Howard Marks, Oaktree Capital — 2024-08-22
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Memos from Howard Marks 2024-08-22T07:00:00.0000000Z" pubdate title="Time posted: >8/22/2024 7:00:00 AM (UTC)">Aug 22, 2024
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In his book The Intelligent Investor , first published in 1949, Benjamin Graham, who was Warren Buffett's teacher at Columbia Business School, introduced a fellow he called Mr. Market:
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
Of course, Graham intended Mr. Market as a metaphor for the market as a whole. Given Mr. Market's inconsistent behavior, the prices he assigns to stocks each day can diverge – sometimes wildly – from their fair value. When he's overenthusiastic, you can sell to him at prices that are intrinsically too high. And when he's overly fearful, you can buy from him at prices that are fundamentally too low. Thus, his miscalculations provide profit opportunities to investors interested in taking advantage of them.
There's a great deal to be said about investors' foibles, and I've shared much of it over the years. But the rapid market decline we saw in the first week of August – along with the rapid rebound – compels me to pull together what I've said previously on the subject, along with some priceless investing cartoons from my collection, and add a few new observations.
To set the scene, let's review recent events. As a result of the Covid-19 pandemic, soaring inflation, and the U.S. Federal Reserve's rapid interest rate increases, 2022 was one of the worst years ever for the combination of stocks and bonds. Sentiment reached its low around the middle of 2022, with investors depressed by the universally negative outlook: "We have inflation, and that's bad. And the rate increases to fight it are sure to bring on a recession, and that's bad." Investors could think of few positives.
Then the mood lightened and, late in 2022, investors coalesced around a positive narrative: the slow economic growth would cause inflation to decline, and that would permit the Fed to start lowering rates in 2023, leading to economic vigor and market gains. A significant stock market rally began and continued nearly uninterrupted until this month. Although the rate cuts anticipated in 2022 and 2023 still haven't materialized, optimism has been in the ascendency in the stock market. The S&P 500 stock index rose by 54% (not counting dividends) in the 21 months which ended on July 31, 2024. That day, Fed Chair Jerome Powell confirmed that the Fed was moving closer to a rate cut, and things appeared to be on track for economic growth and further stock market appreciation.
But that same day, the Bank of Japan announced its biggest increase in its short-term interest rate in over 17 years (to a whopping 0.25%!). This shocked the Japanese stock market, to which people had been warming for over a year. In addition, and importantly, the announcement played havoc with investors who had engaged in "the carry trade." For years, Japan's infinitesimal – and often negative – interest rates have meant that people could borrow cheaply in Japan and invest the borrowed funds in any number of assets, there and elsewhere, that promised to return more, for a "positive carry" (aka "free money"). This led to the establishment of highly levered positions. It seems odd that a quarter-point increase in interest rates could require some of these positions to be unwound. But it did, leading to motivated selling in a variety of asset classes as those who had engaged in the practice moved to cut their leverage.
Starting the next day, the U.S. announced mixed economic news. On August 1, we learned that the Manufacturing Purchasing Managers' Index had dipped and initial jobless claims had risen. On the other hand, corporate profit margins continued to look good, and gains in productivity surprised to the upside. A day later, we learned that employment gains had moderated, with hiring rising less than had been expected. The unemployment rate stood at 4.3% at the end of July, up from a low of 3.4% in April 2023. This was still very low by historical standards, but, according to the suddenly popular "Sahm Rule" (don't complain to me; I'd never heard of it either), since 1970, an increase in the three-month average unemployment rate of 0.5 percentage points or more from the low of the prior 12 months has never occurred without the economy already being in recession. Around the same time, Warren Buffett's Berkshire Hathaway announced that it had sold off a good part of its massive holding of Apple shares.
In all, this news constituted a triple whammy. The resulting flip-flop from optimism to pessimism set off a significant stock market rout. The S&P 500 fell on three consecutive trading days – August 1, 2, and 5 – by a total of 6.1%. The replay of the mistakes I've witnessed for decades was so obvious that I can't resist cataloging them below.
What's Behind the Market's Volatility?
On the first two days of August, I was in Brazil, where people often asked me to explain the sudden collapse. I referred them to my 2016 memo On the Couch . Its key observation was that in the real world, things fluctuate between 'pretty good' and 'not so hot,' but in investing, perception often swings from 'flawless' to 'hopeless.' That says about 80% of what you need to know on the subject.
If reality changes so little, why do estimates of value (that's what security prices are supposed to be) change so much? The answer has a lot to do with changes in mood. As I wrote over 33 years ago, in only my second memo:
The mood swings of the securities markets resemble the movement of a pendulum. . . . between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a "happy medium." ( First Quarter Performance , April 1991)
Mood swings do a lot to alter investors' perception of events, causing prices to fluctuate madly. When prices collapse as they did at the start of this month, it's not because conditions have suddenly become bad. Rather, they become perceived as bad. Several factors contribute to this process:
heightened awareness of things on one side of the emotional ledger,
a tendency to overlook things on the other side, and
similarly, a tendency to interpret things in a way that fits the prevailing narrative.
What this means is that in good times, investors obsess about the positives, ignore the negatives, and interpret things favorably. Then, when the pendulum swings, they do the opposite, with dramatic effects.
One important idea underpinning economics is the theory of rational expectations, described by Investopedia as follows:
The rational expectations theory . . . posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and