Howard Marks
All investors look for gains, but the best investors look at risks, too. The mediocre and underperforming investors are definitely aware of the risks of downfalls, but their approach to risk is uneven. When markets are bearish, risk is a bigger consideration; when markets are bullish, worries about risk fall to the background while returns become the central focal point.
Due to the cyclical nature of markets, mediocre investors’ focus on risks will be cyclical as well, so tracking these investors’ concerns about risk is a great indicator of what is going to happen in the market. Looking for amateur investors’ perceptions of the risks in the market vis-a-vis the potential rewards of the market is a great way of spotting bears on the horizon.
Howard Marks discusses the phenomenon in his recent memo, which is worth reading carefully in its entirety. There are three main points to take away from Marks’s memo:
- Risk aversion remains, and we aren’t at 2006-2007 levels of euphoria. While Marks identifies some clear signs of frothiness, such as Twitter’s (TWTR) recent iPO, gains in low-grade bonds, and the growth of riskier derivatives in the credit market, he emphasizes that uncertainty is still present enough to suggest that we are not at the high of the market. Cab drivers aren’t handing stock tips to passengers quite yet.
- We are in an experimental market where asset appreciation is driven by a growth in the monetary supply and low interest rates. True to form, Marks avoids the polemical, politicized responses to QE and Fed responses to liquidity traps, and simply asks the question: “Can low interest rates and high levels of money creation return economic growth rates to previous levels?” As Marks says, the evidence is mixed. We don’t know how this is going to impact stocks, and so it is a systemic risk factor.
- Investors are becoming more risk tolerant. We are not at the stage in the market where people are seriously saying that there is no way to lose as long as you are in stocks, but we are approaching that point. It may take a few years, but it seems that we have definitely gone from growing more worried about risk to being more tolerant of risk.
Marks’ conclusion is very much common sense:
“In short, it’s my belief that when investors take on added risks – whether because of increased optimism or because they’re coerced to do so (as now) – they often forget to apply the caution they should. That’s bad for them. But if we’re not cognizant of the implications, it can also be bad for the rest of us.”
Of course, Marks is completely correct, but it’s something that daytraders, retirees, and retail investors don’t want to hear. The best of them want to see their capital grow and the worst of them want to get rich quick, and they will use whatever tools they have—penny stocks, investing on technicals only, speculating on prices instead of investing in fundamentals—to beat the market. Of course, in the long run, they will lose if they don’t get out while they’re still ahead before it’s too late.
For institutional investors, Marks’ words are well worth heeding. The long-term investor whose mandate is to provide risk-adjusted returns on a long time horizon needs to start modeling for the inevitable crash that follows a period of irrational exuberance. Fortunately, 2008 provides plenty of data to model on.