Howard Marks And The Bearish Argument

Howard Marks in his latest investment letter does a wonderful job of laying out many of the issues and concerns in today's market.   Below I've laid out some of the salient points from his letter that I think might interest my readers.  He is more negative than me overall but I think my readers and clients deserve to be shown both sides of the argument.  I'm going to republish a revised copy of my latest investment letter in a few days that takes on some of these arguments.  Marks does not spare ETFs in his latest issue.  All bold print as emphasis is his.

Howard Marks Introduction To His Letter.

"Since I’ve written so many cautionary memos, you might conclude that I’m just a born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time.  I absolutely cannot disprove that interpretation.  But my response would be that it’s essential to take note when sentiment (and thus market behavior) crosses into too-bullish territory, even though we know rising trends may well roll on for some time, and thus that such warnings are often premature.  I think it’s better to turn cautious too soon (and thus perhaps underperform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses.

Since I’m convinced “they” are at it again – engaging in willing risk-taking, funding risky deals and creating risky market conditions – it’s time for yet another cautionary memo.  Too soon?  I hope so; we’d rather make money for our clients in the next year or two than see the kind of bust that gives rise to bargains.  (We all want there to be bargains, but no one’s eager to endure the price declines that create them.)  Since we never know when risky behavior will bring on a market correction, I’m going to issue a warning today rather than wait until one is upon us.....

Howard Marks On Today’s Investment Environment

Because I don’t intend this to be a “macro memo,” incorporating a thorough review of the economic and market environment, I’ll merely reference what I think are the four most noteworthy components of current conditions:

• The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.
• In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been. 
• Asset prices are high across the board.  Almost nothing can be bought below its intrinsic value, and there are few bargains.In general the best we can do is look for things that are less over-priced than others.
• Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.

Howard Marks On U.S. Equities

The good news is that the U.S. economy is the envy of the world, with the highest growth rate among developed nations and a slowdown unlikely in the near term.  The bad news is that this status generates demand for U.S. equities that has raised their prices to lofty levels.

• The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
• The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16.  This multiple was exceeded only in 1929 and 2000 – both clearly bubbles.
• While the “p” in p/e ratios is high today, the “e” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity.  Thus today’s reported valuations, while high, may actually be understated relative to underlying profits.
• The “Buffett Yardstick” – total U.S. stock market capitalization as a percentage of GDP – is immune to company-level accounting issues (although it isn’t perfect either).  It hit a new all-time high last month of around 145, as opposed to a 1970-95 norm of about 60 and a 1995-2017 median of about 100.
• Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established.

Howard Marks On Passive Investing/ETFs

Like all investment fashions, passive investing is being warmly embraced for its positives:

• Passive portfolios have outperformed active investing over the last decade or so.
• With passive investing you’re guaranteed not to underperform the index.
• Finally, the much lower fees and expenses on passive vehicles are certain to constitute a permanent advantage relative to active management.

Does that mean passive investing, index funds and ETFs are a no-lose proposition?  Certainly not:

• While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming.
• The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.
• As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.

Other Observations and Implications

As I said, most of the phenomena described above seem reasonable given the rest of what’s going on in today’s economic and financial world.  But step back for perspective and put them together, and what do we see?

• Some of the highest equity valuations in history.
• The so-called complacency index at an all-time high.
• The elevation of a can’t-lose group of stocks.
• The movement of more than a trillion dollars into value-agnostic investing.
• The lowest yields in history on low-rated bonds and loans.
• Yields on emerging market debt that are lower still.
• The most fundraising in history for private equity.
• The biggest fund of all time raised for levered tech investing.
• Billions in digital currencies whose value has multiplied dramatically.

 I absolutely am not saying stocks are too high, the FAANGs will falter, credit investing is risky, digital currencies are sure to end up worthless, or private equity commitments won’t pay off.  All I’m saying is that for all the things listed above to simultaneously be gaining in popularity and attracting so much capital, credulousness has to be high and risk aversion has to be low.  It’s not that these things are doomed, just that their returns may not fully justify their risk.  And, more importantly, that they show the temperature of today’s market to be elevated.  Not a nonsensical bubble – just high and therefore risky. 

Try to think of the things that could knock today’s market off kilter, like a surprising spike in inflation, a significant slowdown in growth, central banks losing control, or the big tech stocks running into trouble.  The good news is that they all seem unlikely.  The bad news is that their unlikelihood causes all these concerns to be dismissed, leaving the markets susceptible should any of them actually occur.  That means this is a market in which riskiness is being tolerated and perhaps ignored, and one in which most investors are happy to bear risk.  Thus it’s not one in which we should do so.

What else:

• My observations are always indicative, not predictive.  The usual consequences of the conditions I describe – like an eventual increase in risk aversion – should happen, but they don’t have to happen.
• And they certainly don’t have to happen soon.  No one knows anything about timing.Certain consequences are implied, but even if they’re going to happen, we have no way of knowing when.It feels like we’re in the eighth inning, but I have no idea how long the game will go on.
• I’m never sure of my market observations.  As you’ll see in my new book, I believe strongly that where we are in a cycle says a lot about the market’s likely tendencies, but I never state opinions on this subject with high confidence.
• As a natural worrier, I tend to be early with warnings, as described on page one.  'Nuff said.
• Finally, while my observations are uncertain and should be taken with a grain of salt, what I am sure of is that valuations and markets are elevated, and the easy money in this cycle has been made.

There is so much more to this letter and there is no way possible to cover all of it in one posting.  As I said at the top of this article I have tried to point out the parts of Mark's article that I think would interest my clients and readers.  As such, I have left many of Mr. Mark's observations out of this post on subjects like credit markets, the vix and digital currencies.  I have also left out his closing paragraph that he calls "What to Do".  I think the best thing is for you to go read the article itself.  I'm going to chew on this over the weekend and revisit some of it next week.  

Back Monday.

Link:  Oaktree CapitalManagement:  Howard Marks:  "There They Go Again...Again".