MI365: The Memos of Howard Marks w/ Shawn O'Malley

24:57Including this moment in 2008, there are at least five memos that Marks highlighted in 2023 as having stood out for their accuracy in identifying key turning points in markets. He also jokes that while each of these forecasts in his career were right, he had the benefit of only making five major market bets over the course of a 50-year career, so he waited for the most extreme moments of market dysfunction. His 2023 memo, Taking the Temperature, walks through these moments. One of them was his 2008 call for investors to get aggressive about looking for bargains, as we already discussed, so I'll go through the other four.

25:34The rest of his successful five market calls came in the early 2000s against the backdrop of a massive run-up in tech, media, and telecom stocks. He writes that he had recently read Edward Chancellor's book Devil Takes the Hindmost, which helped him realize how the dot-com bubble of the late 90s was so similar to past historical bubbles. The masses were lured by the promise of easy trading profits as some quit their jobs to go full-time trading the market, even if most of these companies supposedly on the cutting edge of technology were money losers. His memo, Bubble.com, outlines how investors were euphorically bidding up prices for companies that not only had no profits, but in some cases, no revenue.

26:16He wrote, quote, In short, I find the evidence of an overheated speculative market in technology, internet, and telecommunication stocks overwhelming, as are the similarities to past manias. To say they have benefited from a boom of colossal proportions and should be examined very skeptically is something I feel I owe you. In hindsight, Marx adds that he thinks this bubble burst for the simple reason that prices had become unsustainably high. The S &P 500 index would go on to fall 46 % from its 2000 high to the low in 2002, while the more tech-heavy NASDAQ index declined by 80%. The incident painfully instilled the true meaning of the word bubble into the minds of a whole new generation of investors.

26:57From 2004 through 2007, Marx's memos made several more calls in the aftermath of the dot-com bubble and in the lead up to the 2008 financial crisis. In his 2004 memo, Risk and Return Today, Marx expressed that he still thought a more slow motion train wreck was forming, with the Federal Reserve still maintaining a low interest rates around 1 % and accommodative monetary policy four years after the bubble in internet stocks peaked. With low interest rates making it difficult to earn meaningful returns without taking on riskier investments, that's exactly what many did. They sought less certain investments for the sake of higher returns since treasury bond yields were so meager.

27:38This point is built around the more fundamental idea that investors dislike risk and prefer safety, where risk is the uncertainty around whether they will actually earn the return they expect to. The proof behind this point is that if the US government finances itself by selling 30-year bonds that pay 5 % interest rates, no one would turn around and instead buy 30-year bonds paying 5 % from a startup company. Because the US government has the ability to tax the world's largest economy, while also being able to print money to pay bills issued in its own currency, it's seen as the gold standard for borrowers.

28:12It's very unlikely that America won't be able to pay its bills, so buying bonds from the US government where it promises to pay you back in the future isn't considered particularly risky. Obviously, the same can't be said for a startup or any company, really. As Marx makes the point in his 2004 memo on risk and return, for investors to take on risk, they must be induced to. Normally, this happens when an investments potential return is sufficiently attractive to justify the added risk. If that same startup company offered bonds paying 12 % yields, investors might reconsider. As we've already mentioned, though, an inability to earn meaningful returns on low-risk investments can also induce investors to take on more risk.

28:53This sort of risk bearing is more out of necessity than because investors want to. To make the point, consider that you manage a state pension fund for teachers and other governmental employees. Now, imagine that the pension is modestly underfunded, such that for it to be able to pay future retirees, it must invest more aggressively today and earn at least a 7 % return per year on average. When the Fed sets higher interest rates and you can earn 5 % or 6 % on government bonds, you can hit your target return without too much extra risk. At 1 % or 2 % risk-free interest rates, all of a sudden you have to make up a lot of ground to get to your 7 % target return that's required to keep the pension fund operating smoothly.

29:34You start looking at bonds from more financially shaky companies that pay higher rates. Maybe you look at highly leveraged real estate projects, tech stocks, private equity, whatever it takes. So in 2004, investors were falling over themselves to get away from low risk, low return investments, which was setting the groundwork for a new bubble to form. Near the end of the memo, he writes, quote, there are times for aggressiveness. I think this is a time for caution. The problem is that even when the returns available in markets do not justify the risks, as was broadly the case during this time, investors are often too stubborn, proud, or impatient to wait for circumstances to change.

30:15As Marks writes, no one wants to throw in the towel with regard to investment returns. No one likes to admit that their intelligence and hard work won't be enough to get them to their target. But at times when the markets are offering paltry absolute returns and inadequate compensation for bearing risk, it's the only thing to do. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you. We've got a handful of other shows for you to explore, from learning about Bitcoin to embracing a richer, wiser, happier lifestyle.

30:49Just go into your podcast app and type in We Study Billionaires to find our collection of shows. We Study Billionaires is our flagship podcast, and we've made a name for ourselves over the years by interviewing the best investors in the world, including Ray Dalio, Howard Marks, Joel Greenblatt, and many, many more. My colleagues Stig Brodersen, Clay Fink, Kyle Greve, Preston Pysh, and William Green each host their own We Study Billionaires episodes and bring their own unique perspectives. A whole new world of insights awaits you. Just go ahead and type in We Study Billionaires into your podcast app and see what you've been missing out on.

31:25Seriously, go ahead. I promise you'll like what you find. Bonus points if you show your support for our work by clicking follow. If something piques your interest, just start listening. No hard feelings. I'll be waiting for you back here. Just like everybody else, there was a time when I was a beginner investor, and I have to say, investing is particularly filled with jargon that can just make it so difficult for new investors to understand what is going on. But it's never too late to get smarter about stock investing from the ground up. At The Investor's Podcast Network, we've made a habit of studying the world's best investors, and now I'm distilling those learnings into a simple course for you or for anyone in your life who you might want to share the gift of knowledge with.

32:03With my How to Get Started with Stocks course, you can master the principles of excellent lifelong investing with valuable insights for both beginners and pros. The course covers 10 different sections, beginning with the basics of what a stock actually is and how the stock markets work, to strategies to optimize your retirement savings, how to pick great companies for the long term, what to look for in ETFs, and how to monitor your investments, plus so much more. To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks.

32:39And for a limited time, you can use code stocks15 for a 15 % discount at checkout. Not to be cliche, but building a market-beating portfolio really doesn't have to be a mystery, at least with the right tools. If you've listened to our podcast for a while, then you know we spend a lot of time learning from savvy investors. So why not use the same tools we do? With TIP Finance, you can. Screening for great companies, calculating intrinsic value, Keeping up with legendary investors' portfolios and more are all not just possible, but easy to do. TIP Finance was created by investors for investors. It's quite literally the tools we wanted to use ourselves when researching investments in a simple-to-use interface.

33:22You can get started by creating an account for free. Who knows, maybe TIP Finance will help you find your next 100 to 1 investment. Between the screener and Legend Investment Portfolios to reference, I've gotten a ton of ideas from TIP Finance. What are you waiting for? Take the next step in your investment journey today with the right tools at your fingertips. Grab your device and type into your browser, theinvestorspodcast.com slash TIP-finance to get started. That's theinvestorspodcast.com slash TIP-finance. All right, back to the show. In his 2005 memo, There They Go Again, Marks details how in the pursuit of meaningful returns, many were relying on the fallacy that home prices only go up.

34:09There was a lot of optimism surrounding new financial products tied to real estate that created an illusion of safety, prompting many to believe the four most dangerous words in finance. This time, it's different. That statement is almost always followed by a brazen disregard for learning the lessons of past economic cycles. He cites a few classic illustrations of the types of flawed thinking that grips markets as bubbles form. In aggregate, it's a combination of beliefs ranging from thinking that a given type of investment is guaranteed to continue delivering high returns to falling for surface level stories that ignore how markets really work, like believing no price is too high for a good growth company.

34:48The most recurring and harmful of these bubble mindsets is the projection of future returns based on the past. I see this all the time. Personally, friends ask me what mutual funds they should invest in for their 401k. And they say, Oh, look, this one has done better over the past decade. So I want to invest in it. Marx writes in response to this, instead of being encouraged by months or years of price appreciation, investors should be forewarned. That's because of financial gravity. Nothing can rise forever. And if a stock or asset class like emerging markets have been outperforming for a decade, the odds are stacked against it that that trend will continue.

35:28In response to the real estate deals going on at this time in 2005 that embraced these elements of classic bubble thinking, Marx and his co-founder at Oaktree would say to each other, quote, if deals like this can get done, there's something wrong with the market. As they still do, people at the time justified real estate investments by calling them a good inflation hedge or saying that they aren't making any more of it. While that's true, Marx retorts that there's a lot of land left to develop and something is only an inflation hedge if it's bought at a fair price to begin with. On top of this, the real economic value of homes was declining at the same time prices were surging.

36:05Home prices rose 16.4 % from 2003 to 2004, yet the average rent payment was flat. From an investment perspective, a home's economic value stems from the rent you expect to collect while owning it. If homes are worth more and more, but the actual cash flows from rent they can generate are not growing, then clearly there's an unsustainable disconnect. The question Marks tries to wrap his head around is why people were willing to pay these higher valuations for houses. Similar to investing in internet stocks during the dot-com bubble, there was a belief that buying homes as an investment couldn't go wrong.

36:41At the same time, there was a lot of FOMO from seeing others get rich off of piling into real estate. No one wanted to regret not having bought into real estate, and these decisions were rationalized by arguments that suggested a shortage of land combined with demand for property from baby boomers and foreigners would prolong the good times indefinitely. In response to all this, Oaktree went defensive. They sold off large amounts of assets, liquidated large funds, and significantly raised the bar for what investments they would consider. By July 2007, Marx was still warning investors that risks on the horizon were now much closer than before in his memo, It's All Good.

37:20Eight months after he wrote that memo, the investment bank Bear Stearns melted down thanks to its investments in subprime mortgages, and a rapid succession of bankruptcies and bailouts began after that. The S &P 500 would fall 53 % from its 2007 peak to its low in February 2009. While the rest of the world panicked over what to do about these real estate woes, Oaktree held on with zero exposure to subprime mortgages or mortgage-backed securities. That decision wasn't made because Marx and his team were subject matter experts on real estate though. In fact, he writes in hindsight in 2023 that much of these troubled assets were being traded in a relatively remote corner of the investment world, and what helped Oaktree was their ability to, quote, take the temperature of the market and recognize things felt off.

38:09His 2007 memo shows that philosophy in real time. Marx wrote then that one thing I believe in most strongly is the inevitability of cycles. I always say that while we can't know where we're going, we ought to know where we are. He makes the point that markets are like a pendulum swinging between extremes. Although the middle is technically the average, they spend very little time in this average midpoint. Depending on where we are in a cycle, the market swings toward one extreme or the other. That is between extreme greed and optimism or extreme fear and pessimism. These swings occur because a majority of market participants' psyches join together in the same direction like a herd.

38:49Marks adds that, quote, no matter how favorable and steady fundamentals may be, the markets will always be subject to substantial cyclical fluctuation. The reason is simple. Even ideal conditions can become overrated and therefore overpriced, so don't fall into the trap of thinking that good fundamentals equal positive market outlook. In the same way that moviegoers suspend disbelief in the name of having fun and enjoying a film, investors caught up in bubbles suspend disbelief by implicitly accepting that the good times will go on forever, or that they will see the bad times coming before others and know when to get out.

39:26In the 90s, no one could fathom a reason why online retailers and new internet-enabled companies wouldn't work out, similar to how many today can only see a version of reality where the hype around AI not only comes true, but that its effects are overwhelmingly positive and not negative. I think the following passage from Marx was quite prescient in mid-2007. Quote, It seems the value of outstanding credit default swaps, insurance against defaults among corporate debt instruments, exceeds the value of the instruments insured. How will this work if a wave of defaults occur? How well are the provisions of these insurance contracts documented?

40:04How readily will the writers of the insurance pay up? What will be the effect if the conditions are chaotic? Certainly didn't know exactly how things would unfold, but he knew the setup was getting dangerous, and we'd soon learn the costs of these new financial innovations. This overlaps a lot with what we've already talked about in Marx's other letters from the 2004 to 2008 period here, but the evolution in his thinking is really fascinating to read through. Whereas in 2004, he was sort of abstractly musing on how bad things were starting to happen and would continue to happen with interest rates so low, by 2007, he was case by case pointing fingers at the biggest vulnerabilities, brewing beneath the surface that many didn't understand until years after the 2008 crisis.

40:50During this time in 2007 and 2008, Oaktree organized an$11 billion reserve fund to purchase highly distressed debt, which are typically bonds from companies that have either already defaulted, are in bankruptcy protection, or are facing immediate bankruptcy. Marx made the decision, as we've discussed, that if the financial world melted down, then it didn't matter what they did. But if it didn't, not acting would have meant they weren't doing their job. So after Lehman went under, Oaktree began investing$400 million a week from September 2008 through year-end for a total of$6 billion in a single quarter.

41:25I just want to emphasize how uncommon this was. Almost no one else was doing this as markets cratered and warnings about the complete destruction of the financial system gripped mainstream media. It was almost unimaginable to have any shred of optimism about the future, let alone to plow billions of dollars into distressed assets. As Marx framed things in his 2008 memo, The Limits to Negativism, he asserts that skepticism and pessimism aren't synonymous. Skepticism calls for pessimism when optimism is excessive, but it also calls for optimism when pessimism is excessive. In the third stage of a bear market, everyone agrees things can only get worse.

42:06The risk in that, in terms of opportunity costs or foregone profits is equally clear. There's no doubt in my mind that the bear market reached the third stage last week. That doesn't mean it can't decline further or that a bull market's about to start, but it does mean the negatives are on the table. Optimism is thoroughly lacking and the greater long-term risk probably lies in not investing. So Mark's made the market calls in his career that he's most proud of in 2000, 2004 through 2007, 2012, and 2020. Let's jump Jump ahead to 2012 and see what happened then. With the global financial crisis in the rearview mirror and S &P 500 returns essentially flat for over a decade from 2000 to 2011, poor performance had led investors to lose interest in stocks.

42:55But lows and optimism actually meant things probably couldn't get any worse. This is second order thinking. Rather than looking around and thinking, wow, markets are in rough shape and most people are feeling negatively about investing, so I should feel negatively too. A sophisticated investor recognizes that this negativity will not last forever and is actually making financial assets relatively cheap. In the 2012 memo Deja Vu All Over Again, he talks about an article he read in 1979 in Businessweek titled The Death of Equities, which declared that high inflation had killed the enthusiasm for owning stocks among millions of investors.

43:31The conclusion the article reached was precisely wrong though. It argued that the death of stock investing was a near permanent condition that wouldn't reverse anytime soon. But from there on for the next 21 years, stock indexes delivered an average annual return of 17.9 % that would have 32X every dollar invested in 1979. Sentiment falling so low that Businessweek could confidently proclaim the death of stock investing was exactly the moment to be getting bullish on stocks. Mark says that 2012 was similar. After the great financial crisis, investors were depressed, and four years later, enough time had passed that it was just the right time to be turning bullish again.

44:12From 2012 through 2021, the market returned 16.5 % a year and has continued to hit new highs into 2024. Once again, excessively negative sentiment resulted in major gains. And that brings us to Marx's next and final defining market prediction we'll cover from March 2020. In a memo titled Nobody Knows 2, inspired by his original Nobody Knows memo from 2008, Marx gave his perspective on markets amid the COVID-induced pandemic. He told clients that just because the course of a pandemic was unknowable, that doesn't mean no action should be taken. In a weekly memo at the time, he added that, quote, the bottom is the day before the recovery begins.

44:55Thus, it's absolutely impossible to know when the bottom has ever been reached. Even though there's no way to say the bottom is at hand, the conditions that make bargains available certainly are materializing. No one can argue that you should spend all your money today, but equally, no one can argue that you shouldn't spend any. Compared with his previous market calls that relied on history and logical analysis, Mark's recommendation here is more of an acknowledgement of ignorance. All that was known for sure was that a pandemic was underway and the US stock market was down one third. Although the fundamentals of companies couldn't be assessed because no one knew what would happen to the economy, he did know that an incredible amount of selling had already transpired and logically as people have sold, the less they have left to sell, which leaves them with cash to use when their outlook becomes less pessimistic.

45:43That was enough to know that bargains are being offered even without rigorous analysis. Sometimes he writes, it's really as simple as that. When most investors' knee-jerk reaction is to sell or hide on the sidelines, a contrarian decision to buy may be more than justified. The trick is to keep your head when others are losing theirs. So in reflecting on these five moments of decisive market bets, Marx writes in his 2023 memo, taking the temperature that this is not meant to be self-congratulatory. Instead, we all go through life hoping to learn from our experiences. And on occasion, it's helpful to look back at the key moments to see what patterns emerge.

46:22Once or twice a decade, markets go so high or low that the probability of being contrarian and right becomes compellingly high. But there were only a handful of these moments in Marx's career. There are five market calls that he had conviction in and is proud of, not 50. More market calls creates more noise at times when the odds are less clear that make it more likely you'll be wrong. The takeaway then is to avoid making macro calls too often and certainly don't try and make a living doing so. When markets hit extremes, outperformance comes from both being able to understand the fundamentals, like going through companies' financial statements and understanding their valuations, and also being able to read the temperature of the market.

47:02There is often a flawed notion among value investors that they can solely focus on evaluating companies from the bottom up and that nothing else matters. But at least according to Howard Marx, that isn't true. Any bottoms-up analysis relies on making estimates about the future, and estimates about the future are predicated on the macro environment. If you think a company can keep compounding sales at 10 % a year, that gets pretty hard to justify with a recession on the horizon. So to some limited extent at least, investors have to have an awareness of the macro environment and the temperature of markets.

47:34To do that, Marx encourages us to be students of history, to recognize the types of patterns and cycles that underpin peaks and bottoms. He also says to watch for moments when most people are so optimistic that they think things can only get better or the converse, and that what happens in markets and economies is ultimately not some mechanical process, but the result of swings in human emotion. Investors who stand out can resist emotionality, avoiding the crowd rather than joining in, and can recognize illogical propositions like stocks haven't fallen so far that no one should be interested in them.

48:09His book, Mastering the Market Cycle, is an excellent read and provides tangible insights on how Marx has come to understand what drive cycles, how they evolve, and how to know at what point in the cycle we're in. The one thing he says they never do at Oak Tree is predict that the macro environment will be distinctly better than normal. It's their goal to build portfolios that surprise to the upside and relying on optimistic assumptions is rarely part of that process. Their assumptions are much more often neutral. By necessity, oak tree models with assumptions, but they're seldom boldly idiosyncratic or optimistic.

48:44Marx ends the memo with an intriguing question. Would you rather buy at what turns out to be a market top or sell at the bottom? He says the answer is actually easy. He'd much rather buy at the top. That's because with markets, the next top is usually higher than the next, so you'll eventually come out ahead. But when you sell out at the bottom, you make that downward fluctuation permanent. There is no redemption to be had. This is why he calls selling at the bottom the cardinal sin of investing. That's all I have for you today. We've been through a ton of Marx's writings, and I've attached links to all the memos mentioned today in the show notes if you want to read them yourself, as well as links to the books that Marx mentions.

49:23Howard Marx is one of my favorite investors to learn from, and his memos across his career provide an incredible opportunity to see what things are like at different points in financial history through the eyes of a great investor who lived through it all. Thank you for listening to TIP. Make sure to follow Millennial Investing on your favorite podcast app and never miss out on our episodes. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network.

49:59Written permission must be granted before syndication or rebroadcasting.