As first reported yesterday, in his latest nearly-30 page memo, a distinctly less optimistic Howard Marks - hardly known for his extreme positions - "sounded the alarm" on markets by laying out a plethora of reasons why investors should be turning far more cautious on the risk, and summarizing his current view on the investing environment with the following 4 bullet points:
- The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.
- In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.
- Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains.In general the best we can do is look for things that are less over-priced than others.
- Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.
Among the items on Marks' of the items, the one we focused on yesterday, had to do with Marks recurring warnings on ETFs and passive investing. To be sure, he also covered pretty much everything else from equities, to the record low VIX, to FAANG stocks, to record tight credit spreads, to EM debt, to PE and even Bitcoin.
To those who haven't read it yet, it can be found here. However we wanted to bring attention to one particular section, which lays out the necessary conditions which if met "will deliver a boom or bubble." In other words, Howard Marks' bubble checklist. The issue is that if these conditions (all of them) have to be present to validate a bubble, at least in the eyes of one of the world's most respected investors, then we may have a problem because at least according to the more skeptical market participants, most of these are currently present.
Here is Marks:
My son Andrew worked extensively with me in preparing this memo. We particularly enjoyed making a list of the elements that typically form the foundation for a bull market, boom or bubble. We concluded that some or all of the following are necessary conditions. A few will give us a bull market. All of them together will deliver a boom or bubble:
- A benign environment – good results lull investors into complacency, as they get used to having their positive expectations rewarded.Gains in the recent past encourage the heated pursuit of further gains in the future (rather than suggest that past gains might have borrowed from future gains).
- A grain of truth – the story supporting a boom isn’t created out of whole cloth; it generally coalesces around something real.The seed usually isn’t imaginary, just eventually overblown.
- Early success – the gains enjoyed by the “wise man in the beginning” – the first to seize upon the grain of truth – tends to attract “the fool in the end” who jumps in too late.
- More money than ideas – when capital is in oversupply, it is inevitable that risk aversion dries up, gullibility expands, and investment standards are relaxed.
- Willing suspension of disbelief – the quest for gain overcomes prudence and deference to history.Everyone concludes “this time it’s different.”No story is too good to be true.
- Rejection of valuation norms – all we hear is, “the asset is so great: there’s no price too high.”Buying into a fad regardless of price is the absolute hallmark of a bubble.
- The pursuit of the new – old timers fare worst in a boom, with the gains going disproportionately to those who are untrammeled by knowledge of the past and thus able to buy into an entirely new future.
- The virtuous circle – no one can see any end to the potential of the underlying truth or how high it can push the prices of related assets.It’s broadly accepted that trees can grow to the sky: “It can only go up.Nothing can stop it.”Certainly no one can picture things taking a turn for the worse.
- Fear of missing out – when all the above becomes widespread, optimism prevails and no one can imagine a glitch.That causes most people to conclude that the greatest potential error lies in failing to participate in the current market darling.
So where are we on this list according to Marks? The answer: almost there.
Certainly many of the things listed above are in play today. Performance has been good – with minor exceptions, quickly rectified – since the beginning of 2009 (that’s more than eight years). There’s certainly more money around these days than high-return possibilities. “New ideas” are readily accepted, and some things are viewed as representing virtuous circles.
On the other hand, some of the usual ingredients are missing. Most people (a) are conscious of the uncertainties listed above, (b) recognize that prospective returns are quite skimpy, and (c) accept that things are unlikely to go well forever. That’s all healthy.
But on the third hand, most people can’t think of what might cause trouble anytime soon. But it’s precisely when people can’t see what it is that could make things turn down that risk is highest, since they tend not to price in risks they can’t see. With the negative catalyst so elusive and the return on cash at punitive levels, people worry more about being underinvested or bearing too little risk (and thus earning too low a return in good markets) than they do about losing money.
This combination of elements presents today’s investors with a highly challenging environment. The result is a world in which assets have appreciated significantly, risk aversion is low, and propositions are accepted that would be questioned if investors were more wary.