Preston Pysh  1:31  

Howard, you have a brand new book titled “Mastering the Market Cycle.” In your book, you start off with an excellent example that talks about the importance of understanding risk and probabilities. 

To demonstrate this idea, you talked about a jar of black and white balls. I just loved this example that you provided and I was wondering if you could share this idea with our audience.

Howard Marks  1:54  

My first premise in investing is that we never know what’s going to happen. We don’t know what events will unfold. We don’t know how the market will react to those. 

The future, in all regards, is a probability distribution. The best investors don’t know what’s going to happen, but they understand the possible events. They can reasonably assign them probabilities. 

Your future as an investor in anything at any time is similarly a matter of a probability distribution. Now, that’s not to say that the distribution is always the same. 

One of the things that the book is about is it talks about where we stand in the cycle and *inaudible* the shaping of the probability distribution. 

If we’re high in the cycle, if psychology and prices are elevated, then the probability distribution shifts to the left. It becomes harder to make money and easier to lose money. The expected outcome is less good.

If we’re low in the cycle, prices and psychology are depressed, then the probability distribution shifts to the right, and it’s easier to make money. 

I compare it, as you say, to a bowl full of balls or lottery tickets. You’re going to pick one. That’s the outcome from a bowl that contains many. Those are the possibilities. 

It sounds like an uncertain process, but if you develop the skill, if you understand what’s going on and what the ramifications are, then you can say, “Well, now I know there are a lot of good balls in the bowl. Not too many bad ones. The distribution of possibilities is favorable. I’m going to invest heavily, and I’m going to be aggressive.” 

If at another time you understand that the cycle is precarious, you might say, “Now, I think there are not too many good balls in the bowl. Only bad balls. I’m going to take some chips off the table and invest more defensively.” 

In both cases you don’t know what’s going to happen. However, I think it’s obviously essential to understand how the probability distribution shifts the distribution of balls in the bowl. There will still only be one chosen. There will be uncertainty and randomness associated with that choosing, but that doesn’t mean we can’t know something about what’s going on.

Stig Brodersen  4:24  

One of the reasons why Preston and I, and really the show are such big fans of yours, is that in value investing, we typically do not talk too much about macro and cycles. I mean, it almost seems like it’s a curse word. Here, we look at it differently.

We know that you do, too. I’m curious if anything happened to you in your career and personal career, perhaps in some of the early years that led you to the opinion that you should understand the market cycles, and it needs to be a part of your overall analysis.

Howard Marks  4:59  

Sure. This summer marked my 50th anniversary in the business. I started with equities. After 10 years, I shifted to high yield bonds and convertibles. The first time I was doing research in the *inaudible*, I was managing money. 

Then 20 years, in 1988, I was joined by my partner and co-founder of Oaktree, Bruce Karsh. We set about organizing or what I think was the first distressed debt fund from a mainstream financial institution. We organized the fund in 1988, and then in 1990, we had a sense that the LBOs of the 80s had been over levered and were precarious. The economy might falter. 

We then raised a very large fund and the ability to add more capital if what we thought would materialize did, and it did. That fund was much larger than the first one and invested very aggressively and had an extremely high unlevered rate of return. 

Then, we saw that the economy improved and the credit window reopened and became easy to borrow again and companies were doing well. The incidence of distress massively subsided in the mid 90s. There was, again, very little to do. We contracted the size of our funds, and we invested more carefully. We had to be more creative.

Then, of course, in 2001 to 2002, we had the telecom meltdown, and we had Enron scandals. We, again, had economic weakness and we invested aggressively. Things got so good that we quickly liquidated one or two funds and didn’t raise the funds. 

Oaktree raised much smaller funds in 2004 to 2005, but then found ourselves on the first day of 2007 on what we thought was a doorstep with another opportunity. Now, we raised the biggest fund in history: $11 billion. 

The point is, after 20 years, in which I had a sense that the environment was stable. In fact, it didn’t change very much from 1968 to 1988 in terms of the impact on me. I started to live with and be highly affected by these cyclical swings and adapted to them. I profited from them greatly. 

Every once in a while, we’d have a big fund in a distressed moment that had a high return, then we’d go through some years of quiet when we did small funds that had low returns. My life became cyclical and that’s when and how I gained the appreciation that I have.

Preston Pysh  7:49  

Howard, for many people that are listening to this show, their number one question might be where are we at today in the current credit cycle? I would assume that the approach that a lot of people might take to understand where we’re at in a credit cycle would be to start with a narrative. Then, go back in history and study what was happening in that period of time to see if it looks similar. 

Let me give you an example. If someone thought today that we were at a market high, maybe they’d go back to 2007, and look for clues and see whether it’s similar to what we’re experiencing right now. My question for you is, is that a good idea? Or is that really a bad approach?

Howard Marks  8:27  

First of all, one of the main themes in the book, maybe the main unifying theme is the Mark Twain attributed quote, “History doesn’t repeat itself, but it does rhyme.” 

The cycles that we talked about are never the same from one to the next. The speed, the duration, the amplitude, the reasons, the features, the effects are always different from one cycle to another. You’ll never find two that are exactly the same.

However, we look for analogies in order to understand patterns, so that we can know what happened in the past and prepare for what might happen in the future. I just put out a memo last week entitled, “The Seven Worst Words in the World,” and for a credit investor, which is what we are at Oaktree, the seven worst words in the world are “Too much money chasing too few deals.” 

I wrote a memo in February 2007 too, entitled, “The Race to the Bottom.” I felt there was too much money chasing too few deals, which has a very deleterious effect on prospective returns and unsafety. Of course, that memo is considered to have been roughly right. 

I feel that in many ways, the current environment is also analogous to that period and reflects that theme in the memo. I’ve talked about what’s going on in the markets. Nobody wants to invest in the safer markets, which pay 1%, 2% or 3%. So, the money is crowding into the smaller risk markets that people hope will pay 6 or 10. 

However, with the effects that I described of forcing up prices, down yields, up risk, down safety. I think the analogy is there. 

Now, it doesn’t hold in every detail. I go to lengths and the memo to say, “I’m not saying we’re in a bubble. It is not a repeat of 2007 in that regard. I’m not telling people they should be out of the market, but I believe that people should behave with caution today, because of the race to the bottom that I think is going on.” 

How is it different from 2007? Well, first of all, the banks are not nearly as levered as they were. They’re unlikely to get into systemic trouble and require a bailout which panics the whole system. 

The building block for the 2007 events were subprime mortgages and mortgage backed securities. There is no analogue to that today. There is nothing out there today, which is as massive in scale. Also, though, I’ll say fraudulent. The analogy is good as to the race to the bottom, but not good, in my opinion, as to bubble and crash.

Stig Brodersen  11:15  

One of the value investors that we follow on the podcast is Sanjay Bakshi. He talks about stress-adjusted returns, so it’s not only about embracing that volatility as just as much living a good life while you’re managing your portfolio. 

I’m curious if that way of thinking is also applicable to you. You are managing so much money on behalf of not just yourself, but also clients. It might seem that we are at the peak of the market cycle. Do you look towards stress-adjusted returns? Or are you looking to optimize returns? How do you see that trade off, perhaps if there’s even a trade off?

Howard Marks  11:57  

For the past several years we’ve been operating under a mantra: “Move forward, but with caution.” 

I reached the conclusion some years back, and I still feel the same. Although, a little less that the outlook is not so bad and prices are not so high that we have to go to maximum defense, as we did in let’s say, 2006. 

On the other hand, the prices are not so good. The outlook is not so good that we should be aggressive. We’re trying to balance investing with defense also, but [we] stay in the game. 

When I came up with that mantra some years back, and that moment since, there were times when you might have said, “This is a scary market. I want to take some chips off the table. I’m going to cash virtually at any point in time in the last 10 years.” [This] would have been a mistake. 

“Move forward, but with caution” means to us, if we’re investing, we invest every day. We are endeavoring to be fully invested other than funds, which have specific reserve components. However, we are investing with caution. Since we consider ourselves a cautious firm, that means more caution than usual. 

One way you see that, that we haven’t grown our AUM, our assets under management, in about five years. We changed our accounting this year to reflect 20% of double lines assets, where we own 20% of the company. 

Other than that accounting change, we haven’t really expanded our business in five years, not because we couldn’t, but because we think this is not a time that warrants depending on the business. 

We try to do what I just said. We try to expand when we’re in the propitious part of the cycle, and not expand…, or even contract as we have at times, when we’re in a precarious mark. 

I think I should mention a little bit about something you touched on. [It’s] this question about whether what I call “cycle positioning” [or] what other people might call “market timing” have any place for a value investor.

Clearly, Warren and Charlie don’t time markets, as far as we know. The goal is to buy into good situations, hopefully, at good prices and hold for the long run. That is absolutely the right thing to do. 

However, the question is, is that your underlying theme? And if you do that, then can you enhance the results by also thinking about the cycle? I think you can, and frankly, not everybody is in the same position as Berkshire with regards to both the permanence of capital and the permanence of jobs. 

I wrote a foreword for a book called “The Warren Buffett Way,” and I described the things that I think make Warren Warren. The last one of which is that he’s not worried about losing his job. That’s a blessing. 

People who are in the business commercially of running money or people who might lose their nerve and sell out at the bottom, which is tantamount to losing your job, if you’re managing your own money, they can’t ignore it. 

If the market is going to go through an upcycle for many years, they want to be part of it. If it’s going to go through a down cycle, they might like to not bear the full brunt. 

I think then that the two can be integrated. We are value investors, but we try to amp it up when the time is right and cool it off when the time is wrong.

Preston Pysh  15:36  

Howard, when we look at the 10-year Treasury for the last 30 years, we can see that rates were as high as 16-17% or something like that back in 1981. They’ve progressively gone down since. Whenever I think about Warren and Charlie and one of their main engines for creating cash inside of their company, it’s Geico and the insurance industry in general. 

When you look at the model on why it has been such a great model, it’s because they’ve got a huge float that they can invest in. However, what happens when interest rates, assuming that this trend that we’ve seen for the last 30 years, and that central banks, when they get in any kind of trouble, it seems like QE is the tool of choice.  

We know that when you use QE, the impact on bonds is that the prices go higher, and the yields go down. If that’s the case, and we start pegging our interest rates at zero percent, does the insurance industry become a big risk at that point, because the only thing you can buy with a lot of this capital and a lot of this float are bonds that are yielding nothing? 

I’m kind of curious, just to hear your opinion on that. 

Howard Marks  16:44  

That’s really a high level question. That’s a $64 question. Going back to what Twain said, “History doesn’t repeat.” You have to accept the ability of events of the future to depart from the ability, from the events of the past. 

You described accurately, the 36-year *inaudible*, since I would say, in 1982, in which interest rates essentially have gone down. Now, arguably, they stopped going down about four years ago, but they’re still awful. 

We went from my so-called normal environment to a high return environment as a result of the inflation of the 70s and early 80s. Then, we went through this period of compression of yields, and as you say, the 10-year [Treasury] went from, I think, 14% or 16% to 1.5%.

You can’t overstate the salutary of that on assets directly when interest rates go down, bond prices go up, and old outstanding bonds, an old interest rate becomes more valuable in a new environment in which contemporary rates are lower. That’s a direct impact. 

You take any income producing asset, be it a company, stock, or a piece of real estate. Either in fact or implicitly, we value these things on discounted cash flow. We take the cash flows of the future. We discount them back to the present, and we figure out what the thing is worth. 

Clearly, the discount rate changes when you discount a given stream of future cash flows at a low interest… At a high interest rate, you get a low value. When you discount it at a lower interest rate, you get a higher value. That happened.

With QE and the interest rate cuts and all of the stimulative measures, add the effect to respond to the global financial crisis… It had the effect of hitting savers and hitting people living on their income from their portfolios. It may cause asset appreciation, and it helps people who own assets. 

These things, the incremental impact of that is in the past. Rates got down to zero. And today, they’re two, but I have a piece of paper on my wall from a slip I had from the bank in 1982 with an interest rate of three quarters over prime. I also have a slip from the bank saying the rate on your loan is now 22 and three quarters. 

More recently, I borrowed money at two and change. So, that’s not going to happen again, because we are at low levels. Businesses that depend on income, and insurance is the prime one, don’t have the opportunities today that they did then.

Just today the 10-year [Treasury] is at 3%. The model in which it was modelled, the investing float, is just not as good. No doubt about it. Of course, if you can go into businesses today, which pencil out based on the return on float of 3, and rates go up to 6, maybe you’ll be back in the chips again. 

In the years just before the crisis, all the money I had in the world that wasn’t at Oaktree was in treasuries. I have 1, 2, 3, 4, 5, 6-year maturities, the laddered portfolio. The dumbest form of investing. No demand. 

I was perfectly happy, because I had total safety, total liquidity, and the yield in the sixes. Of course, today, that portfolio would yield in the twos. It’s a very different story. The interesting question is: Will it go back to 6 someday?

Preston Pysh  20:43  

That’s the million-dollar question. That’s the billion-dollar question.

Howard Marks  20:47  

Yes. And clearly, the world is a very mysterious place in that regard. We can’t predict the economy. We can’t predict inflation. If 5 was right for that environment, shouldn’t we go back to 6 now? But who would bet there is money and that the 5-year will yield six? 

I feel the Fed and the central banks of the world did something in the global financial crisis by taking their balance sheet up to 20 odd trillion, tripling or quadrupling their balance sheets. They did something that had never been done before, and now, they’re, at least the Fed, is in the process of unwinding. 

In Europe, they’re going to stop QE and someday they’ll unwind, I believe. You can’t say you know how it’s going to go. You can theorize.

Preston Pysh  21:41  

Howard, one of the things that we talk a lot about on our show with respect to where we’re at in the credit cycle is the bond yield curve. What we’ve seen since the cycle that we’ve been going through, if you’re calling the bottom of the last one 2009 summer.

2009 was the bottom, and we’ve seen this huge upturn in the market, specifically talking about the equity market. We have been looking at the bond yield curve, because typically when the bond yield curve goes flat, it starts to go inverted, and you’re starting to see a top. That’s one of the main metrics that I’ve personally used, whether that’s a good metric or not, but it’s something that I pay very close attention to. 

What we’ve seen recently is that the bond yield curve is really starting to flatten itself out. It’s definitely not inverted at this point, but it’s flattening itself. 

Well, I’m kind of curious to hear your thoughts on the bond yield curve as being one of those metrics to kind of gauge where you’re at in the credit cycle. Then, maybe some other really critical variables that you would assign to kind of giving yourself an idea where you’re at in the cycle.

Howard Marks  22:44  

For the most part, I’m not given to technical indicators of that nature. The flat yield curve or the inverted yield curve certainly seems to have been coincident with recessions in the past, but I’m not sure of the causality. 

If I’m not sure [about] the causality, then I can’t be too convinced that it’s always going to be the case. It’s not the main kind of thing I look at. I tend to look more at things that are internal to the markets like valuation and behavioral. 

As I said, taking the temperature. How are people thinking and acting? What are their attitudes? When people are fearless and unconcerned about risk and risk-tolerant, greedy, confident, and credulous, bad things happen. They pay too much for securities. They overlook risk. They bid too highly. They forget the demand risk premiums. They forget the demand protective covenants and so forth. Then, prices go too high. 

When people are fearful and exceptionally risk-averse and skeptical, pessimistic and so forth, then they demand a high-risk premium. Even good companies can’t get money. They insist on strong covenants and deals go begging. That’s the climate I want to invest in. That’s what I watch for. 

So far it has worked back in October of 2008, which for us investors in credit was pretty much the low point, in terms of prices were very low, and you could buy huge quantities from entities that were melting down. 

I noted extreme negativism, and I wrote a memo called “The Limits to Negativism.” I said that, “One of our main jobs as investors is skepticism. Somebody comes in. He says, ‘I’ve managed money for 30 years, and I’ve made 10% a year between a range of 9 to 11. I’ve never had a down month.'”

Your job is to say, “You know what? That’s too good to be true.” 

But if somebody comes in and says, “The world is ending.” You posit some assumptions, and you show that even under those conservative assumptions, the portfolio will still do well. That person says, “No, I think it could be worse than that.” 

So, you posit a more conservative assumption. They say, “It could be worse than that.” Then, you posit a more conservative assumption, and they say, “No, it could be more.” 

At some point, you have to say, “No, that’s too bad to be true.” That’s what we were seeing in the Fall 2008, post Lehman. It’s all you had to know. There was only pessimism and no optimism.

Stig Brodersen  25:38  

That really goes back to one of the first things we talked about knowing your probabilities and estimating the array or what’s going to happen.

Howard Marks  25:45  

Yeah. People say, “Give me your worst-case scenario.” I’ve learned through my experience that there is no worst-case scenario that can’t be exceeded. 

However, the fact that you can posit an incredibly negative scenario, doesn’t mean that you should assign it a high probability. People get confused, and you can only deal with the world. You can only be a good investor and deal with the future, if you think probabilistically. 

To say it could happen is not to say it will happen or that it has a reasonable chance of happening. We have to think in terms of probability distributions and assign odds and have a sense for what the future distribution looks like and how it shifts. 

Stig Brodersen  26:36  

If you look at the current cycle, and perhaps the cycle has been longer than what most of us expected, you have a wealth of experience here, Howard. But I’m still curious, have you learned anything new from this cycle that you didn’t know before?

Howard Marks  26:50  

Well, I would postulate now we’re into the ninth year of recovery, and the ninth year of the bull market. Historically, there’s never been a recovery that went more than 10 years. So, I think one thing we’ve all learned is that history can be violated. As they say in sports: “Records are made to be broken.” 

One of the things when people deal with cycles, and they set out rules like “This has to happen in two years,” “This can only go for years,” and “This has to happen when the market rises 10%, 20 to 30%.” I reject all rules. 

That’s the part that does not repeat. It affects the probabilities, but I absolutely reject rule-based investing with regard to history. So, that’s an important lesson. 

I think we’ve learned another important lesson in this recovery, because for a long time, this has been the slowest recovery in history. Everybody kind of despaired about that. I believe what I’ve learned is that a slow recovery, all things being equal, has a better chance of being a long recovery, because the slowness of the recovery suggests that excesses are not being created. It is from excesses on the upside, that the need for a downward turn comes. 

Stig Brodersen  28:23  

Howard, I would love to talk more about the reflections that you have. What really materialized for you that you didn’t know before? Like as you were typing up all the experiences you have, and we’re passing it on to the next generation of investors, did you have any one piece of advice?

Howard Marks  28:39  

Great question. There’s a good answer. I had an outline. I think most authors probably have an outline, and I knew which chapter as I was going to write. I was going to write, “What is a cycle and do they recur?” Afterwards, [I’ll] talk about the economic cycle, corporate profit cycle, and swing in psychology. Then, the credit cycle phenomenon. 

As I was writing, one of the real reasons that I love to write is because I think of new things as I write that I hadn’t thought of before. I’m a real believer in the importance of risk aversion in the market. 

The market only makes sense if investors are risk averse. As I was writing the chapter on psychology, I realized that risk aversion is such an important element in understanding markets and their potential that it deserved a chapter of its own. 

So, I added a chapter called “The Cycle in Attitudes Towards Risk.” That and the credit cycle are probably the two most influential and most volatile and most important. How are people thinking about it? 

Frankly, the way I do it in the good times, when everything’s going smoothly, what do people say? They say, “Risk is my friend. The more risk I take, the more money I’m going to make. So I’m going to max out my risk.” 

I’ve actually had people tell me that they’re not going to hire Oaktree for a given assignment because they want to maximize risk. They know they can’t do that with Oaktree. 

But people say, “Risk is my friend. The more you take, the more I’m going to make. By the way, I don’t see anything to worry about.” That’s how they think or speak in the good times. You want to get the hell out of the market. 

If everybody says, “Never bear risk again. Risk bearing is a big mistake,” then you want to get in, and it’s rather simple. Now, knowing what’s going on is not always so simple. 

Doing what I think is called for and being very different, it’s uncomfortable to be a buyer when everybody else is the seller, for the simple reason that the reasons that motivate everybody else to sell will bear on you as well. 

When I was finishing my last book, I had lunch with Charlie Munger. At the end, when I got up to go, he said, “Just remember, none of this is meant to be easy and anybody who thinks this is just easy is stupid.” 

I never want to portray that it’s easy to come to correct superior conclusions and implement them, but it’s pretty clear what we must do. 

Do you know David Swensen who runs the endowment in Yale and does a fantastic job; wrote that investment management by which I think he means superior investment, [which] requires the adoption of uncomfortably idiosyncratic decisions?

First of all, the herd is usually wrong. Secondly, if you do the same as the herd, you cannot expect to outperform the herd. That doesn’t make any sense. 

To be a superior investor, you have to figure out what the herd is doing and why the herd is wrong and do the opposite. By definition, it has to be uncomfortable. 

Now, it can be satisfactory intellectually, but it’s rare for it to be easy emotionally. I think that understanding the attitude toward risk was a revelation to me as I wrote the book, and as I say, I think it’s one of the most important chapters in the book.

Preston Pysh  32:28  

Howard, we can’t even begin to thank you for taking time out of your day to chat with us. You had mentioned in the interview, the letters that you write… Stig and I are both on your email list. We receive these letters. These letters are gold, folks! 

We will have a link in our show notes for you to sign up on his email list for these letters that he puts out there. They are absolutely gold. 

The name of the book is “Mastering the Market Cycle: Getting the Odds on Your Side” by Howard Marks. Stig, has read the entire book. I’m about halfway through the book, and I’ll tell you that this thing is awesome. As you can see, the thoughtfulness and hearing Howard respond to some of the questions, this is what the book is completely filled with. 

I know Stig and I aren’t probably the best endorsement, but here’s an endorsement for you, Ray Dalio says, “Howard Marks’ ‘Mastering the Market Cycle’ is a must read.” 

Charlie Munger says, “I’ve always said there’s no better teacher than history in determining the future. Howard’s book tells us how to learn from history, and thus get better ideas of what the future holds.” 

So, Howard, thank you so much. Seriously, this was just incredible. We are big fans. We’ve been big fans for quite a few years, and it’s just an honor to talk to you.

Howard Marks  33:42  

Well, it’s been a great pleasure to respond to your questions. Thank you for having me. 

Preston Pysh  33:46  

Thank you, Howard. 

Howard Marks  33:47  

Pleasure.

Stig Brodersen  33:48  

All right, guys. That was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro 33:56  

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