Good morning. Yesterday US stock went sideways as Treasury yields crept up. It still feels like we are still between acts in the market drama. But there is still plenty to talk about. Email me
Howard Marks is co-chairman and co-founder of Oaktree Capital Management, which manages $150bn in alternative assets. He is also a noted author, known for his books and investor letters, which are required reading on Wall Street. We spoke on the phone over the weekend.
The first topic was inflation. As befits a man who has built his career on risk management, his views are carefully balanced, and he dislikes making predictions. We simply do not know whether inflation will be transitory or not, he says. Marks puts the odds that inflation will be higher than 3 per cent in three years — above the Federal Reserve’s long-term comfort zone — at roughly even.
That said, the Fed and political establishment lean dovish these days. “Even [Fed chair Jay] Powell has to get re-chosen, and I think it’s a year from now, and so he’s probably not going to do anything hawkish in the next year.” So the odds that inflation really becomes a problem for financial markets is more like 30 per cent, Marks reckons.
In addition, there seems likely to be strong economic growth ahead, at least for this year and possibly more. That should keep markets steady for now:
Investors, therefore, should be in their “normal risk position”: neither particularly bullish nor particularly bearish, perhaps a shade to the defensive side.
Why not more bullish, given the economic growth? Because high current asset prices will constrain long-term returns:
Marks sees five options for investors, none of them wonderfully appealing. You can accept lower returns. You can position yourself defensively “in which case the return will probably be lower still”. You can go to cash, and accept a return of zero. Or you can add risk, “but is this really the time you want to increase your risk?” Finally:
It is simply “illogical”, in short, to think you can “safely and dependably” make a high return in today’s low return world. Marks described talking to the chief investment officer of a state pension fund who asked for his recommendation, given the fund’s return target of 7 per cent. Marks recommended the CIO get a new target.
At the same time, Marks says, you have to be in the market. Successfully avoiding a bubble requires two decisions: to get out and to get back in, and most people blow one or the other.
There are some times, Marks says, when the prices the market offers are so extreme that the logic of market timing are compelling and the probability of success are high. But this is not one of those times. “In between those once-a-decade opportunities, there is nothing intelligent to say.”
There is a single narrative that dominates market chatter now. It is the inflation story, and the corresponding strategy is the reflation trade. That is: buy “value” stocks in sectors that thrive on economic growth and inflation, from materials to banking, and sell “growth” stocks, for the most part in technology. Here is a chart that tells that story. It shows the relative performance of the Russell 2000 growth and value indices:
In the second week of February, growth rolled over and value roared on. The value half of this trade makes perfect sense to me. Cyclical stocks, from industrials to banks, do better in a hot economy with a little inflation. But why the beat down for growth?
The popular story goes as follows. A lot of the growth value of a company is from profits that are years in the future. They are “long duration”, in the argot. For value stocks, more of the value is near-term. Interest rates are the rate at which those distant profits are discounted. So rising rates, as we have now, hit growth stocks particularly hard. It is a “duration sell-off”.
This story makes some sense, but I’m a little sceptical, because it discounts the role of speculation and euphoria (and their dissipation) in the growth sell-off. My guess is that we are seeing more than an upward adjustment in investors’ discount rates. We are also seeing investors’ speculative appetites fall. The two are different.
A change in the discount rate is an adjustment in how future cash flows are determined. A change in speculative appetite is a change in the degree to which investors care about cash flows at all — the degree to which they believe that there will always be another person (the “greater fool”) who will pay more for an asset than they did.
An example. Since things changed so abruptly in February, the very growthy Nasdaq 100 tech index has fallen by 5 per cent. But some index members have done very nicely. Here’s the five best performers in the index:
Of these four, only Applied could possibly be called a value stock. Yes, all of them are very economically sensitive. Facebook and Google are in the advertising business, and the other three make equipment for semiconductor manufacture (so the current chip shortage puts wind at their back). But they are not only growing very well right now. They all have high long-term average revenue growth rates, too (even Applied; compounding sales at 6 per cent is well beyond the hopes of your standard value stock). All of them, in other words, have a lot of their value in cash flows that will occur years in the future, and yet somehow the duration trade has left them unscathed.
These are all solid businesses that sell at appropriate valuations (note the PE/growth ratios under 1.5). Their shares did well, but did not go completely mad in the speculative frenzy for growth in the run-up to February’s reversal. These are solid growth investments.
The five worst performers in the Nasdaq 100 since the February reversal, by contrast, are DocuSign, Zoom, Okta, Splunk and Baidu. Splunk is an outlier, but the other four ran up by 200 per cent, 388 per cent, 108 per cent and 131 per cent respectively in the year before that, making them four of the five top performers in the index over that period. Their PE ratios, other than Baidu’s, are all well over 50.
We are not selling duration. We’re selling insanity.
One of the great market puzzles is when commercial property is going to have what feels like an inevitable crackup, as flexible working kills demand. The Economist does a nice job of explaining why the dam has held this long.