Howard Marks of Oaktree Capital is a well-known distressed debt investor. In effect, he's a value investor, but specialising in the bond market rather than the stockmarket.
In his latest memo to clients, he outlines his basic philosophy and how it affects Oaktree's investment process at the moment (the timing of this "big picture" outlook is partly because he has a book coming out this month Mastering the Market Cycle which I'm looking forward to reading, and which I'll review here once I've done so).
Anyway, Marks' basic point which appears pretty self-evident, though you'd be surprised by how many people try to deny it is that markets move in cycles.
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The tricky part is trying to work out when the cycle is going to turn.
The problem with cycles
Now, if markets move in cycles, they should be predictable, shouldn't they? After all, the sun rises in the morning and it sets at night. After autumn comes winter, and then spring returns. The whole point of a cycle is that we know it's going to turn.
Of course, it's not that simple. You might know that winter is coming; you'll also know when it's here. But can that knowledge tell you when the first snow will fall or if it will fall at all?
And there's your problem right there. Markets might be cyclical but timing them is almost impossible. You might know that the equivalent of an asset-market winter is coming. But you don't know when it will hit and you don't know how severe it will be.
So to put it bluntly what is the use of a theory of market cycles if it can't tell you when to invest and when to pull out?
Marks is pretty honest about this: he has no magic formula. There is no timing device or crystal ball that can tell you "go to cash now" or "go all in today".
But he does suggest that there are general warning signs to look out for, ones that suggest we're nearer the top than the bottom. And looking at the markets today, he concludes that there are plenty of warning signs about now.
Marks talks about what he says are "the seven worst words in the investment world: too much money chasing too few deals.'"
Too much money chasing too few deals
Let's explain what that means.
Pundits often describe this as the most-hated bull market in history. Now, I'm not sure whether I agree with this take or not. Sentiment towards the stockmarket doesn't seem to be overly gloomy. There might be lots of political anger around but it wouldn't be the first time that political anger has coincided with rising markets.
But even if it's true, this lack of exuberance shouldn't be taken as a sign of anything particularly insightful about markets. As Marks points out, global central banks have effectively short-circuited the long process of emotional recovery typically needed after a major stockmarket crash.
2008 knocked the stuffing out of investors. Marks says that he had thought "that the pain of the crisis would cause investors to remain highly risk-averse for years". However, the Federal Reserve and its fellows have flooded the world with cheap money to the point where investors virtually have no choice but to take risks.
So regardless of whether they do so under duress or not, they are in the market. As Marks puts it: "Investors may not feel optimistic, but because the returns available on low-risk investments are so low, they've been forced to undertake optimistic-type actions."
And because of that, "capital markets have become very accommodating". Investors are worrying too much about not missing the upside, rather than being hit by the downside.
This is perhaps most obvious in the market for corporate lending. We've said a few times here that the next crisis is likely to centre on debt, and probably private sector company debt rather than household or even public sector debt (high as both of those are).
Marks cites several points to back that up. We've run through many of them here before: private equity funds are raising record amounts of money to invest; a record proportion of loans are now classed as "covenant-lite" (ie, few if any protections for the lenders); the quality of debt is deteriorating; and investors are paying ever-higher multiples for increasingly-indebted companies.
In other words, investors are behaving imprudently. And that suggests there's a need to be wary.
Be defensive when everyone else is being aggressive
The problem of course, is this: what can you do about this?
Marks is not overly worried about stocks in terms of valuation they're expensive but not wildly so, he thinks. But as he points out, the stockmarket wasn't the real problem in 2008 either, and it still took a big hit when things went wrong.
And while investors are over-excited, the level of leverage and ropey derivatives is not at 2007 conditions. "I'm not describing a credit bubble or predicting a resulting crash", he emphasises. There's no point on being entirely or largely in cash: the "likely opportunity cost is just too great to justify being out of markets."
In the end, Marks' answer on "what do I do?", dissatisfying as it is, is the only one that makes any sense: you have to be aware of the risk and you have to invest accordingly.
Just now, there's a lot of money chasing a limited number of opportunities. That means you don't get paid a lot for taking quite substantial risks. At those sorts of times, you want to invest more defensively.
Why? So that when the time comes when there are lots of opportunities but hardly any money around (and it will come, because markets are cyclical and winter eventually arrives again), you'll be in a position to take advantage.
And keep an eye on corporate debt. That's where we'll see the strains first. Indeed, as I'm typing this story up, the Indian government has just had to step in to tackle a struggling infrastructure and shadow-banking group (Infrastructure Leasing & Financial Services). We'll be watching closely for any knock-on effects from that event.
