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Howard Marks on four riskiest words: No Price Too High

On 16 March 2021, Howard Marks spoke at an Australian Israel Chamber of Commerce webinar. Marks is well known to regular Firstlinks readers as the Co-Chairman of Oaktree Capital Management, which he co-founded in 1995 and is the world's largest distressed debt investor.

 

The moderator, Alicia Gregory from Australia’s Future Fund, started by asking Marks about the potential for inflation. He discussed the consequences of the steps taken by the US Federal Reserve and Treasury to rescue the economy in the face of COVID. 

Defining a bubble

“That was very strong action and it worked. It turned the economy and the markets around but lowering interest rates has a lot of strong impacts. It raises the value of assets, it reduces the competition that bonds pose for stocks, and lets the stock market rise. The low rate of interest on cash forces people to go out and buy assets, and also the low returns on safe investments force people to become more risk tolerant and move out to riskier investments to get a decent return. 

The impact on the price/earnings (P/E) ratio applied to stocks is particularly strong, and the lower interest rates go, the higher stock P/Es and stock prices that can go. That's the mechanical linkage. Now, today, after the stock market has risen roughly 80% from the March low, are we in a bubble?

First you have to say, what is a bubble?

It's not just any bull market, it's not just any rise. A bubble, to me, starts with a grain of truth. It might be that the internet will change the world or the tulips are beautiful back in 17th century Holland. It's usually about something new because when it's something new, the limitations have not been found and there's no past to hold it back. So, if this a grain of truth is taken to an extreme, the assumption is that every company in that field will be successful.

And finally, we have irrational optimism, and the four words that seal the deal: no price too high. And back in 1999 for example, they were saying the internet's going to change the world so there's no price too high for an e-commerce company. The internet did change the world, of course, but most of those e-commerce companies closed worthless."

Marks then switched to today's market, justifying high valuations due to historically low rates: 

"Are we in a bubble? I say compared to that definition, asset prices and particularly stock prices, and especially probably technology, are high, but not irrational. I think that as I described the mechanism through which lower interest rates produce higher stock prices, on that basis, today’s stock prices are justified and justifiable, albeit high. 

Now that's very important, because that means they are dependent for their current level on interest rates staying low for longer."

Can the Fed keep interest rates low forever?

Despite the actions of the Fed and Treasury pumping up the economy, Marks sees few signs of inflation, but he uses a fascinating analogy, with a warning:

"I think of the Fed actions as a kind of like a waterspout coming out of the sea and there's a ball on top. As long as the spout is coming out, the ball can stand suspended above the level of the water. As soon as the waterspout stops, the ball falls to earth because its former level was an artificial one. That's what I think about interest rates. The Fed can try to keep interest rates low for a long time, as it has direct control over short interest rates. But it does not have the same degree of control over the longer parts of the bond market, and from a low of 0.6% yield on the 10-year Treasury during the height of a COVID, we're already at 1.6%.

But if you ask me, can you pump trillions of new money into the economy, year after year with interest rates staying low for long? I'm not convinced. I'm not firm enough in my views about the future to say what will happen, but we have to give room in our portfolios for the occurrence of inflation and higher rates."

Private market premiums

Alicia Gregory then asked about his views on the existence of an illiquidity premium as an incentive (and reward) for investing in private markets.

“People always talk about the illiquidity premium or any risk premiums. Risk premiums are not naturally occurring. They're not part of nature, they only happen if people are risk averse. If people say, I don't want to tie up my money, and in order to do so, I have to be induced, then there'll be an illiquidity premium.

But if people say I'm eager to tie up my money, and they're all crowded into the illiquid markets, then you won't have a risk premium. Risk premiums exists to bribe people to do things that they don't want to do.

So I think it's very important to realise that. A lot of universities emulated Yale into the private markets and then when we had the global financial crisis, they were in a big jam because they had taken on more illiquidity than they could live with.

No investor needs 100% liquidity for all their portfolio. I think of it as like geological layers. As you dig down, you get to more and more illiquid assets, but you can have a layer of illiquid assets and partially liquid and semi liquid and meet your needs that way. But you have to accurately assess your ability to live with illiquidity, and I've seen people skip that."

Private markets are alpha, public markets are beta

Marks makes an interesting distinction between the skill needed to generate excess returns in private versus public markets, with what sounds like a criticism of active managers in listed securities.

"In the private markets of private debt or infrastructure or real estate, you become dependent on the managers. These are what we call alpha markets, where alpha is personal skill. And in these markets, you need personal skill.

And if you go into the stock market, in the long run, it doesn't make much of a difference who you hire because these are not alpha markets. These are what we call beta markets where most of the return comes from the performance of the market. So, which manager you choose is much less critical.

But if you go into a locked up, private illiquid investment fund, with a manager you're relying on for a skill, who turns out to have what we call negative alpha, which is the ability to hurt a portfolio, then you have manager risk. If you turn to the private markets you may get a higher return, some of them will be reward for illiquidity, some of it will be hopefully from picking a manager with skill."

Special Purpose Acquisition Companies (SPACs)

Marks is tolerant of SPACs, but as in private markets, he sees manager skill ultimately determining who will be successful:

"SPACs are a form of financial innovation and financial innovation can only take place when markets are optimistic. When markets are downcast and skeptical and depressed, you can't bring out something new. So the fact that SPACs have been so popular is an indicator, but that doesn’t mean they are fallacious.

They serve a purpose as a way to get companies public without the torturous process of going public through an IPO. And over time, just like with private equity, they'll sort out. And after there's been 1,000 SPACs, they'll say XYZ is somebody who has brought out SPACs that consistently have done well and ABC is somebody who was a fly-by-night and was unsuccessful. Right now, when there's a SPAC frenzy (as I said about bubbles), they are being treated as if everybody is likely to be successful."

Howard Marks released his latest memo to clients this week and it can be read here

Howard Marks spoke at an Australian Israel Chamber of Commerce webinar in partnership with Spire Capital. This article is general information and does not consider the circumstances of any investor.

 

3 Comments
Ruth
March 25, 2021

Well of course he's right. But with money so easily created, people are piling it into hard assets, including stocks, in the hope of getting something back. And you might, but then they will tax you more. SPAC's some will be OK some will not. Good luck figuring out the difference.

Scott
March 19, 2021

Mr Marks is Right!. The 10yr treasury influences the price of assets.
The 10yr treasury yield has been in a declining downtrend since 1981 from a high of 15.0%. To break that trend, it would need to move sustainably past 2.5% (currently 1.7%).
The 12 mth historical PE for S&P 500 is 48 and the 12 mth forward estimate is 22
The 12 mth historical PE for Nasdaq 100 is 37 and the 12 mth forward estimate is 28
Source: Birinyi Associates https://www.wsj.com/market-data/stocks/peyields.
I agree that the bull market is not yet at crazy levels and will continue upward for the next 12-24 months.
Bull markets tend to gain a momentum and move way past what people think is possible. Then the crash that follows has the same effect (the bigger the party, the worse the hangover).
The crypto world is growing exponentially. It's sucking money from the real world into a fairytale land, where the evil empire is the Fed.
The collapse of crypto will be the match that ignites the next financial crisis.





Gary M
March 18, 2021

I always like Marks but in contrast to his comfort level implied here, I see in a previous article in June 2020, Marks said, “the fundamental outlook may be positive on balance, but with listed security prices where they are, the odds aren’t in investors’ favour.” And the markets have run strongly since. So as he says, he does not have much more foresight than the rest of us.

 

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