Billionaire investor Howard Marks called time on the dotcom bubble in January 2000, just months before the crash. In February 2007, he correctly warned the "race to the bottom" in financial markets would end badly. Now, Marks is worried today's conditions increasingly resemble 2007's, with investors once again throwing caution to the wind in a desperate search for yield. Marks is the founder of Oaktree Capital, some of whose $99 billion in assets under management has been deployed in Irish property.
While the fund is reviled in some Irish circles as a vulture fund, Marks has long been regarded as one of the most thoughtful and prescient money managers in the investment world, where his long client letters are regarded as essential reading. Marks is a value investor, not a perma-bear given to extreme statements, but the concerned tone of his latest letter is unmistakeable. In it, he warns his description of the financial world in 2007 – “a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere” – is equally applicable today.
Bubble criteria
The prevalence of certain factors helps distinguish a bull market from a boom or bubble, according to Marks. These include, among others, a benign environment that lulls investors into complacency; a “grain of truth” in the underlying investment thesis; strong investment returns that draw in naive investors; “more money than ideas”; a “this time it’s different” mentality; rejection of valuation norms; and a fear of missing out that leads investors to think the biggest risk lies in not participating.
A few such features equates to a bull market, but all of them together denotes a boom or bubble. Not all are currently present, says Marks, but many “are in play today”. The obvious problem is valuations, Marks noting that US stocks trade on 25 times trailing earnings, compared to a long-term norm of 15, and a cyclically-adjusted price-earnings ratio of 30 that has only ever been exceeded in 1929 and 2000, both major bubbles.
Another valuation metric – US stock market capitalisation as a percentage of gross domestic product (GDP), Warren Buffett’s favourite valuation measure – is at record levels, adds Marks. Despite valuations leaving little room for error, Marks sees widespread evidence of complacency. He points to the Vix, Wall Street’s much-watched fear index, which recently hit the lowest levels in its 27-year history.
Marks is not the only one concerned by the lack of volatility. Nobel economist Robert Shiller says it is making him "lie awake worrying", while analysts at JP Morgan warn that, although low volatility in itself is not inherently problematic, there is potential for trouble due to exuberant investors using "strategies that increase leverage when volatility declines". Marks sees lots of anecdotal evidence indicating such exuberance. The bubble in bitcoin and other cryptocurrencies; the "most fundraising in history for private equity"; the worship of a "can't-lose group of stocks" (the FAANGs – Facebook, Amazon, Apple, Netflix, and Google); the "willingness of investors to invest in a shockingly large fund for levered tech investing with a questionable structure" (a reference to Japanese telecom SoftBank, which has raised almost $100 billion from investors despite never having managed money for third parties) – it all points to "an exuberant, unquestioning market".
Not convinced
Or does it? Ritholtz Wealth Management chief executive
Josh Brown
isn’t convinced by the anecdotal evidence.
“The plural of anecdote isn’t data,” says Brown. Marks is “grabbing a bunch of stories from the headlines to build the case that people are, in general, acting speculatively”. However, you can always find such examples. You could point to Facebook’s “monstrously large” initial public offering in 2012, the S&P 500 hitting all-time after all-time high in 2013, Alibaba’s huge flotation in 2014 – just “pick a year”, says Brown, “I’ll show you a dozen examples that could be spun as speculative excess.” Brown sees little evidence of excessive sentiment. Millennial investors prefer cash and bonds to stocks, he says; they aren’t day trading the markets or speculating in IPOs.
“And we’re calling this 1929? Or 2000? Or 2007? Valuations may tell a similar story to those eras,” argues Brown, “but the behaviour of the crowd tells an opposite story.” Marks’ letter acknowledges his thesis is “anecdotal” and “not complete and scientific”. In past client letters, he also pointed to possible indicators of exuberance – for example, in November 2013 he discussed whether investors should be spooked by Twitter’s much-hyped IPO. Nevertheless, he ultimately took a “middling stance”, concluding that was no time to “bail out of the markets”.
Brown might argue that every year has examples of excess, but the evolution in Marks’ thinking suggests he is spotting many more in 2017 compared to previous years. Nevertheless, Marks admits some of the “usual ingredients” of a boom or bubble are missing. Merrill Lynch’s monthly fund manager surveys show investors are cautious and holding high cash levels rather than piling into risky assets. Goldman Sachs is continually warning that almost all metrics indicate stocks to be overvalued. Most people are conscious of today’s uncertainties, recognise future returns will be “quite skimpy” and accept things will not stay rosy indefinitely, says Marks. “That’s all healthy.”
‘We agree, but...
’ The problem, he says, is most investors can’t think of what might cause trouble anytime soon. Recession risk is minimal, earnings are growing and cash returns are “punitive”, meaning investors are more worried about being underinvested than about losing money.
When investment risks are pointed out to managers, the attitude tends to be one of “We agree, but...”. Commenting on Argentina’s recent issuance of 100-year bonds and the large investor appetite for same, Marks relates how the head of research at one brokerage viewed it as shocking that the country could get away with issuing a century bond, having just exited default.
“Nevertheless, she is advising her clients to buy the bonds as at least a short-term trade,” added Marks. “It’s a sign of the times: ‘something may go wrong, but probably not soon.’” Stocks are little different, says Marks. Investors see an extended eight-year bull market, elevated prices and high uncertainty, but they’re still buying because the rally won’t die anytime soon. Just as St Augustine implored the Lord to “give me chastity and continence, but not yet”, investors’ attitude is “there’ll be a time for caution, just not today”. Bulls might argue there is a rationale for the St Augustine mentality. Firstly, academic evidence shows most booms don’t actually go bad and that investors typically miss out on big gains by bailing out too early. Big returns usually accrue in the latter stages of bull markets, and strategists at Barclays argue evidence indicates we are now entering the “high conviction” phase of the economic recovery. Marks acknowledges many arguments underlying the case for cash “could have been made years ago”, but exiting stocks then “would have resulted in huge penalties”. His suspicion is the long bull market is “in the eighth inning”, but admits he ultimately has “no idea how long the game will go on”. Nevertheless, investors should not be getting aggressive in a “low-return, high-risk world”, says Marks. “This is a time for caution.”
