Howard Marks seems to have finally made something that sounds vaguely like peace with the rally in risk assets from the March panic lows. Judging by the cadence he adopted across more than a half-dozen memos penned during the crisis, coming to terms with the situation was not always easy.
But, in his latest memo, out Thursday, Marks’s tone is measured. He has returned to form, which is a welcome development. It was touch and go there for a while.
As late as May 18, Howard was still going on about “fake, Potemkin markets”, a sure sign that the scope of the surge and the attendant disconnect between equities and economic reality was getting the best of him – if not financially, at least mentally.
Howard kicks off his new piece with a quick retrospective, in case anyone needs a refresher.
“The advance started off with a bang — a 17.6% gain for the S&P 500 on March 24-26, the biggest three-day advance in more than 80 years — and by June 8 it had lifted stocks from the low by almost 45%”, Marks writes, recapping.
“The market rose on 33 of the 53 trading days between March 24 and June 8, and on 24 of those 33 up days (including the first nine in a row), it gained more than one percent”, he goes on to marvel. “By June 8, the S&P 500 was down only 4.5% from the February peak and even for the year to date”.
He then lists the three top questions he’s received from investors. They are the same questions many of you are asking, and would probably ask Marks if you could:
- How can stocks be doing so well during a severe pandemic and recession?
- Have the securities markets decoupled from reality?
- Is this irrational exuberance?”
At the risk of coming across as presumptuous (something I’ve chanced before), it’s not hard to answer those questions. In order:
- Unprecedented stimulus, both monetary and fiscal
- We don’t know because we can’t predict what “reality” will look like six months from now, and stocks pull forward future outcomes
- Probably not, because even if it all falls apart tomorrow, positioning from key investor cohorts still isn’t really euphoric
Marks rewrites the questions into one larger inquiry which encapsulates the great mystery that has so far eluded Paul Tudor Jones, Stan Druckenmiller, Jeremy Grantham, and especially Warren Buffett. To wit:
The world is combatting the greatest pandemic in a century and the worst economic contraction of the last 80+ years. And yet the stock market — supposedly a gauge of current conditions and a barometer regarding the future — was able to compile a record advance and nearly recapture an all-time high that had been achieved at a time when the economy was humming, the outlook was rosy, and the risk of a pandemic hadn’t registered. How could that be?
Below are Marks’s bullet point answers, which I see no utility in attempting to paraphrase. Here is the list:
- Investors placed great credence in the ability of the Fed and Treasury to bring about an economic recovery. Investors were cheered by the steps taken to support the economy during the shutdown, reopen it, put people back to work and begin the return to normalcy. Everyone understands that the recovery will be gradual and perhaps even bumpy — few people are talking about a powerful V-shaped recovery these days — but a broad consensus developed that recovery is a sure thing.
- As the market recovery took hold, the total number of Covid-19 cases and deaths, and the statistics in states like New York that had experienced the earliest and worst outbreaks, were going in the right direction. Daily new cases declined to very low levels in many places, and the signs of a second-wave rebound were limited. The curve in most locations clearly had been flattened.
- In short, the worst fears — things like massive shortages of hospital beds and PPE, and an immediate “second wave” as soon as reopening began — weren’t realized. This was cause for relief.
- Rising optimism with regard to vaccines, tests and treatments added to investors’ willingness to write off the present episode.
- People became comfortable looking past the pandemic, considering it one-of-a-kind and thus not fundamental. In other words, for some it seemed easy to say, “I’m glad that’s over (or soon will be).”
- Positive economic announcements reinforced this conclusion. And the unprecedented extent of the economic carnage in the current quarter made it highly likely that we’ll see substantial quarter-over-quarter gains in the next three quarters and dramatic year-over-year comparisons in mid-2021.
- Thus, overall, investors were glad to “look across the valley” at better times ahead. There will be a substantial dip this year in GDP and corporate earnings, but investors became willing to anticipate a time — perhaps in 2022 — when full-year earnings for the S&P 500 would exceed what they were in 2019 and had been expected to be in 2020.
- With the outlook now positive, investors likely concluded that they no longer needed to insist on the generous risk premiums afforded by low entry prices, meaning purchase prices could rise.
- In other words, with regard to economic and corporate developments, investors concluded that it was “all good” or at least heading in the right direction.
I suppose what I have trouble understanding in a world where information is disseminated in the blink of an eye, and where the macro narrative is discussed and debated ad nauseam in real-time, is how these kinds of summary treatments count as “incremental” or otherwise additive.
That may simply reflect my own immersion in the narrative and my (very small) role in crafting it. Put differently: perhaps all of this information is, in fact, difficult for most people to process in real-time, and as such, Marks is doing a great service by laying it all out in bullet points, and employing his formidable writing abilities to make sense of it all. And then there’s the fact that the weight his name carries means lots of very important people will read what he has to say.
Still, I think it’s important to point out that this crisis has laid bare the extent to which the people who are supposed to have the answers, don’t always have them. In extreme cases like a pandemic, these people struggle to come up with anything meaningful at all, which is just another way of saying that when push comes to shove, they’re just regular guys — fallible, and trying to make sense of the world like the rest of us.
That isn’t a criticism of Marks. It’s just to suggest that in times like these, nobody knows much. It is a veritable free-for-all. I think he would readily admit that. Indeed, he tried to in a May memo about uncertainty which ultimately fell flat. It was a misguided attempt to wax philosophical about indeterminacy in the face of unprecedented circumstances and it just wasn’t very good.
But, what Howard does know a thing or two about is valuing assets, and in that regard, the following bullet points are at least some semblance of useful even though, again, there’s nothing earthshattering in the following:
- When the Fed buys securities, it puts money into the hands of the sellers, and that money has to be reinvested. The reinvestment process, in turn, drives up the prices of assets while driving down interest rates and prospective returns.
- There’s been a related expectation that the Fed’s buying might be less than discriminating. That is, there’s no reason to believe the Fed insists on good value, high prospective returns, strong creditworthiness to protect it from possible defaults, or adequate risk premiums. Rather, its goal seems to be to keep the markets liquid and capital flowing freely to companies that need it. This orientation suggests it has no aversion to prices that overstate financial reality.
- Everyone is convinced that interest rates will be lower for longer. (On June 10, the Fed strongly indicated that there will be no rate increases through 2021 and possibly 2022.)
- The lower the fed funds rate, the lower the discount rate used by investors and, as a result, the higher the discounted present value of future cash flows. This is one of the ways in which declining interest rates increase asset values.
- The risk-free rate represents the origin of the yield curve and the capital market line. Thus a low risk-free rate brings down demanded returns all along these continua. All a priori returns on potential investments are viewed in relation to the risk-free rate, and when it’s low, even low returns seem attractive.
- The pricing of all assets is interconnected through these relative considerations. Even if the Fed is buying asset A but not asset B, the rising price and falling expected return on A mean that B doesn’t have to appear likely to return as much as it used to, so its price can rise, too. Thus if buying on the part of the Fed raises the price of investment grade debt, the price of non-investment grade debt is likely to follow suit. And if the Fed buys “fallen angels” that have gone from BBB to BB, that’s likely to lift the price of B-rated bonds.
- Lower yields on bonds means they offer less competition to stocks, etc. This is yet another way of saying relative considerations dominate. Fewer people refuse to buy just because prospective returns are low in the absolute.
He doesn’t manage to make it through the whole memo without reference to moral hazard and “zombies”. Every, single take on the Fed’s emergency actions comes with at least one “zombie” reference – it’s become a prerequisite.
“As long as money-losing companies are enabled to refinance their debt and borrow more, they’re likely to stay alive and out of bankruptcy, regardless of how bad their business models might be”, Marks writes, adding that “zombie companies (debt service > EBITDA) and moral hazard don’t appear to trouble the Fed”.
I’ve been over this so much lately that I don’t wish to delve into it anew. Regular readers are fully apprised of my views as the situation stands now. The time to worry about zombies was last year and the year before that and the year before that – not during a pandemic. Unless of course you’re talking about real, literal zombies, in which case I suppose pandemic discussions and the walking dead may plausibly belong in the same conversation.
Read more: Don’t Fear The Zombies.
Next, Marks runs through the behavioral aspects of recent price action, including the Hertz story, which will doubtlessly go down as one of the most absurd sagas in modern market history.
Howard also suggests (somewhat unfortunately) that government benefit checks are being used to speculate in equities. It’s not that I doubt the veracity of that claim when it comes to those receiving checks who had sufficient funds to weather at least the early stages of the storm. Rather, it’s that the implication invariably ends up perpetuating the idea that low-income families are misusing taxpayer money. If enough headlines to that effect make it onto the desks and mobile phones of GOP lawmakers, it could influence their decision on whether to support the extension of benefits to those who need them. That would be highly unfortunate. In any case, here’s Marks again:
- Although suspended from February 19 until March 23, the ever-hopeful “buy the dips” mentality and belief in momentum quickly came back to life. The large percentage of trading in today’s markets accounted for by index funds, ETFs and other entities that don’t make value judgments probably contributes to the perpetuation of trends like these once they’re set in motion.
- Investors have been cheered by the fact that today’s Fed seems to be offering a “Powell put,” a successor to the Greenspan put of the late 1990s/early 2000s and the Bernanke put induced by the Global Financial Crisis. The belief in the Powell put stems from the view that the Fed has no choice but to keep the markets levitated to reassure financial market participants and keep the credit markets wide open for borrowers.
- Thus FOMO — fear of missing out — seemed to take over from the prior fear of losing money, a transition that’s always pivotal in determining the mood of the market.
- Retail investors are said to have contributed substantially to the stock market’s rise, and certainly to its most irrational aspects, like the huge gains in the stock prices of some bankrupt companies. In the exceptional case of Hertz, it seemed for a while that the buoyant stock price might enable the company to sell large amounts of new equity, even though the equity would probably end up worthless. (Equity capital raised by a company in bankruptcy is extremely likely to end up going straight to the creditors, whose improbability of otherwise being paid gave rise to the bankruptcy filing in the first place.) Large numbers of call options have been bought in recent days, and it was reported that small investors accounted for much of the volume. Developments like these suggest the influence of speculative fever and the absence of careful analysis.
- There’s a widely held theory that government benefit checks have been behind some of the retail investors’ purchases. And that makes sense: in the last three months, there’ve been no games for sports bettors to wager on, and the stock market was the only casino that was open.
- Importantly, fundamentals and valuations appeared to be of limited relevance. The stock prices of beneficiaries of the virus — such as digital service providers and on-line merchants — approached “no-price-too-high” proportions. And the stocks of companies in negatively affected industries like travel, restaurants, time-sharing and casinos saw massive recoveries, even though their businesses remained shut down or barely functioning. Investors were likely attracted to the former by their positive stories and to the latter by their huge percentage declines and the resulting low absolute dollar prices.
His conclusion from all of that is that the terms “melt-up” and “buying panic” could be “applicable” to the current circumstances.
Later, after listing a variety of risk factors (and you could make the same list yourself), Marks seems to acknowledge what I alluded to above — namely that the speed with which information is disseminated and how readily available that information is, makes this kind of exhaustive postmortem redundant, at best. To wit:
Maybe it’s the increased availability of information and opinion; maybe it’s the popularization of investing; and maybe it’s the vastly increased emphasis on short-term performance. But for whatever reason, things seem to happen faster in the markets these days.
Marks cites Druckenmiller and David Tepper in reminding everyone that he’s “in good company” when it comes to being skeptical.
“In this line of work, if you never feel humbled, it just means you haven’t realistically appraised your performance”, Howard says, before again referencing “a lot of smart, experienced people” who all agree that asset prices are “too high”.
The contradiction between claiming to be humble and then, in the same breath, citing “smart people” who believe what you believe, seems to escape Marks completely.
The best line from the entire memo comes after Marks says that while some recovery in asset prices was justified, the question is whether “the stock market’s 45% gain from the low and the halving of high yield bond yields from their high” makes sense.
“Was the magnitude that occurred justified?”, he asks, of the visual.
He then answers his own question. “The answers lie in the eye of the beholder”, Marks writes. “If there were a straightforward, reliable and universally accepted way to arrive at appropriate security prices, securities would likely sell at or near those prices”.
Still, he can’t help himself. The last line of the memo reads: “…the odds aren’t in investors’ favor”.