Wall Street legend Howard Marks has commandeered my notebook.
The billionaire founder of Oaktree Capital Management is sketching a graph (see below) that shows how equity market valuations oscillate between very rich and very poor, as investors swing from euphoria to despair.
This rollercoaster provides endless fodder for traders and the media, but it also demonstrates how regularly valuations move away from fair value.
“Most people want to know where the market is at a given point in time. Is it rich? Is it cheap? But that leads to too much short-term thinking and hyperactivity for naught,” Marks says.
Mr Market, he says, is a manic depressive – and investors shouldn’t get caught in the same trap.
So, forget trying to pinpoint when the Federal Reserve will cut interest rates. Don’t worry about trying to predict where US employment data will come in on Friday night. It’s the direction of travel that matters, Marks says, not the details.
“Oaktree doesn’t have an economist on staff; we don’t invite economists in for a chat. We just think that figuring out what’s in store in the macro cannot be a source of superior results for us – or for pretty much anybody else,” he says.
Howard Marks’ scribbled graph. Picture: Eamon Gallagher
“The world is an uncertain place. One more piece of data is not going to make you smarter. Attaching importance to one report is really just a mistake.
“The most important thing for most people who have some money to invest is to be in the market on a steady basis – and not screw it up.
“If you get in, get out; get in, get out; get in, get out – you’re unlikely to have a return on all that energy.”
Marks argues that markets are trading in what he calls the “zone of reasonableness”. Yes, equities markets are reasonably expensive, but they’re not at the extremes we saw in the dotcom boom. Yes, money is flooding into private credit, “but it’s not crazy – I’ve seen crazy”.
The US economy is proving relatively resilient, and the Federal Reserve will have room to bring down interest rates as inflation falls. But crucially, Marks expects the Fed funds rate – sitting between 5.25 per cent and 5.5 per cent – will remain above 3 per cent.
History says rates at this level are hardly abnormal. But again, it’s the direction of travel that matters. There will be no retreat to the ultra-low levels that investors got used to following the global financial crisis, and that will cause pain.
So, while Marks says the global equity market rally is evidence that “the optimists have won the tug of war over the last couple of years”, he believes there will be a level of distress that an opportunistic investor such as Oaktree can take advantage of.
“We think that there are still some tough times ahead, primarily for our world,” he says. “There’ll be financing shortfalls, there’ll be defaults, bankruptcies, higher interest costs, all those things.
“We’re not in the easy times any more. We’re in moderate times, normal times.”
Marks is famous in global markets for his public memos to Oaktree clients, which are a unique mix of insight, history and commonsense. He eschews big calls and instead urges investors to stay the course; in many ways, he is the personification of the zone of reasonableness.
He says the story of the second half of the 20th century is one of “the best periods known to man”, where a combination of positive social changes, advances in technology and management techniques, and the advent of globalisation created a tide of growth that lifted all boats.
“But it’s not going to be the same in the first half of the 21st century,” Marks argues.
Most countries are not going to grow as quickly as investors have come to expect, in large part due to the demographic challenges created by ageing populations.
Inflation is likely to remain higher for longer, so a return to a world of declining interest rates, ultra-low interest rates, or both, is unlikely.
Again, this is hardly a cause for panic – it will throw up as many opportunities for investors as it does challenges. But the key is to realise that the environment has changed, and investors must too.
“Einstein is famous for having said that the definition of insanity is doing the same thing over and over and expecting a different result,” Marks says.
“I think another definition of insanity is doing the same thing in a different environment and expecting the same result. The environment we operate and live in is extremely influential, and I believe it’s going to be different than what we saw.”
When Chanticleer asks Marks to comment on the rise and rise of private capital – a huge topic of interest after this week’s AirTrunk deal – he is far more sanguine than commentators who see an irreversible shift in global markets.
“I think reversion to the mean is a very strong force,” he says.
Marks points out that if investors were to lose money in private equity and/or be caught out by a lack of liquidity in this sector, then there could be a renewed preference for public markets.
Similarly, while the boom in private credit – which has grown from about $US250 billion in 2007 to about $US1.5 trillion ($2.24 trillion) today – has been very rapid, the sector remains in its infancy and not immune from problems.
“When something is new – and private lending is still new – and it’s successful for a while, everybody jumps on board, and they can’t imagine how it’s going to turn out to be a problem,” he says.
“So, maybe they do it to excess and without caution – and that’s not a good formula.”
Marks sees opportunities for Oaktree in the explosive growth of private capital. In part, this is a story of the structure of the sector.
“When you do things in private and without liquidity, the swings can be even more volatile, yeah, which gives the opportunist more opportunities.”
But it also reflects the fact that a big chunk of the growth in private credit has taken place against the backdrop of low interest rates and steady economic conditions.
He retains faith in the banking adage that the worst loans are made in the best times.
When loans made between 2015 and 2020 mature in 2026 and 2027, borrowers are likely to find they’re facing much higher rates; Marks says a business that borrowed $US900 million in 2017 at an interest rate of 5 per cent, for example, may find they’re offered $US500 million at 9 per cent this time around.
Oaktree has seen demand for what Marks calls “rescue loans” increase in the last few years, although “with optimism in the majority and money available, the need has declined” more recently.
“But we think it’ll increase again. Some of those loans were too optimistic. Some of them will present problems in the years ahead. That’s our thesis.”
Marks is already working on his next memo – it’s working title is Shall we repeal the laws of economics? – and he’s looking ahead to the US election with more than a touch of trepidation.
“I’m very worried about the election because I have a sneaking suspicion one of them will win,” he jokes.
But he has no plans for retirement. His role at Oaktree now is to think about the big picture, and it’s an intellectual challenge that still excites him.
“It’s fun to win, and it’s also fun to challenge yourself. That’s what investing is.”
The Financial Review is a media partner of Sohn Hearts & Minds.
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