Portfolio Positioning
Solid advice from Howard Marks as always concerning how to position and adjust one's investment portfolio in lieu of the current market environment. The object of this exercise is to expunge your emotions from the investment process and take a longer term view as to where the market is in its cyclic process...
One of the benefits I derive from writing my memos is that the more I work on a memo about something, the more it comes into focus. Thus the four March memos gave me a great opportunity to ponder what the events imply for investment behavior. I’m glad to say I’ve reached a conclusion on that subject. I feel strongly that it’s right . . . and I fully expect to amend it in the future. (To set the scene, the next few paragraphs will be repeat things I’ve said in the past.)
In recent years I’ve become more and more convinced that the fund manager’s most important job for the intermediate term isn’t to decide the allocation of capital between stocks versus bonds; U.S. versus foreign; developed markets versus emerging; large-cap versus small-cap; high-quality versus low-quality; or growth versus value. And it isn’t choosing among strategies, funds and managers. The most important job is to strike the appropriate balance between offense and defense. Those other things won’t help much if you get offense/defense wrong. And if you get offense/ defense right, those other things will take care of themselves.
One way to think about the balance between offense and defense is to consider the “twin risks” investors face every day: the risk of losing money and the risk of missing opportunity. At least in theory, you can eliminate either one but not both. Moreover, eliminating one exposes you entirely to the other. Thus we tend to compromise or balance the two risks, and every individual investor or institution should develop a view as to what their normal balance between the two should be.
Next, investors might consider trying to calibrate their balance over time in response to conditions in the environment – thus the title of this memo:
The more propitious the environment – the more prudently other investors are behaving, the better the outlook for earnings, and the lower security prices are relative to intrinsic value or “fundamentals” – the more an investor might want to shift toward offense.
- On the other hand, the more precarious the environment – the more others are embracing risk, the more headwinds to profits there are, and the higher valuations are – the more an investor might choose to emphasize defense.
In recent years, it’s been my view that the investment world was marked by the following characteristics:
- more uncertainty than usual,
- extremely low prospective returns,
- full to high asset prices, and
- pro-risk behavior on the part of investors reaching for higher returns.
These things told me the world was a risky, low-return place, and for that reason Oaktree’s mantra has been “move forward, but with caution.” We’ve generally been fully invested, but with even more than our usual caution. We made a decision to overweight defense, and there were years in which higher risk produced higher returns, and we paid a price for being cautious. We had no idea what the catalyst would be that turned the risk into loss, and there were no obvious candidates. But we felt the world was a risky place, exposed to negative developments. Now we know the catalyst, and now portfolio risk has produced loss. That’s the background.
As described above, I felt the uncertain, low-return environment called for defense to be over-weighted relative to offense. Now, however, as opposed to the conditions of 2, 6, 12 or 24 months ago:
- the risks in the environment are recognized and largely understood,
- prospective returns have turned from paltry to attractive (for example, the average yield on high yield bonds ex. energy has gone from 3½% to almost 9%),
- security prices have declined, and
- investors have been chastened, causing risk-taking to dry up.
Given these new conditions, I no longer feel defense should be favored. Yes, the fundamentals have deteriorated and may deteriorate further, and the disease makes for risk (remember, I’m the one who leans toward the negative case). But there’s a big difference between a market where no one can find a flaw and one where people have given up on risk-taking. And there’s a big difference between one that’s priced for perfection and one that allows for bad outcomes.
Cautious positioning in recent years has served its purpose. Investors who favored defense over offense have experienced smaller losses this year, have the satisfaction that comes from relative outperformance, and are able to spend more of their time looking for bargains than dealing with legacy problems. Thus, I feel it’s a time when previously cautious investors can reduce their overemphasis on defense and begin to move toward a more neutral position or even toward offense (depending on how sure they want to be of grasping early opportunities).
I’m not saying the outlook is positive. I’m saying conditions have changed such that caution is no longer as imperative. With part of the crisis-related losses having already taken place, I’m somewhat less worried about losing money and somewhat more interested in making sure our clients participate in gains. My 2018 book, Mastering the Market Cycle, carries the subtitle Getting the Odds on Your Side. In that vein, I now feel the odds are more in investors’ favor or, at a minimum, somewhat less against them. Portfolios should be calibrated accordingly.
Looking for the Bottom
Before I close, just a word on market bottoms. Some of the most interesting questions in investing are especially appropriate today: “Since you expect more bad news and feel the markets may fall further, isn’t it premature to do any buying? Shouldn’t you wait for the bottom?”
To me, the answer clearly is “no.” As mentioned earlier, we never know when we’re at the bottom. A bottom can only be recognized in retrospect: it was the day before the market started to go up. By definition, we can’t know today whether it’s been reached, since that’s a function of what will happen tomorrow. Thus, “I’m going to wait for the bottom” is an irrational statement.
If you want, you might choose to say, “I’m going to wait until the bottom has been passed and the market has started upward.” That’s more rational. However, number one, you’re saying you’re willing to miss the bottom. And number two, one of the reasons for a market to start to rise is that the sellers’ sense of urgency has abated, and along with it the selling pressure. That, in turn, means (a) the supply for sale shrinks and (b) the buyers’ very buying forces the market upward, as it’s now they who are highly motivated. These are the things that make markets rise. So if investors want to buy, they should buy on the way down. That’s when the sellers are feeling the most urgency and the buyers’ buying won’t arrest the downward cascade of security prices.
Back in 2008, on the heels of Lehman Brothers’ September 15 bankruptcy filing, Bruce Karsh and his team embarked on an unprecedented program to buy the debt of companies in distress. They invested an average of roughly $450 million per week over the last 15 weeks of the year, for a total of nearly $7 billion. Debt prices collapsed throughout that period, and they continued to fall in the first quarter of 2009 (along with the stock market). But because the hedge funds facing withdrawals had been gated – and because the leveraged, securitized vehicles that would melt down had all been liquidated – large amounts ceased to be for sale after year-end. In short, if we hadn’t bought in the fourth quarter, we would have missed our chance.
The old saying goes, “The perfect is the enemy of the good.” Likewise, waiting for the bottom can keep investors from making good purchases. The investor’s goal should be to make a large number of good buys, not just a few perfect ones. Think about your normal behavior. Before every purchase, do you insist on being sure the thing in question will never be available lower? That is, that you’re buying at the bottom? I doubt it. You probably buy because you think you’re getting a good asset at an attractive price. Isn’t that enough? And I trust you sell because you think the selling price is adequate or more, not because you’re convinced the price can never go higher. To insist on buying only at bottoms and selling only at tops would be paralyzing.
On the contrary, I gave this memo the title Calibrating because of my view that a portfolio’s positioning should change over time in response to what’s going on in the environment. As the environment becomes more precarious (with prices high, risk aversion low and fear lacking), a portfolio’s defensiveness should be increased. And as the environment becomes more propitious (with prices low, risk aversion high and fear prevalent), its aggressiveness should be ramped up. Clearly, this process is one of gradual readjustment, not a matter of all-or-nothing. It shouldn’t be the goal to do this only at bottoms and tops.
So it’s my view that waiting for the bottom is folly. What, then, should be the investor’s criteria? The answer’s simple: if something’s cheap – based on the relationship between price and intrinsic value – you should buy, and if it cheapens further, you should buy more.
I don’t want to give the impression that it’s easy to buy while prices are tumbling. It isn’t, and in 2008, Bruce and I spent a lot of time supporting each other and debating whether we were buying too fast (or too slow). The news was terrible, and for a good while it seemed as if the vicious circle of financial institution meltdowns would continue unchecked. Terrible news makes it hard to buy and causes many people to say, “I’m not going to try to catch a falling knife.” But it’s also what pushes prices to absurdly low levels. That’s why I so like the headline from Doug Kass that I referred to above: “When the Time Comes to Buy, You Won’t Want To.” It’s not easy to buy when the news is terrible, prices are collapsing and it’s impossible to have an idea where the bottom lies. But doing so should be the investor’s greatest aspiration.
As for the current episode, here’s some data from Gavekal Research’s Monthly Strategy piece for April, bearing on the question of whether the bottom was passed in March:
. . . markets rarely clear after one massive decline. In 15 bear markets since 1950, only one did not see the initial major low tested within three months . . . In all other cases, the bottom has been tested once or twice. Since news-flow in this crisis will likely worsen before it improves, a repeat seems likely.
And here’s some data from my son Andrew regarding the movements of the S&P 500 index around the time of the last two big crises. The first and second declines were followed by substantial rallies . . . which then gave way to even bigger declines:
9/1/00 - 4/4/01
|
-27%
|
4/4/01 - 5/21/01
|
+19%
|
5/21/01 - 9/21/01
|
-26%
|
9/21/01 - 3/19/02
|
+22%
|
3/19/02 - 10/9/02
|
-33%
|
10/9/07 - 3/10/08
|
-18%
|
3/10/08 - 5/19/08
|
+12%
|
5/19/08 - 11/20/08
|
-47%
|
11/20/08 - 1/6/09
|
+25%
|
1/6/09 - 3/9/09
|
-27%
|
Gavekal’s and Andrew’s data tell us markets rarely rally in a straight line. Rather, their movements represent a continuous tug-of-war between the bulls and the bears, and the result rarely goes in just one direction. After the optimistic buyers of the initial dips have responded to the low prices and bought, the pessimists find the new, higher prices unsustainable and engage in another round of selling. And so it goes for a while. Thus, as Oaktree’s Wayne Dahl points out, it took until mid-May 2007, or almost seven years, for the stock market to regain the September 2000 highs, and it took until mid-March 2013, or five and a half years, to regain the highs of October 2007.
The bottom line for me is that I’m not at all troubled saying (a) markets may well be considerably lower sometime in the coming months and (b) we’re buying today when we find good value. I don’t find these statements inconsistent.
Howard Marks, Excerpt from latest Memo, April 6, 2020
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