The Challenge

Howard Marks, the accomplished investors and author of the Most Important Thing, has recently published a memo called – There they go again…again.

The memo isn’t meant to serve as a predictive forecast, rather it is an assessment of present state of affairs on the stock market. Like a pendulum, the markets gyrate between the extremes of fear induced panic, when investors rush for exit to avoid further losses, and irrational exuberance, when investors pile in more money in pursuit of ever diminishing returns whilst assuming ever greater risks in fear of missing out.

Whilst making predictions about markets is a very difficult task, especially if it concerns the future, an intelligent investor should be able to assess where on the continuum of two extremes the market presently finds itself.

Here are my key takeaways from Mr Marks’ memo that caught my attention:

  1. Easy money is this cycle has already been made: With SP500 at record levels in the US and markets generally high across the world, further re-rating of PE ratios leading to ever increasing multiples is unlikely. The additional returns will have to come from profit growth, further compression of interest rates (unlikely) or additional risks that investors need to carry (riskier investments, higher leverage – both dangerous). 10 years ago in the midst of financial crisis, investors were able to get high prospective returns for low risk – risk free treasuries were yielding 6% and stocks were cheap with high prospective yields. Neither of these statements n holds true today.
  2. Risk free rate, the anchor for returns on all other assets, is set very low: As Buffett has said many times, interest rates act like a gravity on stock market prices. Investors have a choice to put money in bonds or shares and decide based on prospective yields. Current treasury bonds yield low single digit and in Europe government bond yields are negative. For investors who require returns (pension funds, insurance companies, retirees) the stock market is the only viable alternative. As Mr Buffett repeated in Feb ’17 if present interest rates remain the same for the next 5-10 years, current stock market prices are cheap. As Fed gradually normalizes the interest rates, and other central banks are compelled to follow the suit, the “anchor” for stock market returns may reset higher, thus pulling prices of stocks lower
  3. Asset prices are high across the board: With exception of few companies that are experiencing secular challenges, nothing can be demonstrably bought for significant discount to its intrinsic value. One can only look for things that are less overpriced than others, however this is no sure way to riches. To take this point further, the prospective returns on stocks and bonds are correspondingly very low. Shiller adjusted PE ratio is at 25 (implying 4%-6% stock yield) and bond yields are close to zero.
  4. Pro-risk behavior is commonplace: Shares of hot internet stocks FANG (Facebook, Amazon, Google, Netflix) are hitting record highs with ever more emphasis on future earnings rather than today’s reality, banks stock prices reflect record low loan default rates, emerging markets command hefty valuations as if the trajectory of their growth will be ever so smooth and upward sloping.
  5. Uncertainties prevail: The world economic imbalances remain, high levels of consumer and government debt in developed and developing countries, savings glut with lot of money chasing few ideas, imbalances of payments, and numerous geo-political risks. The market volatility as measured by VIX gauge is at record low.
    Whilst investors should generally not make investment decisions based on macro factors and instead focus on individual companies, the fact that Mr Buffett and other great investors aren’t adding to their portfolios and instead hoarding cash is a telling signs of their assessment about the number of opportunities that exist in today’s market.

My personal take is on Mr Marks memo is that on the pendulum scale, with 1 being extreme fear and 10 being irrational exuberance, we’re today at around 7-8. Certainly a time for caution and eschewing of further risk.