The week in review: Finding rhyme in reason

When you’ve been in the investment business for over half a century, seen four major debt crises, several recessions and countless other exogenous shocks, and through it all you’ve maintained a track record as one of the most successful fund managers in living history, you’ve likely learned a thing or two about market cycles.

Studying and understanding the patterns in these cycles is the one thing investors can do to get the odds on their side, says Howard Marks, Director and Co-Chairman of multibillion-dollar asset management firm Oaktree Capital.

Participating in the sixth episode of Investec Wealth & Investment’s webcast series, “Markets and investing in a time of Covid-19”, Marks had a candid chat with Max Richardson, Senior Investment Director at Investec Wealth & Investment UK, about using similarities with previous market crashes to navigate the current Coronavirus crisis.

Citing the premise of his 2018 book Mastering the Market Cycle, Marks says that while we can never be sure what will happen in the future, “we can get to a point where the odds are on our side. And I think that understanding cycles is the most important element in that”.

When analysing the past 11 years, the longest bull run in history, Marks points to the “rhymes” that have characterised every period of investor exuberance since the dawn of market cycles:

• Too much willingness to bear risk
  
• Too much optimism with regard to the future
• Too much money in the hands of investors
• Too much eagerness to put that money to work

With record-low interest rates in the US and even negative rates in Europe and Japan, “we had people willing to do risky things in order to make good returns in a low return world,” he says. So, the firewood was stacked high and the match that lit it was the arrival of Covid-19. “This was not a cyclical event. This was a sunspot type event - a random event thrown in by the gods or the fates into this normal cyclical experience,” he explains.

When the Coronavirus crisis hit in February, the S&P 500 plummeted 34% in five weeks, its fastest decline in history, sending investors into a panicked frenzy. “In the investment world we go from flawless to hopeless, and when investors flip from being optimistic to being pessimistic and fatalistic and suicidal, then we get big declines in prices and we get bargains to buy.”

When assessing risk, Marks believes that it’s critical to understand that the rhymes in these situations are not so much the events themselves, but the psychological patterns of market sentiment. 

“The more optimistic people are, the higher the price is likely to be relative to its intrinsic value. You want to buy when the price is low relative to the intrinsic value; and you don't want to hold that much – maybe you even want to sell – when the price is very high relative to the intrinsic value,” says Marks.

In one of his recent memos – hotly anticipated reading for traders and investment professionals the world over – he explained his investment approach as “calibrating” the market: “First we [Oaktree] thought the risk was great in past years and we were defensive, then people panicked over the exposure of the risk and we bought, and then people got more comfortable and our buying slowed. That's the way I think about calibrating.”

While the S&P 500 rose almost as fast as it fell, following the announcement of unprecedented liquidity measures by the US Fed, Marks isn’t ruling out another significant drop, or perhaps even two. Pointing to lessons learned from the 2000 technology, media and telecoms (TMT) bubble and the 2008 Global Financial Crisis: “Each of the stock market declines saw a big drop, a rally, another big drop, a rally and another big drop before we reached the bottom.”

He urges investors to have patience and to take a long-term view. “Do we really think that it's appropriate for the stock market in the US to be back at its highs after two or three months? It took seven years to get back to the stock market high of 2000 [pre the TMT bubble bursting] and it took five and a half years [post GFC] to get back to the high of the stock market in 2007.”

Ironically, it turns out that the times of greatest panic may also be the moments of lowest investment risk. Because risk is not about volatility, says Marks; it’s about the probability of permanently losing money. And that probability is far lower following a market crash.

“Our job is to own more when things are on sale,” says Marks whose Oaktree Capital invested aggressively in credit instruments at the height of the Covid-19 market hysteria in March. “The S&P went from 3300 to 2300 and the average investor says, ‘oh the market is so much riskier today.’ Well, I think the market is so much less risky.”

The corollary to this is that times of market exuberance are times of greatest risk, and this is when the savvy investor should be preparing to take advantage of the next market shock, even if one has no idea what that shock will look like.

“You have to prepare when the cycle is not on your side. When investors are optimistic and risk aversion is at a low and investors have a lot of money and are eager to put it to work and as a consequence asset prices are high. This is the time to prepare for a worsening of the environment, even though you can't predict what's going to make it happen.”

About Howard Marks

Howard Marks is Director and Co-Chairman of Oaktree Capital and since its formation in 1995, Mr. Marks has been responsible for ensuring the firm’s adherence to its core investment philosophy; communicating closely with clients concerning products and strategies; and contributing his experience to big-picture decisions relating to investments and corporate direction. Howard is highly regarded in the global investment community is a prolific author of bestselling investment books but arguably most famous for memo’s he has published on Oaktree’s website since 1990. 

From 1985 until 1995, Mr. Marks 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. Previously, Mr. Marks was with Citicorp Investment Management for 16 years, where from 1978 to 1985 he was Vice President and senior portfolio manager in charge of convertible and high yield securities. Between 1969 and 1978, he was an equity research analyst and, subsequently, Citicorp's Director of Research.

Mr. Marks holds a B.S.Ec. degree cum laude from the Wharton School of the University of Pennsylvania with a major in finance and an M.B.A. in accounting and marketing from the Booth School of Business of the University of Chicago, where he received the George Hay Brown Prize.

About Max Richardson 

Max Richardson is a Senior Investment Director at Investec Wealth & Investment in London. He has worked in the same team as an investment manager since 1999 and also sits on the IW&I Investment Committee and Stock Selection Committee. Max also leads the IW&I Investment Academy, an initiative that seeks to develop a culture of perpetual learning and optimised decision making for the benefit of both clients and investment managers.