Investing legend Howard Marks, co-chair and co-founder of Oaktree Capital Management, with more than $120 billion in assets under management, argues: “It’s time to take some risk off the table. The odds have shifted against you,” he tells ThinkAdvisor in an interview.
In the depth of the financial crisis, Oaktree, a leading institutional alternative investment management firm, invested more than half a billion dollars a week during the final 15 weeks of 2008 — and reaped a high rate of return.
Today, Marks’ cautious stance is based largely on this: Asset prices are elevated versus intrinsic values, institutional investors have let go of their risk aversion, and the recovering economy and soaring stock market have lasted for 10 years now.
Marks, 72, is famed for sending clients insightful memos about the markets and economy. Warren Buffett has commented: “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something.”
The expert in credit strategies made gutsy, correct market calls in 1999, 2001-2002, 2005-2006 and 2008, all of which he discussed in the interview.
Marks ascribes much of his investing success to paying close attention to and assessing a number of different cycles, which, he says, can show when to cut risk and when to turn more aggressive.
His new book, “Mastering the Market Cycle: Getting the Odds on Your Side” (Houghton Mifflin Harcourt) is an examination of about a dozen different market cycles and how “listening” to them can help discover investing opportunities — and avoid mistakes.
In the interview, he talks about why, in his view, market timing is critical and stresses the need for objective, vs. emotional, investing.
“Mastering the Market Cycle,” following his bestselling “The Most Important Thing: Uncommon Sense for the Thoughtful Investor” (2009), explores the cycle in profits and government involvement in the economic cycle, among others.
ThinkAdvisor recently interviewed the investment manager, on the phone from his New York City office. He began his 50 years in financial services as a research equity analyst and was investment management vice president and senior portfolio manager at Citicorp before leading groups at The TCW Group from 1985 to 1995, when he co-founded Oaktree. Clients include 75 of the largest U.S. pension funds and more than 400 corporations globally. Based in Los Angeles, the firm owns 20% of DoubleLine Capital, whose start-up it helped organize.
In the interview, Marks raised the issue of investor behavior several times because “The risk in investing comes from the behavior of the market participants — and so do most of the opportunities for exceptional returns,” he says.
Here are highlights:
THINKADVISOR: What is Oaktree’s current investing approach?
HOWARD MARKS: Our mantra at present, as it’s been for a couple of years, is: Move forward, but with caution. We’re investing every day. We’re trying to be fully invested, but we’re putting a higher-than-usual emphasis on caution.
Why is that your stance?
We’re in practically the longest economic recovery in history. The bull market has gone on for almost 10 years. The S&P has quadrupled. There’s a lot of optimism in prices. We’re in a low-return environment because of the Fed’s having lowered rates so much. So investors have had to drop their risk aversion in order to participate — to squeeze out good returns in a low-return world. All that results in asset prices being elevated relative to intrinsic values.
You write that if you could ask only one question regarding every investment you consider it would be: “How much optimism is factored into the price?” Please elaborate.
It’s not what you buy — it’s what you pay for. The question is: How does the price you’re paying compare with the intrinsic value of the company — the tangible fundamental value of it? You want to buy when the price is below the value. You don’t want to buy when the price is above the value — that’s dangerous. The point is that the price deviates from the value.
What causes the deviation?
Emotion. When people are optimistic and feeling good, and the news has been terrific, the market is rising every day, the media are positive, people are making money and their friends are making money, that makes people expansive and causes asset prices to soar above intrinsic value.
Is that where we are now?
We’re on the way. I don’t think we’re in an extreme bubble, but there are very few assets available on a bargain basis, and the prices of most things are on the high side. The economy is doing well, corporations are reporting massive profits, the market is soaring — and there’s a belief that these things will go on for years. The compilation of that “positiveness” produces elevated assets.
In what stage of the three stages of a bull market are we in?
The early part of the third phase. That’s when people begin [to think] that improvement will go on forever. They’re saying that the market should go one, two, three, four more years — what could slow it down?
And your reaction to that?
Well, nobody can say that it can’t go on. But I do think that when we’re elevated in the [market] cycle, as we are now, the odds are shifted against you. You want to buy when the odds are on your side, and that happens mostly when the market is low in its cycle. I don’t think anybody can argue that it’s low in its cycle now.
Some people forecast that a crash is imminent.
I don’t see many of those [people]. I think that, because of the Fed’s lowering rates so much, people have become “handcuff volunteers” — they’re not doing what they want to do. They’re doing what they have to do. To achieve the returns that institutional investors need, they’ve dropped their characteristic risk aversion. It’s risk aversion that keeps the market safe and sane. When people forget to be risk-averse, prices can go to levels higher than they should, and that has proven to be dangerous.
“The riskiest thing in the world is the belief that there is no risk,” you write. Please explain.
If people think there’s no risk, they’ll do risky tings. When that happens, the market becomes risky for [others]. So we should take the temperature of the market: Assess people’s moods, their psyche and behavior.
“Widespread risk tolerance is the greatest harbinger of subsequent market decline,” you write.
Attitudes toward risk fluctuate highly. You can’t have a market boom without risk tolerance, without people feeling good about the assumption of risk or without people being able to ignore risk. If you don’t have a boom, then you can’t have a bust.
How can financial advisors help their clients in today’s environment?
If you agree that there are few bargains, that the market is elevated and that the bull market has gone on for a long time, then this is the time to take some risk off the table. In the fourth quarter of ‘08 in the credit markets or the first quarter of ‘09 in the stock market, ideally you put on full risk because people were anticipating the end of the world.
I’m not saying it’s time to get out. I would never say, “Get out.” In this business, we can’t be that black and white. But today I think we should have less risk. What we can do is understand the environment and assess where we stand in the market cycle and calibrate our behavior accordingly. You should try to hold more assets — riskier ones — when the market is poised to do well, and less of them when it’s poised to do poorly.
So that’s an aspect of being aware of cycles?
You’ll succeed at cycle positioning by studying the history and causation of cycles, learning how to “listen” to cycles, understand where we are in the current one and recognize how you should behave as a result.
What’s the best way for investors to determine the amount of risk they should take on right now?
People should first [determine] what their normal risk position is [based largely on age]. Think of risk as being like a speedometer that goes from zero to 100, where zero is cash and 100 is invested in risky assets and maybe you’re using some leverage.
You say it’s important to time the market. Why? Many say not to do that.
One state of nature is that you don’t do any timing activity: You just buy a position, hold it and never increase or decrease. For many people, that would produce a very good result. The problem with the second state of nature — in which most people are captives of their emotions — is that when the market and economy are doing well and things are going swimmingly, they buy more assets at higher prices. But when those things turn down — the economy looks like trouble and the market is collapsing — they sell at lower prices. That’s clearly inferior to buying and holding.
What’s the third state?
The best of all worlds: The third state is when you can figure out where the market is in a cycle and adjust your portfolio accordingly — and maybe buy low and sell high.
When did you see major opportunities to capitalize on cycles?
In 1999, 2002, 2005-2006 and 2008. I hope, and believe, that other decades aren’t going to be like that one — with two bubbles and two crashes. But at the extremes, if you take an objective view, you can figure out what’s going on in the market. If your emotions are under control, you can do the right thing.
“Don’t target the bottom,” you write. Are you referring to investors who say, “Let’s wait till the market bottoms” before committing assets?
A lot of people do that: “I’m not going to catch a falling knife. I’ll wait till the bottom has passed.” But that may be too late. It’s while the knife is falling that the desperation is the greatest, prices are lowest and buying is easiest — not emotionally easy, but financially easy. Once the bottom has passed and things are heading north, maybe it becomes emotionally easy to buy. But everybody else is trying to buy at the same time; and every purchase forces the price higher. In most investing, I think it’s better to be early than late.
Please elaborate on those correct calls that you made.
In 1990, we understood that the LBOs [leveraged buyouts] of the ‘80s had been financed precariously, and we prepared to do a lot of investing in distressed debt. We did it again in ‘01-‘02. We formed the biggest distressed debt [fund] we had ever raised in advance of the telecom meltdown  and Enron scandals . In ‘05-‘06, we saw that the market was permitting very flimsy deals and reasoned that that connoted a lack of discipline on the part of the market, which should be a warning sign to everybody in it.
What happened next?
Lehman went bankrupt, and most assumed that the financial system was about to come to an end.
But you didn’t, I gather?
We thought it was an emotional response, and we objectively concluded that we could buy the debt of very good LBL companies, connoting a value for the whole company, that was a small fraction of what the great buy-out shops had paid a year or two earlier.
What was your strategy?
In October ‘08, the thinking was that it was “too bad to be true.” If the attitude that’s being incorporated in stock prices is too bad to be true, it means that I can probably buy at a bargain price [I reasoned]. So we invested over half a billion dollars a week in the last 15 weeks of ‘08.
Smart investing certainly takes guts!
Well, it does take guts. None of this stuff is easy. We all want to make money. It can’t be easy to make a lot of money. It’ a struggle. You have to study, observe unemotionally and do the hard thing. It wasn’t easy to sell in ‘06. It wasn’t easy to buy right after the Lehman bankruptcy. We were really struggling with the decision to invest half a billion a week in those last 15 weeks of the year.
You were struggling because it was risky?
Merrill Lynch disappeared. Bear Stearns disappeared. Washington Mutual, Wachovia Bank disappeared. Everybody was saying that Morgan Stanley was next and then Goldman Sachs. It looked like a meltdown. When a vicious cycle gets going, it takes on the appearance of being unstoppable.
What were you thinking?
You just had to conclude that a meltdown was unlikely to be the outcome, and gut it out. You can never prove anything about the future; and in tough times, it becomes emotionally difficult. The only thing you can do is prepare intellectually.
At that terrible time, it would seem that it made sense to invest in distressed debt.
If it was obvious, why didn’t everybody else make the investment too? Clearly, if everyone else agreed that it made sense to make those purchases, we wouldn’t have gotten them on such a bargain basis. We’ve had a very high rate of return on our distressed debt investments over the last three decades. What people say was obvious is not always obvious at the time. Success is always obvious in retrospect.
More wisdom for readers to contemplate: You write: “The linkage between economic growth and profit growth is highly imperfect.” Why is it flawed?
Growth of the economy provides the backdrop for profit growth. But different businesses respond differently to changes in the economy. The general response of profits to the economy is very much influenced by, in most companies, the presence of operating leverage and financial leverage.
— Related on ThinkAdvisor: