Howard Marks of Oaktree Capital is not quite as famous as Warren Buffett (who is?). But he’s managed to produce similarly impressive investment results over the decades.
Oaktree Capital has returned more than 19% a year after fees, over more than 20 years now.
That’s a fantastic result by anyone’s standards.
So when he’s worried about the market, it pays to listen….
Everything is awesome… ly expensive
Oaktree Capital invests in high-yield bonds and distressed debt, as well as private equity. So – as if his record wouldn’t have told you – Howard Marks knows his stuff. This is proper, in-the-weeds, detailed, hunting-for-bargains investing.
Marks comes across as a reasonably cautious guy – most debt investors do, because they naturally focus more on the downside than equity investors. But he’s not a perma-bear by any means – he’s not constantly trying to grab headlines by ranting about impending doom, or a government conspiracy. He’s a sober-minded and thoughtful commentator.
This week I read his latest memo. They’re always well written. But this one – all 22 pages of it – was among the best I’ve read. It’s basically a long overview of everything that’s out of whack about the current state of the investment world.
Marks talks about US equities being overvalued, the volatility index being at record lows, the fixation with the FANG stocks (Facebook, Amazon, Netflix, and Google), the boom in exchange-traded funds and passive investing, the lack of covenants on junk bonds, the great rates that risky emerging market governments are getting on their sovereign debt, crypto currencies… the list goes on, and all of his points are valid ones.
But it ultimately boils down to one thing: many asset classes look very expensive compared to their history. Investors remain remarkably complacent about this. “There’s too much money and too little fear.” And overall, that’s a recipe for pain.
To be clear, Marks acknowledges that he’s “a natural worrier” and so tends “to be early with warnings”. And “no one knows anything about timing”. But “what I am sure of is that valuations and markets are elevated, and the easy money in this cycle has been made”.
The problem with the financial industry
One of the key things to take away from Marks’ memo is a valuable reminder about one of the main areas where individual investors have a real advantage over institutional investors.
Having run through his big list of reasons to be bearish, Marks notes that one of his colleagues had been discussing all of these problems with some fund managers.
How did they respond? As Marks puts it: “We agree, but…”
In other words, they had no argument with the notion that markets are generally overvalued. However, they weren’t planning to change their strategies because “we can’t take the risk of being out of the market” or “there’s no alternative”.
There’s a lot of this about at the moment. Ray Dalio of hedge fund giant Bridgewater recently wrote about how he was going “to keep dancing but closer to the exit” (“and with a sharp eye on the tea leaves”, he added, a little oddly).
It’s interesting. We’re always told that exuberance is a key indicator of market highs. I’m not entirely convinced by that argument. I’ve noticed that among professional investors at least, when it comes to expensive markets, there’s often more a sense of resigned collective shrugging. “Sure, stuff’s expensive, but what else are you going to do? This is our job.”
There’s also usually a feeling that they’ll be the ones who manage to get out before things go totally pear-shaped. But the problem with this idea of dancing near the door is that there’s still only one door. If everyone is dancing nearer the door, all it means is that the only way out of the place will get jammed even more quickly than before.
This is where being an individual investor really does help. The biggest problem for institutions is that – as we’ve discussed many times before – is that their incentives are quite different to yours.
As an individual investor, your biggest worry is to avoid losing money in “real” terms (in other words, you want to make a return after inflation). Your second objective after that, is probably to build a big enough pot to meet a retirement goal, so you will have a target level of return in mind.
But at no point in your investing career are you going to be happy with the idea of losing money. Not even if it turns out that your next-door neighbour lost a lot more money than you. Relative outperformance is of no value whatsoever to the individual investor.
And this is where one of the biggest differences lies. An institutional investor would call losing 10% of your wealth, when the wider market loses 15%, a good outcome. You’d call it a disaster. And yet, often, these are the people that you’ve left your money with.
There’s always an alternative. The danger at times like these is that you see a lot of people making what seems to be a lot of money by piling into “sure things”. You worry about how you can do the same.
But this is precisely when you should be getting cautious. When Buffett talks about being greedy when others are fearful, and fearful when others are greedy, this is the sort of environment he’s getting at.
You don’t have to take out all of your money and put it in cash. You can’t make a real return that way, for a start. But what you want to resist is the urge to “get rich quick”. In this environment, it’s easy to feel forced to “reach for return” as Marks puts it. That’s the big mistake.
Put simply, at times like this, when everyone is looking for the big gains, you want to be the sober-headed one who is satisfied with less. When nothing less than double-digit returns will do for others, you want to be satisfied with inflation plus a few percent.
That way, you invest defensively – with one eye on the tea leaves, if you like – and are less likely to take a hammering when the downturn inevitably comes.
And then, when everyone else is panicking and no longer cares about the return on their money – just the return of their money, any of it – you get greedy. You seek out the double-digit returns. And you’ll have the “dry powder” to enable you to do it, because you were defensive at the right time.
Sounds easy. Of course, it’s not. But before you pile into any investment right now, strive to focus on the worst-case scenario even more than normal. Write it down in your investment journal. And if you can’t survive that worst-case outcome, then don’t make the investment.