How Oaktree's Howard Marks Spots a Market Bubble

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1:30Hello and welcome to another episode of the Odd Lots podcast. I'm Traci Alloway. And I'm Joe Weisenthal. So, Joe, we recently recorded an episode with Kevin Muir where we were talking about concentration risk in stock indices and, I guess, historical analogies with the dot-com bubble of the 2000s. And I know that this is one of your favorite subjects. I think I said it was like your own personal catnip. That's right. And so I thought, you know what? I did not get, Joe, a Christmas present this year. In fact, I don't think I've ever gotten you a Christmas present. But wouldn't it be nice if I got him a whole episode where we're talking to one of the world's most famous investors who correctly called the internet bubble?

2:14Let's do it. Let's jump right into it. No more intro. I'm so thrilled about this conversation. Let's just get it started. All right. I will also admit this is a belated Christmas present to myself as well. So we are going to be speaking with Howard Marks. He is, of course, the co-founder and co-chair of Oak Tree Capital Management. investment he's famously a credit investor but he did call as I said the dot-com bubble correctly so Howard thank you so much for coming on the show it's a pleasure to be with you Tracy and also Joe maybe just to begin with give us some context around what the early 2000s late 1990s were like for you?

2:56What were you doing and what were you observing at that time? Well, the 1990s were a slow time for credit investors. We're kind of opportunistic and bargain hunters and bargains come from dislocations and people feeling urgency to get out of positions. And the 90s were generally a placid period, except for the around 98, we had a devaluation of the Russian ruble and a Southeast Asian crisis. And we had the meltdown of a highly levered hedge fund called long-term capital management. But those were all kind of idiosyncratic events, not macro and not broad-based. Other than that, the investment environment was placid.

3:46Importantly, it was the best decade in history, I think, for stocks. and the S &P 500 rose an average of 20 % a year for 10 years, which is an astronomical accomplishment. If you rise 20 % a year for 10 years, I would guess that something goes up roughly eight times in 10 years, which is incredible. And of course, this was all powered by what we call the TMT bubble, tech, media, and telecom bubble. Some people call it the internet bubble, which prevailed in 98, 99 and into 2000. So it was hot times, not for credit investors, hot times for equity investors. You know, you recently wrote a memo that called back to a memo that you had written basically exactly 25 years ago.

4:33So right at the start of 2000, of course, the dot com bubble or the TMT bubble peaked. I think it was in March of that year. You got the timing right. And that's sort of extraordinary because there were a lot of people probably starting in 1998 and 1999, maybe even earlier, like this is ridiculous. There's all these companies, they literally don't have a penny in earnings or perhaps don't even have a penny in revenue. They just have the name.com in their name. They IPO at crazy prices. What is the experience like? I mean, that was very fortunate timing on your part, but there were a lot of people who were famously correct and early And they had clients abandoned them and so forth.

5:16And they were thought, oh, you don't understand the new paradigm, et cetera. What's that like in the years before that, as it feels like the market is becoming increasingly untethered from any sort of reality, and yet there's no payoff in being correct? Right. Well, there's so much to say in response to your question. You know, I use a lot of quotes and adages when I write because, you know, other people have said things so much better than we can. And one of the first adages I learned in the early 70s was that being too far ahead of your time is indistinguishable from being wrong. So, yeah, it's painful to say something and predict something and then have to wait years and years for it to come true.

6:03So Alan Greenspan famously said, I think it was in 96, that we're beginning to see signs of irrational exuberance in the stock market. And of course, the market went straight up for the next four years. And there are people who pronounced that we were in a stock market bubble. I think I can think of one in June of 2020. And here we are almost five years later. And of course, we did stall out in 22. But if you went out in 20 and weren't smart enough to come back in in 22, you've missed a big ride. So I think, well, you know, one thing I argue strenuously, Joe, is that in the investment business, there's no place for certainty.

6:49And Mark Twain said, it ain't what you don't know that gets you into trouble. It's what you know for certain that just ain't true. And so you can have opinions, but you should never be certain that you're right. And you should never arrange your financial affairs on the assumption that your forecast is right, because it can be right intellectually or factually or rationally, but just take a long time to materialize. And if you can't survive between when you take your position and when your expectation comes true, then obviously it's not something you should do. And one of my colleagues once wrote a note to his clients.

7:32He says, if you name a price, don't name a date. And if you name a date, don't name a price. That's good advice for journalists, too. But anybody who names a price and a date is probably going to get carried out of it sooner or later. So what was it like then when you hit the publish button on the note? I think it was called bubble.com and you published it. I think it was right at the start of January 1st. What was it? It was January 2nd, 2000. It was the first business day of 2000. And then stocks peaked later that month, right? Yeah. No, I think a little later that year. Joe said it was in March.

8:14I don't remember exactly. I thought it was a little later than that. But, you know, I'd started writing these memos in 1990. I've been writing for 10 years. Of course, in those days, they went out in the mail and to a limited audience, just my clients. And, you know, for 10 years, I never had a response. And then I spent the fall of 99 working on this memo, bubble.com, and was ready to push the button. I guess I polished it over Christmas, probably, and sent it out the first day. And let me just clarify one thing for the record and for the benefit of the listeners. If you read that memo, it does not predict the bubble.

8:55And it does not say the market's going to collapse. All it did is describe the current conditions. And that's two different things. Now I don't make predictions. I only describe current conditions. And my motto is we never know where we're going, but we sure as hell ought to know where we are. And I believe, you know, this is a little bit of a matter of semantics. I believe that where we are, if we properly assess it, informs where we're going. But I think people who waste their time figuring out, making predictions, which I'm strongly against, are wasting their time. I think that describing current conditions can be done accurately and obviously has an impact on what the future holds.

9:53So as I say, read the memo. I think it reads well in retrospect, but don't expect to find a place where I say, get out of the market or the market's going to collapse or we're in a bubble that's going to pop. What I say there is, I just want to call your attention to all these forms of excessive or overheated behavior and let you know what I think is going on. That's all it says. So in the art of just identifying where we are, and when we're talking about financial markets, obviously, we can use all kinds of ratios, et cetera, price to earnings, price to forward earnings, valuations, a million different ratios that you can come up with.

10:37And then there are sort of cultural markers. And I remember in summer 99, I would get lunch every day at the same pizza shop, and the pizza shop owner had CNBC on, and he was trading tech stocks at the time. and these other sort of indicators that people are just excited about the prospect of making money and making money fast. And when you do an assessment and you say, OK, here's where we are, how much do you sort of hew strictly to the math, so to speak? And how do you systematically incorporate other indicators of exuberance, which perhaps can't always be captured on a Bloomberg terminal, for example?

11:18No, look, I think you're absolutely on the right track, Joe. You read the memo. My observations are, I would say, 99 % what you called cultural markers, which I think is great, or behavioral indicators, and 1 % math. And to me, it's the behavior that is so indicative. And in my first book, which is called The Most Important Thing, I have something in there called The Poor Man's Guide to Market Assessment. And it really takes mostly cultural markers and puts them in two columns, left and right. and whichever column is prevailing, it tells you something. And for example, I say in there that if people like me are being invited to cocktail parties and are the center of attention and so forth, then it probably means that investing has been doing well and everybody's optimistic about it and it indicates that maybe things are too hot.

12:28And if people like me are not invited or shunted off to the corner, Maybe the markets are too cold, too cheap, and it's time to strike. So I think that these behavioral indicators are extremely important. And I wrote a memo in, I think it was the summer of 23, called Taking the Temperature. And I describe what I do in this regard as taking the temperature of the market to figure out if it's hot or cold. And when I was working on my second book, which is called Mastering the Market Cycle, and I was speaking with my son, Andrew, who's a venture capitalist, I said to him, you know, I think my forecast over the course of my career have been about right.

13:11And he says to me, yeah, dad, that's because you did it five times in 50 years. Five times in 50 years. I found the market either so crazy high or crazy low that you could make a logical case that was either overextended or too cheap. And you could do so with a high degree of confidence. And I recount the five times I did it and why. But if I had tried to do it 500 times or 5 ,000 times in my career, I mean, I've probably been in the investment business for about almost 20 ,000 days. If I tried to do it 5 ,000 times every fourth day, you know, I'd probably be 50-50 at best. So to me, it's noting extremes of behavior.

14:06And that's what I was doing with bubble.com. And that's what I did in the five other observations.

14:17Thank you.

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15:27To learn more, visit easycater.com slash podcast. So you've emphasized that you're describing current conditions, not necessarily making predictions. I'm curious how you translate those, you know, let's say, accurate assessments of the current environment into actionable investments? Or I guess another way of asking this is, you know, if you're looking at stocks and thinking they're overvalued or there might be signs of overvaluation, how does that translate into the credit space? Good question, Tracy. To me, the main axis along which one establishes one's behavior as an investor is the axis that runs from aggressive to defensive.

16:28Each of us should figure out, based on our personal conditions, our wealth, our income, our needs, our dependence, our age, plans, etc., and also ability to withstand fluctuations. Each of us should figure out what our normal risk posture should be. Normally, should I be a low-risk person, normal, or a high-risk person? and then you should build a portfolio that responds to that decision. But then you might try to vary your position from time to time as conditions in the markets change. And I believe that, as I said, that the main axis along which one should think about varying one's position is between offense and defense.

17:22So, you know, you establish a position, which is your normal position, which has a certain amount of aggressiveness, has a certain amount of defensiveness. But then are there times when you should become more aggressive? And are there times when you should become more defensive? And that's what I did on those five occasions. And I'll give you an example. And by the way, these are all described in taking the temperature. And I've mentioned, or you've mentioned the memos from time to time. And I just want to note for the listeners that they're all available at oaktreecapital.com under the heading of insights.

17:57There's 35 years worth of memos there, about 200. And there's no price of admission. They're all free. And anybody who wants to sign up for a subscription can do so. But in taking the temperature, I described the way in 05, 06, I was getting really leery of the markets. What was my indicator? My indicator, or as Joe would say, my cultural marker, my indicator was that I'm reading in the paper about new deals that are getting done. And the deals were crazy deals. Deals that, in my opinion, should not get done. They were too good for the issuer, and in my opinion, too bad for the investor, and the deals were getting done anyway.

18:50And one of the investor's main jobs is to decline to engage in stupid deals. And if somebody comes and says, I'm going to sell you a gold mine, and if you can put up a million dollars, you're going to make$100 ,000 a month for the rest of your life. Your job is to say, no, that's too good to be true. Or, you know, if I say, I think there's a gold mine in Australia, and if you put up a million dollars, it'll probably pay you a million dollars a year the rest of your life if we find gold. You should say, no, that sounds too risky. I just think that we're unlikely to find gold. But if you see those deals getting done, it tells you that investors are not applying vigilance.

19:42They're not doing their job of resisting deals that are too risky or structured, not in their favor. And in 05-06, I was seeing these deals done that made absolutely no sense. And I describe myself as wearing out the carpet between my office and my partner, Bruce Karsh. And every day I would go and say, look at this piece of crap that got issued yesterday. A deal like this shouldn't get done. And if a deal like this can get done, there's something wrong. That was 99 % of my observation at that time, that investors were not being suitably skeptical, cautious, demanding, and risk averse. And, you know, Buffett has a great saying, which feeds right into this.

20:33He says, the less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs. And when others are wacky, we should head to the sidelines. That was the foundation of that conclusion. Now, what happened was it turned out we were in a housing bubble, and the housing bubble gave rise to a mortgage bubble. And the mortgages, the subprime mortgages issued to people who could not or would not document their income or their assets were packaged into mortgage-backed securities. And the people who bought the riskier tranches of those securities lost all their money, which the rating agencies rated very highly because they didn't understand anything.

21:21And this was going on en masse. And it was the collapse of the mortgage-backed securities of which the banks had, in many cases, retained the risky portions when they structured them. It was the collapse that took Bear Stearns and Merrill Lynch and Lehman Brothers and other AIG, etc., out of business as independent entities. I hasten to point out, I didn't know anything about mortgage-backed securities. I didn't understand subprime. I didn't know what was going on. It was going on in a distant corner of the investment world, which I was not in on. I just knew that the climate was too permissive and the mortgage-backed developments were a manifestation of that.

22:11But your question, I always try to come back to the question. Your question was, what do you do about it? So what did we do? We sold most of our real estate holdings. We reduced holdings in many areas. We liquidated holdings in large funds, our opportunistic debt funds that we had formed in 01, 02, 04, et cetera. We sold those holdings. We raised either small funds or no funds. And we waited for this behavior to produce opportunities after it passed. On the first day of 07, Bruce and I sent a memo to our clients saying we'd like to have$3.5 billion for a distressed debt fund. The largest distressed debt fund in history had been$2 billion.

23:13It was our 01 fund. We wanted$3.5 because we thought there was something big coming. And within a month, we had$8 billion. We went to our investors. We said, we can't use$8 billion. We'll take$3.5. We closed that fund in March of 2007. But we said, we'd like to have the rest of your appetite for a standby fund. And we continued for a year to raise a standby fund. Again, in an area where the biggest fund in history was$2 billion, we raised$11 billion. And that was our fund 7B. And we put it on the shelf. And we said, this is for when the stuff hits the fan. And we're not going to invest it until that time.

23:59And we're not going to charge any fees. And it's just commitments on the shelf because we'd like to have capital we can draw. And when Lehman went bankrupt on September 15th of 08, we had that$11 billion. We had only invested about$1 billion. We had$10 billion that we could call on. And so unlike most people, we didn't have to worry about where are we going to get money or can we invest or are our clients going to withdraw their money rather than we had commitments we were sure we could draw. And so we could plunge in and we started to invest. Bruce does the investing and we developed our position jointly and we decided to get down to work.

24:49So the next week after the Lehman bankruptcy was Friday the 15th, we started investing. And he invested for that fund alone,$450 million a week on average for the next 15 weeks. That's$7 billion in one quarter, remember, in an area where the biggest fund in history was$2 billion. Why? Because we had prepared mentally. We had noted the bad climate. we had prepared for a denouement and we swung into action when it arrived. And I was very proud of him for taking that position. And people on the street have told me that in that quarter, we were the only buyer. Well, that's how you get good deals. If you can buy where nobody else is buying, you get your pick of the litter at low prices.

25:45So that's, I just gave you a four or five year, I guess, four year description of a process. But man, you have to be patient. Because in 05, 06, we were doing nothing, just selling. And we were not rewarded in 05 or 06 for that behavior. The reward came at the end of 08. But, you know, I think it's not everybody's in a position to apply that process to that extent, but I think it describes the process. And of course, I use it as an example for one simple reason. It was successful. Always a good outcome when you have the success from it. Obviously, fantastic story. Your latest memo, which inspired us to reach out and want to chat with you on Bubble Watch.

26:34And as you mentioned, is the 25th anniversary of the bubble.com memo. And so 25 year anniversaries are just probably a good time to go back. But on the other hand, there is also this moment that we alluded to in the intro of incredible enthusiasm, really for like a handful of tech AI related names that's lifting the entire market up. Is this one of the moments? I mean, what is the temperature right now as you see it? You've mentioned you've had five moments, sort of maybe five calls in your career. Is this a sixth right now? No, it's not. Okay. Because you asked before, behavioral or numerical?

27:15The main observations today are numerical. The P-E ratio on the S &P 500 is elevated relative to historic norms. And the so-called Magnificent Seven, the biggest companies in the S &P, dominate its behavior, are going up or have been going up rapidly. And they're hot stocks. And when you see one group perform especially well, you have to ask whether it's a bubble. And the S &P, of course, has gone up more than 20 % a year for the last two years. And it's only the, I think, the fifth time, according to JP Morgan, the fifth time in history. So you have to ask these questions. But the troubling aspects, those are numerical.

28:09And what I say in the memo is that, in my opinion, it lacks the behavioral aspects of a bubble. And I talk about some of them. And I say that a bubble is not just numerical. It is behavioral. And a bubble is really, it's not a rise. It's that's a bull market. It's not high prices. A bubble is a temporary mania in which people are so agog at things that they throw over all discipline, all caution. And I just don't it just doesn't feel to me like we're there. We're high priced. I say lofty, but not nutty. And the bubbles I've seen and I've lived through starting with the day I joined this business in 69.

28:59We had what we call was called the 50 50. What you see going on is what they call in literature, the willing suspension of disbelief. You know, I know it's high, but if I don't go in, I could miss something. Or I know it's high, but I don't think it's going to end tomorrow. And by the way, if it ends, I'll just get out. And, of course, as I mentioned in the memo, the real hallmark of a bubble is when people say, it's so great, this thing we're talking about, whether it's the 50-50 stocks in 69 or NVIDIA today or TMT in 99. They say it's so great that there's no price too high. And that was the official dictum in the money center banks in 69.

29:55with regard to the 5050, it was the official victim with regard to the internet in 99. What did people say? The internet will change the world. And so for the stocks, there's no price too high. Well, guess what? The internet did change the world. But because they bid up the stock so high, the people who invested in them lost almost all their money. So, you know, people become psychologically unhinged and not tethered to reality and their portfolios slip their moorings and they think that they've found a perpetual motion machine or a tree that'll grow to the sky. And I just don't see those psychological or behavioral aspects today.

30:44So one of the things that Joe likes to emphasize when it comes to, well, the tech bubble specifically is the importance of stories or narratives. So one of the things that will drive this kind of behavior is you'll see a company come out with this huge ambition. I think Joe's favorite example is, wasn't there a car company that claimed to have found the cure to AIDS? That's right. This is a good story. This was 1999, and people were just so optimistic that they thought a used car dealership in Nevada had in their back office found a cure for AIDS. That never ceases too amazing. This is a real story.