Howard Marks, Oaktree Capital — 2022-11-22
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Memos from Howard Marks 2022-11-22T08:00:00.0000000Z" pubdate title="Time posted: >11/22/2022 8:00:00 AM (UTC)">Nov 22, 2022
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I've gathered a few ideas from several of my memos this year – plus some recent musings and conversations – to form the subject of this memo: what really matters or should matter for investors. I'll start by examining a number of things that I think don't matter.
What Doesn't Matter: Short-Term Events
In The Illusion of Knowledge (September 2022), I railed against macro forecasting, which in our profession mostly concerns the next year or two. And in I Beg to Differ (July 2022), I discussed the questions I was asked most frequently at Oaktree's June 21 conference in London: How bad will inflation get? How much will the Fed raise interest rates to fight it? Will those increases cause a recession? How bad and for how long? The bottom line, I told the attendees, was that these things all relate to the short term, and this is what I know about the short term:
Most investors can't do a superior job of predicting short-term phenomena like these.
Thus, they shouldn't put much stock in opinions on these subjects (theirs or those of others).
They're unlikely to make major changes in their portfolios in response to these opinions.
The changes they do make are unlikely to be consistently right.
Thus, these aren't the things that matter.
Consider an example. In response to the first tremors of the Global Financial Crisis, the Federal Reserve began to cut the fed funds rate in 3Q2007. They then lowered it to zero around the end of 2008 and left it there for seven years. In late 2015, virtually the only question I got was "When will the first rate increase occur?" My answer was always the same: "Why do you care? If I say 'February,' what will you do? And if I later change my mind and say 'May,' what will you do differently? If everyone knows rates are about to rise, what difference does it make which month the process starts?" No one ever offered a convincing answer. Investors probably think asking such questions is part of behaving professionally, but I doubt they could explain why.
The vast majority of investors can't know for sure what macro events lie just ahead or how the markets will react to the things that do happen. In The Illusion of Knowledge , I wrote at length about the way unforeseen events make a hash of economic and market forecasts. In summary, most forecasts are extrapolations, and most of the time things don't change, so extrapolations are usually correct, but not particularly profitable. On the other hand, accurate forecasts of deviations from trend can be very profitable, but they're hard to make and hard to act on. These are some of the reasons why most people can't predict the future well enough to repeatably produce superior performance.
Why is doing this so hard? Don't most of us know what events are likely to transpire? Can't we just buy the securities of the companies that are most likely to benefit from those events? In the long run, maybe, but I want to turn to a theme that Bruce Karsh has been emphasizing lately, regarding a major reason why it's particularly challenging to profit from a short-term focus: It's very difficult to know which expectations regarding events are already incorporated in security prices.
One of the critical mistakes people are guilty of – we see it all the time in the media – is believing that changes in security prices are the result of events: that favorable events lead to rising prices and negative events lead to falling prices. I think that's what most people believe – especially first-level thinkers – but that's not right. Security prices are determined by events and how investors react to those events, which is largely a function of how the events stack up against investors' expectations.
How can we explain the company that reports higher earnings, only to see its stock price drop? The answer, of course, is that the reported improvement fell short of expectations and thus disappointed investors. So, at the most elementary level, it's not whether the event is simply positive or not, but how the event compares with what was expected.
In my earliest working years, I used to spend a few minutes each day looking over the earnings reports printed in The Wall Street Journal . But after a while, it dawned on me that since I didn't know what numbers had been expected, I had no idea whether an announcement from a company I didn't follow was good news or bad.
Investors can become expert regarding a few companies and their securities, but no one is likely to know enough about macro events to (a) be able to understand the macro expectations that underlie the prices of securities, (b) anticipate the broad events, and (c) predict how those securities will react. Where can a prospective buyer look to find out what the investors who set securities prices already anticipate in terms of inflation, GDP, or unemployment? Inferences regarding expectations can sometimes be drawn from asset prices, but the inferred levels often aren't proved correct when the actual results come in.
Further, in the short term, security prices are highly susceptible to random and exogenous events that can swamp the impact of fundamental events. Macro events and the ups and downs of companies' near-term fortunes are unpredictable and not necessarily indicative of – or relevant to – companies' long-term prospects. So little attention should be paid to them. For example, companies often deliberately reduce current earnings by investing in the future of their businesses; thus, low reported earnings can imply high future earnings, not continued low earnings. To know the difference, you have to have an in-depth understanding of the company.
No one should be fooled into thinking security pricing is a dependable process that accurately follows a set of rules. Events are unpredictable; they can be altered by unpredictable influences; and investors' reactions to the events that occur are unpredictable. Due to the presence of so much uncertainty, most investors are unable to improve their results by focusing on the short term.
It's clear from observation that security prices fluctuate much more than economic output or company profits. What accounts for this? It must be the fact that, in the short term, the ups and downs of prices are influenced far more by swings in investor psychology than by changes in companies' long-term prospects. Because swings in psychology matter more in the near term than changes in fundamentals – and are so hard to predict – most short-term trading is a waste of time . . . or worse.
What Doesn't Matter: The Trading Mentality
Over the years, my memos have often included some of my father's jokes from the 1950s, based on my strong belief that humor often reflects truths about the human condition. Given its relevance here, I'm going to devote a bit of space to a joke I've shared before:
Two friends meet in the street, and Joe asks Sam what's new. "Oh," he replies, "I just got a case of great sardines."
Joe:
Great, I love sardines. I'll take some. How much are they?
Sam:
$10,000 a tin.
Joe:
What! How can a tin of sardines cost $10,000?
Sam:
These are the greatest sardines in the world. Each one is a pedigreed purebred, with papers. They were caught by net, not hook; deboned by hand; and packed in the finest extra-virgin olive oil. And the label was