Howard Marks Graciously Admits He Was Wrong: "Sees No Reason Why Bitcoin Can't Be A Currency"

Billionaire investor (and self-professed "Bitcoin Dinosaur") Howard Marks made headlines in July when he called Bitcoin a "unfounded fad.. a pyramid scheme" in one of his famous memos, igniting a firestorm of backlash from cryptocurrency advocates.

However, in his most recent Oaktree Capital memo, Marks retracted his position after being educated by some of his Bitcoin-loving friends regarding the cryptocurrency.

There has been particularly spirited response to my comments on digital currencies.  It prompted me to sit down with people ranging from some of my Oaktree colleagues to Steven Bregman and Murray Stahl of Horizon Kinetics (my July memo incorporated some of Steven’s observations on ETFs), and I learned that I’ve been looking at Bitcoin the wrong way.  In particular, I realized that the memo incorporated the wrong joke from my father; instead of “the half-million-dollar hamster,” it should have been this one:

Two friends meet in the street, and Jim tells Sue he has some great sardines for sale. 

The fish are pedigreed and pure-bred, with full papers and high IQs.  They were individually de-boned by hand and packed in the purest virgin olive oil.  And the label was painted by a world-renowned artist.
 
Sue says, “That sounds great.  I could use a tin.  How much are they?” and Jim tells her they’re $10,000. 

Sue responds, “That’s crazy, who would eat $10,000 sardines?” 

“Oh,” says Jim, “these aren’t eating sardines; these are trading sardines.”

I had been thinking about digital currencies like Bitcoin as investing sardines, and that may have been a mistake.  Their fans tell me they’re spending sardines, and while that may be the case, I think at the moment they’re being treated largely as trading sardines.  The question remains open as to whether Bitcoin is (a) a currency, (b) a payment mechanism, (c) an asset class, or (d) a medium for speculation.

The main complaint expressed in my memo was as follows:

Serious investing consists of buying things because the price is attractive relative to intrinsic value.  Speculation, on the other hand, occurs when people buy something without any consideration of its underlying value or the appropriateness of its price, solely because they think others will pay more for it in the future.

In the memo I talked about Bitcoin as an investment asset that should have a value that can be appraised.  While its fans tell me this isn’t the right way to view it, I note that in their February “Bitcoin Review,” even Steven and Murray called it “a new asset class.”  I think this is the weakest claim being made about Bitcoin.  As I said in the memo, “it’s not real” – there is no intrinsic value behind it.

What Bitcoin partisans have told me subsequently is that Bitcoin should be thought of as a currency – a medium of exchange – not an investment asset.  Given that the evolution of Bitcoin is so topical, I think further discussion is in order.  To start, I’m going to present the case for it as a currency.  What are the characteristics of a currency?

• Most importantly, it’s something that people agree can be used as legal tender (to buy things and pay debts), used as a store of value, and exchanged for other currencies.


• Currencies generally are created by governments. However, there have been exceptions: banks issued their own currencies in our nation’s first century, and it can be argued that the “Green Stamps” of my childhood, and airline miles today, have a lot in common with currencies.


• For a long time currencies were backed by (and exchangeable for) gold or silver, but that’s no longer the case. The truth is, there’s nothing behind currencies these days other than their issuing governments’ “full faith and credit.” But what do they promise? New currencies are sometimes created out of thin air (like the euro, which wasn’t legal tender sixteen years ago), and sometimes they’re devalued.


• Currencies change in value relative to each other, in theory based on differential purchasing power, and in practice based on changes in supply and demand (which can stem, among other things, from changes in purchasing power).

Bitcoin fans argue that it qualifies as a currency under these criteria: most importantly, it’s something that parties can agree to accept as legal tender and a store of value.  That actually seems right.

When I first responded to comments on the memo – even before my recent enlightenment – I found myself admitting that much of the criticism I had leveled at Bitcoin is applicable to the dollar as well.  Whereas I said Bitcoin “isn’t real” because it has no intrinsic or underlying value, that’s certainly true of the dollar and other fiat currencies: there’s nothing behind them either.  You can no longer exchange them for gold (and what is gold, anyway?  But that’s another subject).  In fact, government-issued fiat currencies are accorded value only because of a government edict.  Why, the fans of Bitcoin ask, is such an edict superior to an agreement among people to accept a non-government-issued currency?  Fiat currencies have value simply because of faith in the governments that issue them.  If enough people believe in it, why can’t faith in Bitcoin suffice?  If you consider the properties of fiat currencies, these are darn good questions.

So my initial bottom line is that I see no reason why Bitcoin can’t be a currency, since it shares the characteristics listed above, especially the fact that there are people (and businesses and even countries) that accept it as legal tender.

But that’s not good enough for Bitcoin’s fans.  It’s not the same as the dollar, they say; it’s better.   In all the following ways, they’ve told me, Bitcoin is superior to government-issued currency:

• All the relevant data regarding Bitcoin – number outstanding, number newly created, and transactions – are recorded in the “blockchain,” a sort of transparent electronic ledger of which everyone can have his or her own copy.


• Bitcoin can’t be debased by unlimited issuance, since the blockchain process has been set to permit only a gradual increase from today’s 16 million, to 21 million in 2140. In this sense Bitcoin is better than the dollar, of which a lot more can be issued at any time, diminishing its purchasing power through inflation. As Steven and Murray have written, “a purchase of Bitcoin is nothing other than a short sale of the currencies of the world.Merely by limiting the growth of supply, Bitcoin would become more valuable as other currencies devalue.”


• Since the blockchain exists on each person’s individual computer, rather than in a central location, it can’t be hacked, and thus Bitcoin can’t be stolen, counterfeited, or secretly created in amounts exceeding the authorized total. Likewise, Bitcoin isn’t subject to the currency controls on portability that are often imposed by failing governments. (But I wonder whether the technological claims made for the blockchain might be its Achilles’ heel. While I certainly don’t have the ability to assess these claims for myself, I wonder how many of Bitcoin’s advocates do either.)

Where will we go from here?  The partisans claim the outlook for Bitcoin as a currency is bright:

• Since very few people own it today but millions more will want it in the future, demand is sure to rise faster than supply, meaning the price will rise.


• Specifically, the U.S. money supply is almost $14 trillion, so if people and businesses decide to hold just one-third of their wealth in Bitcoin rather than dollars, (and who wouldn’t want to do so given all the advantages described above?), the value of the Bitcoin in circulation will rise to $4.5 trillion, from today’s $73 billion, for a gain of roughly 60x.


• There’s sure to be a network effect: the more people join the Bitcoin movement, the more it will be accepted as legal tender, the more useful it will be, and the more demand will increase.


• Ignoring Bitcoin’s utility as currency, many people will buy just because they believe someone else will pay them more for it. (This time-honored “greater-fool theory” lies at the heart of all speculative manias.) Likewise, people will buy it because of fear of missing out, another bull-market standard.

There’s absolutely no reason why Bitcoin – or anything else – can’t serve as a currency if enough people accept it as such.  While I’d point out that no private currency has gained widespread use in a long, long time, there’s nothing to say it can’t happen.

*  *  *

However, before Bitcoin enthusiasts get too over-excited by Marks" "acceptance," he is not convinced it"s not a speculative bubble...

Being willing to agree that Bitcoin may become an accepted medium of exchange is not the same as saying you should buy it now to make money.  Think about the fact that the price of Bitcoin has risen more than 350% so far this year and 3,900% in the last three years.  To the degree people argue that Bitcoin is a currency, then (a) why is it so volatile? and (b) is that desirable?  You might want to consider whether a real currency can do that, or whether speculative buying is determining Bitcoin’s price.  And whether what’s gone up can come down.

The immediate issue of Bitcoin as a currency still comes down to the question of whether today’s price is right.  The price of a Bitcoin is around $4,600 today.  Can one Bitcoin buy the same amount of goods as 4,600 dollar bills?  Or the much higher amounts that Bitcoin bulls think it will soon be worth?  I don’t think we have enough information to know, but the question isn’t irrelevant.  If it were, this would be another case of “there’s no price too high.”

The other purported use for Bitcoin, given its status as what Marc Andreessen calls a “digital bearer instrument,” is as a payment mechanism.  Its advantages in this regard include the following:

• transactions in Bitcoin can be anonymous (I understand it is often used to pay for opioids),


• payments are made without fees like those charged on credit card transactions and wire transfers,


• there can’t be fraud and merchant charge-backs like with credit cards, and


• it can be particularly useful in emerging nations lacking developed payment systems.

But I see two issues here:

First, I expect there to be many competing transaction systems. Will the banks and other financial institutions cede this territory to Bitcoin? Wouldn’t banks’ systems be more likely to gain acceptance from people other than perhaps millennials? What would happen to Bitcoin’s utility as a payment mechanism if Amazon announced its own? Would you rather transact in Bitcoin or Amazonians?

Second, if Bitcoin were to become the leading non-governmental payment system, what would cause it to appreciate? If you want to pay me in Bitcoin and I’ll accept it, what would cause its price to rise?Adherents would argue that the limited supply relative to the growing use will make the price rise. But that assumes there’s no price so high for Bitcoin that transferees won’t accept it in lieu of dollars. The “pro” side of the argument foresees limitless appreciation, but that doesn’t make sense. Think of any other currency: isn’t there a price at which you wouldn’t accept it? Would you sell your house for euros that are said to be worth two or three times as much as the dollar?

Marc Andreessen wrote an excellent article in The New York Times’ Dealbook, titled “Why Bitcoin Matters” (January 21, 2014).  The article outlined Bitcoin’s potential as a payment system and described many of the advantages listed above.  But it didn’t include one word about why these advantages give Bitcoin appreciation potential.

So what’s my real bottom line?

• Advocates say if Bitcoin is accepted as described above, you’ll make more than 50 times your money. Thus success doesn’t have to be highly probable for buying Bitcoin to have a huge expected return. This is called “lottery-ticket thinking,” under which it seems smart to bet on an improbable outcome that offers a huge potential payoff. We saw it in full flower in the dot-com boom in 1999-2000, and I think we’re seeing it in action again today with regard to Bitcoin.Nothing is as seductive as the possibility of vast wealth.


• Several of the “seeds for a boom” that I listed in “There They Go Again . . . Again” are at work in the Bitcoin surge: (a) there is a grain of underlying truth as set out above; (b) there’s the prospect of a virtuous circle: widespread demand will lead to wider acceptance as legal tender, which will lead to widespread demand; and (c) thus this tree may grow to the sky, as there is no obvious limit to this logic. None of these things necessarily make Bitcoin a mistake. They merely say elements that contributed to past bubbles can be detected today with regard to Bitcoin.


• Finally, Bitcoin isn’t alone. There are hundreds of digital currencies already – including eleven with market capitalizations over a billion dollars – and no limits on the creation of new ones. So even if digital currencies are here to stay, who knows which one will turn out to be the winner? Hundreds of e-commerce start-ups appreciated rapidly in the tech bubble based on the premise that “the Internet will change the world.” It did, but most of the companies ended up worthless.

Marks concludes graciously...

Thanks to the people who took the time to educate me, I’m a little less of a dinosaur regarding Bitcoin than I was when I wrote my last memo. 

I think I understand what a digital currency is, how Bitcoin works, and some of the arguments for it. 

But I still don’t feel like putting my money into it, because I consider it a speculative bubble.  I’m willing to be proved wrong.

Matt King: Global QE And "ETFs Everywhere" Have Created An Unstable, One-Way Market

While the financial industry remains divided over what precisely is the cause of the malaise that affects modern markets, characterized by plunging volumes and trading activity, record low volatility and dispersion, a relentless ascent disconnected from fundamentals, and generally a sense of foreboding doom, manifested by an all time high OMT skew - or record high price for crash insurance - as discussed previously...

... it can agree on one thing: it has something to do with the interplay of QE, the artificial force that has disconnected market prices from values for the past 8 years, and ETFs, which as some prominent investors have said are "devouring capitalism." They also agree that the combination of QE and ETFs have made the market almost entirely "one-sided", and thus prone to collapse when conditions finally reverse.

Indeed, as Citi"s Matt King - our favorite sellside cross-asset strategist - writes in his latest report, a growing number of institutional managers, from Oaktree to Elliott to  Bridgewater, have recently been expressing concerns not only about elevated valuations and the potential for a correction, but in many cases also about the potential for herding and the risk that markets have grown one-sided."

King points out a trend observed among the financial literature over the past 2-3 years (starting with Howard Marks" March 2015 note in which he asked, rhetorically "What Would Happen If ETF Holders Sold All At Once? Howard Marks Explains"), "everyone’s number-one suspect in potentially creating such a tendency seems to be ETFs. In Paul Singer’s memorable words, passive investment through the likes of ETFs “is unsustainable and brittle” and “is in danger of devouring capitalism”.

But are ETFs really to blame, King wonders, or simply a symptom of some other underlying tendency? His answer is the latter, and begins with an explanation we have shown many times on this website: the relentless shift away from active to passive management:

It’s easy to see why active managers are complaining. Over the past ten years, the cumulative inflow to US HY mutual funds is precisely zero, while HY ETFs have netted $40bn. In US IG, where inflows have been stronger, more than a quarter of the money over the past decade has gone to ETFs; in EM FI in recent years, the proportion is more like one-third. For European credit, ETF outstandings may look far smaller, and yet these belie the true size of the threat since (unlike the US) most trading occurs OTC and hence goes unrecorded. All of these are nothing compared to the massive rotational shift being seen in equities, in which around $500bn has flowed away from active managers and into ETFs over the past 12 months alone, and where ETFs now account for over one-quarter of markets’ traded volume.

It"s not just investors who are worried about ETF flows: regulators are too, having become "alarmed at the dramatic growth in ETFs, focusing in particular on the potential for a sudden reversal, notwithstanding ETF managers’ robust defence that ETFs’ potential to trade at a discount to NAV gives them an additional escape valve relative to traditional open-ended mutual funds."

But, as King shows in the following chart, there is a puzzle here, or rather a pair of them. "Rather than being the fickle retail fad of the popular imagination, ETF flows have actually proved much more stable than mutual fund flows (Figure 1). Either the potential for a future reversal is far greater than anything seen in the historical data, or the problem is not unique to ETFs."

Furthermore, it is odd for fund managers - professional investors trained to capture market short and long-term  market inefficiencies - to be complaining about something which in principle should be creating additional opportunities for them.Here King makes an absolutely spot on point about inefficient markets, which however we have to note, is only relevant inasmuch as central banks don"t do everything in their power to perpetuate the inefficiencies, now in their 9th year:

Indiscriminate buying and selling by ETFs should add to the potential for active managers to spot mispriced securities. The greater the proportion of trading done by passive entities, the greater should be the opportunities.

So are fund managers simply suffering from a case of sour grapes, King asks, "or is there some other factor preventing these opportunities from occurring in the way theory says they should be?"

His answer for why the current market regime has made active investors a species facing extinction, is due to two things: record low volatility and record low dispersion:

The obvious culprit is the lack of volatility. Our Cross-Asset Volatility Indices show that realized volatility now stands at multi-decade lows in every major asset class bar FX (Figure 2). But even worse for active managers is the lack of dispersion. A manager can still make money when markets themselves are involatile provided there is sufficient variation in the performance of individual securities. Dispersion, or the cross-sectional standard deviation, effectively captures how much a manager with perfect  foresight could have made by overweighting the best performing securities or sectors and

underweighting the worst performers. Dispersion in both credit and equities is now at the lowest levels on record.

As Citi points out, this lack of potential for outperformance might seem surprising on the back of obvious single-name sell-offs like Teva or Provident Financial. However as he explains, "these names have been too small to offer much outperformance potential: even managers who had zero-weighted them prior to the sell-offs would only have increased total returns by 1.4bp with Teva in € and 1.3bp with Provident in £ respectively. To outperform, managers need there to be multiple names moving in opposite directions – to have, if you like, a genuine two-way market. The only market which has come close to this description in recent years is the only one where volatility is not making new record lows: FX. Is this a coincidence, or a feature?"

King then reverts back to this key point: the confluence of QE and ETFs have led to one-way markets, in which the main feature is investor clustering, and herding: "for us, the real damage in markets in recent years is an increase in herding. ETFs are contributing to this tendency but they are not its primary driver."

The result is an increasingly illiquid market: "What we think has been happening in recent years is that investors are displaying an increased tendency to position themselves the same way round. In the process we are therefore losing the heterogeneity which is the source of a liquid market. This tendency is likely to have been strongest in the markets where the price action has largely been one-way. With the notable exception of markets with currency pegs, FX has some built-in protection against this because its securities automatically have two sides. Thanks to the fragmented nature of trading and the large role carry plays in driving returns, credit is particularly vulnerable."

Of course, it"s not just the shift to passive investing that is forcing active investors to group together for their very survivla: other factors are also exacerbating this trend.

"The combination of global credit growth and QE has created such a sustained bull market in many asset classes that investors are inevitably concluding that their best trade is simply to close their eyes and go long the market in the cheapest way possible. ETFs in principle offer a panoply of potentially uncorrelated factors, but in practice trading volumes have been overwhelmingly concentrated on the major indices. The rise of algorithmic trading and regulators’ increased tendency to insist on marking to market likewise build in a short-termism which is likely to be self-reinforcing. Whatever factor or trade has been doing well is likely to receive inflows; whatever has been doing poorly will be shifted away from."

Which brings us to the conclusion: whether QE is the driving force behind ETF-mediate herding, or some different factor is responsible, the trouble with one-way markets is that they are not really one-way, and as Citi"s King warns "wooner or later the herd turns around. This creates a risk that current record lows in volatility are misleading."

Here King points out something we brought to readers" attention last week when we showed the record high cost of market crash insurance: "To some extent this is reflected in high levels of OTM skew, but conceivably not enough given the potential for asymmetry."

The problem, according to Citi - and certainly central bankers who however will never admit this in public - is that when the herd has been moving in one direction for long enough, it becomes hard to envisage what might turn it around. For credit  investors, the “buy on dips” mentality has become deeply entrenched – even if the justification for doing so is never valuations, and always “the strength of technicals".

Typically these are attributed to some sort of irresistible but poorly understood external force, such as mutual fund inflows (in IG, but interestingly not HY at present) or “the strength of the Asian bid”. Rather like the blurb from a London estate agent which recently landed in my letter box, investors are urged to buy precisely because prices have gone up so much: the idea that the demand which led to those price rises might one day reverse is unthinkable.

Still, despite the "fake markets" of the past 8 years, in which every dip has so far been bought - profitably - Citi says that investors should be thinking about such reversals, preferably before they actually occur.

Will mutual fund inflows always remain strong even as deposit rates rise? Will Japanese investors’ bid for US credit remain as intense even as reduced BoJ purchases mean private investors have to absorb more net supply in JGBs, or are there signs that is fading already. In particular, what is the potential for abrupt discontinuities on this front?

The answer, according to King, very high, but "to say that this or that threshold is automatically a danger" is not the point: Citi"s punchline is that increases in herding, or equivalently a reduction in the diversity of the investor ecosystem, create large asymmetries which are in themselves a threat to financial stability – whether or not they are accompanied by financial leverage, something which not even Fed presidents can grasp.

And yet, while King can warn until he is blue in the face, the reality for an entire generation of "investors" in artifical markets is that no matter what happened, risk assets would keep going up, as did mutual funds and ETFs. That may change soon: King looks at fund flows among equity and debt (IG and HY) fund flows, and calculates that the standard deviations and maximum moves, are much larger for outflows than for inflows – modestly so in some cases, shockingly so for equities.

Even if ETF flows have not shown this tendency to date, there is every reason to think that both ETF and mutual fund flows will exhibit these characteristics in future. One-way markets trend for extended periods with very little volatility, but are then vulnerable to abrupt turnarounds.

All of the above leads King to an ironic conclusion, one which we have discussed previously and which we will comment on more shortly, namely that in this fake market, the one thing that can potentially save the active management community, is a reversal, or as King puts it, "paradoxically, the very thing required to save active managers is a reversal of the conditions which gave rise to their tremendous growth in the first place."

Namely, a crash. Unfortunately, with central banks more concerned than ever that markets can simply no longer function on their own without daily central bank support, a crash, or even a correction, may not happen... or rather when it does, trading would simply shut down as this "one-way market" can no longer even discount such a simple alternative outcome as "selling."

Bears Throw In The Towel: FANG Shorts Hit All Time Low

At the end of May, when Bank of America looked at some of the most widely held stocks by active managers, it found that FANG stocks (FB, AMZN, NFLX, GOOG/GOOGL) have returned nearly 30% YTD vs. 8% for the S&P 500. More importantly, it found that managers were 32% overweight Information Technology + Internet & Catalog Retail (a Discretionary industry), which was driven by a remarkable 71% overweight in FANG stocks.

This week, BofA"s Savita Subramanian updated the study of most widely held active manager stocks, and found that while fund managers holdings of FANG and FAAANG (which also includes ACVO and ADBE), have modestly declined over the past two months, they still remains remarkably stretched, or as she puts it "active managers" disproportionate overweight in FAAANG relative to the Tech sector and Internet and Catalog Retail is even more dramatic than the FANG stocks."

But more interesting is BofA finding - both then and now - that since long-only funds did not appears to be bidding up FANG (or FAANG) stocks, which had remained relatively constant among their total portfolio hodings...

... the answer was that "the recent move in FANG may be driven more by short-covering than by active buying."

However, as Bank of America also notes, that short covering, if indeed that is the cause of the levitation, is ending as the short interest for both FANG stocks is now down to all time lows.

A separate analysis released today by Bloomberg"s Stephen Gandel confirms as much, and notes that despite the seemingly pervasive negative sentiment against FANGs, everywhere from Goldman to Howard Marks...

Goldman Sachs Group Inc. strategists predicted an "air pocket" was coming in the FANG bubble. After a survey of investors, Bank of America strategists called FANG and other technology stocks the most crowded trade in the market. Oaktree Capital co-founder Howard Marks recently compared the FANG to the Nifty Fifty and dot-com stocks of the 1970s and 1990s, respectively, as well as other bubbles.

... the short interest for the four companies has sunk to a new record low: "collectively, the short bets against FANG stocks accounted for just 2 percent of their traded shares. Exclude Netflix, and the average short interest for the group drops to just 1 percent. That compares with an average of 4 percent for the S&P 500."

Some have pointed to the recent surge in Netflix and AAPL"s blow off to new all time highs on Tuesday after earnings as confirmation that the shorts are right to stay away, others have said that the move in the company - whose growth rate is a mere shadow of what it used to be, and which has now posted declining Chinese sales for 6 quarters - was so acute precisely due to another batch of shorts throwing in the towel and covering, or as BBG puts it, "tech bears shedding their fur has pushed the stocks higher."

And while the lack of shorts may suggest smooth sailing for the group over the near immediate future, over the long term, a lack of skeptics could be bad. Gendel points out why:

The dearth of short interest suggests an enthusiasm for the shares that could be quickly popped if things turn south. And the falling short interest is odd given that the FANG stocks have risen an average of 37 percent this year, potentially setting them up for a fall, or at least a slip. Amazon, after all, trades at nearly 93 times its expected earnings for this year. Netflix"s unending cash bonfire has burned through $2.1 billion in free cash flow in the past 12 months. The expectations for sales of Apple"s coming iPhone are stratospheric even though the price of one model may top $1,000. Any of these situations would seemingly make for a good short bet, if anyone was willing to make it.

For now, almost nobody is, as most traders remain "paralyzed" (or perhaps complacent) and instead chose the comfort of the passive-investing, ETF, CTA herd which continues to grind stocks ever higher with less volatility than the bond market. Then again, with all the FANG bears having thrown the towel, this may be just the right time to go short... again. Judging by the recent price performance of the group, others may have gotten the same idea.

Deep Thoughts From Howard Marks

Submitted by Lance Roberts via RealInvestmentAdvice.com,

One of my favorite investing legends is Oaktree Management’s, Howard Marks. His investing wisdom have been a major source of education over the years and his deep knowledge and understanding of investor psychology and market dynamics is truly unparalleled.

This past weekend, I was digging through some old research and ran across an interview between Goldman Sach’s Hugo-Scott Gall and Howard Marks on everything from investment decisions to behavioral dynamics.

This interview was originally done back in 2013, and interestingly enough it is just as relevant today as it was then. I hope you find this as informative and educational as I did.

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Hugo Scott-Gall: How can we understand investor psychology and use it to make investment decisions?

Howard Marks: It’s the swings of psychology that get people into the biggest trouble, especially since investors’ emotions invariably swing in the wrong direction at the wrong time. When things are going well people become greedy and enthusiastic, and when times are troubled, people become fearful and reticent. That’s just the wrong thing to do. It’s important to control fear and greed.

Another mistake that people often make is that they compare themselves with others who are making more money than they are and conclude that they should emulate the others’ actions … after they’ve worked. This is the source of the herd behavior that so often gets them into trouble. We’re all human and so we’re subject to these influences, but we mustn’t succumb. This is why the best investors are quite cold-blooded in their professional activities.

We can infer psychology from investor behavior, and that allows us to get an understanding of how risky the market is, even though the direction in which it will head can never be known for certain. By understanding what’s going on, we can infer the “temperature” of the market. In my book, I give a list of characteristics that can give you an idea whether the market is hot or cold, and by using them we can control our buying patterns. They include capital availability, the eagerness of lenders and investors, the ease of entry for new funds, and the width of credit spreads, among others.

We need to remember to buy more when attitudes toward the market are cool and less when they’re heated. For example, the ability to do inherently unsafe deals in quantity suggests a dearth of skepticism on the part of investors. Likewise, when every new fund is oversubscribed, you know there’s eagerness. Too little skepticism and too much eagerness in an up-market – just like too much resistance and pessimism in a down-market – can be very bad for investment results.

Warren Buffett once said,

“The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.”

I agree thoroughly, and in order to understand how much prudence others are applying, we need to observe investor behavior and the kinds of deals that are getting done. In 2006 and 2007, just before the onset of the financial crisis, many deals got done that left me scratching my head. That indicated low levels of risk aversion and prudence. We can’t measure prudence through a quantitative process, and so we have to infer it by observing the behavior of market participants.

The fundamental building block of investment theory is the assumption that investors are risk averse. But, in reality, they are sometimes very risk averse and miss a lot of buying opportunities, and sometimes very risk tolerant and buy when they shouldn’t. Risk aversion isn’t constant or dependable. That’s what Buffett means when he says that when other people apply less, you should apply more.

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Hugo Scott-Gall: Why do behavior patterns and mistakes recur despite the plethora of information available now? Are we doomed to repeat our mistakes?

Howard Marks: Information and knowledge are two different things. We can have a lot of information without much knowledge, and we can have a lot of knowledge without much wisdom. In fact, sometimes too much data keeps us from seeing the big picture; we can “miss the forest for the trees.”

It’s extremely important to know history, but the trouble is that the big events in financial history occur only once every few generations. The latest global financial crisis began in 2008 and the one before that in 1929. That’s a gap of 79 years. So, while memory has the potential to restrain action and induce prudence by reminding us of tough periods, over time as memory fades the lessons fade as well.

In the investment environment, memory and the resultant prudence regularly do battle with greed, and greed tends to win out. Prudence is particularly dismissed when risky investments have paid off for a span of years. John Kenneth Galbraith wrote that the outstanding characteristics of financial markets are shortness of memory and ignorance of history.

In hot times, the few who do remember the past are dismissed as relics of the old, lacking the ability to imagine the new. But it invariably turns out that there’s nothing new in terms of investor behavior. Mark Twain said that “history does not repeat itself but it does rhyme,” and what rhymes are the important themes.

The bottom line is that even though knowing financial history is important, requiring people to study it won’t make a big difference, because they’ll ignore its lessons. There’s a very strong tendency for people to believe in things which, if true, would make them rich. Demosthenes said,

“For that a man wishes, he generally believes to be true”

Just like in the movies, where they show a person in a dilemma to have an angel on one side and a devil on the other, in the case of investing, investors have prudence and memory on one shoulder and greed on the other. Most of the time greed wins. As long as human nature is part of the investment environment, which it always will be, we’ll experience bubbles and crashes.

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Hugo Scott-Gall: What things in your skill set have served you well?

Howard Marks: While knowing financial analysis and accounting is essential, almost any smart person can acquire those skills and get a rough idea of the merits of a company. Superior investors are those who understand both fundamentals and markets and have a better sense for what a given set of merits is worth today and what it will be worth in the future. I don’t think I became less able to do financial analysis over time, but I engaged much more in understanding and sensing markets and values: the “big picture”. A lot of my contribution comes from understanding history and investor behavior, from inferring what’s going on around me, and from controlling my emotions.

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Hugo Scott-Gall: Success in our industry often leads to overconfidence. How do good investors avoid that?

Howard Marks: Mark Twain once said,

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

And I totally agree with that. One of the chapters in my book is about the importance of knowing what you don’t know. People who are smart often overestimate what they know, and this tendency can grow, particularly if they are financially successful. And eventually, you get to the master of the universe problem that Tom Wolfe identified in “The Bonfires of the Vanities.”

I believe there’s a lot we don’t know, and it’s important to acknowledge that. I’m sure I know almost nothing about what the future holds, but a lot of people claim to know exactly what’s going to happen. I consider it very dangerous to listen to them. As John Kenneth Galbraith said,

“There are two kinds of forecasters. Those who don’t know, and those who don’t know they don’t know.”

I’m proud to say I’m a member of the first group. Amos Tversky, who was a great behaviorist at Stanford University, said that,

“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on”.

That is particularly true for investing. I’d much rather have my money run by somebody who acknowledges what he doesn’t know than somebody who’s overconfident. As Henry Kaufman, the noted economist pointed out,

“We have two kinds of people who lose a lot of money; those who know nothing and those who know everything.”

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Hugo Scott-Gall: Have you always been this way, or did you learn to be self-aware and emotionally disciplined?

Howard Marks: I’m inherently unemotional, and I’ve also observed for 45 years that emotions swing in the wrong direction and learned that it’s extremely important to control it. In the market swoon of 1998, I had an employee tell me he was afraid the financial system was going to melt down. I heard him out and then told him to carry on with his work. I don’t compare myself or my colleagues to them, but battlefield heroes aren’t people who are unafraid; they’re people who are afraid and do it anyway. And so we must keep investing; in fact, we should invest even more when it is scary, because that’s when prices are low.

Walter Cronkite once said:

“If you’re not confused you don’t understand what’s going on”.

In the fourth quarter of 2008, I paraphrased that to say, “If you’re not afraid you don’t understand what’s going on.” Those were scary times. But even if you’re afraid, you have to push on. In the depths of the crisis in October ’08 I wrote a memo that I’m particularly proud of, called ‘The Limits to Negativism.’ It touched on the importance of skepticism in an investor. In good times skepticism means recognizing the things that are too good to be true; that’s something everyone knows. But in bad times, it requires sensing when things are too bad to be true. People have a hard time doing that.

The things that terrify other people will probably terrify you too, but to be successful an investor has to be stalwart. After all, most of the time the world doesn’t end, and if you invest when everyone else thinks it will, you’re apt to get some bargains.

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Hugo Scott-Gall: Do you calculate estimates of fair value in advance for the things you want to buy, and do you wait to buy until those are reached in a market downdraft?

Howard Marks: We can try to do analysis in advance, but opportunities often arise unexpectedly. For example, if everyone gets scared due to some sudden bad news about a company, that can give us an opportunity to respond spontaneously and buy its debt cheap. So we can’t plan everything and follow a neat pattern, as a lot of what we do is very opportunistic. We can have estimates of value for some companies, but we can’t know which companies will show up on the troubled list on a given day, or what bonds are going to come up for sale. Most of the inquiries are incoming to us rather than outgoing, meaning we try to buy the things that they want to sell. We have to be generally ready but also be responsive to opportunities to be self-aware and emotionally disciplined?

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Hugo Scott-Gall: How do you think about the current very low interest rate regime?

Howard Marks: Yes. The point is that today you can’t make a decent return safely. Six or seven years back, you could buy three to five-year Treasurys and get a return of 6% or so. So you could have both safety and income. But today, investors have to make a difficult choice: safety or income. If investors want complete safety, they can’t get much income, and if they aim for high income, they can’t completely avoid risk. It’s much more challenging today with rates being suppressed by governments.

This is one of the negative consequences of centrally administered economic decisions. People talk about the wisdom of the free market – of the invisible hand – but there’s no free market in money today. Interest rates are not natural. They are where they are because the governments have set them at that level. Free markets optimize the allocation of resources in the long run, and administered markets distort the allocation of resources. This is not a good thing… although it was absolutely necessary four years ago in order to avoid a complete crash and restart the capital markets.

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Hugo Scott-Gall: If it’s human nature that causes the bubbles and crashes, do you think asset management should be done with more machines and fewer people?

Howard Marks: No, I disagree strenuously. People who doubt the existence of inefficient markets and the ability to profit from them may disagree with me. But if you think you’re operating in an inefficient market like I try to do, a lot can be accomplished by getting great people, developing an effective investment approach, hunting for misvaluations, keeping psychology under control, and understanding where you are in the cycle. I am not saying that everyone should try this. In fact, an algorithm or an index fund may work best for a lot of people. But at Oaktree, we don’t make heavy use of machines. We are fundamentalists and ours is a “non-quant shop.” As long as there are people on the other side making mistakes – failing to fully understand assets, acting emotionally, selling too low and buying too high – we’ll continue to find opportunities to produce superior risk-adjusted returns. This is something I’m very sure of.

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Hugo Scott-Gall: Where would you want to be if you were starting your career as a contrarian today?

Howard Marks: A market being interesting in the long term and being cheap at the moment are two different things. Credit and debt investing is still very, very attractive and interesting to spend time in, even though it may not be especially rife with great bargains today

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The more things change, the more they remain the same.