Swedroe: Passive Investing Misconceptions

September 05, 2017

Howard Marks is one of the financial industry’s most respected investment managers—for good reason. In 1995, he co-founded Oaktree Capital Management and built an enviable track record, with an emphasis on high-yield bonds, distressed debt, private equity and other nontraditional strategies.

His “memos” to Oaktree clients are the only ones of their kind I read (other than market analyses on which I’m asked to comment by our clients). I make it a point to read them because they are almost always filled with investment wisdom that every investor, whether active or passive, can put to work.

Key Insights

Marks’s latest, “There They Go Again … Again,” is no exception. Like many of his memos, this one contains cautionary tales, advising investors to not get caught up in fads. He warns investors:

  • “The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology. 
  • In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.
  • Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general, the best we can do is look for things that are less overpriced than others.
  • Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.”

He then added the following points about U.S. equities:

  • “The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
  • The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16. This multiple was exceeded only in 1929 and 2000—both clearly bubbles.
  • While the “p” in p/e ratios is high today, the “e” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity. Thus today’s reported valuations, while high, may actually be understated relative to underlying profits.
  • The “Buffett Yardstick”—total U.S. stock market capitalization as a percentage of GDP—is immune to company-level accounting issues (although it isn’t perfect either). It hit a new all-time high last month of around 145, as opposed to a 1970-95 norm of about 60 and a 1995-2017 median of about 100.
  • Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established.”

He also added a warning about “super-stocks” (FAANG: Facebook, Amazon, Apple, Netflix, Google) and warned that, while these are great companies, they are selling at historically high multiples and aren’t invulnerable to competition and change.

So far, so good. Investors should be aware that valuations are high. That means forward-looking return expectations are now much lower than historical returns. And just as once nifty-fifty, “sure-thing” stocks such as Polaroid, Eastman Kodak, Digital Equipment, Burroughs and Xerox have “gone with the wind,” the FAANGs could suffer similar fates. In other words, valuations matter, and investors should not be caught up in fads, or chase recent great returns.

 

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