September 20, 2024
By Steve Blumenthal
“Risk is the probability of loss.”
— Howard Marks
I’m a big fan of Howard Marks’s Memos on investing strategies, and I bet you are, too. The investing world has its own vocabulary, and when writing about it, many in the industry often struggle to keep things simple. Not Marks. He writes in a logical, common-sense way that most people can understand––as in this well-known quote of his: “It’s not what you buy; it’s what you pay. And investment success doesn’t come from buying good things, but from buying good things well.” It’s a simple thing to say, though it’s hard for many to do.
Marks focuses on risk management. He says that investors should set investment strategies according to their situations and ask themselves whether they worry more about losing money or missing an opportunity. It is not so trivial.
Marks believes it’s hard to gain an investment advantage through research since so many intelligent people are already doing it; to get an advantage, he says, you have to better infer the consequences implied by current company data, manage the psychology of investing, and assess the present stage of the business and market cycles. He seeks to achieve an average return during a bull market while minimizing losses during bear markets, believing losses do more harm than any benefit investors obtain from gains. Though, gains are important of course.
Here’s another great quote: “Because of the existence of risk, things are going to be different from what we expect from time to time. How well are we prepared to deal when it’s different?” Simple enough, right? But again, it’s not so simple when the “time to time” is happening.
Born in 1946, Marks co-founded Oaktree Capital Management in 1995. Oaktree is now the largest investor in distressed securities worldwide.
Marks’s memos detail his investment strategies and insights into the economy. They’re publicly available to everyone. Even Warren Buffett reads them. “When I see memos from Howard Marks in my mail,” Buffett said, “they’re the first thing I open and read. I always learn something, and that goes double for his book.” Wikipedia. You can find his books on Amazon (I recommend all three) and you can find his latest memo, “Shall We Repeal the Laws of Economics?” on the Oaktree website here. I was also thrilled to see him publish a YouTube video last week titled “How to Think About Risk.” You will find a short summary and a link below.
Grab a coffee and find your favorite chair. Remember, “Investment success doesn’t come from buying good things, but from buying good things well.” Keep this Marks quote top of mind as you view the chart I included on Household Equity Percentage vs. Subsequent 10-year Total Returns. It provides a road map to know when good things are priced well. We’ll briefly look at the housing market courtesy of my good friend Barry Habib, and I will also share my friend Peter Boockvar’s comments on the Fed’s 50 bps rate cut. He weaves in a little Bruce Springsteen. Fun.
On My Radar:
- How to Think About Risk, by Howard Marks
- Household Equity Percentage vs Subsequent Rolling 10-year S&P 500 Index Total Return
- Bullish on the Housing Market
- Personal Note: Mt Joy!
- Trade Signals: Comments On The Fed’s 50 bps Rate Cut
See Important Disclosures at the bottom of this page. Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.
How to Think About Risk, by Howard Marks
Following is a summary of Howard Marks’ perspective on risk in investing and how to think about it effectively. I encourage you to watch the full video here.
Key Takeaways
- Risk is not volatility; “Risk is the probability of loss.”
- Superior investors have a better sense of probability distributions and balance potential gains with risk control.
- Risk management should be continuous, not sporadic; it’s about being prepared for unexpected outcomes.
- Successful investing involves assembling portfolios that produce good returns as expected while resisting declines.
Defining and Measuring Risk
- Risk is the probability of loss, not volatility.
- He believes it is impossible to quantify risk in advance or even in hindsight.
- Multiple forms of risk exist, including missing opportunities and being forced out at market bottoms.
- Risk is counterintuitive and perverse. For example, assets become less risky when prices fall.
Risk-Return Relationship
- Riskier assets don’t necessarily produce higher returns.
- Investments perceived as risky must offer higher potential returns to attract investors.
- As expected returns increase, the range of possible outcomes widens, including worse potential outcomes.
Effective Risk Management
- Marks believes risk is best assessed through subjective judgment by experienced experts.
- Continuous risk management is crucial, not just during perceived “risk-on” or “risk-off” markets.
- Successful risk management balances potential gains with robust risk control.
- Intelligent risk-bearing (like insurance companies) involves taking calculated, well-compensated risks.
Investment Success Factors
- Superior investors have a better grasp of probability distributions.
- Success comes from buying good things well (at good price values).
- Asymmetry in returns (participating in gains while avoiding many losses) is key to superior investing.
Suggestions for investors
- Develop a deeper understanding of probability distributions in investment outcomes.
- Focus on continuous risk management.
- Aim for asymmetry in investment returns through careful risk control and opportunity selection.
Source: Oaktree Capital, Howard Marks
This is not a recommendation to buy or sell any security.
Household Equity Percentage vs Subsequent Rolling 10-year S&P 500 Index Total Return
“Ultimately, markets are the complex social action of human beings. Because of that they are driven by human emotions: fear and greed.”
-Mark Finn
I like the following chart as it frames where we are in an investment cycle. The blue line tracks Equity as a percentage of total household assets––equities, bond and cash (on the left scale). The last reading was on June 30, so there’s a bit of a lag in the data, but it shows that the percentage of household assets in equities is 63.2%. Note that it reached nearly 65% at the top of the Tech bubble in 2000 and again in 2021 before the declines in the equity markets in 2022. It also reached 60% just before the Great Financial Crisis in 2008.
Channeling our inner Howard Marks, this data aims to assess the potential risk vs. return probabilities. Getting the timing exact is almost impossible, but we can use the data to understand better when it might be the best time for, as Marks puts it, “buying good things well.”
To that end, take a look at the dotted orange line next. It plots the subsequent rolling 10-year S&P 500 Index total return. Note how closely the subsequent returns track the blue line. There is a gap between the lines during certain periods; however, over time, they tend to come back together. This is not a guarantee; it is just a logical observation.
The thinking here is that when investor portfolios heavily overweight equities, they are fully invested. Where is the excess cash going to come from to buy more stocks? With more buyers than sellers, prices will go up. The reverse is also true.
But the real value in the chart comes from assessing potential (let’s say probable) future returns. Note the red “we are here” arrow. It points to a projected 10-year annualized return of roughly –2.30%, meaning that an investor in the S&P 500 Index loses that amount yearly. For example, at a –2.3% annualized return, $1,000,000 becomes $811,056. Factor in 2% inflation per year; after 10 years, your original $1,000,000 is $1,195,092. With a –2.3% annualized return, you will be $384,036 in the hole ($1,195,092 minus $811,056) in 10 years.
Comparatively, if you are “buying good things well”–which, let’s say, would be when the Household Equity Percentage declines to 45% instead of its current rate above 60%––you’d be looking at a probable 8% subsequent 10-year annualized total return. In such a case, your $1,000,000 would become $1,999,004. Assuming inflation stays the same at 2% per year, you’d be $803,912 ahead of the inflation in 10 years ($1,999,004 – $1,195,092). The goal is to beat inflation.
The key variables here are (1) the probability of equity market return and (2) inflation. Based on the current debt situation, I don’t think an inflation rate of 2% is the probable outcome; I believe it will be much higher.
I’m waiting for us to reach the green “we’d be better off here” arrow. I believe we’ll get a swing at that pitch, but for now, as Charlie Munger said, the strategy must be “extreme patience combined with extreme decisiveness.”
Simple for Charlie anyway. Most mere mortals are less prepared. The best opportunities come in times of panic. I have no idea when the next time might be, but I’m pretty sure it will come.
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
Bullish on the Housing Market
MBS Highway publishes a daily letter to which I subscribe. Founded by Barry Habib, it is a fun-filled video summary that discusses the economy, real estate, and the mortgage market. I clipped the following from his publication on Monday, September 16, 2024.
In short, the demographic picture is bullish for the housing market. As I shared with you last week, housing is a good asset in the “Inflationary Boom” cycle, which I believe we are in. I think we’re currently on the back end of inflation wave number one. The strength of wave number two will depend on the size and pace of the monetary and fiscal response (QE in the next crisis).
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
Personal Note: Mt Joy
Take a look at the Trade Signals section, which highlights my good friend Peter Boockvar’s thoughts on the Fed rate cut below. Reading Boockvar’s posts has become a bit of an addiction for me. Considering the volume of writing he puts out, I’m honestly not sure when he gets a chance to sleep. His post on the rate cut was very good. I especially appreciated how he wove Bruce Springsteen’s “Blinded by the Light” lyrics into his piece. “Asked him which was the way back home. He said take a right at the light, keep goin’ straight until night, and then boy, you’re on your own,” he quoted. Regarding the Fed, he said, “I feel like that is the situation we’re in now.” Boy, we’re on our own.
Speaking of good music, after the Malvern Prep Friars soccer game this afternoon, Susan and I are attending the Mt. Joy concert. Son Tyler bought three orchestra-level seats at the Mann Music Center in Phila. It’s an outdoor venue, and the weather looks excellent.
Mt. Joy is a five-piece indie rock band based in Los Angeles with roots in Philadelphia, most famous for their 2016 debut single “Astrovan” and the chart-topping “Silver Lining.” If you haven’t heard them before, I highly recommend a listen. I’ll be singing along: “Tell the ones you love you love them.” Amen to that.
I was in Boston for meetings this week—a special hat tip to John and Nancy for hosting me. Two triples and two double bogies crushed my Wednesday afternoon round at Cohasset Golf Club (Donald Ross design built in 1894), but the course, dinner, and company were terrific. Also, a kind thank you to Rob and Jane for hosting me for coffee in their home in Boston. Both the conversation and the view overlooking Boston Harbor were beautiful.
NYC, Boston again, Virginia Beach, and Denver are up next. Travel seems to be back to pre-pandemic form, and to me, it’s nice to connect with people in person.
Kind regards,
Steve
Thoughts around 50 bps Fed cut:
From Peter Boockvar’s morning Boock Report (today, September 19, 2024),
“Well, the one thing that was NOT asked of Fed Chair was anything related to financial conditions. While Powell reiterated his belief that monetary policy is restrictive, and it is for anyone that has too much debt or a loan coming due that was priced pre 2022, and there are notable areas of weakness in the economy, what about the easy financial markets? Chair Powell, was there any discussion within the committee about the record high stock market trading at near a record multiple and the corresponding wealth effect? Or what about very tight credit spreads? Jay, any thoughts on the record high price of gold? What’s that telling us? The Fed ALWAYS has had an asymmetric policy when it comes to financial markets. When conditions tighten up, they want to ease them. When they are easy, let em rip.
What Powell did say that I thought he would was if he was going to cut by 50 bps, he would somewhat walk that back by saying their base case was a 25 bp cadence of cuts from here. And 50 bps would only be used again if the economy really needed it, aka, recession risks were rising.
Also, this will be quite the threading of the needle. In the median economic forecasts, the Fed believes that they can cut interest rates about 200 bps from around 5.375% to a 3.25-3.5% by end of 2025 and that headline PCE will magically fall to 2.1% and to a core rate of 2.3%. If they think that raising rates is supposed to cool inflation, why do they think cutting by 200 bps will further cool them? That said, inflation will continue to calm in the coming months/quarters but we’re setting ourselves up for a 1970’s situation by the back half of 2025 when rents start to rise again, goods pricing likely higher from lower rates, and just as the Fed has gotten comfortable. I’m also bullish and long commodity stocks (said here before and weathering the pullback) believing global central banks are giving them a green light now. (SB here: bold emphasis is mine)
We know life is uncertain and forecasting it is tough, especially about the future, and certainly when it comes to the economy and markets but I have little feel, and I don’t think the Federal Reserve/Jay Powell do themselves on how this all plays out from here in terms of the mix of economic activity, the labor market, where inflation sustainably levels out at and where they will eventual take the fed funds rate and its balance sheet. It is a true hall of mirrors.
While I wasn’t there Sunday night, but my son was, in Asbury Park to see Bruce Springsteen on the beach, he did play Blinded By the Light for the first time since 2017 and in the song Bruce “Asked him which was the way back home. He said take a right at the light, keep goin’ straight until night, and then boy, you’re on your own.” I feel like that is the situation we’re in now.
The Chicago Fed’s National Financial Conditions Index reflects the easiest since January 2022 when rates were still at zero, and the balance sheet was nearing its record high.”
Notable this week:
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“The blue line in the lower section shows how much the orange line is above or below the long-term trend line. It is currently in the “Overvalued” zone. Lastly, the data boxes at the bottom of the chart display the annualized gains based on each zone (Overvalued, Fairly Valued – blue line in the middle zone, or Undervalued).”Please take note of the following text:
“The blue line in the lower section shows how much the orange line is above or below the long-term trend line. It is currently in the “Overvalued” zone. Lastly, the data boxes at the bottom of the chart display the annualized gains based on each zone (Overvalued, Fairly Valued – blue line in the middle zone, or Undervalued).”