"And then things just get crazy."

Yesterday, Oaktree Capital's Founder & Chairman Howard Mark, released a letter to clients entitled "The Outlook for Equities." You can find the document embedded below.


It's a fascinating read that I suggest all market participants take the time to study. Marks goes on to note one of his "first of the time-worn pearls of wisdom that contributed so much to my education as an investor. It described the three stages of a bull market:
  • the first, when a few forward-looking people begin to believe things will get better
  • the second, when most investors realize improvement is actually underway, and
  • the third, when everyone's sure things will get better forever."
This takeaway from the letter is below:
"So now we have a somewhat improved fundamental environment, a generally more optimistic group of investors, and stock prices that are a fair bit higher. No one should say the likelihood of improvement is entirely unrecognized today, as would have to be the case for this to still be stage one. I think the existence of improvement is generally accepted, but that acceptance is neither extremely widespread nor terribly overdone. Thus I’d say we’re somewhere in the first half of stage two. Pessimists no longer control market prices, but certainly neither have carefree optimists taken over"
And a prognostication on the outlook for equities:
"But I like to enumerate the pros and cons and try to put them in perspective, as much as I like skewering excessive generalizations and pat pronouncements.

Of course, doing that isn't enough. I feel I should come down on one side or the other. Thus I’m quite comfortable imagining a few years of equity performance that provide a pleasant surprise relative to what I think is the prevailing expectation of 6% or so per year.

And if I'm wrong  - if there is no rotation from fixed income to stocks –  I'm not that worried that I'll end up with great regret over having failed to pile into T-bills yielding zero or the 10-year note guaranteeing 2.0%. When attitudes are moderate and allocations are low, like I feel is currently the case with equities, there‟s little likelihood of investing being a big mistake. And when interest rates are among the lowest in history, it would take deflation, depression or calamity to make failing to invest in Treasurys and high grade bonds a serious omission."
My grandfather was a barber for his entire life. He started cutting hair when he was 15 years old with some of his older brothers to pay for food and clothing for their younger siblings three states away. His knowledge of the market ends with dollar cost averaging index funds in his IRA his entire life.

In 1999, he asked me about a particular stock. A dot com stock. A customer had given him a tip on a high flying tech start-up and he asked me if I should invest in it. My grandfather, at this point, had lived over 70 years of his life and never once invested in an individual security and now he wanted to invest in a company at infinity multipe of sales because...you know, there were no sales.

I told him it was a terrible idea and he shouldn't do it. He did it and plowed $5,000 or to him 250 haircuts into the stock.

The stock went to zero in 3 years.

I bring this story up to give reference to the current market place. We are no no no nowhere near that sort of environment but the tide is shifting. Many analysts I talk to at value based hedge funds lament that after a stellar January of the year, they are all under performing growth funds. An analyst friend of mine notes that one of the best market timers out there, Chase Coleman of Tiger Global, has been plowing money into high multiple, high growth tech stocks. Yesterday, a friend sent me an email:

"280 stocks hitting 52 week highs, 3 hitting the lows"

I often talk about the pendulum of risk / return:
  1. When the world is extremely bearish and you can buy most things indiscriminately for a sizable gain.  At these times, your friends call you a lunatic / maniac and are one of the few buyers out there (November 2008 is the prime example)
  2. When the world is bearish, there are more buyers, and risk assets will still produce a better than commiserate return for the risk underwritten
  3. When markets are fairly valued and the bulls and bears are equally on the side of the fence.  At this point, investors are taking return for the exact amount of risk  
  4. When markets and the world are bullish, assets are becoming fully valued, and really the best strategy to employ here are event driven ones like merger arbitrage or liquidations (LBHI) that remove market risk from the equation.  Here you start to see short squeezes
  5. When markets are fully valued, everyone is a buyers (except for you hopefully), and you are playing with fire by buying any risk asset
The problem with this is that the end of stage 4-stage 5 is painfully parabolic. As I like to say it "And then things just get crazy."

Things here is a euphemism for market behaviors. My grandfather buying stock in 1999 is a crazy thing. When CLF traded to 120 in June 2008. When new home construction was increasingly exponentially. Etc.

The scary part about being a value investor, and many of the great value investors testify this from the 1999-2000 period (when Julian Robertson packed it up), is those parabolic movements against them are painful from a portfolio and a business perspective. Its ok to underperform some months here and there by a reasonable margin, but when you are underperforming by 300-500 bps on a monthly basis when growth is the go - it hurts.

Value investors are always early. The reason is that the herd that follows us lags in such a greater size relative to the intelligence ones. Intelligent investors get out in month 1, and then 200 investors get out in month 6. In those interim months, there are still people GETTING IN and frankly annoying value investors who scratch their head and say "What in God's name are people thinking out there?"

Is credit again at the "And then things just get crazy." stage? It's probably the crazies thing out there right now but we've yet to see that parabolic movement where 95% those that are buying knows there's a strong chance this will end badly. The huge M&A push has yet to happen despite big piles of cash at private equity funds.  2nd lien dividend deals are out there (more so holdco dividend deals) but only for high quality borrowers. Growth is outperforming, but only in the last 6 weeks.

Excesses will continue and then they will go parabolic as more people than you thought possible pile into that excitement. Luckily my grandfather hasn't asked me yet if he should buy high yield bonds...


Anonymous,  3/14/2013  

I am not sure this captures the full market psychology of it. We've had potentially 2 very big bubble bursts in the last decade-ish.

For people to go into irrational buying spree, they had to have not gotten burned in such a short (relatively) time frame or even recall there being a bear market during their career. Stories of people who were investing in the 1920s who never touched stocks again abound. Many retail investors got burned in 2000 and 2008. I am not so sure we are headed to the same level of irrational exuberance. And one needs to be mindful of boomers and their increasing shift from stocks to bonds.

Anonymous,  3/15/2013  

enjoyed your article; found the link from realclearmarkets.com. one quick question w/regard to spellcheck-- should "2. When the world is bearish, there are more buyers, and risk assets will still produce a better than commiserate return for the risk underwritten..." read "commensurate"? thanks for sharing your work!


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.