Posted by on September 8, 2017 4:27 pm
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Categories: Alpha B+ Bitcoin Capital Markets Doug Kass Economy Economy of the United States Finance Great Depression Halldór Laxness High Yield Horse racing Howard Marks Market Conditions Marks Mortgage Backed Securities None Oak Tree Oaktree recovery Sea Breeze Seabreeze

Via Seabreeze Partners’ Doug Kass,

In late July, Oaktree Capital Management co-chairman Howard Marks issued several market warnings in “There They Go Again … Again,” which I extensively highlighted in my Diary.

“There is plenty more food for thought in this must-read 22 pages of observations. Howard closes his musings with this advice:

“If you refuse to fall into line in carefree markets like today’s, it’s likely that, for a while, you’ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed.

It may not happen this time, but I’ll take that risk. In the meantime, Oaktree and its people will continue to apply the standards that have served us so well over the last [thirty] years.”

From my perch, greed reigns today.

As Howard relates, investors make the most — and safest — money when they do things that other people don’t want to do. But when most investors are unworried and taking unusually high risks, asset prices are typically elevated, risk premiums are low and markets are risky.

It’s what happens when there is too much money and too little fear.”

–Kass Diary, “There They Go Again … Again,” July 27, 2017

In that July memo Howard made these principal points in evaluating current conditions:

* The market uncertainties are unusual in terms of number, scale and insolubility.

* In the vast majority of asset sectors, prospective returns are about the lowest they have ever been.

* Asset prices are high and almost nothing can be purchased at a discount to intrinsic value. In general, the best we can do is find asset classes that are less overvalued than others.

* Pro-risk behavior is commonplace as most investors are embracing increased risk.

In the commentary Howard admitted he was likely issuing a premature warning because it is better to be cautious too early than to be too late in evaluating opportunities and conditions.

Howard is no stranger to cautionary memoranda. Back in 2005, in “There We Go Again,” he shared some non-consensus concerns that were most prescient, as they would precede the worst economic contraction since The Great Depression. Reading that memo would have saved an investor a boatload of money.

I find most of Howard’s commentaries as extraordinarily important in understanding market conditions and reward versus risk. His body of work always makes me think and it is invariably logical in argument and characterized by a heavy dose of analytical dissection.

Fast forward to yesterday’s newest (and another value-added) memorandum from Howard Marks, “Yet Again?

Howard starts his latest commentary with the following introduction:

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.”

–Howard Marks, “Yet Again?

The body of Howard’s memo deals with the media’s reaction to his July memo and a further discussion of his views on bitcoin (and other cryptocurrencies), FANG, the ramifications of passive investing, investing in a low-return world and, of course, evaluating the state of the capital markets.

The State of the Market

There has been a lot of discussion about how elevated I think the market is.  I’ve pushed back strongly against people who describe me as “super-bearish.”  In short, as I wrote in the memo, I believe the market is “not a nonsensical bubble – just high and therefore risky.” 

I wouldn’t use the word “bubble” to describe today’s general investment environment.  It happens that our last two experiences were bubble-crash (1998-2002) and bubble-crash (2005-09).  But that doesn’t mean every advance will become a bubble, or that by definition it will be followed by a crash.

Current psychology cannot be described as “euphoric” or “over-the-moon.”

Most people seem to be aware of the uncertainties that are present and of the fact that the good times won’t roll on forever.

Since there hasn’t been an economic boom in this recovery, there doesn’t have to be a major bust.

Leverage at the banks is a fraction of the levels reached in 2007, and it was those levels that gave rise to the meltdowns we witnessed.

Importantly, sub-prime mortgages and sub-prime-based mortgage backed securities were the key ingredient whose failure directly caused the Global Financial Crisis, and I see no analog to them today, either in magnitude or degree of dubiousness.

It’s time for caution, as I wrote in the memo, not a full-scale exodus.  There is absolutely no reason to expect a crash.  There may be a painful correction, or in theory the markets could simply drift down to more reasonable levels – or stay flat as earnings increase – over a long period (although most of the time, as my partner Sheldon Stone says, “the air goes out of the balloon much faster than it went in”).

Howard concludes his latest memo with the following:

“A lot of the questions I’ve gotten on the memo are one form or another of ‘So what should I do?’ Thus I’ve realized the memo was diagnostic but not sufficiently prescriptive. I should have spent more time on the subject of what behavior is right for the environment I think we’re in.

In the low-return world I described in the memo, the options are limited:

1. Invest as you always have and expect your historic returns.

2. Invest as you always have and settle for today’s low returns.

3. Reduce risk to prepare for a correction and accept still-lower returns.

4. Go to cash at a near-zero return and wait for a better environment.

5. Increase risk in pursuit of higher returns.

6. Put more into special niches and special investment managers.

It would be sheer folly to expect to earn traditional returns today from investing like you’ve done traditionally (#1). With the risk-free rate of interest near zero and the returns on all other investments scaled based on that, I dare say few if any asset classes will return in the next few years what they’ve delivered historically.

Thus one of the sensible courses of action is to invest as you did in the past but accept that returns will be lower. Sensible, but not highly satisfactory. No one wants to make less than they used to, and the return needs of institutions such as pension funds and endowments are little changed. Thus #2 is difficult.

If you believe what I said in the memo about the presence of risk today, you might want to opt for #3. In the future people may demand higher prospective returns or increased prospective risk compensation, and the way investments would provide them would be through a correction that lowers their prices. If you think a correction is coming, reducing your risk makes sense. But what if it takes years for it to arrive? Since Treasurys currently offer 1-2% and high yield bonds offer 5-6%, for example, fleeing to the safety of Treasurys would cost you about 4% per year. What if it takes years to be proved right?

Going to cash (#4) is the extreme example of risk reduction. Are you willing to accept a return of zero as the price for being assured of avoiding a possible correction? Most investors can’t or won’t voluntarily sign on for zero returns.

All the above leads to #5: increasing risk as the way to earn high returns in a low-return world. But if the presence of elevated risk in the environment truly means a correction lies ahead at some point, risk should be increased only with care. As I said in the memo, every investment decision can be implemented in high-risk or low-risk ways, and in risk-conscious or risk-oblivious ways. High risk does not assure higher returns. It means accepting greater uncertainty with the goal of higher returns and the possibility of substantially lower (or negative) returns. I’m convinced that at this juncture it should be done with great care, if at all.

And that leaves #6. “Special niches and special people,” if they can be identified, can deliver higher returns without proportionally more risk. That’s what “special” means to me, and it seems like the ideal solution. But it’s not easy. Pursuing this tack has to be based on the belief that (a) there are inefficient markets and (b) you or your managers have the exceptional skill needed to exploit them. Simply put, this can’t be done without risk, as one’s choice of market or manager can easily backfire.

As I mentioned above, none of these possibilities is attractive or a sure thing. But there are no others. What would I do? For me the answer lies in a combination of numbers 2, 3 and 6.

Expecting normal returns from normal activities (#1) is out in my book, as are settling for zero in cash (#4) and amping up risk in the hope of draws from the favorable part of the probability distribution (#5) (our current position in the elevated part of the cycle decreases the likelihood that outcomes will be favorable).

Thus I would mostly do the things I always have done and accept that returns will be lower than they traditionally have been (#2). While doing the usual, I would increase the caution with which I do it (#3), even at the cost of a reduction in expected return. And I would emphasize “alpha markets” where hard work and skill might add to returns (#6), since there are no “beta markets” that offer generous returns today.

These things are all embodied in our implementation of the mantra that has guided Oaktree in recent years: ‘move forward, but with caution.'” 

*  *  *

Run, don’t walk, to read Howard Marks’ newest commentary.

Move forward, but with caution.

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