“History doesn’t repeat itself, but it does rhyme.” Today we are exploring the venerable Howard Marks' current view on the markets after his last commentary focused on the Greek tragedy. The themes of Oaktree Capital Management's most recent letter to investors are the recurring patterns that permeate capital markets, and what Marks believes is the most useful of all investment adages - “What the wise man does in the beginning, the fool does in the end.”
Quickly becoming one of the most quotable men in financial markets, Marks starts with a brief history of equities. Stocks were largely believed to be a speculative asset classes prior to the 1950s until the advent of brokerage firms like Merill Lynch began to espouse the merits of equity ownership. The growth stock investing craze soon followed in the 1960s and investors witnessed the birth of the “nifty-fifty”.
This group of stocks soon traded at multiples between 80x and 90x earnings, signaling that logic had succumbed to ballyhoo of growth investing mania. When the tide went out in the 1970s, timid investors sought shelter in the form of bonds as prosperity shifted to recession. In August 1979, BusinessWeek published a cover a story entitled “The Death of Equities” as the PE ratio of the formerly lionized growth stocks fell to 8 or 9.
It was during this nadir of investment psychology that Marks became a portfolio manager. As sentiment surrounded stocks rebounded, the S&P saw an annual return of 15.4% from 1979-1990 before improving even further between 1991-99, returning an unprecedented 20.6% a year without a single down year. As we know, this overzealous sentiment propped up the tech bubble. Marks summarizes his main point as follows:
But investors consistently fail to recognize that past above average returns don’t imply future above average returns; rather they’ve probably borrowed from the future and thus imply below average returns ahead, or even losses.
Such market extremes are propagated by the investor's (and all humans for that matters) tendency toward gullibility rather than skepticism. According to Marks, the pivotal question investors must continually ask themselves is not “What has been the normal performance of stocks?” but rather “What has been the normal performance of stocks if purchased when the average p/e ratio is 33?”
According to Marks, over the past 60 years the story of bonds can be viewed as the mirror opposite of what happened to stocks. Bonds were the bedrock of most investment portfolios for the better part of the 20th century. During the roaring 90s, bonds were seen as anchors hindering performance. The decline in bond popularity can also be attributed to the policy of the Greenspan Fed to stimulate the economy by keeping interest rates low for a prolonged period of time. Accordingly, bond allocations reached all-time lows at the most inopportune time, 2008, when treasuries, gold, and cash were the only asset classes that performed well.
Marks is surprised that investors have suddenly “awakened” to bonds’ attraction after missing the boat during the credit crisis, and questions whether this is another example of investing while looking in the rear view mirror. Citing Bloomberg, he notes that roughly $33 billion has left equity funds while investors have sent about $185 billion into bond funds. These inflows and outflows are indicative of the trends in investor psychology.
Marks believes that investors are currently extrapolating the recent poor performance of stocks (following the great hype of the 90s) into the future, despite the lower prices. Such behavior is congruent with the tendency to expect trends to continue rather than regress toward the mean (Marks is betting on the latter). History confirms this tendency, as investors following their herd mentality appear to systematically buy high and sell low.
The proverbial pendulum has swung, as it always does, because investors are still not asking the fundamental question, “At what price?” If investors asked themselves this question they wouldn’t succumb to the blanket statements that have previously brought so much pain, i.e. “internet stocks will always outperform the market” or “home prices can only go up”.
The Oaktree Capital Chairman believes the economic recovery will be lackluster and has recently recommended buying solid, non-levered and non-cyclical companies, and owning more bonds than stocks. However, now that stock prices have fallen so low while bonds have surged, he finds himself reconsidering. In his words, Marks is not an “equity guy” yet he sees substantial merits in the stock market currently.
First, companies are leaner than ever after the massive layoffs and have become increasingly efficient. Second, corporations are piling up the cash on their balance sheets, which adds greatly to their financial security and allows for dividend increases and share buybacks. Third, stocks currently trade at very attractive valuations, as PE ratios are lower than the historical average and annual free cash flow of American corporations (excluding banks) is currently at 6.8% of their market value. When juxtaposed with the current yield on bonds, this “cash flow yield” becomes very attractive. Legendary investor John Paulson just highlighted this too, proclaiming you should buy stocks and sell bonds.
Marks summarizes the issue plainly:
The bottom line is that, as bond prices rise (reducing yields) and p/e ratios fall, the chances increase that stocks will outperform bonds. Thus the benefits high grade bond investors feel they’re gaining through what they’re buying can be undone by what they’re paying. I’ll say it another way: the attractiveness of one investment relative to another doesn’t come from what it’s called or how it’s positioned in the capital structure, but largely from how it’s priced relative to the other.
The letter finishes by recommending investors
assemble a portfolio of iconic, high quality, large-cap U.S. growth stocks that will provide appreciation in a strong environment, a measure of protection in a weak environment, and a meaningful dividend yield regardless.
This is the same advice we've seen numerous other hedge fund managers dole out. Other investors have recommended the likes of Johnson & Johnson (JNJ), Microsoft (MSFT), Pfizer (PFE), and Kraft (KFT). Market strategist Jeremy Grantham has also favored high quality stocks.
Embedded below is Oaktree Capital's latest commentary from Howard Marks: