Howard Marks: 5 Strategies to Outperform the Market in 2021

Or number five, you can try to look for exceptions. What I call special niches, special people, who hopefully can produce a good return with safety in a low return world. But those people are truly exceptional and not easy to find.

What inning do you see our current cycle being in, and have we started a new game? First person to ask that question in this cycle.

I haven't given it that much thought. You know, it's unusually hard to answer that question today. We normally think that the market has a certain ebb and flow, and that the cycles are their difference in detail, their difference in duration, their amplitude. But certain things do tend to repeat, or at least to rhyme, as Mark Twain said.

You know, normally what happens is that we have an upcycle. We have increasing optimism, increasing risk tolerance, increasing good feelings because the upcycle is so rewarding and rising prices, and eventual excesses of valuation. And the same thing through the economy. We have excessive expansion, excessive hiring, and leverage, and so forth.

Then things reverse, and we get movement on the downside. We get falling prices, worse corporate results, and deteriorating psychology. This switch from greed to fear, and we also get economic deterioration. That's the normal cycle.

It's a matter, I think the best way to think of the economic cycle and the market cycle is excesses and corrections, excesses and corrections, excesses and corrections. A lot of the changes are endogenous; they are within the economy and within the market.

This is unique because this is exogenous. It wasn't excesses of markets and economies; it was the pandemic. We had a recovery. It was basically a healthy recovery; it was a slow, gradual recovery, the longest in history but the slowest in post-war history. And not too many excesses in the economy or even in the market.

But then we had the pandemic, and the pandemic required us to close our economy in order to keep people apart and control the spread. We had the worst quarter in history; the second quarter was down 33% on an annualized basis.

So it's very hard to say what inning we're in because this is not a routine game, I guess I would say. We are at the beginning. We know we're only about four months, five months into an economic recovery. We believe that recovery will last at least as long as it takes to get the economy back to its 2019 level in terms of GDP.

There's some doubt now with the failure of Washington to provide support payments. There's some doubt as to whether the recovery will live up to everyone's expectations. But I think we are in a recovery.

You know, an interesting question is: we never had a normal recession. We had an artificially induced recession. Are we still slated for a normal recession, or has this entire cycle been reset? Since it's only five months old, do we have years and years to go?

I don't think anybody can say. The extent to which the Fed and the Treasury and the recovery rebuild people's liquidity and rebuild their willingness to consume, and the extent to which life returns to what it always has been is very uncertain. So I think we’re in the second inning vis-a-vis the economy.

Of course, the market being at an all-time high despite the negative fundamentals, or I should say modest fundamentals, that juxtaposition gives me more pause. I would say that the rally in the market is in the sixth inning or the seventh inning. But who's to say?

If the economy is stagnatory for the next five years on an uptrend, the market will do pretty well, although I do think that the recovery from the all-time lows in March has been very dramatic, and it feels to me like most of us think the market is ahead of the economy.

Yeah, Howard, to follow up on that, it's been an extremely interesting and diverse recovery across styles and classes. One thing you've read about in the memo is risk-adjusted return, which of course in some sense leads us back to the academic notion of the Sharpe ratio.

Of course, you can't eat the Sharpe ratio, right? And you can't spend the Sharpe ratio. We need to require a return. There are a small number of ways to get there. What's your view on whether we're getting paid at the right level today?

I love how in the memo you bring in the capital market line, so it fits right into my lecture notes, so thank you for that. That's a great one!

But then, one thing about that is the dispersion across sectors, which is really unusual, with growth and large-cap stocks, for example, doing well, but there's still a large number of industries and sectors in deep distress.

Well, Chris, in reference to the capital market line, if you think about a graph with return on the vertical axis and risk on the horizontal axis, we have a point on the left side where at zero risk you have the risk-free rate. That's usually 30-day bills, which have no credit risk and no inflation risk, and that's the lowest return you can get on anything.

As you move up from that in risk, there should be an increase in the expected return. People shouldn't invest in riskier assets if they're not expected to be higher returning than safe assets. So the line goes at an angle from the left; it goes up and to the right.

We call that a positive correlation, a positive relationship between risk and expected return. And you know, when that line does go up into the right at a reasonable pace, we say the market's at equilibrium. If all the asset classes are on the line, we say they're at equilibrium because they're in a reasonable relationship to each other in terms of risk-adjusted return.

As the risk rises, the return rises, and that's only right if nothing else would make sense. The problem today is that the Fed took that risk-free rate, which is here—it's the point from which all returns begin and emanate—and they pulled it down.

When you pull down the risk-free rate on the left-hand axis, the line also falls. Now sometimes it falls not in parallel; sometimes different parts of the line fall more than others. This slope could increase or decrease. That's the slope of the line, which is the risk premium.

But the point is, I believe that most asset classes appear to be in equilibrium with each other. The risk-free rates appear to be proportional; the returns appear to be proportional to the risk. But the problem is that all returns are at a very low level.

And as I said, you know, the pension fund that needs seven has a hard time getting it today in stocks and bonds. Most of them have given up on that and put substantial money into alternative investments with their illiquidity and their manager reliance and so forth.

Now the great question that I usually end up speaking about is: how do you pursue a high return in a low return world? What should you do in a low return world? There, I've come up with five possibilities, and I can't think of any more.

You can continue to invest as you always have and understand that the return you make will be lower than ever. You can worry about the level of asset prices, reduce your risk to cushion the blow if a correction comes, but then your return will be lower still.

You can go all the way to cash, the ultimate preparation for a correction, but then your return will be zero, and you better be right fast. Because if you're in cash for two years and the market goes up, you may be looking for another job or new clients rather than risk reduction.

You can go in the opposite direction: you can increase your risk in pursuit of a higher return. But is this the time to be increasing risk when there's great uncertainty as to the fundamentals, geopolitical, political uncertainty in addition to economic?

Or number five, you can try to look for exceptions, what I call special niches, special people, who hopefully can produce a good return with safety in a low return world, but those people are truly exceptional and not easy to find.

Yeah, truly! You know, alpha should be, in some sense, that's right—yes, it's hard to find. What we've spoken together, when we have been so lucky to have you on campus about the use of leverage, and in some cases you railed against it, in other cases maybe not.

With low yields, it might be tempting to lever a portfolio, and of course theory would say you can move along the capital market line either by adding capital structure to an investment, de-levering or levering it up. What's your view as a practical matter about the use of leverage today?

Well, after the—I mean the global financial crisis of '08 was really a demonstration of the effect of leverage. Because the world essentially had taken mainly mortgage-backed securities, but also loans to some extent, corporate loans, and put them into leveraged entities, structured leveraged entities, CLOs, RMBS, and so forth.

What they did is they had internal leverage, which is to say that you could buy a highly levered piece at the bottom of the structure with an extremely high levered return, or you could buy the tap of the structure where you are not participating in the leverage with a low safe return over-collateralized by the junior tranches.

What happened is that, you know, when you leverage, you say, "Well, if this happens, I'll be great. If that happens, I'll still be okay. If this happens, I'll probably make it through." The outcome in terms of defaults on mortgages was a multiple of the worst case that anybody had modeled.

After the global financial crisis, I put out a memo that entitled, "Leverage plus volatility equals dynamite." You know, a lot of there were thousands of defaults in mortgage-backed securities, because of the over-leverage.

People should understand that leverage does not make any investments better; it magnifies the gains if you win and the losses if you lose. And so, you know, I think to make an investment better, you have to increase what I call the asymmetry.

The goal in active investing should be to look for asymmetry situations where if things go well, you'll make a lot of money, and if things go poorly, you won't lose a lot. If you can find those, that’s the holy grail.

If you find an investment where if things go well, you'll make 30%, and if things go poorly, you lose 30%, you know, it’s not a great thing. We're looking for this asymmetry.

Leverage does not produce an asymmetry; it produces an absolute symmetry. It magnifies the gains if you win and the losses if you lose. But there's one other aspect, which is not symmetrical, which is it reduces the likelihood that you can get through tough times.

If there's a downward fluctuation, an unlevered portfolio will make it through; a leveraged portfolio may not. So I think that, you know, leverage is far from a magic solution. Most of the real challenges in economic history have come from people who overestimated their ability to live through bad times with leveraged structure.

So live by the sword, die by the sword. Exactly. In fact, if you think about it, leverage is an example, Chris: in investing, everything is a two-edged sword except for alpha. If an individual really has alpha— which I define as superior skill and insight—that will help you in good times and bad.

But the other things in investing, like leverage and concentration as opposed to diversification, these are two-edged swords. They help you if the outcomes are good, but they hurt you if the outcomes are bad. Agreed.