«The Biggest Risk Is Rising Interest Rates»
Howard Marks, co-chairman of Oaktree Capital, explains why he thinks high valuations in financial markets should be a reason for concern. The legendary investor argues for a prudent approach and says where he spots opportunities in today’s challenging environment.
The mood is tense. After stock markets started the year with momentum, wild speculation involving small caps such as GameStop or AMC is dominating the news. Away from all this noise, however, more important changes are taking place: The dollar is getting stronger and yields are trending downward once again.
Who better to comment on the current developments than Howard Marks? Few investors have a better long-term track record than the co-founder of Los Angeles-based investment boutique Oaktree Capital. His Memos from the Chairman, sent out sporadically to clients, have cult status.
«Start young, try to figure out which companies will do best in the long run and hold them»: Howard Marks.
«Certainly, nobody is downcast. Nobody is depressed, and everybody is even or better off,» he notes of the current market mentality. «Nobody has any discomfort about holding risk assets like stocks. In fact, the opposite is true: The discomfort of the last four months has been with regard to not holding risk assets.»
In this in-depth conversation with The Market NZZ, Mr. Marks explains why he sees the greatest threat in a sustained rise in interest rates. He also explains what investors should pay particular attention to when navigating the current environment, and where he sees opportunities for promising investments.
Mr. Marks, we’re living in a strange world: We’re in the midst of a pandemic, yet stock prices are at record highs and bond yields are at record lows. What’s the appropriate approach for a prudent investor in today’s environment?
This is the most difficult kind of market because asset prices are high and prospective returns are low. Compared to each other, most assets are priced relatively fairly, but they’re all priced to deliver low prospective returns. In other words, we’re living in a low return world, so the question is how should one behave in such an environment.
What’s your answer to that question?
The choices are limited. On one hand, you can say that asset prices are high. In this case, you’re concerned about a decline and want to cut your risk. But if you make your portfolio safer, you reduce the prospective return even further. On the other hand, some people might say: We’re living in a low return world, but I want a high return. You can only hope to get that by taking more risk. Neither of those two options is that attractive.
What does that mean for investors?
The market provides opportunities, but you have to decide what to do. About twenty years ago, I wrote a memo to Oaktree clients called «It Is What It Is». In this memo, I made the point that the one thing you can’t do is to say: I want a different environment. You’re not going to get that. The great investment sage Peter Bernstein once wrote to me saying: «The market is not an accommodating machine. It will not give you high returns just because you want them.» So you have to figure out what’s most important to you: to pursue higher returns, or to pursue safety. You can’t do both simultaneously.
What’s the risk investors should be especially aware of right now?
In the United States, the economy is in good shape, and it will be getting stronger. In 2021, the US economy will probably have a very good year. What’s more, since we had that brief recession a year ago, we may not have another recession for several years. The fundamental outlook is good, but the problem is that asset prices are high. They’re high largely because interest rates are so low. So if the economy is in good shape, then the biggest risk is rising interest rates, which would mean declining valuations stemming from higher demanded returns.
In your memos, you often state that we never know where we're going. Therefore, we ought to know where we are. Where do we stand today?
The actions of the Federal Reserve and the US Treasury, especially the reduction of the Fed Funds Rate to zero, had a very coercive effect on the market. It has required people to invest. They don’t want to sit around with cash since U.S. money market funds or bank deposits are all earning zero. Investors also don’t want Treasuries at a yield of 1%, or high grade bonds at 2%. So they have to push out into risk-assets like stocks, non-gilt-edged bonds, private equity or venture capital.
It sure looks like risky assets are in high favor when we consider the boom in technology, Bitcoin or concept stocks in general. What does this say about the psyche of the market?
As I laid out in my latest book, «Mastering the Market Cycle», there are three stages of a bull market. The first stage is when only a few foresighted people believe improvement is possible. The next stage is when most people accept that improvement is taking place. And the third stage is when everybody thinks improvement will go on forever. Back in March, we were in phase one. Things were collapsing, and nobody thought things could get better. That’s the time to buy, when nobody has any optimism. Then, things started to get better, the market rose, and by June or July most people came to the conclusion that things are really improving.
So at what stage are we today when you look at the new retail investor mania and wild speculation in stock options?
Certainly, nobody is downcast. Nobody is depressed, and everybody is even or better off. Nobody has any discomfort about holding risk assets like stocks. In fact, the opposite is true: The discomfort of the last four months has been with regard to not holding risk assets. Today, everybody thinks the economy is going to get better, we’re going to solve the coronavirus crisis, life will get back to normal around the third quarter, we’re not going to have a recession for several years, interest rates will stay low and companies will succeed. But you have to take into account the fact that when everybody is optimistic, they can get only a little more optimistic. Then again, they can certainly switch to pessimism, in which case markets go down.
Does this mean we’re approaching the final stage of the bull market?
That’s hard to say. Usually, the later stages of a bull market in stocks correspond to the later stages of the economic recovery. But now, we’re really just at the beginning of the recovery.
How long can this exceptional situation continue?
Every once in a while, the world says we’re in a «Goldilocks» environment: Not too hot, not too cold – just right. But it usually doesn’t stay that way forever. If interest rates go up, then the value of everything else comes down. Today, people are buying the ten-year Treasury bond to make 1% because cash pays 0%. So what if cash pays 2% in about five years? Nobody is going to buy the ten-year Treasury bond for 1%. Investors are going to demand 3% or 4%. Consequently, if a bond which is now yielding 1% has to yield 3% to satisfy the demands of the marketplace, there is only one way to do that: The price has to go down.
What would be the consequences for investors?
In 1981, I had a loan outstanding from a bank, and I still have the slip on my wall that says: «The rate on your loan is now 22.75%.» Today, I can borrow at 2.25%. Interest rates have been coming down for forty years. That has raised the price of assets and has been a tailwind. But it can’t be a tailwind anymore, because we won’t go below zero – the Fed says they’re not going to go into negative territory. So you don’t have that tailwind anymore, and in the best case, rates could stay where they are, in which case we have a Goldilocks environment. But they can also go up, and then it’s a headwind.
Central banks like the Federal Reserve or the European Central Bank are striving for inflation. And today’s stimulative actions normally would suggest rising inflation. Can the financial system handle higher inflation, implying raising interest rates?
Most countries want 2% inflation, but they haven’t been able to get it. Japan and Europe have been trying for a long time, and they haven’t been able to get it. Since the Global Financial Crisis, we have been in an environment of moderate economic growth, declining unemployment and low interest rates. That’s quite ideal. Some people say: «We’ve had 12 years of deficit spending, and the slack going out of the economy, yet no inflation. So we’re optimistic that inflation will stay low, and with it, interest rates.» That’s great if it goes that way, but there has been a lot of floating-rate borrowing, especially by governments. In addition to that, governments have to refinance their debt when it comes due. Right now, the US is issuing ten-year Treasuries at 1%, and our deficit is quite high. When that debt comes due, and we have to pay 4% for the money, then that will increase the cost of servicing our debt, and the deficit will grow at an even faster rate.
During the darkest weeks of the Global Financial Crisis, you wrote a memo entitled «Volatility + Leverage = Dynamite». How explosive is the situation today?
In the middle of the 2000s, we had this unique development which was the use of leveraged structures like CDOs, CMOs and CLOs; collateralized debt structures with tranching. The people who took the most risk bought the equity and many of them got wiped out. We don’t have much of that kind of thing today. The financial innovation of the past decade was primarily centered around the growth things like Bitcoin and SPACs. None of these imply the use of leverage. What’s more, certainly the financial institutions are less levered and less risky today. In general, the investment world is less leveraged.
In your newest memo, entitled «Something of Value», you argue that there doesn’t need to be a firm schism between value and growth investing. Therefore, investors should follow a more eclectic approach. Why has value investing become so difficult?
When I started my career in the late 1960s, the world was a pretty dumb place. If you wanted to study a company, you had to write them and ask for the annual report, which took two weeks. So few people had much information. There were hidden gems, and when you put your mind to it more than others, you could find them quite easily. As I wrote in my recent memo, this approach was referred to as «cigar butt» investing, because Warren Buffett likened it to searching the street for used cigar butts that had one last puff left in them. Today, everybody has a computer data feed and spreadsheet program. You can search the whole universe, every company, in ten seconds. There is really no such thing as hidden gems now – or, at least, they are much harder to find. There is no reason to believe that just a standard interpretation of public data will give you superior results.
Although the outlook for the broader economy is positive, many industries are still under stress. Which of these sectors will get back to the historic level before the pandemic, and where will we see permanent changes?
That’s really the $64 question. Obviously, the stocks of companies that did well in the pandemic, like Amazon and Netflix, have boomed. Then, we have a group of companies that did poorly: hospitality, travel, entertainment, retail and so forth. Their share prices remain depressed, and that’s the pile where the bargains may be found. If you want to make money, you look at other people’s discards, just like the cigar butts. The problem is that a lot of things that are cheap are cheap for a good reason because they deserve to be cheap.
How do you approach this problem when it comes to the credit markets?
Some real estate investments have had issues. If they’re concentrated in shopping malls or office buildings in big cities, there has been pressure. For example, what’s going to happen with a company that owns a lot of New York City office buildings? Are people going to go back to work? And, if the way things were in 2019 is normal, how much of the way are we going to retrace to normal? Few people think we’re going to be back to 2019 conditions, because everybody learned that it’s nice to work from home and you can be highly productive. Moreover, some concerns of the virus may linger for some time, especially if it turns out that the vaccine doesn’t exterminate it. The key phrase here is variant perception: How do you perceive it, and does the market perceive it? There’s no question that there will be a rebound in office use. People will go back to work, but we don’t know how much of a rebound the market is factoring in, and how much there will be. If the market is right, and that company is priced fair, then you’re not going to make big money. But if it’s wrong and you’re right, there are profit opportunities.
That brings us back to the beginning of our conversation: How should an investor navigate this challenging environment without taking irresponsible risks?
The most important decision is how you feel about risk. When people want my advice, I ask them what’s more important: keeping what you have safe, or making a lot more. Of course, they say «both». But you can’t do both, you have to choose. In American football, you have an offense team and a defense team, and they change places. But that’s not investing. Investing is more like European football, where every player has to play both offense and defense. You don’t get to change players very often. So you have to come up with a portfolio which embodies offense and defense in the right balance.
What exactly do you mean by that?
There is no one size fits all approach. I tend to think of it as the speedometer in a car that goes from zero to one hundred. Zero is no risk, full defense: You put all your money in cash or in T-Bills. One hundred is complete risk, straight offense: You’re fully invested in aggressive securities, maybe with leverage. Every person should figure out what their normal position on that speedometer should look like. This decision depends on your age, income, assets, aspirations, dependence, outlook for future income and intestinal strength, etc. How will you feel to live with big markdowns? People should not overlook that last point, their emotional makeup.
Why is the emotional makeup so important?
If you overestimate your intestinal strength, you could wake up and find your portfolio down substantially. In that case, you may panic and sell, crystallizing that loss. Yet, markets fluctuate around a rising trendline. If you buy at a high price and it falls, that's not the worst thing in the world, because the next high will likely be higher. So if you hold on for the long-term, you will make money. But if you buy high, the price falls and you sell, then you never get to participate in the subsequent recovery. That’s the cardinal sin: selling out at the bottom. That’s the reason it’s so important to not overestimate your risk tolerance.
What advice would you give against this background?
Here’s my most important advice: Start young, try to figure out which companies will do best in the long run and hold them. Invest in good, solid companies, not promotional stocks, not the company of the day. That way, you can’t miss accumulating a lot of money. The big mistake is selling. About six years ago, I wrote a memo about liquidity where I stated that liquidity is not necessarily a good thing, because most people trade too much. I quoted my son Andrew, who said: When you look at the chart for something that’s gone up for twenty years, think about all the times a holder would have had to convince himself not to sell.
Where would you look for attractive constellations between opportunities and risks?
Emerging markets, for instance. They are a good play because they have a bright future. They were up very well last year, but they are still reasonably priced on the basis of history. One of the big decisions you have to make today is how much China to have in your portfolio, since its economy is very powerful and rapidly growing. People often think: I should have representation in China, so I’m going to put in 2%. But that’s pretty close to zero. So the question is: Do you have the nerve to make it a big piece of your portfolio? That’s the interesting thing about investing. Everything you do to try to be right exposes you to the risk of being wrong. If you stay at 2% for China, and it goes well, you will regret that you didn’t do enough. On the other hand, if you are at 20%, and it does badly, you will shoot yourself. There are no easy answers or sure things. A friend of mine, Richard Oldfield, wrote a good book on investing. The title sums up investing quite well: «Simple, but not easy».
Howard Marks
