As readers of this commentary know, I have written about market cycles on more than one occasion. I believe the master on this subject is investing legend Howard Marks, who I hold in the highest regard for his successful long-term successful track record and deep examination of market behavior. In advance of his new book, Mastering the Market Cycle: Getting the Odds on Your Side, he has released one of his must-read memos entitled “The Seven Worst Words in the World” defined as too much money chasing too few deals. The overriding theme of the memo is to explore certain market behaviors he is now observing as clues to where we might be in the current cycle. Because there is so much debate today about whether the bull market in U.S. stocks (not foreign stocks as they are down on the year) will continue for years or is about to roll over, I thought I would use this commentary to excerpt from Mr. Marks' latest memo to share some of the evidence he cites as clues to the answer.
Before getting into the excerpts from the memo, I want to begin by listing the positive factors we are currently observing.
- Unemployment is near record lows at 3.8%
- Job openings have exceeded the number of unemployed for 5 consecutive months and by 659,000 in July.
- The final reading on 2nd quarter GDP growth came in at a very healthy 4.2%
- Corporate profitability remains strong
- Although interest rates have crept up they remain very low by historical standards
- Small business confidence is at a record high
- The probability of a recession remains very low for the immediate future given the underlying momentum in the economy
Now to the excerpts from Mr. Marks' recent 12 page memo.
"The ideas that run through my book are best captured by an observation attributed to Mark Twain: “History doesn’t repeat itself, but it does rhyme.” ... The following paragraph from the book serves to illustrate:
The themes that provide warning signals in every boom/bust are the general ones: that excessive optimism is a dangerous thing; that risk aversion is an essential ingredient for the market to be safe; and that overly generous capital markets ultimately lead to unwise financing, and thus to danger for participants.
An important ingredient in investment success consists of recognizing when the elements mentioned above make for unwise behavior on the part of market participants, elevated asset prices and high risk, and when the opposite is true. We should cut our risk when trends in these things render the market precarious, and we should turn more aggressive when the reverse is true.
The Current Environment
What are the elements that have created the current investment environment? In my view, they’re these:
- In order to counter the contractionary effects of the Crisis, the world’s central banks flooded their economies with liquidity and made credit available at artificially low interest rates.
- This caused the yields on investments at the safer end of the risk/return continuum to range from historically low in the United States to negative (and near zero) in Europe and elsewhere. ...
- Whereas I thought while it was raging that the pain of the Crisis would cause investors to remain highly risk-averse for years, by injecting massive liquidity into the economy and lowering interest rates, the Fed limited the losses and forced the credit window back open, rekindling investors’ willingness to bear risk.
- The combination of the need for return and the willingness to bear risk caused large amounts of capital to flow to smaller niche markets for risk assets offering the possibility of high returns in a low-return world. And what are the effects of such flows? Higher prices, lower prospective returns, and weaker security structures and increased risk.
In the current financial environment, the number “ten” has taken on particular significance:
- Thanks to the response of the Fed and the Treasury to the Crisis, the U.S. has seen roughly ten years of artificially low interest rates, quantitative easing and other forms of stimulus.
- The resulting economic recovery in the U.S. has entered its tenth year (and it’s worth noting that the longest U.S. recovery on record lasted ten years).
- The market’s upswing from its low during the Crisis is in its tenth year. ...
What are the implications of these events? I think they’re these:
- Enough time has passed for the trauma of the Crisis to have worn off; memories of those terrible times to have grown dim; and the reasons for stringent credit standards to have receded into the past....
- Investors have had plenty of time to get used to monetary stimulus and reliance on the Fed to inject liquidity to support economic activity.
- While there certainly is no hard-and-fast rule that limits economic recoveries to ten years, it seems reasonable to assume based on history that the odds are against a ten-year-old recovery continuing much longer. ...
- Finally, it’s worth noting that nobody who entered the market in nearly ten years has experienced a bear market or even a really bad year, or seen dips that didn’t correct quickly. Thus newly minted investment managers haven’t had a chance to learn firsthand about the importance of risk aversion, and they haven’t been tested in times of economic slowness, prolonged market declines, rising defaults or scarce capital.
For the reasons described above, I feel the requirements have been fulfilled for a frothy market as set forth in the citation from my new book on this memo’s first page.
- Investors may not feel optimistic, but because the returns available on low-risk investments are so low, they’ve been forced to undertake optimistic-type actions.
- Likewise, in order to achieve acceptable results in the low-return world described above, many investors have had to abandon their usual risk aversion and move out the risk curve.
- As a result of the above two factors, capital markets have become very accommodating.
Instead of equities, the main building blocks for the Crisis of 2007-08 were sub-prime mortgage backed securities, other structured and levered investment products fashioned from debt, and derivatives, all examples of financial engineering. In other words, not securities and debt instruments themselves, but the uses to which they were put.
This time around, it’s mainly public and private debt that’s the subject of highly increased popularity, the hunt by investors for return without commensurate risk, and the aggressive behavior described above. Thus it appears to be debt instruments that will be found at ground zero when things next go wrong.
Conditions overall aren’t nearly as bad as they were in 2007, when banks were levered 32-to-1... Thus I’m not describing a credit bubble or predicting a crash. But I do think this is the kind of environment - marked by too much money chasing too few deals - in which investors should emphasize caution over aggressiveness.
On the other hand, and in investing there’s always another hand - there is little reason to think today’s risky behavior will result in defaults and losses until we see serious economic weakness. And there’s certainly no reason to think weakness will arrive anytime soon. The economy, growing but relatively free of excesses, feels right now like it could go on a good bit longer.
But on the third hand - the possible effects of economic overstimulation, increasing inflation, contractionary monetary policy, rising interest rates, rising corporate debt service burdens, soaring government deficits and escalating trade disputes do create uncertainty. And so it goes.
But for me, the import of all the above is that investors should favor strategies, managers and approaches that emphasize limiting losses in declines above ensuring full participation in gains. You simply can’t have it both ways.
Just about everything in the investment world can be done either aggressively or defensively. In my view, market conditions make this a time for caution."
PYA Waltman’s guiding philosophy in this environment remains proceed with caution. In our model portfolios this means our exposure to risk assets is below our upper band and the value we demand for purchasing new businesses remains uncompromising. While diversified portfolios containing exposure to foreign stocks, bonds, and real estate invest trusts haven’t performed nearly as well as the major market cap-weighted indices this year, it remains the most prudent approach for investors over the long-term.
As always, we remain committed to helping you reach your financial goals.
The views contained herein are those of PYA Waltman Capital, LLC, and should not be taken as financial advice or a recommendation to buy or sell any security. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only.
PYA Waltman Capital, LLC, is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about PYA Waltman including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request. PYA-18-06