Legendary Investor, Howard Marks, on the Coronavirus

Howard Marks, legendary investor and founder of Oaktree Capital ($125 billion under management as of 12/31/2019), is someone we admire and follow closely given his long tenure navigating financial markets, and wise insights into how markets and the behaviors of investors can drive markets away from reality. Marks recently wrote a memo to investors titled, Nobody Knows II, a title of a prior memo he wrote on September 19, 2008, two days after Lehman Brother’s filed for bankruptcy. Marks felt like it was appropriate to dust of this title once again. And we encourage clients and investors to consider his thoughts given the recent market volatility.

“Over the last few weeks, I’ve been asked repeatedly for my view of the coronavirus and its implications for the markets.  I’ve had a ready answer, thanks to something from my January memo, You Bet!  As you may remember, I drew heavily on quotations from Annie Duke’s book on decision making, Thinking in Bets.  The one that stayed with me most – and that I’ve used a lot since the memo was published on January 13 – is this one:

‘An expert in any field will have an advantage over a rookie.  But neither the veteran nor the rookie can be sure what the next flip will look like.  The veteran will just have a better guess.’ (Emphasis added)

In other words, if I said anything about the coronavirus, it would be nothing but a guess.

I’ve written in the past about my reaction when people in China ask for my view of their country’s future.  ‘You live there,’ I say. ‘I don’t.  Why are you asking me?’  Not only am I not an expert on China, but I firmly believe the future of a country isn’t subject to prediction, especially one that operates under a system that’s unique.  I furnish my opinion of China’s future, but I hasten to point out that it’s nothing but a hunch.  People may ask me for my opinion because they think I’m intelligent, think I’ve been a successful investor, or know I’ve lived through a lot of history.  But none of that should be confused with expertise on subjects of every kind.

Investor Reaction

The markets’ decline in the seven trading days February 20-28 certainly represents a very strong negative reaction.  The S&P 500, for example, declined by 432 points, or 12.8%.  Here are a couple of indications of its magnitude:

The market crash in the past two weeks has been truly historic: its probability of occurrence is ~0.1% since 1896; the velocity of the plunge and of the VIX surge is the fastest on record; and the 10-year [Treasury yield] is at all-time low.  (Hao Hong, BOCOM International, a subsidiary of Bank of Communications, March 1)

While we are merely days into it, this stress episode is already among the most substantial of the last 25 years, joining an elite group that includes Asian Contagion (1997), LTCM (1998), the WTC attack (2001), the Accounting Scandals (2002), the Big One (2008-2009), the Flash Crash (2010), the Eurozone Crisis (2011), the China “re-peg” (2015) and the VIX event (2018).  (Dean Curnutt, Macro Risk Advisors, March 1)

There’s no doubt about the fact that the coronavirus represents a major problem, or that the reaction so far has been severe.  What really matters is whether the price change is proportional to the worsening of fundamentals.

For most people, the easy thing is to say that (a) the disease is dangerous, (b) it will have a negative impact on business, (c) it has kicked off a major reaction to date, and (d) we have no way of knowing how far the decline will go, so (e) we should sell to avoid further carnage.  But none of the above means selling is necessarily the right thing to do.

All these statements reflect a measure of pessimism.  However, there’s no way to tell whether that pessimism is appropriate, inadequate or excessive.  I wrote in On the Couch, (January 2016) that “in the real world, things generally fluctuate between ‘pretty good’ and ‘not so hot.’  But in the world of investing, perception often swings from ‘flawless’ to ‘hopeless.’  What I can say is that a month ago, most people thought the macro outlook was uniformly favorable, and they had trouble thinking of a possible negative catalyst with a serious likelihood of materializing.  And now the unimaginable catalyst is here and terrifying.

(There are a few important lessons here.  First, the catalyst for a recession or correction isn’t always foreseeable.  Second, it can seemingly appear out of thin air, as this virus seems to have done.  And third, the negative effect of an unforeseeable catalyst is likely greater when it collides with a market that reflects so much optimism that it is “priced for perfection.”)

Finally I want to call your attention to the “elite group of stress episodes” of the last 25 years enumerated just above by Dean Curnutt.  Every one of them was gut-wrenching.  And they were followed by recoveries that produced significant gains for stalwart investors.

Most investors seem to think in terms of a very simple relationship: bad news → price declines.  And certainly we’ve seen some of that over the last week or so.  But I’ve argued in the past that there’s more to the story.  The real process is: bad news + decline in psychology → price declines.  We’ve had bad news, and we’ve had price declines.  But if psychology has declined too much, it might be argued that the price declines have been excessive given the news, as bad as it is.

Monetary and Fiscal Policy

The good news is that many market participants are counting on the world’s central banks and treasuries to help pull us out of any economic slowdown.  Here’s one example:

[On February 28,] Fed Chairman Powell released a short statement saying, ‘The fundamentals of the U.S. economy remain strong.  However, the coronavirus poses evolving risks to economic activity.  The Federal Reserve is closely monitoring developments and their implications for the economic outlook.  We will use our tools and act as appropriate to support the economy.’  Following Powell’s statement, futures markets moved to fully price in a 50‐basis‐point rate cut on March 18.  (RDQ Economics, February 28)

Market participants seem to think that (a) rate cuts and other stimulus are always a good thing and (b) they’ll work.  Yet, given that the economic impact of the disease is unknowable, how can investors be sanguine about the ability of the Fed (plus other central banks and treasuries) to counteract it?

Fifty basis points this month may or may not be enough to stem the tide.  But investors probably infer from Powell’s ‘we will use our tools and act as appropriate’ language that the Fed will ‘do what it takes.’  But we must be mindful of the limitations on “ammunition” that exist.  In On the Other Hand (August 2019), I supplied a list of ‘ways in which low rates are undesirable and potentially harmful.’  The last one was this:

‘Finally, but very importantly, when interest rates are low, central banks don’t have at their disposal as much of their best tool for stimulating economies: the ability to cut rates.’

The normal program of rate cuts covers roughly 500 basis points.  That’s not a very encouraging thought when we think about the fact that the short rate already stands at a mere 150 bps.  So the one thing we know is that the Fed doesn’t have room for a normal regime of rate-cutting (there’s uniform insistence that it won’t cut into negative territory).

Further, we have to wonder about the desirability of using 50 bps of the 150 bps the Fed does have at its disposal.  Will it be enough?  And what will the Fed be able to do when the economic impact of the virus has been muted but we only have 100 bps or less left with which to fight any recession that appears?

The facts regarding monetary and fiscal policy are these:

  • In 2009, to fight the Global Financial Crisis, the Fed cut short-term rates to zero for the first time.
  • Not wanting to derail the subsequent recovery, it hesitated to raise rates before Chair Yellen enacted a series of rate increases in 2015-18 that took the Fed funds rate to 2.25-2.50%.
  • When around the end of 2018 interest rates reached levels that investors feared would jeopardize the economic expansion, Chair Powell’s Fed reversed course and embarked on a series of three rate cuts.
  • Thus today we have the 150 bps I mentioned above – “limited ammunition.”
  • In addition to rate cuts, the Fed has the ability to pump liquidity into the economy by engaging in quantitative easing through purchases of government securities. But we can’t know the long-term impact of expansion of the Fed’s balance sheet.
  • Finally, looking away from the Fed, we can think about fiscal policy (i.e., increased deficit spending).But this will add even more to our national debt.

Normally, fiscal and monetary stimulus is applied in times of economic weakness.  (Even Lord Keynes, whom many people consider the father of deficit spending, advocated running deficits and accumulating debt when the economy grows too slow to create jobs, and then repaying the debt when the stimulus produces surpluses.)  Now we have near-zero interest rates and trillion-dollar deficits in times of prosperity.  No one wants a recession, but using up our ammunition preemptively may not have been smart.

The Fed/government’s tool for fighting the economic impact of coronavirus are very limited.  Thus I believe it’s undesirable to be highly sanguine about their powers at this juncture.

What to Do?

These days, people have been asking me whether this is the time to buy.  My answer is more nuanced: it’s probably a time to buy.  There can be no unique time to buy that we can identify.  The only thing we can be sure of today is that stock prices, for example, are a lot lower in the absolute than they were two weeks ago.

Will stocks decline in the coming days, weeks and months?  This is the wrong question to ask . . . primarily because it is entirely unanswerable.  Since we don’t have answers to the questions about the virus listed on page two, there’s no way to decide intelligently what the markets will do.  We know the market declined by 13% in seven trading days.  There can be absolutely no basis on which to conclude that they’ll lose another 13% in the weeks ahead – or that they’ll rise by a like amount – since the answer will be determined largely by changes in investor psychology.  (I say “largely” because it will also be influenced by developments regarding the virus . . . but likewise we have no basis on which to judge how actual developments will compare against the expectations investors already have factored into asset prices.)

Instead, intelligent investing has to be based – as always – on the relationship between price and value.  In other words, not ‘will the collapse go further?’  But rather ‘has the collapse to date caused securities to be priced right; or are they overpriced given the fundamentals; or have they become cheap?’  I have no doubt that assessing price relative to value remains the most reliable way to invest for the long term.  (It is the thrust of the whole discussion just above that there’s nothing that provides reliable help in the short term.)

I want to acknowledge up front that ascertaining intrinsic value is never a simple, cut-and-dried thing.  Now – given the possibility that the virus will cause the world of the future to be very different from the world we knew – is value too unascertainable to be relied upon?  In short, I don’t think so.  What I think we do know is that the coronavirus is not a rerun of the Spanish flu pandemic of 1918, ‘which infected an estimated 500 million people worldwide – about one-third of the planet’s population – and killed an estimated 20 million to 50 million victims, including some 675,000 Americans.’ (history.com)  Rather, it’s one more seasonal disease like the flu, something we’ve had for years, have developed vaccines for, and have learned to deal with.  The flu kills about 30,000-60,000 Americans each year, and that’s terrible, but it’s very different from an unmanageable scourge.

So, especially after we’ve learned more about the coronavirus and developed a vaccine, it seems to me that it is unlikely to fundamentally and permanently change life as we know it, make the world of the future unrecognizable, and decimate business or make valuing it impossible.  (Yes, this is a guess: we have to make some of them.)

The U.S. stock market’s down about 13% from the top.  That’s a big decline.  It would be a lot to accept that the U.S. business world – and the cash flows it will produce in the future – are worth 13% less today than they were on February 19.  That sentence may make it sound like I think the market’s undervalued.  But that’s not the proper interpretation.  If it was overvalued on the 19th, rather than being undervalued today, after the decline, it could just be less overvalued.  Or it could be fairly valued, or even undervalued, but it isn’t necessarily.

I think the stock market was overvalued two weeks ago . . . somewhat.  That means I think that today, even with the short-term prospects of business somewhat diminished, it’s closer to fairly valued, but not necessarily a giveaway.  In the starkest numerical terms, before the rout, the p/e ratio on the S&P 500 was 19 or so, roughly 20% above the post-World War II average (and there are arguments on both sides regarding the current applicability of that average).  Thus, after a 13% decline, you’d have to say the p/e ratio is pretty close to fair (unless earnings for the year will be very different from what they previously had been expected to be).

Buy, sell or hold?  I think it’s okay to do some buying, because things are cheaper.  But there’s no logical argument for spending all your cash, given that we have no idea how negative future events will be.  What I would do is figure out how much you’ll want to have invested by the time the bottom is reached – whenever that is – and spend part of it today.  Stocks may turn around and head north, and you’ll be glad you bought some.  Or they may continue down, in which case you’ll have money left (and hopefully the nerve) to buy more.  That’s life for people who accept that they don’t know what the future holds.

But no one can tell you this is the time to buy.  Nobody knows.”

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written.  Actual economic or market events may turn out differently than as presented. © 2020 Madison Wealth Management