Howard Marks: The “Easy Times” are Over for the Stock Market

If it's the change I think it is, then what you should have in your portfolio going forward can be very different from what it has been. Billionaire investor Howard Marx is warning that the easy times in the stock market are likely over. In a recent interview, Marx talked about a quote “C change” that is taking place as we speak that will fundamentally change the economy and the way people invest. So make sure to stick around till the end of the video because Marx provides details on how he recommends people invest to take advantage of a once-in-a-40-year opportunity.

Here's what he had to say. "Let's talk about two memos that you've written, uh, not too long ago that are fairly well known. One was written last year called 'Sea Change' and in 'Sea Change,' as I understand it and as I remember from reading the memo, you said in your lifetime in the investment world there have been three SE changes. Two of them occurred earlier. You describ what they are and now there's a third C change and that third C change is basically that interest rates are not coming down anytime soon and we have to live in a higher interest rate environment for quite some time. Is that fair?"

"Uh, it's about fair. What I would say is that since 19—remember in 1980 the FED funds rate was 20% and I had a loan outstanding from a 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 prominent factor in the financial world. I think it was the most important single event in the financial world in the last 50 years. Doesn't get the credit."

"Well, okay, was that the first C change in your investment?"

"This, well, that was no, that was really the second, but the third, uh, follows on from that. In the period '09 through '13, 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, 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 easy money environment. And the main point of C change is we're no longer in an easy money environment."

"So, you mean all the geniuses of private equity are not geniuses?"

"We've been benefited from, uh, low interest rates. You well, you know, uh, there is a part in C change where I talk about the fact that, uh, a guy says, oh, we can buy this company and make 10% a year, then he turns to his capital markets person and says, what will it cost to get the money? We can borrow at eight, borrow at eight, invest at 10, great, we do it. You buy the company. But in the stimulated environment of low interest rates, the company does better. You make more than 10%, your cost of money declines from 8% to 6% to 5%, it costs you less to borrow the money, and you say, boy, I'm a genius."

"The US stock market has been on an amazing run for the better part of the last four decades. As we can see in this chart here, the S&P 500 has risen from roughly 100 at the start of 1980 all the way to a high of nearly 4,800 at the start of 2022. This means that $1,000 invested in the stock market in 1980 would have turned into a whopping $48,000 by the start of 2022, not even including dividends. If you include reinvested dividends, that $1,000 would have turned into a staggering $122,000. With these types of impressive returns, the last 40 years was arguably the golden era of the stock market."

"During this time period, amazing companies were founded. The average publicly traded company became more profitable. American corporations grew as international markets opened and business became a global affair. All of these factors helped contribute to the extremely impressive returns the stock market generated. However, according to Howard Marks, all of those factors paled in comparison to what he considered the dominant driver of stock market returns over the last four decades: declining interest rates."

"Take a look at this chart here of the federal funds effective rate, a proxy for interest rates in the US economy. As we can see, interest rates peaked in the early '80s with the FED funds rate hitting nearly 20%. From 1980 to 2010, interest rates continued to fall with each passing decade. That was until rates simply couldn't go down any further. The FED funds rate was lowered to 0% in response to the great financial crisis and spent much of the following decade at that level. 40 years of consistently declining interest rates created a massive tailwind for the stock market."

"Let me explain. The value of any type of asset, whether it's a stock, bond, or a piece of real estate, is based on the cash it will generate for you as the owner, discounted back to the present day using an appropriate interest rate. I know the definition may sound a bit complex, but it's actually incredibly simple. Here's an interesting thought experiment to demonstrate: Let's say as a thank you for being a loyal viewer of this channel, I decided to reward you with $11,000 in cash. Which, as a reminder, makes sure to hit that subscribe button if you aren't already because our community of investors is approaching 300,000, and it would be even better with you as a part of it."

"Okay, back to our example. This $11,000 comes with one condition. You will receive the $1,000, but it won't be today; it will be exactly 10 years in the future. We make this an official agreement and sign a contract. Let's call this document Contract A. Contract A gives you the legal right to receive $1,000 in 10 years. This makes for an interesting question I want you to think about: since you aren't receiving this money until 10 years from now, how much is the fact that you're receiving $11,000 10 years worth to you today?"

"Put another way, imagine someone approached you today and wanted to purchase your legal right to receive the money in 10 years. What would be a fair price to sell Contract A for? I want you to think about this for a second because it gets to the heart of what Howard Marks is talking about. Remember earlier how I said the value of any asset is based on the cash flow it will generate for the owner, discounted back to the present day using an appropriate interest rate? That concept applies here. The value of Contract A is extremely dependent on what interest rates currently are."

"The $1,000 has to be so-called discounted back using current interest rates to reflect the fact that a dollar 10 years from now is not worth as much as a dollar today. This is a concept referred to as the time value of money. Let's see this concept in action using a 20% interest rate. The value of Contract A is worth $162. Let's see what happens as we lower the interest rate. At a 15% rate, the value of Contract A increases to $247. If we take the interest rate down further to 10%, the value increases even more all the way to $386."

"Let's make things interesting and really take down the interest rate. At 7%, the value of Contract A jumps to $58. If we get really aggressive and take the interest rate down to 2%, the value skyrockets all the way to $820. Notice how the value of Contract A increased from $162 at the beginning all the way to $820 just from the interest rate declining. This is what Howard Marks meant when he talked about how constantly declining interest rates over the last 40 years has been a massive tailwind for stocks."

"In this example, we calculated the value of a contract that provided the owner the legal right to receive a certain amount of money in the future. That is exactly what a stock is. A stock represents a fractional ownership in a business and provides you with a legal claim on the cash that business generates in the future. What the future holds for the stock market will depend in large part on what happens with interest rates. Here's what Howard Marks had to say on that topic."

"Um, let me make sure I understand. Uh, your view is that interest rates have come up and they're fairly high right now, um, but the conventional wisdom in Washington, which is not always right—in fact, it's wrong more than it's right—is that the FED probably next year will begin to lower interest rates. And if the FED does begin to lower interest rates because inflation's getting down to 2%, their target, you don't think interest rates will come down and we'll go back to another 20 years of low interest rates. Why do you think that we're going to keep interest rates relatively high?"

"I think that what I said in the memo is that rates are likely to be between 2% and 4%, not between 0% and 2%. The FED funds rate and, uh, you know, between 0% and 2% is an emergency measure. And you know, rates were—the FED funds rate was zero much of the—probably the majority of the time in the '09 to '21 period, and that's inappropriate. It stimulates you. You can't live on a—a dose of adrenaline every morning for 13 years and it does, uh, subsidize borrowers and penalize lenders and savers. Um, and I would like to see a Fed get to a neutral position that is neither stimulative nor restrictive. And I—I describe that as 2% to 4%. If inflation's 2%, then the FED funds rate should be higher than that so that there's a positive real FED funds rate."

"Earlier in this video, we talked about the theory behind how higher interest rates lead to lower stock prices. While this is how things should work in theory, as is often the case, sometimes how things play out in reality can be a bit more complicated. Over the last roughly 18 months, interest rates have increased at the fastest rate in generations. As we can see here, the federal funds rate started 2020 at roughly 0%. Over the course of less than 2 years, it increased to its current level of over 5%. Given these drastically higher rates, one would think that stock prices would have to come down, right? Well, that hasn't really been the case. Despite significantly higher interest rates, the US stock market is only down roughly 10% from its all-time highs."

"This is because many investors and economists think these higher interest rates are only temporary. The thought is that as inflation starts to come down and the economy slows, the FED will have no choice but to cut interest rates back to near historically low levels. This is why the stock market hasn't reacted more negatively to the steep rise in interest rates. Howard Marks disagrees. To understand why, you have to understand what so-called real rates are. In simple terms, the real interest rate is an interest rate that has been adjusted to account for the impact of inflation."

"Here's the shorthand way to calculate the real interest rate. Let's say the current interest rate is 5%. This is referred to as the nominal interest rate. Think of this as the interest rate before factoring in inflation. Additionally, in this example, let's say inflation is currently at 4%. The way you approximate the real interest rate is by taking the stated interest rate, so in this example 5%, and subtracting out inflation—in this example 4%. This leaves you with a quote-unquote real interest rate of 1%. Marks believes that higher nominal interest rates are here to stay."

"This is because Marx makes the argument that in order to lend out money, lenders need to receive a positive real return. Using our example, if nominal interest rates fell to 2% and inflation remains at 4%, the real interest rate is now -2%. According to Marx, this would be unsustainable. No sane investor would lend money if their return, after factoring in inflation, is negative. As a result, Howard Marks believes interest rates will need to be higher over the next decade than they were in the prior decade. This is how he recommends investing in the so-called new normal environment of higher interest rates."

"Okay, let's talk about your other memo. You have another one called 'Further Thoughts on C Change.' Yes, and that one, which was written a couple of months ago, uh, the essence of it, if I can describe it—and you'll correct me if I'm wrong—is that because of the C change that you described in your earlier memo, you think that there's going to be a C change in assets that people are going to want to own and they're going to want to own more fixed income assets because interest rates are going to be high for quite some time. Is that fair?"

"That's fair. You know, the S&P has returned—the S&P 500 stock index has returned 10% a year, plus just a little over 10%, for 100 years. That was enough to turn a dollar in 1920 into $155,000. That's a good rate of return. Today, you can get equity-type returns from what we call credit instruments—loans, uh, corporate loans, loans for buyouts. Uh, you can get high single digits on high-yield bonds and leveraged loans—public instruments that are tradable and liquid, or low double digits on, um, on private loans for buyouts. The best buyouts, the biggest buyouts—double-digit returns. Isn't that enough?"

"And, and loans on credit instruments—I mean, returns on credit are much safer than equity. Equity just gets the residual after everybody gets paid—they get what's left. Credit gets paid early in the process. And if people don't pay you, you get the company because they go bankrupt. So it's quite safe, and, uh, returns that are fully competitive with equities with a good level of safety."

"For the roughly two-decade period from 2001 to 2021, if you wanted to generate a decent return on your money, you almost had to invest nearly exclusively in stocks. Returns from things such as savings accounts and bonds were simply too low to produce a meaningful return on investors' cash. With higher interest rates becoming the new normal, Howard Marks is predicting a shift from stocks to safer, so-called credit instruments."

"Here's what that means for background. Marks graduated from the University of Chicago with an MBA in 1969. During that time, one of his professors introduced the concept of the risk curve. In simple terms, what this chart is saying is that in order for investors to produce higher expected returns, they need to invest in increasingly more risky investments. Put another way, if all investments generated similar returns, why would someone invest in a volatile stock market when they could keep their money in a savings account and have that same return? The only way investors will invest in riskier assets is the incentive of higher expected returns."

"This line here is called the risk curve. As investors move farther out on the risk curve, risk increases, but so does expected return. Let's say we have an investor that is looking to generate a 10% return. When interest rates are low, investors may have to go farther out on the risk curve to hit the return target. In this example, that means investing in more aggressive stocks."

"However, let's see how higher interest rates change things. As interest rates increase in the economy, it shifts the risk curve up. Now that interest rates are higher, to generate that same 10% return, our investor here doesn't have to go as far out on the risk curve. That 10% return target can be achieved by investing in high-grade bonds instead of stocks. Bonds are considered less risky than stocks because in the event of a bankruptcy, bondholders have to be paid back in full before stock investors receive a single penny of their money back."

"If higher interest rates are here to stay, it has the potential to completely shift the way many people and institutions go about investing. Gone will be the days when people had no choice but to invest in the stock market. Only time will tell if Marks's prediction comes to pass."

"So, there we have it. I hope you enjoyed this video and make sure to hit that subscribe button because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon."