Monday, September 13, 2010

Howard Marks Memo: Hemlines and Investment Styles

While the details change, the pendulum-like fluctuation of investment styles is a constant. Fear versus greed, pursuit of safety versus aggressiveness, stocks versus bonds, and growth versus value are just a few examples of the areas in which we see this take place. In this way, the investment world proves the wisdom of Mark Twain’s observation that, “History doesn’t repeat itself, but it does rhyme.”

The limits of the pendulum’s swing are fixed, and it tends to move back and forth over the territory between them. This occurs because (a) people tend to take trends to extremes, (b) neither extreme of the pendulum’s arc represents a perfect or permanent solution, and (c) there’s no place else to go in these regards. Thus the best way to view investment trends may be through an analogy to hemlines: all they can do is go up and down, and so they do.


Additional excerpts:

At What Price?

That question – at what price? – isn’t just the right question to ask about bonds versus stocks today. It’s the right question regarding every investment at every point in time.

I try every chance I get to convince people that in investing, there’s no such thing as a good idea . . . or a bad idea. Anything can be a good idea at one price and time, and a bad one at another.

The thing to think about isn’t whether you’d rather have junior or senior securities in a recession, or fixed rate securities versus variable ones in deflation. The question is which securities are priced right for the future possibilities: which ones are priced to give good returns if things work out as expected and not lose a lot if they don’t? You mustn’t fixate on a security’s intrinsic merits, but rather on how it’s priced relative to those merits.

So, for example, it’s not enough to say “We want fixed rate securities in deflationary times.” You’ll be glad to be holding 2½% ten-year Treasurys if deflation materializes, but how will you feel if it doesn’t? And what’s the probability of each outcome?

If bonds are ideal for deflation and stocks will bear the brunt of the associated economic weakness, is that all that matters? Would you rather buy overpriced bonds than underpriced stocks? Is there an objective standard for overpriced and underpriced? And, for example, if the ten-year note will pay 2½% regardless of the environment, and stocks will return 15% if deflation is avoided and lose 10% if it’s not, doesn’t deflation have to have a likelihood exceeding 50% for bonds to be preferred? (Check the math.)

My point here is that simplistic blanket statements are no help at all in making investment decisions.

Most of today’s positive articles about bonds are totally devoid of discussion of prices and probabilities. But it’s only by assessing those things that attractiveness can be determined.


The bottom line is that, as bond prices rise (reducing yields) and p/e ratios fall, the chances increase that stocks will outperform bonds. Thus the benefits high grade bond investors feel they’re gaining through what they’re buying can be undone by what they’re paying. I’ll say it another way: the attractiveness of one investment relative to another doesn’t come from what it’s called or how it’s positioned in the capital structure, but largely from how it’s priced relative to the other.

I’m impressed today by the ability to assemble a portfolio of iconic, high quality, large-cap U.S. growth stocks that will provide appreciation in a strong environment, a measure of protection in a weak environment, and a meaningful dividend yield regardless. To me, and given my standard view that we don’t know what the macro future holds, these stocks’ potential over a range of possible scenarios is more attractive than bonds which will do well in periods of economic weakness or deflation but poorly in strength or inflation.

Compared to stocks, I feel Treasurys and high grade bonds currently reflect all of the environmental factors in their favor and perhaps more and are priced rich relative to stocks. For them to do well from here, with yields so low, everything has to work out as the bond bulls hope.


Since few investment trends continue forever, it’s usually smarter to expect ultimate regression to the mean rather than growth to the sky. No one should view the great popularity of bonds relative to stocks without reservation.