this commentator seems to be saying we should be equally greedy (and equally fearful) all the time.

I feel strongly that it’s possible to improve investment results by adjusting your positioning to fit the market, and Oaktree was able to do so by turning highly cautious in 2005-06 and highly aggressive in 1990-91, 2001-02 and immediately after the Lehman bankruptcy filing in 2008. This was done on the basis of reasoned judgments concerning:

  • how markets have been acting,
  • the level of valuations,
  • the ease of executing risky financings,
  • the status of investor psychology and behavior,
  • the presence of greed versus fear, and
  • where the markets stand in their usual cycle.

Is this effort in conflict with the tenet of Oaktree’s investment philosophy that says macro-forecasting isn’t key to our investing? My answer is an emphatic “no.” Importantly, assessing these things only requires observations regarding the present, not a single forecast.

As I say regularly, “We may not know where we’re going, but we sure as heck ought to know where we stand.” Observations regarding valuation and investor behavior can’t tell you what’ll happen tomorrow, but they say a lot about where we stand today, and thus about the odds that will govern the intermediate term. They can tell you whether to be more aggressive or more defensive; they just can’t be expected to always be correct, and certainly not correct right away.

The person who said “there is no better or worse time” was on TV with me, giving me a chance to push back. What he meant, he said, was that the vast majority of people lack the ability to discern where we stand in this regard, so they might as well not try.

I agree that it’s hard. Up-and-down cycles are usually triggered by changes in fundamentals and pushed to their extremes by swings in emotion. Everyone is exposed to the same fundamental information and emotional influences, and if you respond to them in a typical fashion, your behavior will be typical: pro-cyclical and painfully wrong at the extremes. To do better – to succeed at being contrarian and anti-cyclical – you have to (a) have an understanding of cycles, which can be gained through either experience or studying history, and (b) be able to control your emotional reaction to external stimuli. Clearly this isn’t easy, and if average investors (i.e., the people who drive cycles to extremes) could do it, the extremes wouldn’t be as high and low as they are. But investors should still try. If they can’t be explicitly contrarian – doing the opposite at the extremes (which admittedly is hard) – how about just refusing to go along with the herd?

Here’s what I wrote with respect to the difficulty of doing this in “On the Couch” (January 2016):

I want to make it abundantly clear that when I call for caution in 2006-07, or active buying in late 2008, or renewed caution in 2012, or a somewhat more aggressive stance here in early 2016, I do it with considerable uncertainty. My conclusions are the result of my reasoning, applied with the benefit of my experience (and collaboration with my Oaktree colleagues), but I never consider them 100% likely to be correct, or even 80%. I think they’re right, of course, but I always make my recommendations with trepidation.

When widespread euphoria and optimism cause asset prices to meaningfully exceed intrinsic values and normal valuation metrics, at some point we must take note and increase caution. And yet, invariably, the market will continue to march upward for a while to even greater excesses, making us look wrong. This is an inescapable consequence of trying to know where we stand and take appropriate action. But it’s still worthwhile. Even though no one can ascertain when we’re at the exact top or bottom, a key to successful investing lies in selling – or lightening up – when we’re closer to the top, and buying – or, hopefully, loading up – when we’re closer to the bottom.