Sometimes it’s reassuring to know that someone else is going through the same things you are. Particularly when the someone is a billionaire and one of the world’s most respected investors.
“We stay in the same one place for both work and non-work leisure; weekdays aren’t very different from weekends; and the idea of vacation seems almost irrelevant: where would we go and what would we do?” asks Howard Marks, the founder and head of Oaktree Capital.
“My acronym of choice is SSDD, the family-friendly translation of which is ‘same stuff, different day’.”
Like many of us here in Melbourne, where the harsh stage four lockdown is in full effect, Marks is coming to grips with the fact the early lockdowns in the US have proven to have been wasted – although the reasons for that have been different than in Melbourne.
While mistakes have been made in Melbourne and the US, Marks pinpoints a toxic mix of hubris and the politicisation of economic reopenings for what he calls the wasting of a crisis by America.
This resurgence has confirmed to Marks that the pandemic should be placed outside of any normal economic cycle.
“In the current case, a moderate recovery – marked by reasonable growth, realistic expectations, an absence of corporate overexpansion and a lack of investor euphoria – was struck down by an unexpected meteor strike.”
Another factor that pushes the pandemic outside normal economic cycles is the extraordinary rebound in investor sentiment, spurred largely by the intervention by central banks generally, and the Federal Reserve specifically, as well as huge government stimulus.
Does it really make sense that bank reserves, the Fed balance sheet and the federal deficit can be increased ad infinitum without negative effects?
— Howard Marks, Oaktree Capital
This has set up a fascinating fight in Marks’ view.
“In short, titanic forces are arrayed against each other: Fed and Treasury versus disease and recession. Which will win?”
Marks is a value investor and concedes he’s prone to natural scepticism. So he’s been studying the bull case for markets closely to try to understand why it’s won out in such emphatic style so far.
A clear driver of the rally is the actions of the Fed, and Marks argues “many investors have underestimated the impact of low rates on valuations”.
“Simplistically, when Treasuries yield less than 1 per cent and you add in the traditional equity premium, perhaps the earnings yield should be 4 per cent,” Marks explains.
“That yield of 4/100 suggests a price to earnings ratio (the inverse) of 100/4, or 25. Thus the S&P 500 shouldn’t trade at its traditional 16 times earnings, but roughly 50 per cent higher.”
But even that underestimates the impact of low rates, because it ignores the fact that company earnings grow, and bond interest doesn’t.
“If the earnings on the S&P 500 will grow to eternity at 2 per cent per year, for example, the right earnings yield isn’t 4 per cent, but 2 per cent (for a P/E ratio of 50). And, mathematically, for a company whose growth rate exceeds the sum of the bond yield and the equity premium, the right P/E ratio is infinity. On that basis, stocks may have a long way to go.”
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Of course, this raises important questions about rates settings and Fed intervention. Will prices fall if the Fed pulls back? And can the Fed – and, for that matter, the US government with its stimulus spending – keep it up forever?
Cautious on tech
This gets us into the fascinating territory of Modern Monetary Theory, an area in which Marks (and your correspondent) does not profess to have much expertise. Suffice to say, Marks can see the case for the US Treasury to keep funding deficits while interest rates remain low. But he’s curious, like many, about the long-term implications of such a policy.
“Does it really make sense that bank reserves, the Fed balance sheet and the federal deficit can be increased ad infinitum without negative effects?” he asks.
Another part of the bull case that has grabbed Marks’ attention is around the mega tech stocks that have largely powered Wall Street’s rally.
Marks can see the argument for these stocks to be valued in a different way. And he’s happy to concede, that in the words of John Templeton, the idea that “this time is different” can be correct 20 per cent of the time – and given the rate that technology and digital business models are changing, tech stocks may fit into that 20 per cent.
“It certainly can be argued that the tech champions of today are smarter and stronger and enjoy bigger leads than the big companies of the past, and that they have created virtuous circles for themselves that will bring rapid growth for decades, justifying valuations well above past norms.
“Today’s ultra-low interest rates further justify unusually high valuations, and they’re unlikely to rise anytime soon.”
But the old value investor can’t resist a pointer to the past. He says that when he started investing in 1969, companies such as IBM and Xerox were “likewise expected to outgrow the rest and prove impervious to competition and economic cycles, and thus were awarded unprecedented multiples”.
“In the next five years, their stockholders lost almost all their money.”
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Australian shares gained 2 per cent over the week, posting its biggest weekly gain since the first week of July. The S&P/ASX200 rose 0.6 per cent on Friday. Afterpay surged 6.3 per cent to a record close of $75.80. Mesoblast soared 39 per cent.
- Robert Guy, Vesna Poljak, Sarah Turner, William McInnes, Luke Housego and Tom Richardson