Master the Market Cycle, by Howard Marks

It's such an honor and a privilege to be joined by Howard Marks, the legendary investor and co-founder of Oaktree Capital Management. In addition to running a firm that manages one hundred and twenty billion dollars, Howard is quite an author. His newsletters and memos about markets and economics are read all around the industry and across a variety of different trading desks. He just released his latest book, Mastering the Market Cycle. Howard, welcome to Goldman Sachs.

So before we get into the book, let's start a little bit with your background and history. What sparked your curiosity in finance?

In 1995, you started Oaktree, right? Why?

Did you ever envision Oaktree becoming what it is today?

So along those lines, if you look at really probably up until July 2016, maybe after Brexit if you want to mark an inflection point, we've been in this sort of disinflationary bull market run in bonds for really close to thirty years. If we are again no longer in a bull bond market—forget about calling it a bear bond market—how do you think about that? How do you think about the impact on Oaktree, but more specifically the impact on how you would invest?

They want to raise rates to prevent the economy from overheating and lapsing into hyperinflation. So it has been clear that eventually rates would start going up. How could that have come as a surprise to anybody? Who could have been in the investment world or in the financial world and been surprised by rising rates? It's just that short rates rose for a long time without long-term rates rising, that doesn't make any sense.

So given that Oaktree is now one hundred and twenty billion, and I understand not all pools of money are the same, realistically, given the size of that tanker, how much time would you really need to meaningfully adjust the portfolio?

And you talked about the pain associated with going to cash, and then if you engage in abstention and the market keeps going up, then obviously you underperform. And let's point out the most important—one of the most important attitudes in investing—that being too far ahead of your time is indistinguishable from being wrong.

And eventually long-term rates started to rise, and everybody freaked out. The failure of people to anticipate rising rates and the ability to be surprised by rising rates earlier this month just shows you how myopic and blind the markets can be.

Well, first of all, I appreciate your use of the word 'adjust,' because a lot of people who are less astute than you would say, 'How long would it take to go to cash?' The answer is, going to cash—we don't go to cash. Going to cash is under almost all circumstances stupid, because among other things, when you go to cash, you have to be right right away. If you go to cash and prices keep going up for a while, as they invariably will, and returns continue to be positive, you fall so far behind by being in cash that you may even jeopardize your business's staying in business, and you'll certainly jeopardize a lot of your client accounts. But you used the term 'adjust portfolios,' and if you read the book, as I hope you will, you'll see that we don't think about when the turn is going to come or when the bottom is going to come. In fact, 'when' is one of the words I reject in our business, because we sometimes have an idea what's going to happen, and we never know when the turn's going to happen. The economy is a little bit volatile—sometimes it's up three, sometimes it's up one, sometimes it's down one. Company profits are more volatile because companies are leveraged, both operating and financial. But market prices do this because they're driven by people, by people's emotion, by what we call human nature. To figure out when things are going to happen, you would have to be able to predict emotion, which is impossible. So we don't ever think about 'when' at Oaktree. One of my mottos is: we never know where we're going, but we sure as hell know where we are, what's going on around us, and what that implies about the future. If we conclude that the present developments justify a more defensive position, then there's no time like the present. We start and do what we can, and hopefully we do enough before the stuff hits the fan.

Absolutely, early is wrong, sure. But along those lines, has that changed over the course of the last, you know, again, call it twenty-five years?

And obviously, we came through a pretty formidable financial crisis and ensuing recession. Where do you think the market is with respect to remembering the financial crisis of '08, and how much do you think that is manifesting itself in investor behavior?

So when you decided to write a book, what was the story that you wanted to tell?

So one of the things in that twenty-one was knowing where we stand in the cycle. Now, I think there are two among the twenty-one most important things—I think two are really the most important, except for the others. And they are, number one, risk and controlling risk, because I think controlling risk is the mark of a professional. Anybody can make money when the market goes up, and most of the time the market goes up, and anybody who takes above-average risk can do above-average when the market rises. So achieving returns is not a point of distinction in good times, in my opinion. The distinction of a superior investor is achieving returns in good times with the risk under control, because you never know when the environment is going to shift from favorable to unfavorable, and the question is, are you prepared? Somebody who if the market's up ten and you're up twelve, and the market's down ten and you're down twelve—you didn't accomplish anything. The question is, can you make more in the good times than you give back in the bad times? And then I think the other thing that's the most important is the cycle and where we stand in it. I don't believe in predicting the future. We never know where we're going. We should understand the present. Where we are in the present, where the market is relative to its cycle, tells you something about the odds that govern the future. It doesn't tell you what's going to happen tomorrow, but I believe that we can only understand, since the world is an uncertain place filled with randomness, we can't know what's going to happen in the future. But those of us who see the world more clearly than others can have a superior understanding of the probability distribution that governs the future—which things can happen, which are most likely, which are somewhat likely, which are unlikely. If you have that consistently, you are a superior understander, and you can be a superior investor. So I think the question is, what today is the probability distribution that governs the future? And one of the things I say in the book, which I'm happy with, is that future investment performance, in particular for me, is like a bowl full of lottery tickets. You never know which ticket's going to be chosen. Sometimes the bowl has seventy percent winning tickets and thirty percent losing tickets, sometimes it has seventy percent losing tickets and thirty percent winning tickets. Wouldn't it be nice to know the difference? I think it's possible, but you want to go all-in when it's seventy percent winners and thirty percent losers—you want to invest heavily in aggressive securities. And you reach into the bowl, or maybe the gods of fate reach into the bowl, and they pull out a ticket, and it's a loser. So as my best friend Bruce Newberg says out in California, when we play backgammon, which is a game dominated by dice, there are probabilities and outcomes. We can get the probabilities on our side—that does not ensure a favorable outcome, but it's the only thing we can try to do. And that's what the book is all about.

When I write the memos, I always think of something that I didn't have in mind before I started the memo. I'll give you a simple example since we've been talking about risk and probabilities. Six years ago, I wrote a memo with the clever title 'Risk,' and I tried to put down everything that I could think of about risk that I know. And sitting there typing it out, I wrote that you can't measure risk in advance, you can't quantify risk in advance. And I think that's true. You can't measure risk even after the fact. You buy something for a hundred dollars, a year later you sell it for two hundred dollars—was it risky? Maybe. The point is, in my opinion, you can't measure risk even after the fact. That's something that I—I literally hadn't thought about it before I sat down. In the book, when I was writing about psychology, I realized that there was something that deserved—I hadn't planned to write about it—that deserved its own chapter, and that was the cycle in attitudes towards risk. Because I think that the way people think about risk has an enormous impact on the market, and it changes volatilely. People are supposed to be these computers who look at risk-adjusted returns and make intelligent decisions on that basis, and nothing could be further from the truth. When the market is doing well, the economy is thriving, companies are reporting good profits, the media are telling good stories, and everybody feels good, what do they say? 'Risk is my friend. The more risk you take, the more money you make. I feel entirely comfortable taking risks today, and by the way, I don't see any risks on the horizon, so bring it on.' And then for the next year or two, the economy suffers, corporate profits disappoint, the media now turn into telling scare stories, prices are cascading down, and emotion goes through the floor. Now what do people say? 'Risk-bearing is just another way to lose money. I don't care if I ever make a penny in the market again. I just don't want to lose any more. Get me out at any price.' This fluctuation in attitudes towards risk probably does more than any other one thing to influence the swings of the market. Again, this is an idea that I had no thought that I would write a chapter about that. The great thing about writing is you have to think things through. You can't have some rough, unformed, imprecise view—it has to be crisp.

Yeah, so I think in order to convince others, you have to convince yourself. Sure.

Thank you, Howard, for joining us today and sharing your insights.