History Rhymes

This article is a summary of Howard Mark’s recent memo. “There they go again… Again”. It’s a long memo (24 pages) which focuses on market cycles and suggests we are nearing the top of this one.

The most noteworthy learning of the memo is that Marks has said it all before — twice! 1999–2000 was the first time, 2007 was the other.

Why do ‘very few people’ predict large corrections? Because ‘most investors’ are actually causing it. For bubbles to form, it requires consensus participation in the widespread pro-risk behaviour creating the bubble in the first place.

Are we near a peak now? Almost certainly, yes. Current market conditions can be characterised by high uncertainty, low expected returns, full valuations, and pro-risk behaviour. These are four of the hallmarks of the upper end of a cycle.

”The market is not an accommodating machine, it won’t give you returns just because you want them”

— Peter Bernstein

When faced with low returns and high risk (mostly evident in stretched valuations), the worst thing to do is ‘reach for returns’.

It is clear as day to me that our investment decisions must be predicated by the protection of capital — not the seeking of returns.

Howard says: “if you refuse to fall into line in carefree markets like today’s, you’ll a) lag in terms of return and b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs.”

Despite its misgivings in the short-term, contrarian activity has served the clients of Lugarno Partners well so far.

In the memo, Howard references the four most noteworthy components of current conditions. I have included with them some of today’s specific examples which are provided elsewhere in the memo.

1. Uncertainties are unusual in terms of number, scale, and insolubility.

This is evident by Political dysfunction; Geo-political risk; Rising interest rates; The impact of Technology; Environmental concerns; and closer to home — a heavily indebted consumer exposed to an expensive housing market.

2. Prospective Returns are about the lowest they’ve ever been.

Australian Investors currently face bank interest rates which are sub 2%; 10 Year returns offered by government bonds are 2.68% pa; Investment Grade corporate bond returns are ~2.8% pa; and Quality Commercial real-estate is yielding below 6% in some cases.

3. Asset Prices are high across the board

The US Stock market is trading at 25x trailing earnings compared to a historical median of 15x. The Shiller PE is at +30x versus its historical median of 16x (this multiple was only higher in 1920 & 2000); and finally, the asset everyone owns (housing) is expensive — Sydney’s median house price is $1.15m! Over 10x Australia’s average household income.

4. Pro-Risk investor behaviour is common-place

Below is some anecdotal evidence of pro-risk bubble like behaviour. These are the type of stories told in documentaries post large market corrections.

• Real estate companies in Australia are raising large amounts of capital with not much more than a one-pager headlining a forecast yield.

• Argentina sold $2.75bn of bonds at 8% interest for 100 years! This is despite Argentina having defaulted on their bonds 4 times in the last 100 years (most recently in 2014).

• Ivory Coast sold its own 16 year bonds for a 6.25% yield.

• Netflix sold $1.3bn Eurobonds at 3.625% despite burning through $1.8bn of free-cash flow last year

• The VIX (volatility) index at its lowest point in 27 years.

• $1.4 trillion has been invested in passive investment strategies in the past 10years

• Speculative activity in Bitcoin (we will write about that another time)

• 50% of Westpac’s mortgages are interest only.

• 49% of mortgage holders in Australia have an average Loan-To-Income Ratio of 6.4x and average LVR of 78%.

We all need to remember that every 8 or so years when markets are negative, the prospect of a 2% return is actually a very good one. And, acting defensively before a collapse is rewarded with the ability to act aggressively when it eventually comes. Patience is a virtue and in the investment game its an edge.

“The man who has anticipated the coming of troubles takes away their power when they arrive”

— Seneca

For those who don’t know Howard Marks, he is the co-chairman and founder of Oaktree Capital who manage in excess of $100bn across a range of value-oriented investment strategies. He has written memos since 1990 and a book titled ‘the most important thing’. I am extremely grateful to Howard for so openly sharing his thoughts.

The foundations of our investment philosophy is borrowed from those we believe are the world’s greatest investors. The common trait of these individuals is rationality and a healthy sense of worry.

More often than not, these great investors find themselves waiting patiently for a correction (as we are now) — not scrambling for the exits when it eventually comes around.

Credits: Howard Marks, Peter Bernstein, Mark Twain.

Link to Howard Marks memo (24 pages).
https://www.oaktreecapital.com/docs/default-source/memos/there-they-go-again-again.pdf