Howard Marks of Oaktree Capital is one of the best contrarian investors out there.
He’s not quite the household name that Warren Buffett is (who is?), but he’s certainly up there with the Seth Klarmans, Ray Dalios, and John Paulsons of this world.
So when he tells investors that it’s time to be careful, it makes sense to listen…
Desperation isn’t a good sign
Howard Marks’ latest memo comes hot on the heels of a lengthy and eye-catching letter he put out back in July. In that one, Marks was cautious about the bull market and scathing about digital currencies.
As tends to happen with these things, his long, interesting and nuanced argument was boiled down to a few talking points by all those dreadful media people.
We do love a good snappy headline, us journalists, and sometimes the subtlety gets lost. That’s not a good thing but it’s a well-known side-effect of interacting with the media. And in my experience, the retrospective complaints are often as much a case of “Hmm, I didn’t mean to say that” as a genuine case of “Hang on, I didn’t say that!”
However, having half-heartedly defended my profession, I’m inclined to sympathise with Marks here. It’s hard to get a sensible point across when all anyone wants to hear is “BUY” or “SELL”.
Marks isn’t saying that it’s time to dump stocks wholesale (or anything else for that matter). Instead, as he puts it, his concerns are “all about investors’ willingness to take risks as opposed to insisting on safety… when people are highly willing to take risk, and not concerned about safety, that’s when I get worried”.
I think he’s hit upon a really vital point here. We keep hearing about how unpopular this bull market is. There isn’t enough exuberance around for it to be a true bubble. The implication is that it can carry on for a lot longer.
If you have trouble wrapping your head around this idea, just compare the coverage of the stockmarket to the frenzy surrounding bitcoin right now. One is tentative and resigned, while the other is hysterical, with new excesses erupting every day. It’s the “wall of worry” versus the “express elevator of exuberance”.
Enthusiasm matters. In its absence, it’s hard to believe that there are no more potential buyers left in the market. Over-enthusiasm begets exhaustion, which begets panic. It’s a point that the likes of GMO founder Jeremy Grantham have made, and it’s a fair one.
But enthusiasm and valuation are two different things. A lack of enthusiasm may continue to drive an overvalued market higher, but it doesn’t mean that the market isn’t expensive.
While it’s true that investors might not be especially happy about piling into stocks right now, the fact is that they are buying and taking risk regardless. They might feel forced to by the Federal Reserve, rather than excitement about gains. But while desperation and enthusiasm are very different emotions, in practical investment terms, there’s not a huge gap between them.
As Marks says, “fear of missing out has taken over from value discipline, a development that is a sure sign of a bull market”.
But what does this mean for my money?
So what does it all mean for your portfolio? As Marks puts it, we’re not at hysterical levels yet. “The market is not a nonsensical bubble – just high and therefore risky.” As a result, “there is absolutely no reason to expect a crash.”
So what can you do? The simple historical reality is that overvalued stuff tends to get cheaper, and undervalued stuff tends to get more expensive. So if the market is overvalued today, you should have less exposure to it. If the market is undervalued, then have more.
Right now, “it’s time for caution… not a full-scale exodus”. So, as I’ve said before, the main point is to try to avoid the most overvalued stuff; review your portfolio to make sure that you understand what’s in there and why (remember that it’s the complicated, fuzzy stuff that tends to blow up first); and ease up on risky bets.
You also have to be patient. No one can time the market. All you can do is have a rough understanding of the present environment and take action accordingly. But overvalued markets can and do keep going up, and undervalued ones can and do keep falling.
And as the market continues to march upwards, you will suffer from “fear of missing out” too. The pain caused by foregoing paper gains during a bull market is – in my view – at least as acute as the pain of suffering paper losses during a bear market.
That’s because, in the first instance, while you don’t actively lose money, you do feel like an idiot next to those who are making money. In the second instance, losing money is not pleasant, but as long as everyone else is, you don’t get the added kick to the ego.
Your ability to resist this discomfort is something you need to consider (and work on) when adjusting your asset allocation. You don’t want to put yourself in a position where your levels of regret get so extreme that they force you back into the market at exactly the wrong time.
That’s the point about timing – it’s why you don’t sell everything on the back of a hunch that the market will fall. Because if you get it wrong, your regret will push you back into the market just in time to catch the top.
The key is to stick to your diversified portfolio, but tweak the allocation so that it tilts towards defence rather than offence. For most of us, that means increasing the allocation to cash in our portfolios, and decreasing it in other areas.