‘Too much money chasing too few deals.’
Those are “the seven worst words in the world,” and they could mean trouble for the stock market, according to Oaktree Capital’s Howard Marks.
In other words, “excessive optimism is a dangerous thing,” and “risk aversion is an essential ingredient for the market to be safe.” The “danger for participants,” he says in his latest memo, boils down to the fact that “overly generous capital markets ultimately lead to unwise financing.”
For perspective, Marks recounted how Oaktree took a “highly defensive” posture in 2005-2006: selling assets, liquidating distressed debt funds, shunning high-yield bonds and basically raising the standards for every investment they made.
“What caused us to turn so negative on the environment?” he said. “The economy was doing quite well. Stocks weren’t particularly overpriced. And I can assure you we had no idea that subprime mortgages and subprime mortgage backed securities would go bad in huge numbers, bringing on the Global Financial Crisis.”
That’s where the seven words come in. At the time, the Fed was cutting rates to prevent problems and investors were eager to deploy capital in risky investments.
“Thus almost every day we saw deals being done that we felt wouldn’t be doable in a market marked by appropriate levels of caution, discipline, skepticism and risk aversion,” Marks said. He borrowed the words of Berkshire Hathaway’s
Warren Buffett: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
How does that apply to the current environment?
“In order to counter the contractionary effects of the Crisis, the world’s central banks flooded their economies with liquidity and made credit available at artificially low interest rates,” Mark said. “This caused the yields on investments at the safer end of the risk/return continuum to range from historically low in the U.S. to negative (and near zero) in Europe and elsewhere.”
Hence, some of the money that would have gone to more low-risk investments in this climate has been on the hunt for better returns from riskier assets.
“Whereas I thought while it was raging that the pain of the Crisis would cause investors to remain highly risk-averse for years — and thus to refuse to provide risk capital — by injecting massive liquidity into the economy and lowering interest rates, the Fed limited the losses and forced the credit window back open, rekindling investors’ willingness to bear risk,” Marks wrote.
And that has led us to “higher prices, lower prospective returns, weaker security structures and increased risk,” he warned, saying that enough time has passed for the trauma of 2008 to heal.
“The requirements have been fulfilled for a frothy market,” Marks said. “Investors may not feel optimistic, but because the returns available on low-risk investments are so low, they’ve been forced to undertake optimistic-type actions.”
He’s not saying investors should load up on cash or live in fear of an imminent crash, but he is urging a cautious stance going forward.
“Investors should favor strategies, managers and approaches that emphasize limiting losses in declines above ensuring full participation in gains,” he said. “Just about everything in the investment world can be done either aggressively or defensively. In my view, market conditions make this a time for caution.”