Market is in an expensive territory but not a crazy territory: Howard Marks

You may say well why now, not six months ago? This is not a magic time but markets have gone higher and that means that prospective returns have moved lower at a time in my opinion when the risks have increased. I think that clearly the geopolitical risks are greater today than they were 6, 12, 24 months ago and when you compare greater risks with higher prices and lower prospective returns and so we say accommodative behaviour in the capital markets and the ease of doing risky things in the capital markets all of these things tell me that it is time for caution. There is no magic threshold. There was no day in the last month when I say “Ah-ha! Now we have passed the threshold, now I have to put the memo”. It is just the gradual accumulation and my belief now that we are at the point where I had to speak.

You have historically looked at valuations in three brackets; cheap, fair and expensive. To your mind which asset class is expensive and which asset class is fairly priced?

The phenomenon and I have been discussing so far is a global phenomenon, it is not local to one market or one nation or one region and the logical condition is that all assets be priced similarly because if stocks and bonds become more expensive, it is unlikely that real estate will be really cheap because if it is people would take money out of stocks and bonds pushing down the prices and they will run in to buy real estate pushing up the prices until everything is at what the economists call equilibrium. So especially today, given the fact that the phenomenon that I am interested in are global meaning affecting all markets. I cannot identify one thing which is markedly cheaper or markedly expensive than another. Everything is on the expensive side, not terribly, not bubble territory, not panic territory but expensive. There are no bargains. There is nothing in my opinion that can be bought below its intrinsic value and that is the reason for my generalised caution.

In lieu of that, if I were to ask you as an asset manager, as a fund manager how would you construct a balanced portfolio in this sort of a market environment where you strike a balance between risk and reward, where would you scale up, scale down and how much cash would you keep if there is some sort of benchmark that you are working with in your head?

First of all, a given portfolio is not right for everybody. Everybody has the portfolio that is right for them and it is different. The other thing is Oaktree is not a balanced portfolio manager. We do not traffic in the mainstream asset classes of mainstream stocks and high grade bonds and our clients give us money and say here is x dollars invest in IO bonds or distressed debt or real estate or private lending whatever it might be. So this is not a question that I answer for a living.

Having said that, the universal answer for me is that whatever your normal posture, however you normally balance aggressiveness and defensiveness. I would have considerable more defensiveness today.

First of all, in the world I described which has great uncertainty, low prospective returns, high prices and pro-risk behaviour, you have to worry about losing money and I do not think you have to worry too much about missing opportunity because I do not see a lot of opportunities that I would worry about missing. So, I cannot give you a magic number, I cannot give you a percentage for cash, I cannot give you a balance between stocks and bonds. All I would say is everybody should have, every investor should have in mind his or her normal risk pasture, his or her normal balance between offence and defence and whatever the normal is I would be considerably more cautious today that is the only answer that I can give you.

So I will take a leaf from your answer. You said that we are not in a bubble yet but how far are we away from bubble because markets first have to hit that bubble zone and then they only blow up after that?

I do not know how far we are from a bubble. I cannot express it in miles or in minutes or in percent. I think we are in expensive territory but I do not think we are in crazy territory. I say in the memo that the PE ratio on the S&P is like 24, in 2000 it was 30. That was unprecedented high territory. So I do not know how to express it, I do not know what the bubblishness are. I would not say we are a little high, that understates it, I would not say we are in bubble territory that overstates it. I would say that we are in meaningfully expensive territory in most assets. But you know in the economy we have had not had a boom and I see no reason to have a bust, there are no arguments for or signs of a recession anytime soon. And the financial institutions which were really the site of the problems back in global financial crisis, the financial institutions are not nearly as levered as they were then so I hope that risk is off the table. And then the global financial crisis was caused by something called subprime mortgages and mortgage backed securities and there is no analogue today to subprime mortgages in terms of the magnitude or the fundamental weakness, the inherent weakness.

You have highlighted the FANGs (Facebook, Amazon, Netflix, and Google) super stocks. Every market has its super stocks. In India as well, we have the consumer companies, the large-cap private banks which are trading at super normal levels when it comes to valuations. Most fund managers who we speak to and ask about where is the balance between growth and price, tell us that you are buying into the certainty of growth that these companies can deliver. They are being defensive in that strategy. Do you think that defensive strategy can also turn out to be risky subject to valuations?

You hit the nail on the head. Subjective valuation, one of the important points that I try to make and this is a point which is forgotten in every bull market is that there is no such thing as a good idea in the investment world without reference to price. Anything can be a good idea or a bad idea on its merits depending on how it is priced. If you say I am going to be cautious, I am going to invest in the defensive stocks like the major consumer companies and if everybody says it and if these stocks double and triple in price, then while the companies, businesses may be defensive, the stocks may no longer be defensive.

People have to understand that difference between a company and a stock. A stock is not a company and the main attributes of an investment in a stock may be different from those of the company. In my book, the most important thing chapter 3 says, is value by which I mean trying to figure out the intrinsic value of the stock or other investment. The chapter 4 says the most important thing is the relationship between price and value and that is really determinative. If you are buying a great thing at a modest price, it is wonderful. If you are buying a great thing at a eye-popping price, it may no longer be wonderful, it is probably a mistake.

You can buy a bad asset, a risky stock and a risky company but if you buy it cheap enough, it may be very defensive. All I would say is never forget to differentiate between the thing you are buying and the price at which you are buying and you must consider both and the key to cautious investing is to pay a reasonable price relative to the underlying intrinsic value.

What is your take on China? It is a difficult equity market and a credit market to read the economy is still opaque? Do you think the China fear is real? It is more like a ticking time bomb or right now financial markets can handle this uncertainty from China?

I am not an expert on China and I have not been there in some good time and I do not think that you know the answers to these questions just by visiting for few days as I typically do. You look at China which has the challenge of urbanising its people and growing while limiting the reliance on capital investment and borrowed money. And the growth over the last 10-15 years has been highly dependent on investment in the capital stock based on borrowed money and now they try to transition from that to internal growth and more prudent financial investment. Nobody can prove, nobody can research, nobody can detect whether it is going to work or not. First of all this is something that has never been attempted on this scale before and there are no schematics for how this machine works.

The Chinese have done a very good job of managing things. The people who called for hard landing three years ago are still waiting and the Chinese system seems to have a unique combination of some capitalism, some central control and some very purposeful and effective management. So personally I do not bet against China in this regard but I am going to conclude my answer with what I started with – I am no expert on China. All I have is my hunch that they will be able to accomplish it.

Nobody in this market claims to be a China expert due to the depth of that market and the opaqueness with how the economy operates. But I have to ask you about the path ahead for you. A large of part of your memo is talking about bubbles in asset classes or potential bubbles in asset classes. a) It is premised on the fact that a lot of fund managers, investors do not want to be caught waiting on the sidelines in anticipation of when rates will go up. Even central banks are not clear about the path ahead for interest rates. How much, is all data dependent, what is your own view here?

On May 22nd, 2013 Ben Bernanke said you are going to start to see signs of tapering in our bond buying and everybody started to believe that the road for US interest rates was upward and ever since then, till now-- it has been almost four and a quarter years -- people have been asking when is the Fed going to raise rates? My answer is always the same number one, I do not know and number two, why do you care? First of all, nobody knows what the Fed is going to do and the opinions on what the Fed is going to do change all the time. And secondly, what matter is not what day they are going to raise interest rates or how big the increase will be that day, what matter is what will be the general direction of interest rates over the coming years; will they go up or down and if up will they go up a lot or a little and will they go up slow or fast. And nobody, I can know any more than that, It would be a great thing. So here is what I think. Interest rates will go up and not down because they are unnaturally low which distorts the economy and the markets.

The Fed knows that it is not desirable to have unnaturally occurring interest rates on a permanent basis. And the Fed knows that as the economy tightens as the unemployment rate goes to 4.4 and 4.3 per cent, the slack goes out of the economy and the opportunity for inflation rises and of course one of the Fed’s main job is to limit inflation.

There is every reason to believe that interest rates will go up. I also think that our economy is growing only very slowly and so there is a strong desire not to raise rates so much or so fast to choke off growth. They want to limit inflation without jeopardising growth which is a balancing act which calls, in my opinion, for few modest and slow increases in interest rates. But anybody who bets that interest are not going up is taking a big risk.

Where do you think emerging markets like India would fit in because a market like India is following a different interest rate regime?

Well I do not know anything about interest rates in India. But I am a great believer in the emerging markets. As you know, I made my first trip to India in February and I was very impressed by the people I met and by the power of the country. And I am a great believer in India’s future.