“Among the many pendulums that swing in the investments world – such as between fear and greed, and between depression and euphoria – one of the most important is the swing between risk aversion and risk tolerance.”
Déjà vu permeates most of this memo by Howard Marks because today’s markets bear some uncomfortably close similarities to the days that led up to the 2008 financial crisis – an event on which he issued some remarkably clairvoyant warnings at the time.
Howard Marks on The risk pendulum
The key theme of this thought-provoking memo is the change in the reception of risk by market participants. In Howard Marks’ view, when investors switch from risk aversion (“the essential element in sane markets”) to risk tolerance, the race to the bottom gathers fresh momentum. Why?
Investors feel compelled to embrace more risk when returns otherwise are so low that standard investment routes become unworkable. “As the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures,” Marks said in a 2007 memo.
Howard Marks: Risk is back in fashion
Risk is again rearing its head in today’s markets, says Marks, pointing to recent developments such as:
– “Cov-lite” loans have touched $200B this year, even higher than the $100B in 2007
– Poorly rated bonds (CCC or even lower) are up 11% this year
– LBOs are using larger components of debt
– Subprime loans are back, only this time the vehicle is cars
– A Goldman Sachs index comprised of stocks of companies with weaker balance sheets has rallied 42% this year
– Technology IPOs, such as Twitter, are again listing at supernormal prices
Market conditions harken back to the heady pre-crisis days, as the world is swimming in liquidity, nobody seems to be paying heed to inherent risk and investors are up against an environment of poor “prospective” returns, resulting in low interest in traditional investments like Treasuries and HG bonds.
Howard Marks: Should investors cash out?
No, says Howard Marks. “I think most asset classes are priced fully – in many cases on the high side of fair – but not at bubble-type highs.” Prices and valuations are still not overly stretched considering the S&P 500 is at a P/E of 16, around its long-term post-war average – certainly not bubble territory. “The absolute quantum of risk doesn’t seem as high as in 2006-07.”
That is comforting… for now.
Howard Marks on the usual pattern
“I believe most strongly that the riskiest thing in the investment world is the belief that there’s no risk. When that kind of sentiment prevails, investors will engage in otherwise-risky behavior. By doing so, they make the world a risky place.”
What is not so comforting to this writer is that these ‘eddies’ of risk are swirling ever larger. And unfortunately, it may not be so much as the belief that there is no risk – there is also the dangerous presumption that someone else will hold the can.
The government’s willingness to shield the market from the fallout of the LTCM implosion probably gave the green light to the financial markets to assume that the taxpayers will ultimately backstop risky bets. And so we moved on to the next bigger eddy – the housing market. It was acceptable to grant loans promiscuously, and we all know the size of that tab when the bad loans came home to roost. It then became fashionable to bankroll certain profligate European economies, and the sovereign debt crisis in Europe is another example of risk all gone wrong – and a step up in this chain of serial crises.
These are growing bigger, and the solutions offered to tackle each appear to be similar in method, but larger in scale.
“Prices and valuation parameters are higher than they were a few years ago, and riskier behavior is observed. But what matters is the degree, and I don’t think it has reached the danger zone yet,” says Marks.
Unfortunately, the danger zone, whenever it comes, could dwarf earlier crises, and investors should pay heed, now, to these red flags raised by Howard Marks.