The Seven Worst Words in the World - A memo by the legendary Howard Marks

Howard Marks is a legendary investor who primarily invests in distress debt. He is the co-chairman of Oaktree Capital. The comapnies17 distressed-debt funds have averaged annual gains of 19 percent after fees for the past 22 years (Wiki). He has been regularly publishing memos on markets and investing since 1990 and they are a tresure trove of perspectives.

His latest memo is titled “The Seven Worst Words in the World”. I’d highly recommend you read the full memo here but Here are select excerpts:

The ideas that run through the book are best captured by an observation attributed to Mark Twain: “History doesn’t repeat itself, but it does rhyme.” While the details of market cycles (such as their timing, amplitude and speed of fluctuations) differ from one to the next, as do their particular causes and effects, there are certain themes that prove relevant in cycle after cycle. The following paragraph from the book serves to illustrate:

The themes that provide warning signals in every boom/bust are the general ones: that excessive optimism is a dangerous thing; that risk aversion is an essential ingredient for the market to be safe; and that overly generous capital markets ultimately lead to unwise financing, and thus to danger for participants.

An important ingredient in investment success consists of recognizing when the elements mentioned above make for unwise behavior on the part of market participants, elevated asset prices and high risk, and when the opposite is true. We should cut our risk when trends in these things render the market precarious, and we should turn more aggressive when the reverse is true.

One of the memos I’m happiest about having written is The Race to the Bottom from February 2007. It started with my view that investment markets are an auction house where the item that’s up for sale goes to the person who bids the most (that is, who’s willing to accept the least for his or her money). In investing, the opportunity to buy an asset or make a loan goes to the person who’s willing to pay the highest price, and that means accepting the lowest expected return and shouldering the most risk.

Like any other auction, when potential buyers are scarce and don’t have much money or are reluctant to part with the money they have, the things on sale will go begging and the prices paid will be low.
But when there are many would-be buyers and they have a lot of money and are eager to put it to work, the bidding will be heated and the prices paid will be high. When that’s the case, buyers won’t get much for their money: all else being equal, prospective returns will be low and risk will be high.

Thus the idea for this memo came from the seven worst words in the investment world: “too much money chasing too few deals.”

Parallels to 2008

In 2005-06, Oaktree adopted a highly defensive posture. We sold lots of assets; liquidated larger distressed debt funds and replaced them with smaller ones; avoided the high yield bonds of the most highly levered LBOs; and generally raised our standards for the investments we would make. Importantly, whereas the size of our distressed debt funds historically had ranged up to $2 billion or so, in early 2007 we announced the formation of a fund to be held in reserve until a special buying opportunity materialized. Its committed capital eventually reached nearly $11 billion.

What caused us to turn so negative on the environment? The economy was doing quite well. Stocks weren’t particularly overpriced. And I can assure you we had no idea that sub-prime mortgages and sub-prime mortgage backed securities would go bad in huge numbers, bringing on the Global Financial Crisis. Rather, the reason was simple: with the Fed having cut interest rates in order to prevent problems, investors were too eager to deploy capital in risky but hopefully higher-returning assets. Thus almost every day we saw deals being done that we felt wouldn’t be doable in a market marked by appropriate levels of caution, discipline, skepticism and risk aversion. As Warren Buffett says, “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” Thus the imprudent deals that were getting done in 2005-06 were reason enough for us to increase our caution.

In the current financial environment, the number “ten” has taken on particular significance:

  • This month marks the tenth anniversary of Lehman Brothers’ bankruptcy filing on September 15, 2008, and with it the arrival of the terminal melt-down phase of the Crisis.8
  • Thanks to the response of the Fed and the Treasury to the Crisis, the U.S. has seen roughly ten years of artificially low interest rates, quantitative easing and other forms of stimulus.
  • The resulting economic recovery in the U.S. has entered its tenth year (and it’s worth noting that the longest U.S. recovery on record lasted ten years).
  • The market’s upswing from its low during the Crisis is in its tenth year. Some people define a bull market as a period in which a market rises without experiencing a drop of 20%. On August 22, the S&P 500 passed the point at which it had done so for 3,453 days (113 months), making this the longest bull market in history. (Some quibble, since the market could be said to have risen for 4,494 days in 1987-2000 if you’re willing to overlook a decline in 1990 of 19.92% – i.e., not quite 20%. I don’t think the precise answer on this subject matters. What we can say for sure is that stocks have risen for a long time.)

It’s worth noting that nobody who entered the market in nearly ten years has experienced a bear market or even a really bad year, or seen dips that didn’t correct quickly. Thus newly minted investment managers haven’t had a chance to learn firsthand about the importance of risk aversion, and they haven’t been tested in times of economic slowness, prolonged market declines, rising defaults or scarce capital.

For the reasons described above, I feel the requirements have been fulfilled for a frothy market as set forth in the citation from my new book on this memo’s first page.

  • 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.
  • Likewise, in order to achieve acceptable results in the low-return world described above, many investors have had to abandon their usual risk aversion and move out the risk curve.
    As a result of the above two factors, capital markets have become very accommodating.

The bottom-line question is simple: does the sum of the above evidence suggest today’s market participants are guarded or optimistic? Skeptical or accepting of easy solutions? Insisting on safety or afraid of missing out? Prudent or imprudent? Risk-averse or risk-tolerant? To me, the answer in each case favors the latter, meaning the implications are clear.

Conditions overall aren’t nearly as bad as they were in 2007, when banks were levered 32-to-1; highly levered investment products were being invented (and swallowed) daily; and financial institutions were investing heavily in investment vehicles built out of sub-prime mortgages totally lacking in substance. Thus I’m not describing a credit bubble or predicting a resulting crash. But I do think this is the kind of environment – marked by too much money chasing too few deals – in which investors should emphasize caution over aggressiveness.

On the other hand – and in investing there’s always another hand – there is little reason to think today’s risky behavior will result in defaults and losses until we see serious economic weakness. And there’s certainly no reason to think weakness will arrive anytime soon. The economy, growing but relatively free of excesses, feels right now like it could go on a good bit longer.

But on the third hand, the possible effects of economic overstimulation, increasing inflation, contractionary monetary policy, rising interest rates, rising corporate debt service burdens, soaring government deficits and escalating trade disputes do create uncertainty. And so it goes.

Being alert for the ability of others to issue flimsy securities and execute fly-by-night schemes is a big part of what I call “taking the temperature of the market.” By also incorporating awareness of historically high valuations and euphoric investor attitudes, taking the temperature can give us a sense for whether a market is elevated in its cycle and it’s time for increased defensiveness.

I’m absolutely not saying people shouldn’t invest today, or shouldn’t invest in debt. Oaktree’s mantra recently has been, and continues to be, “move forward, but with caution.” The outlook is not so bad, and asset prices are not so high, that one should be in cash or near-cash. The penalty in terms of likely opportunity cost is just too great to justify being out of the markets.

But for me, the import of all the above is that investors should favor strategies, managers and approaches that emphasize limiting losses in declines above ensuring full participation in gains. You simply can’t have it both ways.

Just about everything in the investment world can be done either aggressively or defensively. In my view, market conditions make this a time for caution.

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