On 11 April 1991, Howard Marks wrote his second general memo to Oaktree clients.
30 years later, the common sense advice he offered still applies today (emphasis added):
‘The mood swings of the securities markets resemble the movement of a pendulum.
‘Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later.
‘In fact, it is the movement toward the extreme itself that supplies the energy for the swing back.’
In my book, The End of Australia, one of the 13 Timeless Wealth Rules is:
‘The pendulum of valuations swings from undervalued to overvalued.
‘Social mood — ranging from pessimism to optimism — drives the valuation process. Buy low and sell high.’
A market extreme — in either direction — supplies the energy for the swing back.
Newton’s Third Law of ‘action and reaction’ is an established scientific fact. Yet when it comes to markets, it’s ignored and replaced with ‘action and more action and even more action with absolutely NO reaction’.
One of the market’s more extreme ‘action’ episodes occurred in the late 1990s…the tech boom.
The pendulum’s reaction was a violent swing back. Slicing more than 80% off the NASDAQ Index.
A decade after Howard Marks counselled investors to the arcing motion of markets, Warren Buffett, in the aftermath of the tech wreck, was interviewed by Fortune magazine.
This is an extract from his 10 December 2001 interview (emphasis added):
‘…The chart shows the market value of all publicly traded securities as a percentage of the country’s business—that is, as a percentage of GNP [Gross National Product].
‘The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.
‘For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.’
From that day forward, the chart of ‘market value of all publicly traded securities as a percentage of GNP’, has been known as the Buffett Indicator.
The most recent reading of the Buffett Indicator registered an all-time extreme…even greater than that of the dotcom peak.
Recall what Buffett said 20 years ago ‘if the ratio approaches 200%…you are playing with fire.’
At 175% (far above the 70-year mean of 76%), this market is glowing white hot…
Source: Advisor Perspectives
If we combine the wisdom of Howard Marks with that of Warren Buffett, here’s a different perspective on the Buffett Indicator.
Source: Advisor Perspectives
The pendulum of the best single measure of where valuations stand at any given moment swings back and forth from under-to overvalued.
The pendulum spends very little time on the average.
Those who believe it’s different this time are betting the Fed can permanently halt the momentum of the valuation pendulum.
Keeping it forever in the over-overvalued section of the arc.
That wasn’t the case after the peaks in 1987, 2000 or 2008. On those prior occasions, the pendulum swung back to the mean or below.
Will it really be different this time? No. Greed. Excessive risk-taking. Junk debt. SPACs etc.
They’ll all drive the pendulum to a point where the force within, when released, will send an audible snap around the world.
The time to prepare for this eventuality is before not after the arc starts swinging like an executioner’s axe.
To assist you in your preparations, these are the other 12 rules from The End of Australia:
‘▪ To create and preserve lasting wealth you must spend less than you earn.
‘This was the basic rule in The Richest Man in Babylon by George Samuel Clason. This rule applies to individuals, corporates and governments. Living within a budget is a discipline that will stand you in good stead when tough times inevitably come.
‘▪ Only invest in things you understand.
‘There is enough risk in “vanilla” investments without adding extra layers of unquantifiable risk. When presented with an investment opportunity, I evaluate the merits of the offer based on Einstein’s wisdom: “If you can’t explain it to a six-year old, you don’t understand it yourself.”
‘▪ What goes up must come down.
‘A bust always follows every boom and it is never different this time.
‘▪ The taxman is not your biggest enemy.
‘The taxman tells you upfront the percentage of income and capital gain he intends to take from you. The markets and their promoters give you no such guarantee. They can take all your capital without you ever making one cent of income or gain. I am no fan of the taxman and advocate you do everything you can to legitimately reduce your tax contribution. However, investments promising to minimise tax — agri-schemes, negative gearing, depreciation allowances etc — should be subject to a very high level of scrutiny before you proceed.
‘▪ Avoid capital destroying losses.
‘If markets fall 50%, you must achieve a 100% return to recover your original starting position. Falling over the cliff happens much faster than climbing back up it — and also hurts a hell of a lot more. An ounce of caution is preferable to a tonne of regret.
‘▪ Patience is absolutely essential to long term wealth creation.
‘Family wealth is not about chasing the “hot” return. It is about identifying trends and either participating in or avoiding those trends. These trends can take a long time to play out — so be it.
‘▪ Avoid excessive debt.
‘The old saying is, “There is no new way to go broke — it is always too much debt.” The investment industry has coined the phrases “good debt” and “bad debt”. In theory margin lending is “good debt” — ask investors in Storm Financial how good that debt turned out to be…“good debt” to buy an overpriced asset is, in my opinion, a bad debt. Borrow cautiously and within your means.
‘▪ What you want and what you get are two different things.
‘Investors may want a certain rate of return to achieve a particular goal, however achieving that rate of return with a degree of safety may not be on offer ie: you may want an 8% return on your capital, but interest rates are only 3% — be very careful trying to chase that extra 5%, it could come with a very hefty capital loss. Therefore, you have to adjust your expectations rather than chase return.
‘▪ If it sounds too good to be true then it usually is.
‘If whatever is offered to you does not pass the “sniff” test, then walk away. It was Donald Trump who said: “Experience taught me a few things. One is to listen to your gut, no matter how good something sounds on paper. The second is that you’re generally better off sticking with what you know. And the third is that sometimes your best investments are the ones you don’t make.”
‘▪ Risk does not always equal reward.
‘Too often investors are under the misapprehension that risk equals reward ie: the higher the risk, the higher the reward. When in fact the higher the risk can mean the greater the loss. Even low risk can mean great loss — just ask the depositors in Cyprus banks.
‘▪ Past performance is a very poor guide to future performance.
‘The world is dynamic. The events that created the past performance are not necessarily going to be replicated in the future. Yet time and again the greatest inflow of money into an investment sector happens when the positive trend is reaching its use by date.’
One final piece of timeless advice: an ounce of prevention is better than a tonne of cure.
Editor, The Rum Rebellion
PS: Vern is also the Editor of The Gowdie Letter and The Gowdie Advisory — investment services designed to help everyday Australians avoid the financial pitfalls of a volatile economy and make informed decisions to grow their wealth for generations to come.