Howard Marks: The #1 lesson investors never learn

Markets have moved past one dangerous period – that of “irrational exuberance” – and are in the middle of another that's the polar opposite but equally risky. That’s according to celebrated global credit investor Howard Marks, co-founder and co-chairman of US firm Oaktree Capital. 

During a podcast recorded alongside his co-portfolio manager Bob O’Leary in mid-October, the pair reflected on their experience of investing before, during and after the tech wreck, the GFC, and the (ongoing) pandemic and post-pandemic era. So, what useful lessons might be applied to the current market environment?

Marks recalls the “sanguine” period between 2005 and late 2006 as one where the economy was smooth though not booming, after investors had suffered through the technology crash of 2001-2002. This had, in turn, followed a period of strong share market returns in the late 1990s.

“People started to believe, as they do in good times, that the outlook was perfect and that you didn't have to worry about any untoward development,” Marks says of this latter period.
“The TMT (technology media telecom) bubble bursting dashed that hope and most people turned very negative on stocks and so people tended to look elsewhere for returns.”

He says this was initially a positive development because it prompted more innovative thinking and sensible consideration of Alternatives. But worrying signs started to emerge in 2004.

“When the psychology in the world turns unreasonably positive – what (former US Fed chairman) Greenspan described as ‘irrational exuberance' … Bob and I and the rest of us at Oaktree tend to … suspect that unfavourable trends are underway,” Marks says.

Marks recalls “wearing out the carpet” in 2005-2006, running to his business partner Bruce’s office at least a couple of times a day. “Holding up a piece of the newspaper, saying ‘Look at this piece of crap that got issued yesterday.' If deals like this can be done, there's something wrong.”

His colleague O’Leary, who joined the firm in 2002, has a similar recollection and says his most prominent memory is the difficulty of finding anything to buy back in 2007.

While he and the Oaktree team were reducing their levels of invested capital, many competitors were doing the opposite, in what O’Leary describes as “a bit of a panic to get risk on.”

Adding his thoughts here, Marks concedes neither he nor the team behind him had any idea about subprime mortgages or mortgage-backed securities - which we now know were pivotal to what unfolded in the US and the subsequent global fallout. “All we knew was that the world had become an unsafe place because of investor practices,” he says. 

Fuelled by the US’s overheated real estate market, during this period, large volumes of cheap money looking for a home flooded the property sector, which was then bid up to levels that were no longer sustainable. (This might sound familiar to those reading along at home in Australia).

What were the other signposts?

O’Leary says one of the watershed moments for him was during a visit to his home state of Oregon, where among the booming housing developments he noticed large numbers of homes where construction appeared to have stalled.

“It was clear that something had happened and that the banks wouldn’t extend any more credit or somehow the person responsible for the development had fallen down. And that indicated to me the system was starting to seize, on a more direct level,” he says.

“We started to get panicky inbound inquiries from banks about large amounts of debt that they had committed to, that they were trying to get off their balance sheet.”

He says we’re seeing something similar happening now, “where the banks have done things they probably regret and are all coming to market.”

“You've seen a lot of the same behaviours that we saw in the run-up to that just more recently. So, history is repeating itself here,” says O’Leary

Other aspects of this period that resonate with our current times were also present during the GFC, including:

• The rise of Special Purpose Acquisition Companies
• Covenants – the financial indicators and debt versus profit levels companies are required to maintain – were, in many cases, systematically degraded or dismantled
• High debt levels
• Elevated capital liquidity

In a memo Marks penned when we were in the midst of the GFC, he wrote: “It's clear when the story of 2002 to 2007 is written, leverage and liquidity will be among the main players.”

The danger inherent in leveraging up investments is one of the key lessons he imparts during the latest podcast.

“In optimistic times people say, ‘Well, I'm only making this investment because I expect the positive outcome, so why shouldn't I lever it up and make more profit?'” Marks says.

“Providers of capital are glad to supply it because they have money they want to put to work, so they outbid each other.”

The danger occurs, as Marks explains, “when the world becomes so highly levered that they can't get through a rough spot, and eventually a rough spot appears.”

How thinking drives investing

The overriding effect of investor sentiment – and the importance of individual psychology and decision-making – are emphasised repeatedly during the interview. Marks has long emphasised his view that it’s the behaviour of market participants themselves that creates market risk, not specific types of products, investment strategies or even financial institutions.

Deciding that anything is either “flawless” or “hopeless” is a clear exaggeration – things are rarely so black-and-white. And yet, that’s the type of thinking that drives investment decisions. As Marks suggests, understanding investor psychology is about 90% of everything you need to know about investing and financial markets.

“When people think the outlook is flawless, they take on too much risk, they lever up too much … And when things change a little bit, people become hopeless. They're afraid everything they own will go lower, so they’d better get out,” Marks says.

“Since everybody feels that way, there are no buyers. And so prices cascade downward, basically. That's what happens.”

The number #1 lesson investors never learn

It’s not that they don’t learn, says Marks. In fact, he says we learn them to excess – as highlighted in the earlier point about thinking anything is either “flawless” or “hopeless”.

Marks believes the main problem is that we’re so quick to forget what we have learnt.

“People have short memories. On the one hand, you have things like prudence, memory, and an awareness of history. And on the other hand, you have the desire to get rich,” he says.

“When you get a few years from the episode, the desire to get rich takes over and the prudence and the memory recede.”

To hear more nuggets of wisdom from Howard Marks and his portfolio manager, you can catch the full interview of The Rewind - Global Financial Crisis on the Oaktree Capital website.

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