By Nick Fisher, Portfolio Manager
Investor expectations for exceptional returns have reached unprecedented heights, verging on the unrealistic.
A 2023 survey showed that investors in the US expect the stock market to return 15.6% annually. This compares to the long-term average annual market return which is more than 4% lower. A significant reason for this unreasonable return expectation is the recency bias of the last 40 years of declining rates.
This week we offer you a summary of a talk that famed investor Howard Marks, Chairman of Oaktree Capital Management and a legendary value investor we greatly admire, shared with his clients. Marks has been quite prescient at turning points in financial markets and it is worth listening to his market wisdom.
Taken from a recent trip Nick (Portfolio Manager) and his wife took to Savannah, Georgia; these incredible and majestic live oak trees with Spanish moss draped endlessly over the passers by as they enjoyed the sites; made him think of the timeless wisdom of Howard Marks, Oaktree Capital Management Chairman.
We have had a 40 year decline in interest rates. It is the single most important thing that has happened in financial markets. Anyone who has been investing for the last 42 years has only seen declining interest rates and zero interest rates or both. When something is the case for a long time everyone thinks it is normal. Zero interest rates are not normal.
Low interest rates have problematic side effects:
They encourage risk taking, leading to potentially unwise investments.
They encourage greater use of leverage, increasing fragility.
They induce optimistic behaviors that lay the groundwork for the next crises.
We think of panics as producing losses but as Manchester banker John Mill said, “…as a rule, panics do not destroy capital, they merely reveal the extent to which it has previously been destroyed by its betrayal into hopelessly unproductive works.” - The Price of Time, Edward Chancellor
The problem is not what is done at the [market] lows, the problem is what was done at the [market] highs which is then disclosed at the lows.
There is the old saying, “Insanity is doing the same thing over and expecting a different result…I might also similarly argue that doing the same thing in a different environment and expecting the same result is insane." If the environment is so thoroughly different over the last period of time it may be folly to expect the same results over the next several years.
Howard Marks’ assumptions and cautions:
The Fed funds rate is likely to be in the 3’s which is well above the rate of the last 13 years, and is likely to be a more normal rate. After a long period in which everything was unusually influenced by declining interest rates, we should be aware of a few things:
Economic growth may be slower
Profit margins may erode
Investor psychology may not be as uniformly positive
Ownership interests may not appreciate as reliably
The cost of borrowing won’t trend down as consistently
Leverage is unlikely to add as much to returns
Businesses may not find it as easy or as inexpensive to obtain financing
Default rates may head higher
The above points to potentially more stock market volatility. Stock market volatility should be embraced, sowing the seeds for future returns.
We pointed out in our Pilot’s log: On Anti-Fragile Investing, “Recognizing volatility not as a threat to be avoided but as an opportunity to be leveraged, investors can cultivate portfolios that not only withstand shocks but emerge stronger from them...in an uncertain world, the path to long-term prosperity lies not in futile attempts to predict the future, but in embracing uncertainty and harnessing its transformative power.”
As investors re-calibrate return expectations, a contrarian portfolio of treasuries, precious metals, commodities and cash offer quite an attractive yield compared to the return that the broad stock market currently offers. There will be a time to aggressively buy the stock market again, but investors will need to recognize that we are in a different world than the previous low/zero interest rate environment offered.
This was the same thought process that led to how we successfully navigated the volatility of 2022. We are prepared for this next phase of uncertainty and will continue to adjust portfolios as opportunities present themselves.
If there is anyone you know or care about who you think might benefit from this information, please feel free to share it with them. As always we welcome your feedback, reactions and critique's. We hope you will find this information valuable and validating.