Howard Marks – Equity Prices are Not in a Bubble
This article is based on a presentation from John Mauldin’s 2021 Virtual Strategic Investment Conference, which is being held from May 5 to 18. To register for this conference, click here. The Strategic Investment Conference was just approved by CIMA and CFP for 19 hours of continuing education credits.
Equity markets are not a bubble, according to Howard Marks. He expects six to nine months of very good economic news, followed by “decent” growth for several years.
Business cycles usually last nine years, but he said he is “hedging his bets” with a three-year prediction for economic growth.
Marks is the co-founder and co-chairman of Oaktree Capital Management, the largest investor in distressed securities worldwide. It has roughly $150 billion under management. He spoke on May 14 at this year’s Strategic Investment Conference, hosted by John Mauldin.
Marks does not place much value on warnings of market overvaluation that are based on metrics like retail investor participation, margin debt or the Buffett ratio.
Normally, when stocks are this highly priced, he said the economy is in the late stages of an expansion, and the future economic news is not so good. It may even foretell a recession.
That is not the case now.
There is a huge amount of unspent income among Americans, he said. Many people received more money than they earned pre-COVID and couldn’t spend it on leisure, travel and related expenses. There is $2 trillion in excess savings waiting to be spent, he said. Last year was the best in 20 years for growing consumer savings. That will deliver “real strong energy to the economy,” he said, along with the lifting of masking restrictions by the CDC.
A recession is “out of the way,” Marks said, and the Fed is not “balancing its concerns.” It has concluded that the enemy is a slowdown and is obsessively preventing and combating any slowdown of growth. The Fed is unconcerned about inflation, according to Marks.
Given the excess liquidity and Fed’s singlemindedness, he said, “we will have good economic news for several years.”
But Marks cautioned against getting carried away with his opinions and acknowledged that, as an investor, he does not bet on macro forecasts.
Does value investing still work?
Marks was asked about the differentiation between value and growth stocks and the decade-long failure of value relative to growth. That was the theme of a recent memo he wrote, Something of Value.
Marks is widely recognized as one of the best practitioners of value investing, but his son, Andrew, is a growth-stock manager.
Marks said that growth investing is better suited to his son, who has a positive and upbeat demeanor, while he and other value managers are more cautious and circumspect.
There is no reason to circumscribe the difference between value and growth as rigorous as it has been done in the past, he said. Warren Buffett made a lot of money in growth stocks, including Coca Cola, the Washington Post and GEICO.
Life is easier when we categorize things into growth and value, Marks said. “It gets hairy when the distinction is blurred.” When growth grew up in the mid- to late-1960s, culminating in the Nifty 50, that gave rise to the popularity of value investing. A gulf emerged between value and growth, he said, with crisp definitions for each.
“The greatest opportunities are between the two,” Marks said. “Nobody is prospecting there.”
Neither Graham and Dodd nor Buffett said that value stocks should be cheap in price or have a low P/E ratio, according to Marks. Investors can find good and bad values even among pricey things, like expensive cars.
Businesses have changed, he said, and much of that is around book value. In a manufacturing economy, businesses needed a lot of capital assets, which increased their book values. In a service and software economy, there is much less capital required to produce marginal goods. That explains why those companies have a low book value and a high P/B ratio. Their main assets are their people, Marks said, “who do not appear on the books.”
“Book value is not a very good source of comfort,” for investors, Marks said.
Marks discussed how the current environment fits in the framework he described in his 2018 book, Mastering the Market Cycle.
How did COVID affect market cycles? The events of 2020 were neither cyclical nor part of a pattern of repeating events, according to Marks.
Marks asked, rhetorically, why there are cycles. The S&P average return has been 9% per year, so why doesn’t it return that every year? Indeed, the market return is almost never between 8% and 12%.
The answer is that we get to excesses on the upside, and then overcorrect to the downside due to investor psychology. A key to his investing methodology is to think about cycles in terms of excesses and corrections.
But that was not the case with COVID, which was from an exogenous factor. We closed the economy, he said, which had nothing to do with cycles. Fiscal and monetary policy brought us back, he said, which was similar to how we have corrected from prior cycles.
“Cycles are dominant,” he said, “but are not the only thing that matters.”
The market is off cycle. Normally there is economic and market appreciation, which are correlated, if loosely so. Market maximums are reached at economic tops and the peaks of investor psychology. That is not where we are, he said. On March 23, 2020, we were at a low, only to be rescued. Interest rate cuts revved up investor appetite for everything, he said. But the economy has not recovered nearly to the degree of the increases in asset prices.
Will capital gains tax rates go up?
Marks discussed the proposed changes to the tax system, including the elimination of 1031 exchanges and the step-up on basis of estates. Many people have built their estate planning on those tax policies for decades. A change would be a “wrenching thing for markets,” he said, and will reduce the appeal of investing.
But what is the alternative?
Money has to go somewhere, he said. Even if you don’t like the stock market, there is nothing else that has a more favorable return. Most people cannot invest in non-market solutions and cannot earn anything on money markets.
He recalled that in August 2011, U.S credit was downgraded, but Treasury prices went up because of a flight to quality. There was no alternative but to invest in them, he said.
“It’s hard to write the obituary of the stock market,” Marks said.
Marks acknowledged that there are lots of arguments to support the existing tax code with its lower taxes on capital gains and dividends. But it is still challenging for society when one group is taxed at a different rate than others. “It doesn’t sound right,” he said. The days of corporations and investors making money and everyone fending for themselves are limited. Shareholder primacy is receding, according to Marks, and corporations are expected to be good citizens in other ways.
Favorable tax rates for everything other than labor have reached an extreme, he said, and need to be adjusted. Those paying lower rates are favored because they have a lot of money. “This is the kind of ideal that cannot go on,” Marks said.
Marks supports a group called “nolabels.org,” whose members include 58 bipartisan House members. It does not have an ideology other than bipartisanship and is dedicated solely to problem solving. It strives for 75% support on policies, including a majority from each party.
For example, on the issue of eliminating the favorable capital gains tax treatment, if a compromise among this group could be reached, it would likely prevent such an action.
The group was created to balance the rights of the majority to rule with the interests of the minority. The answer, Marks said, is to build consensus and avoid extreme outcomes. If a bill with extreme measures is passed by a 51-50 vote, it will be reversed whenever the Republicans rise to power.
It is not a legitimate goal to pass legislation without votes from the other side, Marks said. That happened with Obamacare and the Trump tax cuts, and the other party has spent considerable effort trying to reverse them.
If this group succeeds, we will get outcomes that will be “less extreme and will endure,” Marks said.
When he meets with the group, he has no idea who is a Democrat or a Republican. “If we drop our labels, we can do a better job,” he said.
Marks and modern monetary theory
Marks does not buy into modern monetary theory (MMT) and said its adherents “think they have a credit card with no limit and no requirement to repay.”
MMT is a theory, he said, but it is too good to be true.
He cited a University of Chicago survey that found that78% of economists said MMT was wrong 22% called it “seriously wrong.”
The problem, he said, is that a country could behave so badly that it will lose its ability to print its currency. “If we keep running multi-trillion-dollar deficits,” he said, “there will be a time when the rest of the world will stop buying 10-year Treasury bonds at 1.5%.” That would create significant problems for servicing our debt and for our currency.
But who would take our place? There is no alternative to the dollar as the reserve currency, according to Marks.
The Fed distorts price discovery, he said, and a free market is the best allocator of resources. “We don’t have a free market for money,” Marks said. “When the government sets rates at zero, investors pile into 3% investments thinking it is nirvana.”
The Fed should get out of the business of controlling money as soon as possible, Marks said.
Robert Huebscher is the founder and CEO of Advisor Perspectives.