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Howard Marks, Founder, Oaktree Capital
Bargain Hunter
Howard Marks
“Today, you have to choose between a decent return and total safety”
Special Issue: Masterspeak Masterspeak

His claim to fame is investing but he also has a namesake whose initial claim to fame was marijuana smuggling. While his namesake has an updated website, he doesn’t write regular memos, the way Mark does to his investors. Though there is no fixed frequency, the update is eagerly looked forward to and widely discussed. Not only is Marks a big name in equity investing, he is even bigger in distress debt. He divides his time between Los Angeles, where his firm, Oaktree Capital, is headquartered, and New York, where he reportedly plunked $52.5 million for a 30-room duplex last year. He also funded the ascent of bond market maverick Jeffrey Gundlach, both being ex-TCW fund managers. After his bitter parting from TCW, Gundlach’s DoubleLine Capital was jump-started by capital provided by Marks. At 66, he is sprightly but far from impressed with the current bounce in the S&P 500. According to him, the biggest risk now is edgy uninformed investors who are less worried about losing money and more worried about losing opportunities.

In one of your recent letters to investors, you wrote, “The world seems more uncertain today than at any other time of my life.” What is it that we have to fear in a world where restaurants are full and cabs are hard to find?

The level of economic activity, anecdotal as you describe, is not an indication of health in the future. It is an indication of health in the present. The question is, what are the implications for the future? When you say restaurants are full and you can’t get a cab, there is no contravening the fact that the economy is doing well at the top. The problem is the people who are not in the upper strata; their incomes are flat to down, they are losing their overtime. The joblessness rate is up significantly and that excludes people who aren’t seeking jobs and are unemployed — their future is not good. The ratio of income from the top to bottom is higher than in the past, which itself is unhealthy.

In fact, restaurants were full in 2006 and early 2007 as well. So, don’t get carried away. The point the memo tried to make is that the world went through a period that is now about roughly 50 years old in which it levered up very substantially. Credit was available too freely, used aggressively, and people borrowed money to make expenditures. If you borrow money to take a vacation, a year later the vacation is over but you still have the debt. That is the status of the world today. The world borrowed a lot of money for expenditures, some of which were imprudent and today it is left with a hangover of debt and the current income, especially at today’s moderate levels, aren’t sufficient to amortise the debt. That is very worrisome and that is just one of the main things. You look all around the world and over-leveraging is the common thread.

Look at the average American. I have been telling my friends in Europe for several years that the average American has $1,000 in the bank, owes $10,000 on their credit card, makes $20,000 a year after taxes — by the way, I am exaggerating, these are not specific data but conceptual — and spends $22,000. That is not healthy.

But if you look at what the Fed is trying to do… Of course, it is trying to get the economy moving but apparently, the efforts are not yielding results. What is it not getting right?

It is hard to get people who aren’t feeling positive to spend money. It is not easy to make an economy grow when people aren’t thinking expansively. It is something called animal spirits. You take all the quantitative inputs like population growth, productivity growth, innovation and all those things, and then you multiply it with the level of animal spirits — confidence and aspiration. Today, those things are low. You look at Japan, it hasn’t been able to get its economy going for 25 years. In the early days they kept sending people cheques in the mail in the expectation that people would go out and spend money. Guess what? They put it in the bank. Why did they do that? Because they were worried. They got more psychological benefit from having more money in the bank than they did from buying another pair of jeans. So, it is hard to get an economy going when people don’t want to spend money.

If you borrow money to take a vacation, a year later the vacation is over but you still have the debt
If you go back to 1998 or 2004 or 2005, spending money and shopping was recreational. If you had a slow morning at work, you went out to have lunch and you bought another handbag or watch and put it on the card. It is not that today. If you go back to 1998, everybody thought that in 20 years they would be rich because of the way that their stocks and 401K were going up. In 2005-06 everybody thought they would be rich in 10 years because of the way their house prices were going up. There is something called the wealth effect, which is the ability of appreciating asset prices to make people feel rich and thus spend money. You don’t have much of a wealth effect today. Things were unimaginably good and, in fact, too good in the 1990s and the first half of the decade. That is what people think is good times, I just think we are not getting back there as those times were too good. People were too unworried, they were too optimistic, they borrowed too much and spent too much. Now, when people borrow too much and spend too much, the impact on the economic aggregates is very positive. But it is not very healthy. People have a lot of fun in bubbles. Every day they see the things they own going up. They go out and spend some of the money they had yesterday even though they didn’t sell the appreciated assets. But they do it because they feel richer and it is fun. Nobody is having that kind of fun today.

The S&P is at a five-year high. Will that have no trickle-down effect?

The five-year high is like a statistical trick. That means it is not as high as it was six years ago and not as high as it was 12 years ago. So if people have had money in the stock market for 12 years they haven’t made any money. They lost a lot and they got most of it back. That doesn’t make you feel rich. If you had $100 million in the stock market 12 years ago and today it’s worth $95 million, I don’t think you would feel that rich. You might tend to say, “I haven’t made any money in 12 years so I can’t spend that freely.”

Could the Fed’s worst fears play out because the Fed is desperately trying to stave off deflation? They are trying to avoid a repeat of the Japan situation. Do you think there is more of a chance of deflation than hyperinflation?

I don’t think you are going to have that or deflation. Most of the time inflation runs in low single digits. One of the things I say in my memos is that, every time you make a statement about the future, you not only have to say what you think is going to happen but you have to say how confident you are that you are right. I am not that confident when I say that I think inflation will run in the low single digits. I think that inflation is a very mysterious force; it is dominated by animal spirits and, when it gets going, it tends to keep going and it is hard to stop. We saw that in the 1970s that it can be very troublesome. We don’t even know what starts and stops it.

The one thing that we can probably agree on is that all the governments in the world would like to see a more rapid inflation because the great thing is that if you are living today and a Mercedes Benz cost $100,000 and you have a debt to your neighbour of a $100,000, you owe him a Mercedes. If there is rapid inflation and four years from now Mercedes is $400,000, you only owe him a quarter of a Mercedes. So, the point is that you can pay off your debts in depreciated dollars. All the governments in the world would like to see a more rapid inflation. So, what that says to me is that even the Fed and the central banks with all their powers can’t create inflation when they want to. As for the chances of deflation, nothing can be ruled out. The two words I try to never say are “never” and “always”.

The Fed is determined to keep interest rates low. How do you see this liquidity deluge playing out?

I think that Bernanke, being a student of the Great Crash, understood that it was exacerbated by the lack of liquidity. I think he is hellbent on keeping the level of liquidity extremely high and doing a good job on that. That is one of the important reasons why the US economy is doing so much better than some of the other developing economies. There is some artificialness to that. But one of these days it is desirable to get the economy to what I call a natural state where it is not stimulated or influenced.

You say that “Risk is low when investors behave prudently and high when they don’t.” Are investors behaving prudently now?

The good news is that most people are thinking prudently, most people are worried about the kind of things that you and I have been discussing this morning. Bubbles happen when people are unworried. That is not going on now. The bad news is even though people are not thinking in a wildly optimistic manner, they are still behaving in a pro-risk fashion because they have to, in order to get any return. With interest rates as low as they are, if you stick to totally safe investments you can’t make any money. So they are not thinking bullish but they are acting bullish.

Would you support that with an example?

High-yield bonds… people who never bought high-yield bonds are buying it today to get 6%, because if they stick with T-bills they get 0.25%. These are the same people who didn’t buy high-yield bonds 10 years ago when they paid 12%. People who get their statement from their mutual fund, which says that the return on your treasury portfolio is now zero after expenses, think that 6% is great. These are people who wouldn’t take the risk 12 years ago for 12% or four years ago for 20%. Are they doing it because they are pie-eyed optimists? No, because they have to have income to eat. That is the guy who is the handcuffed volunteer. He is doing things but not because he wants to. He needs six and can’t live with zero.

What risks is the market not pricing in now?

It is hard to get people who aren’t feeling positive to spend money
When you set prices you think about what could happen in the future and you assign each likely event a probability. You set prices for that set of possibilities called the expected value. The trouble is that everybody is thinking about all these things that could be problematic but nobody is assigning them a very high probability. You can’t. For example, will Europe melt down? Will the EU fall apart? Maybe it will. What is the probability? Not terribly high. So if you say 10%, then people are certainly thinking about the possibility but they are not pricing assets on the assumption that it will happen. Europe collapsing is what I call an improbable disaster. It is improbable but if it happens it would be a disaster. All these things are priced probabilistically but the absolute probabilities are not high. So if you ask investors, “Are you aware that something bad could happen in Europe?”, they say, “Of course we are.” But if you ask, is it fully priced in the market then the reply is no.

What kind of challenges do investors face in what you are terming as a low-return world?

Six years ago you could get 6-7% on a T-note. You could get a decent return with total safety. That is impossible today. Today, you have to choose between a decent return and total safety. That is a great problem for investors. If you have to make any modicum of income you have to take some pretty substantial risk. Prior to the 1950s or something like that, stocks yielded more than bonds. Most people don’t know that. The reason was that the stocks were considered risky and so they had to yield more than bonds in order to attract investors to them. Then, starting around 1960, stocks became popularised in the US and they started to yield less than bonds. So in 1999, stock yields were negligible and bond yields were substantial. That has corrected now. A lot of stocks in the S&P 500 now yield more than a lot of bonds.

Is it to early to go into Europe to chase high yield?

It is not too early but bear in mind what I said before, that the risk of something bad happening is priced in probabilistically. So, do have allowance made in the price that there is a 10-20% probability of something really bad happening. But if it really happens it happens 100%, in which case you are not adequately prepared. So you can go into Europe but there is substantial uncompensated possibility. You are compensated for what probably will happen but not what possibly could happen. Those are two different things.

What is your outlook on gold?

There is nothing intelligent to be said about gold. Nobody can tell you the right price for an ounce of gold. People will tell you it should go up or go down. To make any intelligent statements about investments you have to know what the right price is. You can’t do that with an asset like gold, which doesn’t produce any cash flow. So you can buy it out of superstition or ignore it because you are an atheist but you cannot buy it with an analytical foundation.

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