June 21, 2019
By Steve Blumenthal

“A lot of investors feel it isn’t hard, they just don’t know how. Because the more you think this is easy,
the more you persuade yourself that you can take the heat. And then, the sooner the oven gets hot,
the more shocked you are and the worse you get burned. After 50 years in the investment business I still haven’t got it all clear.
And that’s okay, because I understand that I haven’t got it figured out. In a hundred years, I won’t have it all figured out.

Understanding that we do not know the future is such a simple statement, but it’s so important.
Investors do better where risk management is a conscious part of the process.
Maximizing return is a strategy that makes sense only in very specific circumstances.
In general, survival is the only road to riches. You should try to maximize return only if losses would not
threaten your survival and if you have a compelling future need for the extra gains you might earn.”

– Peter L. Bernstein

Over the last five weeks I’ve shared my Mauldin Economics Strategic Investment Conference (SIC) notes with you. Last week highlighted Dr. Mike Roizen, Jim Mellon and Patrick Cox. As a side note, I’m back on baby aspirin and CQ10 and eating more salmon with an added focus on yoga, meditation and time in the gym. “Looking good, Billy Ray.” (Louis Winthorpe III in Trading Places.) “Feeling good, Louis.”

The plan was to wrap up the conference series this week but one more week is needed. Today we are going to focus in on the conversation between Howard Marks and Mark Yusko. Next week, we’ll close, appropriately, with perhaps the most pressing issue of our time, the debt challenges we face globally. Howard Marks, Carmen Reinhart, Bill White and John Mauldin (moderated by Cullum Clark from the George W. Bush Institute) staged the final session: “Generation-Changing Global Debt: The Unintended Consequences.” I’ll then do my best to provide some concluding thoughts and share a few ideas with you from the conference.

Months ago, Mauldin called with excitement in his voice, “Howard Marks is going to speak at my conference.” That was really good news. Years ago I ran a leveraged fund of hedge funds. Marks made us a lot of money. And I’ve followed his writings since. They’re called “Memos from Howard Marks.” You can find all of them here. If you don’t know Howard Marks, you’ll get to know him through his writing and his insights and, I believe, will help you to be a better investor.

Howard Marks, CFA is Co-Chairman of Oaktree Capital, the firm he founded in 1995. From 1985 until 1995, Howard led the groups at The TCW Group, Inc. that were responsible for investments in distressed debt, high yield bonds and convertible securities. He was also Chief Investment Officer for domestic fixed income at TCW. Marks holds a Bachelor of Science degree in economics cum laude from the Wharton School of the University of Pennsylvania and an MBA in accounting and marketing from the Booth School of Business of the University of Chicago.

The Marks-Yusko discussion didn’t disappoint. Howard talked about probabilities and thinking about investing like tickets in a fish bowl (explained below), about diversification and opportunities he is seeing ahead. He talked about the Fed, debt and central bankers and added that we just don’t yet know how this is going to play out. Yusko asked, [I]f QE is the new normal, how does that change the world order that we live in?” Marks answered, “I could be wrong, but I suspect that it can’t work. I can’t tell you exactly why, you know, but I just believe that cyclicality is normal, even if fundamental events go on positive forever, psychology will eventually take us to a position of excess which will then correct.”

I began today’s piece with a quote from the late great Peter L. Bernstein because listening to Marks reminded me of Bernstein. The great investors are humble, emotionally level-headed and well-versed in human behavior. Peter was an American financial historian, economist and educator whose refinement of the efficient market hypothesis made him one of the country’s best-known authorities in teaching investment economics to the general public. Bernstein authored one of my favorite books, Against the Gods: The Remarkable Story of Risk.

Bernstein said, “The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions. Once you’ve been right for long enough, you don’t even consider reducing your winning positions. They feel so good, you can’t even face that. As incredible as it sounds, that makes you comfortable with not being diversified. So, in many ways, it’s better not to be so right. That’s what diversification is for. It’s an explicit recognition of ignorance.”

This past week has been remarkable. Draghi and Powell essentially said, “We are here for ya and a China trade war tweet (or two) was music to the market’s ears.” The Federal Reserve left rates unchanged, but signaled a cut in July and perhaps a second one later this year. Everything rallied, stocks, bonds and gold. The market closed at new high yesterday. The U.S. 10-year yield is 2%.

The following is from the WSJ’s The Daily Shot, “The market is now pricing in a 70% probability of three or more rate cuts this year (with two cuts a near certainty).”  Note the change in probabilities since May. Wow!  Someone is a happy tweeter.

The stock market ride over the last year has been bumpy. Down 20% in Q4…until the Powell Pivot. Today, we are attempting to break out to a new high. It looks like this:

Through last Friday, June 14, 2019, the market stats look like this (trailing 1-year numbers – green arrows). Note how bonds have outperformed (not listed is long-term Treasury Bond performance. As a proxy, good friend Dr. Lacy Hunt’s Wasatch-Hoisington U.S. Treasury Fund is up approximately 13.18% over the trailing 1-year):

On your mind as well as mine is this pressing question: With the Fed and global central bankers back in “whatever it takes” mode, will this continue? Which brings us back to Howard Marks and his conversation with Mark Yusko. I do hope you enjoy this week’s post and notes shared over the past several weeks.

Next week we’ll conclude the OMR Mauldin series by highlighting the Howard Marks, Carmen Reinhart, Bill White and John Mauldin closing presentation. There were a number of great ideas gleaned from the conference. I’ll try to pull the entirety of the conference together in short summary and I’ll suggest a few ideas around how to invest in the period ahead.

Grab that coffee and find a peaceful place to sit down. The edited transcript from the Marks-Yusko session follows.

If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.

Included in this week’s On My Radar:

• Mauldin SIC 2019 – Marks-Yusko Discussion
• Trade Signals – The Beat Goes On (Equity, HY, FI and Gold Trends Remain Bullish)
• Personal Note

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Mauldin SIC 2019 – Marks-Yusko Discussion

Above, I gave you some background information on Howard Marks but I must add that prior to their one-on-one discussion, Mark Yusko presented brilliantly. I’ll see if I can consolidate his outlook in a short summary tied into next week’s conclusion piece. Here is a bit on Mark if you don’t know him. Mark is the founder, CEO and Chief Investment Officer of Morgan Creek Capital Management. Prior to establishing Morgan Creek, Mark was president, Chief Investment Officer and founder of UNC Management Company, the endowment investment office for the University of North Carolina at Chapel Hill, from 1998 to 2004. (OK, he’s a smart guy.)

(Note: The bold emphasis in the edited transcript below is mine.)

Mark began the interview by sharing just how nervous he was to interview his mentor of many years. Mark commented on Howard’s new book, Mastering the Market Cycle: Getting the Odds on Your Side and said it is the single best investment book he has ever read.

QE Forever and High Debt?

MARK: We are in a low interest rate world for longer than people expected, and if QE is the new normal, how does that change the world order that we live in?

HOWARD: First of all, I’m not an economist and I am very proud of that, but when I think about how economies and economics and systems work, I think it is very important to understand that there is no schematic. It is not like electrical engineering and things do not always work the way they are supposed to, so in many cases we do not know:

• So if you look at something like this idea of QE forever, and the question of whether continuous QE can produce continuous prosperity without a recession, you know you have to say, I do not know, and if you think about it, if you start a sentence with I could be wrong, you never get in trouble.
• So what I say is, I could be wrong, but I suspect that it can’t work. I can’t tell you exactly why, but I just believe that cyclicality is normal even if fundamental events go on positive forever, psychology will eventually take us to a position of excess which will then correct.
• And so, you know my bias is that it can’t work.

MARK: Speaking of excesses, the institutions that I have worked for have made a lot of money investing with you over the years. You and your team are really experts in the area of leveraged companies and it appears, I could be wrong, but it appears that we have a problem with leveraged loans, can you comment on that a little bit?

HOWARD: In Las Vegas, when you’re playing blackjack which I do on rare occasion for small stakes, the pit boss wanders over and he says remember the more you bet the more you win when you win. And you cannot argue with that.

• So it is the same with leverage. The more leverage you have, the higher your return on your equity capital. When you’re successful.
• Now what they both leave out is the more you lose when you lose and the truth is that more leverage enhances the returns while things go well, enhances the losses when things go badly and increases the probability of losses in tough times…
• But that’s where we are and the desire to make more when things go well is always with us and distorts behavior. So the longer things go well the more companies and countries and systems will lever up and of course the longer things go well, all things being equal, the closer we are to things going poorly. (SB here: I find myself reflecting back on Peter L. Bernstein’s intro quote above)

MARK: The Minsky moment.

HOWARD: But people don’t feel that way. Now, second in this cycle, in this 10 years of positive environment, what has been the dominant characteristic of the financial world, low interest rates.

• And these are the lowest interest rates that many of us have ever seen. I have a thing on the wall in my office because back in ‘82, I had a bank loan outstanding it floated at three quarters over prime, you remember prime.
• I got a slip each time the rate changed then I kept one from 1982, it said the rate on my loan is now 22.75% and you know a few years ago I was able to borrow some money at 2.75% so we have the lowest rates ever seen and declining interest rates over the last 30-years have been a great tailwind for every activity and so this has, but the lowness of interest rates I mean you know used to be back in 1967, all the money I had in the world, that wasn’t at Oaktree was in treasuries 1-, 2-, 3-, 4-, 5-, and 6-year treasuries. We call that a ladder, it is the dumbest form of investing known to man, and I was making 6.5% a year, and I was perfectly happy. Today, I cannot invest in that because it pays 2.5%
• So everybody has been forced out the risk curve in order to get the adequate returns in a low return world and that will have consequences someday.
• A lot of money has flowed to leverage loans in part because everybody said well the one thing I’m sure of is that interest rates will go up and of course recent events show how unanimity can be wrong.

MARK: Yes, usually it is.

HOWARD: But also I like leverage loans because there is no interest rate risk and I like being at the top of the capital structure, and of course CLOs have come back.

• Back in ‘09, what you would have said we will never see another CLO and now they are back and flourishing, so there is very strong demand for leverage loans.
• In September I published a memo entitled the Seven Worst Words In The World which are “too much money chasing too few deals” and what happens when there’s too much money in the investors hands and there are too eager to put it to work, then prices go up, prospective returns go down, risk goes up.

MARK: Can you repeat that last line.

HOWARD: And risk goes up.

MARK: About prospective returns, but I think that’s what gets lost in our business is current returns do what to prospective returns?

HOWARD: Well what Mark wants me to say is that everybody likes appreciation.

MARK: Exactly.

HOWARD: Appreciation is another word for everything becoming more expensive.

MARK: Right.

HOWARD: The other side of that coin is that the prospective (future) return from that activity has declined and the risk has gone up.

• Every endeavor, every company, every property, etc., will produce a certain amount of profit over its lifetime, it is not exactly fixed, but a quantum of profit. The amount that has been realized to date subtracts from the amount that is remaining. That’s the way I think.

MARK: That is perfect. So the human species wants to persevere and survive, so why is it that we see corporations taking levels of risk where there is a nonzero probability of death.

HOWARD: Well, because we all do things that have nonzero probabilities of death, we all drive every day, do ever think of what keeps the oncoming traffic in its lane?

• I mean you know we all do things, but in addition, number one, it becomes popular.
• It becomes popular in corporate circles to lever up, they think about levering the return on equity, so everybody is doing it.

(MARK added: Everybody is doing it.)

• And it becomes popular to do stock buybacks and the management is not immune to the fact that the more of those things they do to the extent that they work the more the executives will get paid.
• MARK: Remuneration and incentives. HOWARD: Remuneration.
• You know back in 1992, I think Forbes had a special issue on compensation and they quoted an experienced corporate director as saying. I have given up on trying to get people to do what I tell him to do. They do what I pay them to do and so you know if you say to the CEO, we are going to pay you, if the EPS goes, then you’ll get EPS increasing behavior. [SB here again: remember this point as corporations have been the dominant buyer of equities. And their debt levels have sky rocketed. Just how much more can they borrow and buy?]

MARK: Magic.

HOWARD: Yes, and then frankly there is always the possibility that if you have a company that doesn’t lever or levers less than its peers, they will come under attack from activists, you know who will say this management is underachieving and we got to get rid of them and they will be able to extract some greenmail.

On Moral Hazard

MARK: Alright, so let’s do a quick one on this whole construct of should we bail out irresponsible borrowers, student loan forgiveness, maybe we should have forgiveness for you know PepsiCo because they produce a nice product that we all love and maybe they should get their debt forgiven.

HOWARD: Sure, well or there is some guy who ran for President on the ticket that we don’t have to repay the debt. Obviously, sometimes we do that, because we are leery of the consequences of enforcing the debt, as may happen with student loans someday, but in general it’s a bad idea. MARK: Bad idea.

HOWARD: Because it introduces something called moral hazard, which is the belief on the part of the doers that you can do really risky things, the riskier the things you do, for example, the more leverage you put on, the more money you make when things go well, and if things go badly you will get bailed out, so you don’t have to worry

• So that induces risky behavior, which is rational from the standpoint of the doer, but bad for society when it is aggregated.

MARK: So one of the things I really admire about you personally and about Oaktree in particular is the incredible discipline you guys show in your process of investing in distressed debt and in your personal life, I mean you look as good as the day I met you 30 years ago.

HOWARD: Thank you.

MARK: It’s truly amazing, but there seems to be no distress that anybody perceives, so what does a distress debt manager do, when there is no distress?

HOWARD: Well, first of all, there’s distress outside the US?

• So we have been very active in buying NPL (“Non-Performing Loans) portfolios from European banks and we are increasingly active in buying NPL’s in China, for example, and it is the one place in the world where there is a high and rising amount of nonperforming loans, but the other thing you should do as you know is you should reduce your money under management.

MARK: What a novel concept that is.

HOWARD: You know there is something called the 13D report what I learned this week and they always start with a bunch of interesting quotes and about couple of years ago, they had something that they said was a Russian saying, “you can’t drive straight on a crooked road.”

• Investment managers live on a crooked road. How can you possibly have for example, straight-line growth of assets under management? Aren’t there better and worse times in your asset class to have money so should you have more money sometimes and less money the other times and one of the things we are proudest of along the lines of discipline is that we’ve lived, we started our first distress debt fund in 1988, so 31 years ago and we’ve lived through 3-1/2 major cycles over that period of time, and in each cycle, our best-performing fund was our biggest fund and the next funds which could have been much bigger on the strength of those results instead was smaller, because we concluded that the appreciation that had taken place diminished the remaining opportunities.
• Makes sense to me, but you know, when we reduce our assets under management, we reduce our management fee income and I think that to do a great job as an investor, you have to be willing to live with reduced income from time to time.

Mastering the Market Cycle: Getting the Odds on Your Side

MARK: Alright, you used the word cycles a number of times which is the perfect segue. You have written this amazing book and if anyone hasn’t read it, you need to read it this weekend. One of the best investment books. And I was very privileged, again one of the happiest days in the past couple of months when I got a first edition copy from you in the mail, I appreciate that very much.

• So when we talk about cycles, it appears that the old Templeton you know, the four most dangerous words, “it’s different this time,” is it possible that something in this cycle is different?

HOWARD: Yeah, well, I am working on my current memo and that happens, you didn’t know this, but that’s the title, you are prescient.

MARK: Great. I love it.

HOWARD: And those are four of the most dangerous words in the investment business, it’s different this time. [SB here: You can find Howard’s “This Time is Different” memo here.]

• In other words, things aren’t going to work in the future like they worked in the past, valuation norms which applied in the past don’t apply anymore, because it’s different this time and usually it’s not and usually the things that people claim are different are optimistic (from an optimistic mind set), right, they rarely say that we’re going to hell and they are used to rationalize risky behavior at what in the past would have been risky times, but now we say well it’s not risky because it’s different at this time They used to rationalize valuation levels, which in the past were peak valuation levels.
• And so I dredged up the Templeton quote for that memo, and he went on to say 20% of the time it is different.

MARK: Oh, little known fact.

HOWARD: Little-known fact, and of course sometimes it is different.

• If you go back to 1999, what did people say, why did we have the bubble and crash of 1999, 2000 and the answer was because people said it’s different this time, the internet is going to change the world, and consequently if you buy Internet or e-commerce stocks, you are going to get rich.
• Well it did change the world and the stocks all became worthless or almost all stocks became worthless.
• So you know I think it’s important to recognize that sometimes the world does change.
• What I am writing about is there are all these theories, interest rates will stay low forever. QE forever will work, we’ll never have a recession.

MARK: We are all becoming Australia.

HOWARD: We were all becoming Australia a year and half ago, I started to get emails saying Australia has not had a recession in 26 years, maybe we won’t, right after the Trump tax bill was passed. Now Australia is up to 28 years and now of course we have the modern monetary theory,

• which says that debt and deficits don’t matter so there is no reason for a government not to run deficits and borrow as much money as they can and spend as much money as will make people happy or so a cynic might say spend as much as money as will buy votes.

MARK: My Portuguese is really bad, but my guess is that same phrase would’ve been spoken in Portuguese in the 1600s and then it would have been spoken in Spanish. My Spanish is really bad too, which my eight year old reminds me of all the time and they would have said it in the 1700s and then the UK, my English is actually okay they said that the 1800s and the early 1900s, and now we say it in the US, and that part of the cycle is not going to change in my opinion.

HOWARD: Well, you could be right. I was in backstage listening to Carmen Reinhart speak and you know this business about modern monetary theory, take for example an assumption that somebody gave you a credit card with an infinite line of credit, so that means you can buy everything you could imagine wanting and you never run out of room on your credit card and well you say but just imagine how high the interest would be, well you can put the interest on the credit card, you never have to worry about paying the interest, so there really is no limit, debt and deficits don’t matter.

• And the question is, is there something wrong with that assumption and I’m confident the answer is we will find out.

MARK: Is there a time in every cycle that is more important than other times in the cycle?

HOWARD: Well the easy answer is ‘the extremes,’ you know I assume that you are talking about the market cycle. MARK: Yes, the market cycle.

HOWARD: So you know, obviously, when I was little my mother said buy low, sell high… but the cycle induces people to buy high sell low.

• So the error introduced by cycles, which is to get excited and buy at the top and depressed and sell at the bottom is also of course the profit opportunity if you do the opposite.
• So these are very important and my son, who manages our family investments and I were talking about the book as I was writing it and I said to him you know I really think that my major cyclical calls have been correct over my career. He says, yeah dad, that’s because you did it five times in 50 years.
• It’s true, it is true and think about it, the market goes like this and you know when you are near the intrinsic value or at the midpoint or the norm or whatever you want to call it, the probability, the logic behind your directional calls is weak and the probability of being correct is low.
• But at the great extremes of 2000 or ‘02 or ‘08 when you are at the extremes, the logic is compelling, and the probability of success is high. They just don’t come along that often.

MARK: Well it seems to me, when you are talking about probabilities it is probabilities and possibilities and it is always possible something bad could happen or good could happen, but it is probable at these extremes that the other thing is going to happen.

HOWARD: That’s why the subtitle, I’m not crazy about the title of the book mastering the market cycle, which was my publisher’s idea, they said if you make that title you will sell more books. People will think they are going to get rich, but I liked the subtitle, which is getting the odds on your side.

MARK: So that’s my next question. So getting the odds on your side to me sounds like probabilities and possibilities.

HOWARD: Yes, right.

MARK: And managing different points in the cycle, so I will infer that in a non-extreme making big bets is ill-advised because the odds aren’t on your side right.

HOWARD: Exactly, yeah.

MARK: I read the book.

A Bowl Full of Tickets

HOWARD: Well what I say in the book and what works for me you know we all have ways of thinking about things that work for us and others that don’t. What I say in the book is that investment performance is like a lottery because we never know what it is going to be.

• There is no sure thing and there’s a bowl full of tickets and the tickets are all the future possible outcomes and fate or something some people say that it’s very determinable because it’s logical and mechanical, and other people think it’s completely random, but fate or something is going to reach in the bowl and pull out one ticket, now that ticket may be the performance of GDP next year, the performance of the company’s earnings or the performance of the stock market or a given stock.
• They are going to pull out one ticket, one outcome, which becomes the actual outcome from the many outcomes and nobody should think that there is only one ticket in the bowl, you know.

MARK: Really important point.

HOWARD: Yeah, really important point, when I was little my dad used to tell the story about the inveterate gambler who went to the track every week and lost all his money and finally he heard about a race with one horse, so he went out to the track and he put all his money on that horse and halfway around the track, the horse jumped over the fence and ran away.

• The point is, there really are no sure things in life.
• Now if all performance, if all the future, is one ticket drawn from a bowl full of tickets, does that mean we can’t know anything about the future as investors and the answer is no, it doesn’t mean that because sometimes there are more winning tickets in the bowl than losing tickets, sometimes they’re more losing tickets in the bowl than winners and an exceptional investor is someone who has an above average awareness of the tickets in the bowl, even he doesn’t know what the outcome is going to be
• But the great investors that I know, know when they have a bowl full of winning tickets and not losers, you have one stock, and you know that if there’s a 90% chance it will go up but a 10% chance it will go down and if it goes up, it could go up five times, but if goes down, it could go down 30%. That’s a great investment opportunity.
• You still don’t know what the future holds, but that is highly investable and you should invest more, so the point is to bring it back to your question, you should invest more when the tickets in the bowl are in your favor. You should invest less when they are against your favor and what determines the mix of the tickets in the bowl largely where we stand in the cycle.

“We diversify and we hedge.”

MARK: Now it is exactly what I showed in the quote earlier from Stan Druckenmiller (from Mark’s presentation), which is look, when you get that edge, when you have a better awareness and I love your word awareness, when you have a greater awareness of the probabilities in the distribution in the bowl that’s when you should be a pig. But you share with me that you were there down in my neck of the woods for the game, this year UNC vs. Duke (When Zion’s Nike shoe blew out).

• Talk about the shoe, the event, the unknowable, improbable, but nonzero event that shakes up everything. So when you think, you can’t know what the future will be and you think you have the odds in you, but then this really crazy outcome happens. Talk about that.

HOWARD: Well look when I write about risk, I usually write about my good friend Bruce Newberg out in California. He and I like to play cards and backgammon, and we play a million hours and our hourly rate returns probably about $0.10, but we love it and if anybody here played backgammon, it is a game based on throwing the dice and we know with the dice we know what the outcomes are likely to be with two dice, there are 36 possible outcomes, one of them is 1 1 or 2, one of them is 6 6, or 12 and then in between they become more likely, and the most likely outcome is 7, which is 6 1 1 6 5 2 2 5 4 3 3 4 there are six possible ways to get seven and there are five possible ways to get six and five possible ways to get eight and etc.

• So we know exactly what the odds are, and we bet in backgammon based on what the odds are, when the odds are in our favor, we increase our bet and if the other guy offers to increase the bet when the odds are against us, we drop out.
• But as Bruce says, there are probabilities and then there are outcomes. So sometimes you increase your bet because the number you need is highly likely and you don’t get it. And sometimes you are willing to increase the bet because the number that the opponent needs is highly unlikely, and sometimes he gets it.
• So Bruce says, there’s a difference between probabilities and outcomes and probable events fail to happen all the time and improbable events happen all the time so we should not assume that a high probability guarantees success, and the greatest thing I ever heard anybody say about probabilities was a Super Bowl morning, I think it was three years ago when the nugget the Denver Broncos played the Carolina, right and they had a guy an ex-football player, you would not think that he was a Rhodes scholar on TV that morning and they said well who would you think is going to win, he said 8/10 Carolina wins, this could be one of the two, that’s a profound understanding of probability.
• Because if you meet the man on the street and you say you know Carolina is 80% likely to win, would you like to place a bet on the Broncos he would say you are crazy, they are not going to win, 80% is over-come-able, and by the way, that’s not what it means and it means 20% of the time if it’s accurate the Broncos are going to win and they did and back in November 2016 we had an event that was predicted to be 80 or 90% likely that Hillary Clinton would win.
• And she lost, so improbable things happen all the time and we have to allow for that.

MARK: So backstage we were talking about the Zion shoe event and we were talking about tales, right? Most of us live our life in the middle of the bell curve, we think probabilistically everything is going to be beautiful and wonderful like that that bell curve, but these extreme events, a shoe blowing out, so instead of the left tail we call it the left shoe event, talk how you manage those events in investing.

HOWARD: Well, number one, we diversify.

MARK: Okay great.

HOWARD: You went to University of Chicago.

MARK: I did.

HOWARD: And one of the things we learned that at Chicago is that people are risk-averse and in my class which was different from your class, they said how do we know that people are risk-averse. What proof is there they are risk-averse and they said very simple, nobody has a one asset portfolio.

• Every stock market investor has one favorite stock. Nobody owns one stock, why not, because they are risk-averse, they understand that the things they think will happen may not happen. So that’s one example.

HOWARD: We diversify and we hedge, which is another form of diversifying and sometimes we reduce our risk when we are more uncertain, etc. so the point is you know Mark Twain is supposed to have said, “It ain’t what you don’t know that gets you into trouble, it is what you know for certain that just ain’t true.”

• And it’s true. Like I said before, nobody who starts a sentence with, I am not sure, ever got the trouble and if you diversify your portfolio, your bad days will not be as bad as if you don’t diversify.

MARK: So, one other thing I think is interesting is human being investors seem to do the opposite. As things become more uncertain, they tend to get more confident, why you think that is.

HOWARD: Well because, the things that make things more uncertain, for example, appreciation and the higher the market becomes in its cycle, the less likely it is to continue up and the more likely it is to turn down.

• This is what the book is mostly about so I recommend you buy several copies, but the better things go for longer, the more excited people become and the less they think that it will ever not be good.
• Which is exactly the time that it’s likely to become less good.

MARK: I have admired your discipline in so many ways and it has been a real model for me to try to seek that level of discipline in my life both in investing and other things and philanthropy all things you have done, how do you focus on doing the right thing when things get so extreme…

• Everyone telling you, you are stupid and everyone else is doing it, you know how do you stay true to the right thing to discipline?
• How do you be discipline in an undisciplined world?

HOWARD: Well, I think Mark that analytically, at the extremes it is clear what to do.

• The enemy of correctly applying an analytical approach is emotion and if it’s not your emotion, it is the emotion of others of the emotional of weight that people put on you by saying everybody else is doing it.
• You know Dave Swenson in his book on endowment management, pioneering portfolio management had a great statement. One of my favorite quotes in the investment world, which is that “investment management requires the adaption of uncomfortably idiosyncratic positions.”
• You know, if you are going to be an exceptional investor, clearly you have to do something different from what everybody else is doing, but behaving differently is by definition uncomfortable.
• Now, hopefully your intellect permits you to do it, but it’s uncomfortable, and the other thing is you have to have your emotions under control.
• Emotion is the enemy of doing the right thing. Emotion is the thing that makes us excited and buying at the top and depressed and selling at the bottom.
• So every great investor I know, and I assume you know is unemotional.

MARK: Right.

HOWARD: The main question I get at this point in the proceedings is well how do you become unemotional, and it’s very tough.

MARK: Go to University of Chicago, they suck it right out of you.

HOWARD: It helps yeah, but you know I think that some people are inherently unemotional and some people are inherently emotional, I mean, you know investing is a good field for people who have Asperger’s syndrome.

• I say in the book by the way that being unemotional is very good in investing, less so in other forms of endeavor such as marriage. But still I think it’s very important to either be unemotional or have your emotions under control.

MARK: I just have one quick funny story and that’s my wife and I were playing this game, Outburst, where you get a topic and you have to say things it was guys versus girls, my wife and daughter versus my son and I and we got emotions. We went happy, sad, happy, and my wife and daughter just cracking up laughing, what else is there, there was jealously, ennui, and there was a list off 15. Oh, those are emotions, okay.

• One of the things that I really admire about Oaktree is that we were investors day one when you left TCW and had this great long-term relationship, you guys are value, right, you buy things when they’re on sale, you do all things that value investors always do and the greatest investors of all time I believe follow that value, discipline.
• What do you do when it’s so out of favor?
• How do you stick to value and what you know?

HOWARD: Well, that’s why you have to have your emotions under control because you have to be willing to be inactive when other people are active.

• You know Buffet says you know that investing is a great business. It’s kind of like baseball, but in baseball you know you can let pitches go until you get a good one. The trouble is, if you let three good ones go you strike out.
• In investing, short of losing your job or your clients there’s no such thing as striking out. You can let all the pitches go until you get one that you really like.
• But you have to have the discipline. You cannot say well I let ten go, and the fans are starting to boo and you know I’m not going to be a crowd favorite, so I have to swing at the next pitch regardless of what it is.
• Clearly that would be one of the worst things you could ever do.

MARK: So, you just mentioned inaction, there is a question in the audience about the option value of cash and back to this idea of value. I will argue that today cash has the highest option value it has had maybe in a decade.

• How do you view the option value of cash?

HOWARD: Well, it is great. The only thing is that you know you can’t do anything based merely on the merits, which is to say cash yes cash if you have cash rather than being invested, you have optionality so that if the world goes to hell, you can put your money at work.

• That’s a good thing, but that’s not enough.
• You have to say, well what’s the probability that the world goes to hell and number two, what’s the probability that if the world goes to hell I’m going to have the guts to put the money to work.

MARK: Ah, really important.

HOWARD: It is really important. I think that the way to succeed, especially in investing, but in many forms of endeavor, you have to look at the world probabilistically and you know we don’t have any cash right now other than in our distress debt fund, which is a standby fund.

MARK: Right standby fund.

HOWARD: I’m afraid to be invested in this market and I’m afraid to not be invested. So my solution is for the last few years we have been operating under a mantra, which I developed, which is move forward but with caution. We are investing. We are mostly fully invested, but with caution and since we are a cautious firm, that means to me more cautious than usual.

• And we have the highest standards today, probably that we have ever had, but we are fully invested and people will say, but that’s a contradiction in terms, and I would say that over the last eight years, starting with when the US was downgraded, US debt was downgraded, there have been occasions when you could rationalize raising cash.
  • You know August of ‘11, January of ‘16, December of ‘18 and it would have been a mistake.
  • So the trouble with cash is it is binary, right or wrong. If you raise cash and get out of the market, there is no such thing as being a little wrong. Right? And so we almost never would raise cash.

MARK: I feel like we made a little history right now, so you all heard the Gordon Gecko line of greed for lack of a better term is good ladies and gentleman. Howard Marks says fear ladies and gentleman for lack of better word is good. Fear is good, but inaction is not.

HOWARD: Yeah, and they are not the same. And you know I wrote this memo back in 2015 called “Dare to be great.”

MARK: Yes. If you haven’t download it today. [SB here: It was actually in 2014 – you can find it here.] I read it once a year religiously, it is literally your best letter ever. It is incredible.

HOWARD: And by the way, they are all available on Oaktreecapital.com and the price is right.

MARK: Price is right

HOWARD: They are free and what ‘dare to be great’ says is that if you want to be a superior investor, of course everybody dares to be great, that is not the question, the question is do you dare to be different, because as Swenson says, in order to outperform other people you have to do something different.

• You dare to be wrong, that is really the key.
• There is nothing given the uncertainty in investing that I describe, there is nothing you can do to be right that does not have some probability of being wrong.

MARK: Amen, and Howard, you are living the life that you describe in it and you are a value investor, you are a distressed debt expert, yet you and Oaktree had just made a huge play into emerging markets, particularly China, that’s awesome. That is uncomfortable, that is different. That is all the things you were just describe and you are doing it, so talk about that.

HOWARD: You asked about the supply of distressed debt in the world, in the US, you know, historically, we have made a lot of money investing in good companies which had the wrong balance sheet because they got too levered up by people who wanted to make more money on the outside and ran into downside.

• So our mantra is good company bad balance sheet. Today, there are no companies, essentially no companies that are good companies with bad balance sheets.
• Today, any company which is in trouble, defaulting or bankrupt, it’s generally because they have a bad business and or a business which is highly uncertain, like retail and some issues in energy.
• So if we want to invest in quality situations, we have to go abroad as I mentioned to you. China is a big pool of NPLs where we hope our expertise will permit us to make money with the risk under control.
• I can’t tell you how it’s going to work out because you know as far as we know China could wake up any day and say no, we are changing the system.

MARK: But you also made big moves in emerging-market equities, which again is not what people think of when I think of Oaktree, but they should because you guys are amazing at it.

HOWARD: Well I think that if you apply a risk-averse, risk controlled approach like we do, I think you can have superior results on average.

• By the way talking about emotion, if you could say well give me one rule to follow as an investor, just one, it would be, do the things that are unpopular.
• Everything else being equal, the things that are popular are overpriced the things that are unpopular are underpriced, and you know I think that emerging-market investing both debt and equity relative to other forms of investing today in this low return world, I think that emerging market investing is relatively unpopular.

MARK: Okay. So one of the things that you talk about that I think is critical is this idea that we do not know the future. So today, this whole room is eager to think about actionable ideas that we can look at today in the world that is as unknowable as maybe we have ever seen, just in terms of the uncertainty and the turmoil and the lack of leadership globally all this kind of stuff, so where do you look to put capital when the future is even less certain than normal.

HOWARD: Well you look out today. First of all, I think of things as being cheap, fair or rich. And today, broadly speaking, there is nothing cheap and if you draw a midline down that range which we will call intrinsic value, there is almost or maybe nothing or virtually nothing that is selling below its intrinsic value.

• So the question is what’s least overpriced. You know what’s the least worst and I think given the fact that we don’t want to be in cash, you have to look for the things that are least worst
• And then you have to say, given the fact that the economic recovery is going to be pretty soon (SB: On July 1, 2019) the longest in history, and the bull market is the longest in history and the world is leveraged and there are all these cosmic things going on that the results of which are unpredictable, then I think you want to you know the great choice in investing in the medium term is do you want to be on offense or defense.
• Do you want to have investments which will do really well if we have prosperity, but (not well) if we don’t or ones that will do relatively well if we don’t have prosperity, but not kill it, if we do.
• And I think you want to bias your portfolio not extremely but somewhat today toward defense and investments that are not prosperity oriented and for the most part fixed income and credit are biased toward un-prosperity because if you are buyer of debt, and I am not talking about distressed debt but if you are bond investor or fixed income investor, if you think about it, you have to understand the existential nature of this investment.
• The return does not come from the market. If you invest in stocks, your return comes from the market. If you buy a stock for 20 and the market decides to value it at 40, you double your money. If it decides in value to 10, you lose half your money…
• But if you buy a bond, the interest, the return does not come from the market, in the short run it might, but in the long run it comes from the issuer. You give them money, they promise you periodic interest and they promise you your money back and if they don’t keep the promise, you get the company, so it’s a contractual rate of return which is not market derived and I think that this is the time to overweight those.

MARK: I love the fact that the number one question is around my socks, so I have the bitcoin socks on today and I made a case for why I think the bitcoin is an important investment long-term and with this idea that it may be different this time and that we may have this massive devaluation on a global basis and excess debt. Do you have any view on bitcoin, do you think it’s viable.

HOWARD: Well, you know I hate to disagree with you.

MARK: It’s okay.

HOWARD: But I do, and you know.

MARK: You told me if you have two people who have the same opinion, one is unnecessary.

HOWARD: That is true and you know back in my memos of I think June and September of ‘17, I came out against bitcoin, and you know as you described me before as a value investor and I don’t think anybody can put in intrinsic value on bitcoin, so for me it is not investable.

• If you invest in bitcoin, what you’re doing is, in my opinion, you are predicting popularity and if you know bitcoin becomes more popular then the price will go up, so that’s that.
• The other thing I want to say is that you know bitcoin and other crypto currencies are a way to hedge against the possibility of a massive devaluation as you say, then you have to say okay, what’s the probability and I put a massive devaluation under the category that I call improbable disasters. If it happened, it would be a disaster, it is not probable.

MARK: It’s a Zion shoe event.

HOWARD: Exactly.

MARK: So probably not going to happen. So if we think about again back to this idea of cycle investing, I think we have to separate debt cycles and equity cycles, so where are we in the debt cycle?

HOWARD: Well, I think that the one thing I know for sure is

• That the game has gone on for a long time.
• It has advanced greatly, it has reached the point where imprudent behavior is taking place in many ways and in most areas of investing today FOMO which is ‘fear of missing out’ has taken over from fear of losing money.
• And when the fear of missing out on gains takes over from the fear of losing money bad things happen.

MARK: Bad things happen.

HOWARD: Yeah people engage in risky behavior which sets the scene for losses. Now the losses will not occur until there is a recession, because the imprudent behavior that has taken place in the debt market has been the issuance of debt that will not be repaid if things get a little worse, but it will not go bad until things get a little worse and nobody can say when that’s going to be, but still when you’re in the late stages of the game and you think the easy money has been made, you should start taking chips off the table and that’s why I say this is the time to have more defense than usual.

MARK: As you mentioned earlier, instead, the average investor is not only not getting more defensive, they are buying the riskiest debt assets and levering them to try to get a return which as you have said probably ends in disaster. We are on our last few seconds and then will transition, how about the equity part of the cycle, are we at a different point or we are just late stage there too?

HOWARD: Well I think similar late stage. The thing that intrigues me and I know you were cautionary on the equity market but the thing that I puzzle about is that the non-cycle adjusted P/E ratio is not very high and so I don’t think on that metric stocks are not in one of the worst bubbles we have ever seen. I still think that the probability of high returns is low and the probability of low returns is high. I don’t think we are setting the stage for some collapse, but I could be wrong.

That concludes the Howard Marks-Mark Yusko conversation. I hope you found it as thoughtful, in depth and poignant as I did.

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Trade Signals – The Beat Goes On (Equity, HY, FI and Gold Trends Remain Bullish)

June 19, 2019
S&P 500 Index — 2,919

Before we jump in to what is “Notable this week” if you are not familiar with Trade Signals, it is a dashboard summary of the overall trends in various markets: Stocks, bonds, gold and we look at the state of the economy and I share with you my favorite monthly “recession watch” charts. Over the years, it has helped me steady my thinking around the major markets trends. For example, I have the fundamental view that the current bubble is in the debt markets. I believe the next recession will provide you and me with an epic buying opportunity. I expect the HY market to decline more than 60% in price. Yet with that view, the last two HY trend buy signals have been very rewarding. My point is “The trend is your friend” and it may help you, like me, stay on the right side of major trends. Also, I share a few different processes, like the “Golden Cross,” which is a trend signal that triggers when the 50-day moving average trend line crosses above (buy) or below (sell) the 200-day moving average. Diversification is the key. Here is the dashboard from the Wednesday, June 19, 2019 Trade Signals post:

Notable this week:

I came across the next chart (data is from 1952 through March 31, 2019) and thought I’d share it with you. It is another measure of market valuation yet with a interesting take vs. P/Es, Price-to-Sales, etc. The data looks at total household equity assets (how much households hold in stocks) and compares that number to disposable personal income. The data box at the bottom (red and green arrows) shows the performance of the S&P 500 Index when household equity assets as a percentage of disposable personal income was high, average or low.

Alan Greenspan coined the term “irrational exuberance” in late 1996. What he was saying is that excessive speculation leads to market peaks and eventually irrational exuberance leads to corrections. How much more firepower does an investor have if they already put most of their money into the stock market. More buyers than sellers drives prices up, more sellers than buyers drives them down. The middle section (red line) plots the Household Equity Assets as a percentage of Disposable Personal Income. The number at the end of last quarter was 147.36%. That’s very high compared to 2007, 2000 and all other periods since 1952.

Historically, a high percentage of individual investor money allocated to equity assets compared to their disposable personal income has been bearish for the stock market (red arrow/yellow highlight lower data box) while a low percentage has been bullish for stocks (green arrow). We sit at the second highest overvalued period in history and higher than just prior to the Great Financial Crisis in 2008. Risk remains elevated.

Source: Ned Davis Research, CMG

With that said, valuation measures may help us understand when to play more defense than offense or when to get more aggressive but they tell us very little about timing. Thus, my obsession with staying with the predominant trend and risk protecting against major set-backs. As you can see in the dashboard (above, if you are in the TS post, or click through on the Trade Signals link provided below and in the Trade Signals section in On My Radar), all trend indicators remain bullish.) The up trend remains the dominant trend.

The up trend in the bond markets remain in place. Favorable buy signals for high quality corporate bonds and long-term Treasury bond funds and ETFs. HY remains in a favorable buy signal. Note that the NDR Daily Trading Sentiment Composite moved to the “Neutral” zone from “Extreme Pessimism.” Thus, a neutral investor sentiment signal through the NDR Crowd Sentiment Poll (weekly) continues to signal “Extreme Pessimism,” which is short-term bullish for equities. The Gold trend signals remain bullish. You’ll also find the latest recession watch charts below. There is a rising risk of recession though no alarm bells are yet ringing.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizon and risk tolerances. 

Click here for this week’s Trade Signals.

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Personal Note

“It ain’t what you don’t know that gets you into trouble, it is what you know for certain that just ain’t true.”

 – Mark Twain

I love that quote.

Golf at Stonewall tomorrow afternoon with a good friend is on the schedule. Susan returns home from France (World Cup) today and I sure do miss her. A cold IPA and stories from France await. This weekend, her son Kieran and several of Susan’s teams compete in a soccer tournament near Wilmington, Delaware. I’ll be watching from my chair with a golf hat and sunglasses on. A conference in Chicago this coming Tuesday then to Boston on Wednesday to play a great course called The Country Club. It is the oldest country club in the US. A bucket list course. To say I’m excited is an understatement.

I’ll be in New York City on July 1 for meetings and hopefully a drink with Art Cashin, Mauldin and a few friends after the closing bell. On July 2, Mauldin and I will be hosting a small accredited investor dinner (details forthcoming). Los Angeles follows in mid-July. Son Kyle is turning 20 on July 14 and is in LA for an internship. 20 years old! The days are long but the years sure go by fast. Believe in others more than they believe in themselves. And then one day you see that they believe. That’s a really good day. I’m looking forward to celebrating with Kyle.

Do something little for someone. It may turn out to be far bigger than you’ll ever know. Ever forward!

Wishing you and your family the very best!

Subscribe to OMR

Best regards,
Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

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If you find the On My Radar weekly research letter helpful, please tell a friend … also note the social media links below.  I often share articles and charts during the week via Twitter and LinkedIn that I feel may be worth your time.  You can follow me on Twitter @SBlumenthalCMG and on LinkedIn.

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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO.  Steve authors a free weekly e-letter entitled, “On My Radar.”  Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

The objective of the letter is to provide our investment advisors clients and professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and client communication.

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You can sign up for weekly updates to AdvisorCentral here.  If you’re looking for the CMG white paper, “Understanding Tactical Investment Strategies,” you can find that here.

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A Note on Investment Process:

From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years.  I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.

My objective is to position in line with the equity and fixed income market’s primary trends.  I believe risk management is paramount in a long-term investment process.  When to hedge, when to become more aggressive, etc.

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