Having recently warned about the growing socio-economic chasm of income and wealth inequality which has led to a worrying anti-capitalist backlash, Howard Marks – the co-founder and co-chairman of Oaktree Capital Management – is back with another interview, this time for Goldman’s “Top of Mind” periodic publication, he shifts the topic away from populism and the blowback to central bank policies, to where we are in the business cycle (assuming one still exists now that central banks always step in any time there is even a modest threat of a bear market), explaining how investor attitudes towards risk are a valuable gauge for assessing where we are in said cycle, which in turn advises how “smart investors” should behave. He also reveals what “late cycle excesses” worry him the most, arguing that excesses in the credit markets are a key source of risk to the economic expansion.
Below we present Marks’ full interview with Goldman’s Allison Nathan.
Allison Nathan: What do you make of the recent market volatility?
Howard Marks: To me, it just confirms that markets are psychologically volatile. On October 3, everything was fine; on October 4, the equity market began one of the biggest declines ever seen over such a short period of time, leading to the worst December since the Global Financial Crisis (GFC). Fundamentally, of course nothing had changed overnight, and not much has changed even over the prior few months; mostly it’s just that the market swung from looking at things optimistically to looking at them pessimistically. The truth is, most things can be viewed either positively or negatively, and the bias of onlookers influences which perception prevails at any point in time.
All that said, I have argued since roughly mid-2017 that markets were excessively optimistic. And excessive optimism, faith in the future, and greed leave the market vulnerable to this type of sentiment-driven correction. So this episode just illustrates how much market violence emotion can wreak, especially from a place of too much exuberance.
Allison Nathan: How do you determine whether or not markets are too exuberant?
Howard Marks: By assessing how people are thinking and behaving around you. In general, as investors, we can’t predict where we’re going, but we should be able to tell where we are. We can do that by “taking the temperature of the market” through questions like: Where does market psychology stand? To what extent has this psychology been priced in? Are attitudes toward risk prudent or cavalier? Answering these types of questions doesn’t help predict the future, but it does help investors get the odds on their side, because they are better able to determine whether markets are more exposed to upside potential or downside risk. And in my assessment, last year the markets were more exposed to downside risk.
Allison Nathan: But couldn’t at least some of last year’s optimism have been fairly attributed to strong US economic growth?
Howard Marks: What matters most to markets is not a good quarter or a good year, but what the future looks like. Case in point, last year we had some of the fastest US economic growth since the GFC, but some of the worst market performance. In my view, the economic strength post the US tax bill was like a shot of adrenaline in the economy; far from creating a stable platform for more rapid growth, I thought it would give us a couple of good quarters before either receding or necessitating more restrictive actions from the Fed to avoid excessive inflation. But people reacted very positively to it, and—most importantly—they extrapolated into the future the strong growth we were experiencing. I was getting email from people saying, “Look at Australia—they haven’t had a recession in 26 years. Maybe the US won’t have a recession for 26 years.” That kind of Pollyannaish thinking told me there was too much hot air in the balloon. When assets begin pricing in the notion of permanent prosperity, it usually turns out to be an illusion.
Allison Nathan: Does this kind of behavior suggest to you that we are nearing the end of the economic expansion?
Howard Marks: I’m not an economist, and I don’t believe in forecasting; as investors we never know what’s going to happen, like I said, but we can know something about the odds. We’re in the second half of the 10th year of an economic recovery, and US economic recoveries have never lasted more than 10 years. That doesn’t mean that on the 10th anniversary of the current expansion iron gates will come down and the economy will descend into recession. My guess is that this recovery will indeed turn out to be the longest in history, and thus that more Fed rate hikes to correct late-cycle excesses are probably in store. I would be shocked if today’s interest rates are the highest of this cycle. But the odds that the expansion goes on much longer are not great. And knowing that, we can feel somewhat confident that over the next few years, we’ll probably see slower growth and—at some point—a recession, which means pessimism will likely predominate over some period of time, just as optimism has in recent years.
Allison Nathan: What does this mean for markets?
Howard Marks: Two questions I’m often asked are: “Are we in a bubble?” and “Are we going to have another crash?” This is understandable because those who came into the market as much as 25 years ago have seen two bubbles and two crashes. But markets aren’t always about extreme ups and downs; there are bull markets and bear markets, rises and corrections.
With that in mind, I don’t believe that we’re in a bubble, and I don’t think we’re going to have a crash. Stock P/E ratios are pretty much in line with the postwar average. Banks are not highly levered. Most investing hasn’t taken place in vehicles as highly levered as the mortgage and loan vehicles of 2006-07. And I don’t see an analog for subprime mortgages today. So in many ways, the current environment is less precarious than 11 or 12 years ago. But for an investor, I think the next five years simply aren’t going to be as good as the last ten.
Allison Nathan: What late-cycle excesses worry you the most?
Howard Marks: I worry about the amount of debt in the system and about companies’ exposure to rising interest rates. I recently wrote about what I call “the seven worst words in the world”: too much money chasing too few deals. Demand for credit instruments in the last few years has been very strong, driving an influx of capital to the leveraged loan and private lending markets. Such large capital inflows tend to drive up prices, drive down credit standards, drive up risk, and drive down prospective returns. I believe that generally has happened in the credit markets. So I worry about the debt load more than I do about, say, a collapse in stock prices.
Allison Nathan: Are credit markets the most likely cause of the next downturn?
Howard Marks: “Cause” is a funny word. Yes, I would guess that the next big problem in the economy will emanate from the credit markets. But will that start the next recession? Not necessarily. The problem might start because of a trade war or for some other reason. One of my favorite oxymorons is that “we’re not expecting any surprises.” But of course it’s surprises that have the power to knock the market for a loop; after all, very few people saw the subprime crisis coming.
When we learned about the Civil War, we learned about Fort Sumter being the powder keg. Today, leverage in the system seems to me like the area of greatest exposure, but I can’t be sure what the powder keg will be. I’m not cavalier enough to pretend that I know where the trouble will emerge.
Allison Nathan: The GFC was a key buying opportunity for you. Would the limited firepower of monetary policy give you pause before buying risky assets during the next major downturn?
Howard Marks: It will matter if we have a severe recession. In 2007, I held five-year Treasuries that paid six-plus percent. Today, the five-year pays two-plus percent. So by definition, the Fed has less firepower with which to respond to a recession. That’s bad. But the scenario that you’re describing would otherwise probably be a good time to invest: pessimism up, prices down, people pulling in their horns. Weighing those pros and cons is what makes this a tough business, and that’s why nobody gets it right all the time.
Allison Nathan: Considering the Q4 sell-off and the recent rally, how would you rate investor optimism today? Do expectations look more reasonable to you?
Howard Marks: I see the Q4 price action as a dash of cold water that cooled off some enthusiasm. Credit spreads widened and it was hard to raise money. These were positive signs of prudence. That said, those losses have been recovered to a large degree. So I would say that the market is chastened but back to being somewhat optimistic.
Allison Nathan: So how should investors be positioned today?
Howard Marks: To me, the key question is whether this is a time for aggressiveness or a time for caution. I believe it’s a time for caution. Warren Buffett said it best: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” If investors are scared, as they were in the fourth quarter of 2008 or early 2009, I believe you should be aggressive. But if investors look like flaming optimists, then watch out. As I said, I still see some optimism in the market today. So I would want to be in stable, higher-quality and defensive assets more so than in aggressive, optimism-oriented assets.
Of course, it’s not all or none, buy or sell. For example, slower growth would normally mean holding more US than non-US assets, because the US is the more dependable economy. But US securities are also the most expensive. Normally, caution would call for holding more bonds than stocks. But long-term fixed income instruments would suffer the most if rates rise. And at least in the US, bonds are more expensive than stocks. So the trouble is, things aren’t black and white. But overall, I see absolutely zero reason to express the aggressiveness that was appropriate ten years ago. The easy money has been made for this cycle, and today’s conditions call for a more cautious portfolio.