Howard Marks: "It Isn't Just A Windfall, It's A Warning Sign"

Despite the all-knowing Alan Greenspan confirming there is no irrational exuberance currently, Oaktree Capital’s Howard Marks is less convinced. Though he is not bearish, he lays out rather succinctly the current pros and cons for equities – based on the various ‘valuation’ arguments, discusses the folly of the equity risk premia, and highlights the dangers of extrapolation and what history can teach us“appreciation at a rate in excess of the cash flow growth accelerates into the present some appreciation that otherwise might have happened in the future… it isn’t just a windfall but also a warning sign.”

Via Oaktree Capital’s Howard Marks,

The problem with basing a pro-equities argument on the yield comparison is that most of equities’ current attraction on that basis comes from the lowness of interest rates. Just about everyone knows (a) interest rates are artificially low because of central banks’ efforts at stimulus and (b) rates will be considerably higher at some point in the intermediate term. In that case, rising rates would render stocks less attractive.

The Other Pros and Cons of Equities

There are many ways to view valuation, and many elements in the current debate over equities. Here are a few of them (I?ll start by reiterating the above for the sake of completeness):

  • The differential between the S&P earnings yield and the risk-free rate or the yields on bonds – and their ratio – makes stocks look extremely cheap. PRO
  • The attractiveness of these relative valuation parameters is highly dependent on interest rates staying low. CON (or LESS PRO)
  • Relative to normal post-WWII p/e ratios, stock prices are average to slightly low as a multiple of projected earnings for the year ahead. PRO
  • Robert Schiller?s cycle-adjusted p/e ratios are gaining increased attention, and they suggest full rather than fair valuations. CON
  • Arguably earnings growth in the years ahead will be slower than that which prevailed in the decades following WWII. Thus the post-war valuation norms are too high under the changed circumstances and should be discounted. CON
  • The outlook for earnings is restrained by the questionable macro environment, including the challenges in restarting growth and the dire prognosis for the federal deficit. These problems may not be easily solved. CON
  • Among the things keeping earnings high – and thus making stocks seem attractive – are some of the highest profit margins in history. If profit margins were to move toward normal levels, this would bring down earnings, either taking stock prices down with them or lifting p/e ratios and thus reducing stocks? attractiveness. CON
  • Corporate cash hoards are high, implying some combination of safety, potential for stock buybacks, and possible dividend increases. These are all good for shareholders. PRO
  • Investor attitudes toward stocks remain tepid (see below). PRO
  • However, with the S&P 500 up 16% last year and 10% so far this year, it can?t be argued that stocks have been overlooked and or that attitudes towards them are still mired in the doldrums. CON

What History Can Teach Us…

In the mid-1970s I was fortunate to happen upon one of the first of the time-worn pearls of wisdom that contributed so much to my education as an investor. It described the three stages of a bull market:

  • the first, when a few forward-looking people begin to believe things will get better,
  • the second, when most investors realize improvement is actually underway, and
  • the third, when everyone?s sure things will get better forever.

In “The Tide Goes Out,” written in March 2008, several months before the lows of the financial crisis, I applied the same thinking to the converse – the three stages of a bear market:

  • the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won?t always be rosy,
  • the second, when most investors recognize things are deteriorating, and
  • the third, when everyone?s convinced things can only get worse.

Hindsight always makes it clear what was going on at a particular point in time. It?s a snap now to say the second quarter of 2007 marked the third stage of a bull market: no one could think of a way to lose money. And in the fourth quarter of 2008 (for credit) and the first quarter of 2009 (for equities), we were certainly in the third stage of a bear market: most people thought the financial system was about to collapse, and securities that had halved in price could do nothing but halve again.

And On The Dangers of Extrapolation…

To me, the answer is simple: the better returns have been, the less likely they are – all other things being equal – to be good in the future. Generally speaking, I view an asset as having a certain quantum of return potential over its lifetime. The foundation for its return comes from its ability to produce cash flow. To that base number we should add further return potential if the asset is undervalued and thus can be expected to appreciate to fair value, and we should reduce our view of its return potential if it is overvalued and thus can be expected to decline to fair value.


In other words, appreciation at a rate in excess of the cash flow growth accelerates into the present some appreciation that otherwise might have happened in the future. Or to paraphrase Warren Buffett, “when people forget that corporate profits are unlikely to grow faster than 6% per year, they tend to get into trouble.” I doubt he intended anything special about 6%, but rather a reminder that when assets appreciate faster than the rate at which their value grows, it isn’t just a windfall but also a warning sign.

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