The U.S. Economy Just Hit a Big Turning Point. (Howard Marks' Sea Change Is Here)

People believe in the ability to predict the future, and in general, uh, I agree with uh, John Kenneth Galbraith, who said, "There are two kinds of forecasters: the ones who don't know and the ones who don't know they don't know."

There is Howard Marks, co-founder of Oaktree Capital Management and all-around legendary super investor. Over the years, he's built a personal net worth of over $2 billion. But beyond his incredible investing career, you might also know him from his investing memos, where he explains all the important events he sees unfolding in the market. They're mostly a discussion of what I see happening. I'm not a futurist, I'm not a forecaster, but I think that, uh, you know, what I say is we never know where we're going, but we sure as hell ought to know where we are.

Marks has been writing these memos since 1990, but if you've been following along with his thoughts over the past year or so, you'll know that he is currently seeing a major sea change occurring in the stock market. One which will have lasting implications. The sea change here refers to is the fact that the easy money environment we've all become so used to is now over, and it doesn't look like it's coming back for a long time.

Remember in 1980, the Fed funds rate was 20, and I had a loan outstanding from the bank at 22 and a quarter. 40 years later, the Fed funds rate was zero, and I had a loan outstanding from a bank at two and a quarter. So the decline of interest rates by 20 percentage points over that period was a dominant factor in the financial world. I think it was the most important single event in the financial world in the last 50 years.

It doesn't get the credit; when interest rates decline, borrowing money gets easier and easier. The interest rate expense is lower, thus you can service a larger loan. But what this long-standing trend of declining interest rates has created is a lot of inflation in asset prices like stocks and real estate, and it's also created a very high debt environment as everyone leveraged up to their eyeballs because they could.

In the period 2009 through 2013, the Fed took the Fed funds rate to zero to fight the global financial crisis, left it there a long time, and didn't have any luck getting it back up into what you might think are normal ranges. So we had a low interest rate environment which made life very easy for borrowers and asset owners. It was easy to run a business; the economy did well. We had the longest bull market in history, the longest economic recovery in history.

Uh, we had very low incidents of default and bankruptcy. It was an easy world. And if you read articles about, for example, Silicon Valley Bank, they talk about the easy money environment. The main point of the sea change is we're no longer in an easy money environment; that's the problem the world faces currently.

The sea change is happening as we speak. Interest rates are rising, and as Marx says, the easy money period is now over. As interest rates rise, loan repayments become more costly, fewer new loans are taken on, so the economy slows, workers lose jobs, and it's a much tougher time.

But the real issue this time around is that because interest rates have been on a multi-decade downtrend, society has gotten very used to low interest rates being normal interest rates. This has led to households taking on record amounts of debt. Household debt to GDP has skyrocketed since the 1980s. If you came into this business since 1980, which is almost everybody, you have only seen declining interest rates or ultra-low interest rates.

People tend to say, "Well, that's what it's been for 40 years; that's normal. That's what it's going to be." But no, you have to recognize it. That's why I call it the sea change, because you have to recognize this is an important pivot. Beyond just looking at the household, Marks notes that this sea change also heavily impacts businesses and even governments, who now face enormous piles of debt that's coming due that needs to be refinanced on more punishing terms.

Much like what people do with their home loans, it is very common for businesses and even governments to simply refinance their debts. AKA, they don't actually pay back their loan; they simply create a new loan to pay for the old loan.

The problem with this, however, is that because interest rates have risen, now the terms of the new loan are much more punishing than what they were previously. This is already catching out businesses that don't have cash to spare. Most bankruptcies don't occur because you have a business and it loses money, loses money, loses money, goes away. It occurs because a business borrows money. Times get tough, and when it goes to refinance that loan, nobody ever repays their debts; they just refinance it.

And when they go to the bank to refinance it, the bank says, "You're not as good of credit as you used to be," or "We don't have as much money to lend as we used to have," or "Our standards are higher." Most bankruptcies or defaults are associated with a maturity which is unmet.

I think that when you go through a period when it's super easy to raise money for any purpose or no purpose, and you go into a period when it's difficult to raise money, even for a good purpose, clearly many more companies are going to founder. This problem has been particularly prevalent in the world of commercial real estate, which you might have seen catching the news across the last six months or so.

Say a property business took on a $10 million loan to buy a piece of commercial real estate a few years back. Back then, the interest rate was 2%, so it only cost them $200,000 a year to own that building. This was a great deal because they leased out that building and made $800,000 a year in rental income, which gave them a $600,000 profit.

But here's the problem, though. As companies were forced to work from home and interest rates started rising, businesses felt the crunch and decided to ditch their office space. Now, the real estate business only makes $400,000 per year in rental income, but unfortunately, they also need to refinance their original loan with interest rates now at 7%. Now they need to cover $700,000 per year in interest expenses. Ouch.

And beyond that, for a lot of these businesses, the value of the building itself has also fallen over the last few years. So many companies will need to fork out even more cash to the bank to satisfy the loan to value ratio requirements. This equation is already getting so tough for some real estate investors that they're actually deciding to default on their loans and hand back the keys as opposed to trying to refinance in these sort of conditions.

This is exactly the type of scenario that Marks references in this next clip. The way I sum it up in further thoughts, I said, "You found a company to buy; you went to the bank. They said we'll lend you $800 million at 5%. Now the loan is up for renewal. You go in, they say fine, we'll lend you $500 million at 8%. So you have less money, and your cost of capital is higher, and you have a $300 million hole that you can't fill."

This principle applies to the commercial real estate sector, businesses across the board. But another entity that struggles under the weight of rising interest rates is the government itself. Remember, the treasury sells a lot of bonds to investors each year to plug the hole between their spending and their income.

And like businesses, with a lot of government debt coming due and needing to be refinanced through selling new bonds at higher interest rates, the government itself faces a big problem of having to devote more and more of their cash towards interest payments as opposed to using it for things like infrastructure or social security, health care, and so on.

Let's take the US government as an example of somebody that maybe should be bankrupt in some respects because we borrowed so much money. We have $32 trillion of debt; we're running an annual deficit this year that will be roughly $2 trillion. Are you, um, worried about our ability to pay off this debt? And if we can't, will it devalue the dollar?

It's clearly worrisome. There's never been a bankruptcy of the US or a country like it, so we don't know what's going to happen. Right now, the US dollar is what's called the reserve currency of the world, and we get to print them. In the short run, we can print as many as we want, and as long as that's the case, uh, we're not going to go under.

It's like if you have an unlimited checking account, you can pay your credit card bills without limitation. Um, we just don't know where it's going; that's the problem. We don't know where it's going, and that's the problem. That's the key quote. Yes, in the short term, the Federal Reserve can print money and buy government bonds to essentially place money in the hands of the US government.

But where does it lead over the long run? How much can the dollar be devalued until the world loses confidence in it? This has already started to happen. Earlier this year, when the world watched the US politicians push the United States the closest it has ever been to a default in the big nonsensical game of political chicken, we saw Ray Dalio has spoken about this as well, saying how dangerous it is to play games with the debt ceiling.

Marx seems to agree with him 100%. This business about using a default as a negotiating tool is very, very dangerous. It's the golden goose. We have this reserve currency status because the dollar is the safest currency in the world, and the US economy is the best. Why would you jeopardize that?

So, Marx is definitely seeing some issues with the US financial situation, and it's fair to say he's not too impressed. But one thing I admire about Marx and his memos is that while he sees obvious issues in the US financial world with interest rates rising and citizens, businesses, and the government struggling, he's still very careful not to entertain any sort of prediction as to what the future may hold.

This is an important skill as an investor. For Marx, he keeps up to speed with the macroeconomic events, but he does not let them influence his investment decisions.

So if somebody said to you, "What is the most common investment mistake that the average person makes?" what would you say? I think the, well, can I do two? Sure. Number one is that people believe in the ability to predict the future, either their ability or others, that they can identify.

In general, uh, I agree with John Kenneth Galbraith who said there are two kinds of forecasters: the ones who don't know and the ones who don't know they don't know. So I think that the average person has to learn that they don't know what the future holds, and nobody else does either.

And once you accept the idea that you'll never know what the future holds, it's actually quite liberating because you can stop stressing about it, and you can simply get back to your rational investing strategy of looking at businesses in your circle of competence and checking to see whether any of them are undervalued.

It frees your mind to start thinking bottom-up as opposed to top-down, because you know predicting things from the top down, aka predicting the macro, simply doesn't work. And as an investor looking at your portfolio in late 2023 or even early 2024, it's important to remember this.

Warren Buffett always talks about Ted Williams, who batted 400. It means 60% of the time he was out at the plate. The great investors are right 60%, 70%, maybe 80% of the time. If you're the kind of person who has to be right all the time, you shouldn't be in investing.

So free your mind of the idea that you have to know what the future holds and you have to get everything right. It just won't happen. But you really don't need to be right all of the time. As Marks says, 60-40, and you're doing great.

Truth is, it's a difficult time to be doing better than that as an investor with rates on the rise. But remember to stay focused on the long term and just stay the course.

And remember this about stock prices: this is particularly relevant at times like today. People believe that there's kind of a direct and mechanical linkage. If a company has a good event, the securities do well. If they have a bad event, like earnings, securities do poorly. But that's not the case because there's an intermediate step, which is, uh, people's reaction.

So it's not just whether the event was positive; it's how people reacted to the event that determines the impact on the security prices, and that's two different things. So you can't forget the psychological and human factor.

In the short term, the stock market is a voting machine; in the long run, it's a weighing machine. This means that short-term stock performance is a lot more about the investor's reaction to current events, an earnings report, the Fed raising rates, the stock market bouncing around. In the short run, investor psychology moves the market.

But this is a good thing because this is what gives us opportunities to grab high-quality businesses at steep discounts. So in the short term, the stock market is a voting machine. But the exciting thing is that over the long run, the stock market is a weighing machine.

So in 10 years, if a company's stock price has risen 300%, it's because that business has performed well. If it's lost 50% of its value, it's because the business's performance has been poor.

So if things are bouncing around in your portfolio right now, try not to stress. Remember, this is just based on what people think right now. But over the decades, the stock price will reflect how the business has performed.

Anyway, that is Howard Marks' view on the current investing climate and what you can do about it as an investor. Please leave a like if you did enjoy. Uh, you can also now sign up to our course waiting lists if you're interested in early access. That link is in the description of this video.

And I'm actually very, very excited. We are very close to finishing that course content, so definitely sign up to the wait list if you're interested. Um, but with that said, guys, I will see you all in the next video.