In August 1978, young Howard received the phone call that changed his life...
Howard had come up at First National City Bank. Starting as an equity analyst at just 22 years old, he quickly rose through the ranks to become director of research. That's when his boss told him to go meet with a guy named Michael Milken.
Milken would later be known as the "junk bond king" for his pioneering efforts in developing the then-nascent high-yield bond market. (He would eventually go to prison after being charged with securities fraud and insider trading.)
Not all young analysts would have been ready for that phone call. Howard was, because he'd learned a lesson many investors never quite grasp, starting almost the first day of his career...
When Howard started at First National in 1968, his superiors couldn't stop talking about the biggest, fastest-growing companies of the day... companies like Xerox (XRX), IBM (IBM), Kodak, Polaroid, Merck (MRK), Eli Lilly (LLY), Hewlett-Packard (HPQ), Texas Instruments (TXN), Coca-Cola (KO), Avon (AVP), and about 40 others. Collectively, they were called the "Nifty Fifty."
The Nifty Fifty traded for 80-90 times earnings in 1968. Just five years later, they fell as low as eight to nine times earnings in the bear market of 1973-1974. Investors in the best businesses lost 80%-90% of their money. As Howard later wrote...
These companies were considered to be so great that nothing bad could ever happen to them. And it was accepted dictum that it absolutely didn't matter what price you paid. If it was a little too high, no matter: the companies' fast rising earnings would soon grow into it.
Howard's early experience with the Nifty Fifty – and with Milken – taught him a valuable lesson. As he said during an April 2017 interview with Institutional Investor...
Investing well is not a matter of buying good things, it's about buying things well. And people have to understand the difference. If you don't understand the difference, you are in big trouble.
Howard made a career of buying things well and exploiting market cycles...
Today, Howard Marks and his partners at Oaktree Capital (OAK) manage roughly $120 billion. Forbes estimates his net worth at $2 billion. He's a Warren Buffett-like hero among value investors.
Howard's ability to exploit market cycles is legendary. For example, while other investors were losing clients and watching their assets dwindle in the crisis of 2008, Oaktree raised $10.9 billion to launch the largest distressed-debt fund ever. It returned 32% by the end of 2009. It would eventually raise $13.3 billion by 2010, roughly one-quarter of all the distressed-debt funds raised during that period.
In a 2012 press release, Howard said it "generated the strongest risk-adjusted returns for which Oaktree" was known at that time.
His "Memos to Clients" and two books are full of excellent insights. (Buffett reads them and counts Marks as a personal friend.) I've recommended his first book, The Most Important Thing, often and have read it cover to cover multiple times.
Howard's success is based on one of our core principles...
That is, valuations matter. It's dangerous to invest in the market near its most expensive valuation ever (which it hit in late September last year).
We share another core principle, too: Cycles matter. As he writes...
The student's knowledge of cycles and appreciation for where we stand at a point in time can make a big contribution to the edge that must be present in order for an investor to achieve superior results.
After the unpleasantness of late 2018 and subsequent rally to start this year, you're likely thinking – as you should be – about where we stand in the stock market cycle today. (Long story short: It's still a bearish portrait... one of high risk and low opportunity.)
You can understand where we stand in the market cycle in one of two ways: top down and bottom up.
Top down, the first thing you need to know is this...
It's not a bear market – yet.
A bear market is any drop of 20% or more. From its all-time high close of 2,930.75 on September 20 to its recent low close of 2,351.10 on December 24, the S&P 500 fell 19.8%, just a hair shy of the official definition of a bear market.
You can't be certain it was "just a correction" until the market makes a new high – which it hasn't done yet, despite rallying more than 15% from its low... But so far, that's how it looks.
And as I've told my Extreme Value subscribers repeatedly, with stocks near all-time highs, it wouldn't surprise me at all to see the market "Melt Up."
In fact, in mid-January, CNBC talking head Jim Cramer put classic Melt Up thinking on full display for his Twitter followers when he wrote, "It feels dangerous not to buy stocks."
When the biggest, loudest stock tout in history says it's dangerous not to buy stocks, don't hit the "buy" button in your online brokerage account. Shut down your computer, pause, and reflect.
I bet Cramer's remark is exactly the sort of thing young Howard Marks heard his new bosses at First National telling their clients in 1968. It's exactly the sort of comment people make before Melt Ups – and right before bear markets, too.
Think back to the 1990s, when networking-equipment provider Cisco (CSCO) was in 10 of the top 10 mutual funds of the day, touted far and wide as a "must own" stock, falling into millions of 401(k) portfolios. Folks thought it was "dangerous" not to own Cisco... And the stock fell 89% from its 2000 peak to its 2002 bottom, wiping out nearly $500 billion in market value along the way.
Folks who think it's dangerous not to own stocks today need to understand something...
It's one of the most important lessons I've learned in 30 years as an investor and more than 21 years as a published analyst. I've said it before, but I'll repeat it again...
The two times when you need to pay attention to the action in the overall stock market are when it's near extreme lows of valuation (like in early 2009) and when it's near extreme highs of valuation (like it's been since late 2016).
From late August to late September, stocks hit the "most offensive valuation extreme in their history, on the basis of measures best correlated with subsequent returns," according to economist and asset manager John Hussman.
In other words, if you ignore all the numbers that don't matter and focus only on the ones that do, U.S. stocks were more expensive than they've ever been before, just before the correction last fall.
The thing is... the S&P 500 – which represents 80% of all the money in U.S. stocks – is within around 5% of the most expensive moment in its history. I doubt you'll catch Howard Marks pounding the table on U.S. stocks any time soon. Prudent investors simply don't buy stocks hand over fist at the top of the cycle.
Think of it another way...
The Salvator Mundi is a painting of Jesus Christ by Leonardo da Vinci. The Louvre Abu Dhabi museum bought it for $450.3 million in 2017, making it the most expensive painting in history. Even if it sold for a 5% discount, Salvator Mundi would still be the most expensive painting in the world by more than $120 million. (The second-most expensive painting in history, Willem de Kooning's Interchange, sold for $300 million.)
You don't have to know anything about art to know it's crazy to pay hundreds of millions of dollars for a painting. And you don't have to be Warren Buffett to know 5% below the most expensive moment in stock market history means stocks are still expensive.
If you buy stocks today – and you should buy if the price is right – do so with caution...
At today's elevated valuation levels, it's more likely you'll pay too much for any given stock and either lose money or, at the least, endure years of painful drawdowns on the way to mediocre long-term returns.
I hate to be a bore and repeat myself... But frankly, I think a lot of repetition is warranted these days, because nobody else is going to tell you what I'm telling you.
So one more time, I'll remind you of the following: Asset quality won't save you when assets are as vastly overvalued as U.S. stocks are today. That means you should expect the share prices of even the best businesses to get destroyed in a bear market, just like any other stock...
I know it sounds a little crazy, but I've seen it many times. The most popular assets – regardless of quality – will tend to perform extremely poorly when the market cycle turns down.
During the Nifty Fifty bubble of the late 1960s, investors looked at companies like Avon, Xerox, and Polaroid the way they look at Amazon (AMZN) and Google's parent company Alphabet (GOOGL) today. It didn't matter how great those businesses were. They still fell 80%-90% in the ensuing bear market of 1973-1974.
Their popularity turned them from good investments into toxic waste, as often happens in a manic market. That's what Marks is trying to teach us. (I'm no billionaire, but I've learned it from my own experience as well.)
If you think it's impossible to lose 80%-90% of the money you have in stellar companies like Facebook (FB), Amazon, and Alphabet – some of the best businesses in the world today – you're wrong.
Buying great assets regardless of valuation can't save you...
But buying great businesses at big discounts to their intrinsic value can give you the fortitude to ride out the storm.
In the Extreme Value model portfolio, we have multiple examples of businesses near historic cyclical lows, with great management teams, superior business models, and great balance sheets that'll outlast any bear market.
Finding a great business and paying a dirt-cheap price near a cyclical low is the most unbeatable combination an investor can find in stocks.
Likewise, any business trading at an exorbitant valuation near cyclical highs should always give you pause.
I probably sound like a broken record to those familiar with my work. But repeating the best ideas often is perhaps the greatest service Stansberry Research will ever do for you.
As a classically trained musician, I discovered long ago that understanding what's right is only the beginning of learning. After you figure out what works, you still have to repeat it until it becomes second nature, saving you time and trouble later on when the rubber meets the road.
Besides the market's top-down valuation, the bottom-up performance also tells a worrisome story...
The most widely touted no-brainer stocks of the current era are the "FANGs." FANG stands for Facebook, Amazon, Netflix (NFLX), and Google, but at least three other stocks have been included in various incarnations of this market-leading group. All have been hailed among the world's greatest businesses. They're some of the biggest and most popular companies of the past decade.
All but one of these stellar companies – software titan Microsoft (MSFT) – underperformed the S&P 500 from its 2018 top to its correction bottom. As you can see in the following table, an equal-weighted portfolio of these stocks would have lost 37% in that period – a performance almost twice as bad as the market...
I can't repeat enough that owning the most-loved businesses near the top of the most expensive market in history won't save you. It'll crush you.
If you think I'm predicting a bear market, that's not exactly right. I'm not predicting anything. I'm just determining what's reasonable based on historical tendencies and previous market cycles. In a nutshell, I'm showing my respect for the market cycle.
Putting it all together, the picture from top-down and bottom-up is bearish...
Since I was born 57 years ago, the S&P 500's performance suggests we've just seen a correction, not the beginning of a bear market. If the market makes new highs, it's reasonable to expect the ensuing bear market to be worse than if the top is already in.
The S&P 500's valuation history suggests there's enormous downside over the next two to three years, based on Hussman's work and my own study of S&P 500 price-to-sales data.
And of course, from the bottom up, the price action of the most popular individual stocks of the era suggests the bull market might be over, or possibly that a highly volatile topping process has begun. It also suggests that it doesn't matter if these really are the wonderful businesses everyone believes them to be. They'll still get crushed. If you own them today, you'll soon wish you didn't.
For now, I recommend you immediately take the following actions...
- Hold plenty of cash.
- Avoid buying expensive stocks, especially if you think the business is a "no-brainer."
I suspect my colleague Steve Sjuggerud is right, and we'll see a sharp Melt Up rally. If it has already begun and the S&P 500 hits a new high this year, it's likely we'll see another sharp correction not long after... which might just be the start of the bear market I'm expecting.
Bear markets are good. They create bargains that equity investors need to achieve high rates of long-term compounding. And they tend to move asset prices a long way in a short time. The only problem for most people is that prices move down, not up.
The huge moves and short duration create an opportunity to do what we'd all love to do: make a lot of money relatively quickly.
Good investing,
Dan Ferris
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