While perhaps not quite a legend, Howard Marks, the Co-Chairman of Oaktree Capital, is at least well known among the financial cognoscenti. Oaktree manages US$100bn in credit funds for, amongst others, 75 of the 100 largest US pension funds, 350 endowments and foundations and 16 sovereign wealth funds. Every two or three months Howard writes one of his well known “memos’ to investors, and the latest, “There they go again… again” makes for interesting reading.
Prefacing his argument with the point that he is a natural worrier, he sets out why he thinks global markets are getting overstretched. His view is well summarised where he says:
“Where are we today?… Risk is high and prospective return is low, and the low prospective returns on safe investments are pushing people into taking risk – which they’re willing to do – at a time when the reward for doing so is low.”
He sets out his arguments as to why markets are looking frothy, partly because many people simply can’t see what would make the markets falter and you can’t price in risks you cannot see.
I should point out I’m not as pessimistic as Howard at the moment, but two of his arguments particularly resonate with me. First, the c.US$2.6 trillion that has flowed into ‘passive’, or index, investing is looking suspiciously like a bubble itself. In 2010 index investing accounted for 20% of equity mutual fund investments, now it’s 37%, and an increasing proportion of those are so-called ‘smart beta’ funds, some of which invest in quite esoteric securities including illiquid debt instruments. If there’s a rush for the exits on one of those funds it is questionable if there will be sufficient liquidity in the underlying investments for an orderly sell down. As he puts it, those stocks that have been disproportionately bought will have to be disproportionately sold.
Second, he questions some of the characteristics of the credit markets, including the amount of money being invested into emerging market debt. One of the examples he cites is Argentina, a serial defaulter that has stiffed investors five times in the last 100 years, yet was bowled over in the rush for its 100 year bonds offering a return of 8%. Similarly, Netflix raised €1.3 billion in a bond issue paying 3.625% and rated B. While it’s a really exciting company, its reported earnings are running at about $200 million per quarter, but in the year to 31 March it burned through $1.8 billion in cash. As he points out, bondholders can’t participate in a company’s gains, only its losses.
It’s an interesting read, but a key point, which I keep harping on about as well, is that he concedes nobody can call the timing on a correction. Markets can keep going up for a lot longer than seems to make sense.