Howard Marks: We're in an "Everything" Bubble

Today, we're in an everything bubble. If he isn't already, Howard Marks is an investor you should be listening to and learning from. He is the co-founder and co-chairman of Oaktree Capital Management, one of the most highly respected investment firms. In his position, he has a unique perspective on what's happening in the markets today.

Throughout his career, Howard Marks has never been afraid to share his opinions and honest thoughts about what is happening in the markets. That's why it got my attention when I heard him say in a recent interview that we are in a quote "everything bubble." He's saying the bubble extends far beyond the stock market into real estate and bond markets as well.

Make sure to stick around to the end of the video because I promise that you are going to learn something from this video and Howard Marks that will make you a better investor and help you build wealth through investing. Now, let's take a listen to hear what Howard Marks has to say.

"You have spent the better part of your career—in fact, all of your career—although you don't do it hands-on the controls so much any longer, trying to generate double-digit returns. There was a beautiful but brief few weeks of panic selling in March and April of 2020, but we're back to pre-pandemic lows. What's it like for you, for Oaktree, having to put money to work in high yield at spreads of 300 basis points and leveraged loans at spreads of 420?"

"Well, on a small matter, let me just say that I don't think we've ever had a year in which credit losses consumed the yield spread. I believe that 300 on high yield is adequate to defray the future credit losses. I think we'll come out. That's enough of a premium, I think it is. You know, I think we'll come out way ahead of the Treasury investor after the credit losses are all settled. So the investor buying low grade today isn't going to regret it five years. I don't think there may be some days, but I think in the long run they'll earn much more in income than they'll give back in credit losses and come out ahead of the Treasury investor. That's why we do this."

"But you know, I started this at Citi 43 years ago and so far it's holding. Has credit ever been this uninteresting? Is that a fair question?"

"Well, it is a fair question. Of course, it's never been this unrewarding. You know, and two, three, four years ago people were asking me, 'Are we in a high yield bond bubble?' And I would say, 'No, we're in a bond bubble.' Interest rates were low, which means that prospective yields were low. Today, we're in an everything bubble. You know, the stock market is high and, you know, I noticed in the green room the number that stuck out to me: S&P 4,400. Last March: 2,200. It's doubled, exactly doubled. Stock prices are high. You mentioned that real estate has come back. Certain sectors are very strong, like, you know, infrastructure, real estate, distribution centers, and so forth. We're in a low return world, the lowest returns we've ever seen prospectively. And so it's tough on us, but it's even tougher on our clients. Many of our clients, pension funds, endowments, and so forth need seven percent a year. How do you get seven percent a year when the Fed funds rate is zero?"

It’s important to take a brief moment to understand how Howard Marks and his firm make money. This will help improve your context around his perspective of what's happening in the markets today.

According to his company's website, Oaktree Capital Management is a leading global alternative investment management firm with expertise in credit strategies. Now, that is definitely a lot of financial jargon, so I will put it in a more simple way: Oaktree focuses on investing in distressed companies or, to put it even more simply, companies that are struggling to pay their debts and may be headed for bankruptcy or are already there.

Oaktree's business model is focused on making these investments at a discount, so once the company turns itself around, Oaktree and its investors can make a sizable profit. Obviously, there are more of these opportunities when the economy is struggling.

Take a look at this chart that shows the change in the amount of distressed debt outstanding. This shows just how crazy the past 12 to 18 months have been for the economy and the markets.

So now that we have that background, let's explain what Howard Marks means by an everything bubble. It's no secret that prices for everything have skyrocketed. As Howard Marks mentioned in the video, stock prices have doubled since the March 2020 lows. The S&P 500 hit a low of around 2,200 in March of 2020 and is now hovering above 4,400. This is the quickest time it has ever taken the stock market to double.

Then there are U.S. home prices, which have seen the median sale price in the U.S. skyrocket nearly 25%, and that's just the median price increase. Some very hot real estate markets, like Austin, Texas, have seen values go up 40% in the past year. This rise in home values is especially dramatic when you consider that the average home value historically has increased around three to five percent a year.

Now that we better understand what Howard Marks means by an everything bubble, let's briefly touch on how we got here. Over the last 16 months, the Fed, Treasury, and Congress have used huge amounts of money to support, subsidize, and stimulate workers, businesses, state and local governments, the overall economy, and the financial markets. This has resulted in confidence in the prospects for a strong economic recovery, skyrocketing asset prices, and fear of rising inflation.

In particular, the Fed triggered the recovery we're enjoying by cutting the key federal funds rate to zero to 0.25 percent, initiating loan and grant programs, and buying vast amounts of bonds. Let's listen to what Howard Marks thinks the Fed should do in response to these developments.

"Part of the reason stock prices are high, and of course interest rates are low, it's because of central bank, yes, monetary policy. Your latest memo, Howard, is called 'Thinking About Macro,' so I have a macro question for you guys. William McChesney Martin famously said it was the Fed's job to take the punch bowl away just as the party gets going. Right? If you were Jay Powell, the Fed chairman, would you be taking the punch bowl away now before the party gets out of control?"

"You know, the most emphatic thing I want to say is that I am not Jay Powell. I wouldn't know how to do his job, I don't want his job, I don't claim to know better. I would lean toward leaving the markets alone. I talk in the memo about naturally occurring interest rates—in other words, non-interventionist. Yes, but, you know, so you might say, well then you leave the punch bowl. No, they have delivered the punch bowl in their activist role. And so I would like to see the punch bowl removed somewhat so that interest rates are what the economy and the participants want them to be, not what the Fed wants it to be. So, you know, look, they had a hard time raising rates after the global financial crisis, and each time they tried, they got a tantrum. In early '19, they backed down, and I think they missed the opportunity. I wouldn't want to miss the opportunity this time to raise rates as the economy is very strong now. They claim it's not strong enough yet on the job creation side, but I would—I don’t say today—but I say let's not miss the opportunity to let rates float back up."

According to Howard Marks, there is a high consequence of the bubble in asset prices. This consequence is the fact that future returns from investments such as stocks, bonds, and real estate will be lower than they have been historically. You may be asking, why do high prices for assets such as stocks and real estate mean future returns are going to be lower? Let's take stocks as an example to demonstrate this, and let's particularly focus on the Nasdaq, an index made up of many technology companies.

During the tech bubble in the late 1990s, the Nasdaq index fund was around 1,300 in January of 1997. Then in just over three years, the Nasdaq shot up to a peak of around 4,600 in February of 2000, more than tripling. This means investors who had invested at the beginning of 1997 experienced a compounded annual return of more than 50 percent over that three-year period.

With that impressive return, how long do you think it took the Nasdaq to again reach the peak of around 4,600 that it did in the year 2000? Well, it wasn't until nearly 2015 that the Nasdaq reached those levels again. That means if you invested at the top in 2000, you received a zero percent annual return—not including dividends—for nearly 15 years.

The Nasdaq index was full of stocks that were so overvalued it took nearly 15 years for the underlying fundamentals of those companies to catch up with their valuations. As a result, investors suffered poor returns for 15 years. This is just an example, but I hope it helps you better understand the relationship between high asset values now and potentially low future returns.

A consequence of low future returns is on groups and individuals that rely on investment returns to provide income for retirement. Marks says this is going to have a huge impact on investors of pension funds. In the interview, he specifically mentioned that pensions need at least a seven percent return to pay for the retirement benefits for people in their pension plans.

What happens if instead of the seven percent return, the pension funds only receive a four percent return? If this happens, these pension funds would likely not have the ability to pay out the cash payments they promised to retirees and senior citizens. If this happens, and the pension is a government pension, the government would likely have to step in and make up for the difference, with a potentially disastrous impact on government budgets.

Underfunded pension liabilities are a huge issue for states such as Illinois and New Jersey and will likely get significantly worse if future returns are lower than the seven percent many pension plans assume. This is just one example of the negative impact of lower future returns, and as Marks points out, a consequence of inflated asset valuations.

In order to get closer to their return targets, many pension funds are moving away from having just stocks and bonds in their portfolio and including investments that are generally considered more risky, but have higher potential returns, such as real estate, private equity, and venture capital.

In 1987, when 10-year government bonds, which are considered the safest investment out there, had interest rates of more than 10 percent, it was much easier for pension funds to hit return targets. However, with the yield on the 10-year currently just at north of one percent, U.S. government bonds won't help pension plans hit their return targets. This is a consequence of the current low interest rate environment.

Another interesting part of this interview is Howard Marks talking about where we are in the current market cycle, a concept outlined in his great book "Mastering the Market Cycle." Take a listen to what Marks has to say.

"Where does that put us on the famous Howard Marks chart of market cycles?"

"This is very unusual, Eric. Normally stock prices go here. We are—ah, right okay, well that's really the market cycle with the psychological cycle superimposed on it. That's right. But there's something else that's important, which is the economic cycle. Usually, the economic cycle and the stock market cycle coincide. Not exactly; there are leads and lags, but they move fairly together. The high in the stock market is pretty close to the high in the economy, and then the economy turns down and the market does, or sometimes the market anticipates it and the economy does. Today we have high stock prices by anybody's measure—not irrationally high relative to interest rates, but certainly high. And we have—we're early in the economic cycle. That's unusual. So you could say, well this is bad because, you know, the economy is still, you know, just the recovery is nascent, and stock prices are already high. But you could say, well yes, stock prices are high, but we have a lot of economic growth to come. It all depends on how you look at it."

One of the most important things I learned from Howard Marks was mentioned in this video. I apply this concept in my job as a professional investor and in my own personal investing portfolio. That concept is understanding the life cycle of the market, and it's from his book "Mastering the Market Cycle."

While this video is not sponsored by Howard Marks, even though I wish it was, you should 100% read that book if you want to better understand investing. Take a look at the diagram from this book. It explains the psychology behind investing that helps lead to bubbles and crashes in the stock market.

Put simply, each of these dots represents a point in time and how the market is feeling and their general attitude towards stocks and investing at that particular moment. Let's start at the dot on the left titled "Optimism." This is where investors are optimistic about what the future holds.

Next up is "Excitement." This is where people are rushing to invest; in this stage, it is cool and trendy to be an investor. People who have never invested before or cared much about investing are now trying to pick stocks and have heard about their friends and neighbors who have made a lot of money in the market. They think, "Well, certainly if my neighbor, who is dumber than me, has made money in stocks, I can make even more than him."

Next up is "Euphoria." This is when stock prices are the highest, and future prospective returns are the lowest. This represents the peak of a bubble. Despite the recent returns on stocks, euphoria is when investing is the riskiest because here is where investors have the most to potentially lose. This is where investors think stocks can only go up. Everyone thinks they are an investing genius because their investment portfolios are substantially up. At this point, people who just started investing in the past year are calling investors like Warren Buffett washed up.

The next stage is "Denial." Stock prices fall somewhat, and the economy starts to slow down. Investors are in denial that stock prices can actually decrease and that prices for stocks don't always go up. Then moving to the next stop, "Fear." Prices for stocks continue to fall. Investors are fearful as they see their portfolios decrease by 10% or more. This is when investors start to think that maybe things won't always be great in the stock market.

After "Fear" is "Panic." At this stage, investors think the stock market is going to be zero and they better get out immediately or they're going to end up broke. This is where the term panic selling is created. Investors are selling stocks for a fraction of what they happily paid for them not too long ago when they thought stocks would continue to go up forever.

"Despondency" follows "Panic." This is where people view stocks as too risky and don't want to invest at all. Stocks are at low prices, and most investors are down in the dumps about the stock market. The next dot is "Depression."

Somewhere in between the stages of despondency and depression represents the greatest opportunity for investors. This is because stock prices are at historical lows, and as a result, future prospective returns are the highest. This is the bottom of the market. Many investors don't think stocks can actually go up in value or that the economy will ever improve.

Then something miraculous happens: things actually start to get a little bit better, and that moves us into the next stage: "Hope." Some investors actually start to think things could potentially improve, and stock prices start to increase slightly off the generational lows. As things start to improve, "Hope" turns into "Optimism," and the cycle repeats itself.

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