Howard Marks, founder and co-chairman of Oaktree Capital Management LP, sees a number of big risks for the markets, as detailed in a commentary that he wrote for Barron's. Investopedia has studied this exhaustive, wide-ranging piece of over 10,750 words, and found five concerns articulated by Marks that deserve particular attention. These are: widespread uncertainties, excessive asset prices, risk-loving behavior, a liquidity glut and investors unprepared for a market decline.
Marks cites uncertainties in six areas: secular economic growth, the impact of central banks, interest rates and inflation, political dysfunction, geopolitical trouble spots, and the long-term impact of technology, He believes that these current uncertainties are unusually numerous, large and intractable. Against this background, the historically low expectations of market volatility being registered by the VIX Index seem to be out of sync with reality.
Excessive Asset Prices
Marks sees asset prices as being excessive across the board, with few real bargains to be found anywhere. Instead, one has to settle for what's less overpriced than the alternatives. As a result, Marks writes, "In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been." A sure sign of a bubble, he says, is when investors buy into fads regardless of the price.
A related danger sign is when investors become so overly optimistic that they worry more about missing out on the "current market darling" than about the potential downsides, including overpaying. In this vein, Marks offers the five FAANG stocks as an example. These are Facebook Inc. (FB), Amazon.com Inc. (AMZN), Apple Inc. (AAPL), Netflix Inc. (NFLX) and Google parent Alphabet Inc. (GOOGL). He says that bull markets typically are marked by a group of what he calls "super stocks" for which no price seems to be too high, on the expectation that current trends can be extrapolated to infinity. For historical perspective, he cites the so-called "Nifty Fifty" super stocks of an earlier era, many of which have since fallen by the wayside.
Marks cites several indicators of excessive valuations. The 12 month trailing P/E ratio on the S&P 500 Index (SPX) is 25, compared to a long-term median of 15. The Shiller Cyclically Adjusted P/E Ratio is almost 30, versus a historic median of 16. Higher values were reached only in the bubble years of 1929 and 2000. Valuations may be understated because corporate EPS have been inflated by share repurchases, cost cutting and mergers. The "Buffett Yardstick," which compares U.S. stock market capitalization to GDP, hit a record high of 145 in June, compared to a norm of about 60 in the 1970 – 95 period, and to a median of around 100 during the 1995 – 2017 period.
The majority of investors are embracing what Marks calls "pro-risk behavior" in pursuit of higher investment returns. He also quotes from a memo that he wrote in January 2013, in which he expressed the same concern, and which he finds to be even more appropriate today. As then, he finds that investors were accepting historically small increases in return relative to the additional risks that they were taking. Moreover, in this pursuit for returns, investors also are buying into investments that they would have rejected in previous years, when prospective returns were considerably higher. This includes investments with weak deal structures, unduly high leverage, or which involve what he calls "untested derivatives."
Central banks have oversupplied liquidity, artificially reducing the cost of capital. Marks sees this as a principal cause of the evaporation of risk aversion in the markets, which, in turn, has led to declines in investing standards and in the wariness of investors. With "the return on cash at punitive levels" as a result of excessive easing by central banks, Marks observes that investors are worrying more about being under-invested or too cautious, rather than about losing money. (For more, see also: Bill Gross: QE is "Financial Methadone.")
Unprepared for Setbacks
Last but certainly not least, investors appear psychologically unprepared to deal with the inevitable decline in the values of stocks and other assets, Marks notes. They've been lulled into a false sense of security and inevitability, mainly of their own doing as they continue to bid prices ever upward. When a genuine reversal finally sets in, the odds are high that investors unused to adversity will panic. (For more, see also: Why a Stock Market Correction May Lead to Overreaction.)