Howard Marks

Howard Marks makes a Good Point – Markets are more volatile than economies

To paraphrase the much-admired investor Howard Marks, in real life things go from pretty good to not so hot, but in markets, they go from flawless to hopeless (and tend to do so in advance of the economy). This is not market infallibility, but rather that market concerns and emotions themselves tend to feed into economic decisions, only more slowly; that is, economies follow the capital markets rather than the other way around. One can panic far more quickly in the equities markets than, for instance, in the property market (properties require some time to be prepared for sale).

Last month we put two propositions:

  1. Market falls tend to be over relatively quickly with the major of the fall occurring within 12 months; this may not be the end of a bear market, but most of the damage has been done by then.
  2. Major economic downturns tend to be accompanied by financial system trauma; bank collapses are so devastating because the resulting lack of availability of funding makes economic recovery difficult and slow.

We observed that currently banks are financially very strong; they have had conservative lending policies, lots of capital and are unlikely to get into significant difficulty at this point. This would tend to make a nasty economic downturn seem unlikely. One could contrast the situation leading up to the GFC, 15 years ago, with the current one.

Markets have already declined for about a year, although the declines overall have been modest, 9% domestically and 10% for global markets (in A$), in the “flawless” sectors the declines have been very sharp. In the domestic tech sector the falls have been of the order of 45% and in the global sector 35%, with early stage companies falling 80% or more. Not vastly different from what occurred when the 2000 tech bubble burst.

As a result of these falls there are many companies, that were previously extremely expensive, have now moved back into the range of reasonable valuations. Examples we are thinking of are: Microsoft and Nvidia (a leader in high end chips and software for data centres and automation – this technology was derived from their long experience in video gaming).

The same pricing also applies to many of the stocks that are generally classified as cyclical. Examples in say, discretionary retailing, are Harvey Norman or JB HiFi in the domestic market or Home Depot in the US. We feel that the declines in share prices that have already occurred suggest that expectations of difficult economic circumstances are largely priced-in.

Others that fall into the same category are home building and building materials. Construction levels in the US in particular never reached more than long-term average levels, let alone boom conditions. House prices may have gone up, more from shortage than speculative excess. There certainly hasn’t been the overbuild that preceded the GFC. Companies with powerful market positions we think will continue to do well.

There are numerous industries in which the pricing of stock did not reach excessive levels during the speculative periods of the last four years. In a number of cases they have also declined in the last year and now are in our view, extremely attractively priced. Healthcare, ranging from hospital operators, pathology, pharmaceuticals and surgery equipment producers fall into this category. The finance sector also has many examples of quality operators trading at below book value (effectively valuing the franchises at below zero!).

We retain our view that inflationary pressures are moderating and have not become ingrained as they became in the 1970s and over time these pressures are likely to dissipate. Interest rates while they have risen sharply over the year, that has only returned them to more normal levels (remember when banks actually paid interest on deposits). Central banks have indicated a moderation to rises in the future as they assess the effects of recent rises – the lags are of variable extent and timing, as the RBA Governor reminded in a recent address.

While predictions about economic outcomes have to be given a wide margin for error (and possibly direction!) we would not be in the impending disaster camp, thus well-run companies at reasonable prices are very attractive to us. There seem to be a lot of these at present – one does not need to pick bottoms to make an attractive return.

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