Howard Marks — A Great Description of the World

In today’s blog, I want to give you a summary of Howard Marks’ recent 15-page memo, titled “On Uncertain Ground.”  Marks is the Chairman of Oaktree.  He’s a well-respected investor and one of my favorite writers.

The overall theme of this piece is that times are incredibly uncertain.  There are greater risks than he has ever seen.  With that said, people are aware of the great uncertainty and prices aren’t extraordinarily high.  As usual, many of the sentences contained in this write-up have been lifted verbatim.  Others are my summary of his work.

The Great Uncertainty

1. The world seems more uncertain than at any other time in my (Marks’) life.  He also quoted John Bogle who said that this is the worst time for investors he has ever seen (but remember, Bogle has only been in the business for 60 years…).

2. We’ll see relatively sluggish economic growth in the U.S. for a prolonged period of time.  The prospect for other developed countries is even worse.

3. Economic growth is based on population gains, a conducive infrastructure, positive aspiration and profit motive, advances in technology and productivity, and benign exogenous developments.  Unfortunately, the birthrate is down, our infrastructure is out of date, it’s uncertain whether technology can add as much to productivity (as it has in the past) and mobility up the income curve has stagnated.

4. For forty years (leading up to 2008), consumers grew their spending faster than their incomes because of the increasing availability of credit.  That is reversing.  This will limit GDP growth.

5. Psychology is also incredibly important to economic growth.  If people think things will be good in the future, they’ll spend and invest and things will be good.  Now, consumers are traumatized; many have lost jobs, been foreclosed upon or been denied credit.  We constantly see headlines of economic weakness, bailouts and collapse.

6. Business investment is important to recovery.  But, business leaders don’t think that consumers are ready to spend.  These leaders also feel like President Obama doesn’t represent the private sector.  More business leaders support Governor Romney and he’s behind.  In addition, there is uncertainty about the economy, regulation and taxes.  The fiscal cliff looms.

7. Many European countries and banks (especially Portugal, Italy, Ireland, Greece and Spain) owe amounts that they can’t ever repay.  Austerity will weaken their economies in the future.  Bond-buying by the ECB will keep rates low but won’t solve problems.  These countries need to reduce debt and increase competitiveness.

8. The U.S. fiscal situation is not much better (although it may be less pressing).  We spend too much and we cut taxes.  Our deficit situation would be much worse if interest rates weren’t so low (it’s a subsidy of the government by savers).  States are having to do more with less as they collect fewer taxes.  Municipal pension plans are underfunded by $1 – $3 trillion.  More municipal bankruptcies are coming.

9. Politicians now value “ideological purity.”  Tax increases are off limits for many.  Cuts in entitlements are off limits for others.  Compromise is a dirty word.  We basically ignored the Simpson-Bowles Commission.  Voters select political ideologues.  Voters understand the risk presented by entitlement programs but reject any reduction of their own benefits.

10. There’s concern over the ability to count on further stimulus.  While the Fed will do more, the effect will be diminished.  It’s difficult to make an economy grow when people aren’t thinking expansively.

11. Investors are being forced to do business in a low-return yield.

12. The long-term competitive position of the U.S. is threatened by our deteriorating infrastructure in areas like education, healthcare and transportation (and other nations are catching us).

13. Income inequality has risen and is a significant problem.  The ability of those at the bottom to move to the top has declined.  Tax rates applied to income on capital have been cut relative to those on labor.  There are negative ramifications to people at the bottom feeling like they can’t move up.

14. There is a list of intractable challenges: Iraq, Afghanistan, Iran, Israel / Palestine, Syria, Pakistan, North Korea, etc.

15. There is great uncertainty with China.  Growth is slowing.  Internal consumption isn’t enough to give China’s economy the growth it needs, so China needs the rest of the world.  If China has a hard landing, that could feed back to the rest of the world (hurting nations that sell raw materials and finished goods to China).

There are Some Positives

1.   There are some positives: the incipient housing recovery; the possibility of energy self-sufficiency; the fact that U.S. manufacturing has slimmed down and our Chinese competitors have seen costs rise; and the fact that the U.S. still leads in higher education, creativity and entrepreneurship.

2. Things often aren’t as bad (or as good) as they may seem.  Investor psychology is curtailed from pre-crisis levels.

3. Asset prices are reasonable (at least relative to other investments or to history).  The P/E ratio is below our historical average.  (Of course, our growth prospects are lower.)  Yield spreads on high yield bonds are generous by historical measures.  Real estate prices are back to pre-bubble levels of a decade ago.

More Thoughts About Psychology

1. While the macro future seems far more uncertain today than at any time in Howard Marks’ experience, there’s a good chance that it was never as certain as people thought.  Growth, profits, productivity were strong.  Inflation and rates were low.  Equities, houses and retirement accounts appreciated.  We were at peace.

2. Investors tend to extrapolate – they expect recent returns to continue.  The riskiest thing in markets is when you believe that there’s no risk – and that’s not a problem today.  Risk is low when investors behave prudently and high when they don’t.

3. An uncertain world can be safer than people perceive if their concern causes them to behave cautiously (and especially if it causes them to sell down assets to prices from which the likelihood of further declines is reduced).

4. While investors perceive risk (and that’s probably the best thing that can be said about today’s environment), the actions of central banks to minimize interest rates have served to force investors out on the risk curve in search of return.  (Emphasis added by Leeds.  I think this is huge.  We’re aware of risk.  But, we’re being forced to assume more risk because the alternatives seem so poor.)

Some Thoughts About Strategy

1. Investing based on short-term macro forecasts is virtually impossible to do well on a consistent basis.

2. You have to ask whether you expect prosperity or not.  Marks thinks we won’t see a return to the prosperity of pre-crisis years.

3. You must decide which of the two main risks should concern you more: the risk of losing money or the risk of missing opportunities.  We should worry about loss.  But, with low interest rates, we need to assume some risk.

4. New bad developments could be impactful, but are hopefully not likely.  Asset prices are relatively low and investor psychology is tame (which is a positive).

5. When you have slow growth, potential serious problems and great uncertainty, that usually calls for (a) more fixed income than equities; (b) more pursuit of value today than growth tomorrow; and (c) more safe investment and less use of leverage.

6. Marks thinks you should invest in well-priced corporate securities and income-producing assets.  Corporations still have the best chance of adjusting to environmental phenomena such as inflation, dislocation and competition.  Corporate bonds even survived the Great Depression.

7. The tremendous flight to safety means that this safety may be illusory.  (In other words, buying ten-year Treasuries may not prove to be all that safe.)

Have a great week.

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