Howard Marks Memo – Irrational Exuberance – 2000

The second memo of 2000 is a “postmortem” of the tech/dot-com bubble. I wrote postmortem within quotation marks since the memo was written at a time (May 2000) when it was not yet clear how the situation would play out. With the help of hindsight we can now see that the postmortem was more of an mid-mortem. The title for the memo H. Marks borrowed from Alan Greenspan and his famous speech in 1996:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from Irrational Exuberance – 2000

1.

“[…] Julian Robertson, who compiled an incredible record through mid-1998, with a return averaging 31.7% a year for 18 years. Then losses and capital withdrawals knocked his Tiger Fund from $22.8 billion to $5.2 billion over the next 18 months. Every day the stock market was ridiculing both value investors like Robertson and the Old Economy companies they specialized in. Robertson announced a few weeks ago that he was closing up shop, saying, “we are in a market where reason does not prevail” and “there is no point in subjecting our investors to risk in a market which I frankly do not understand.”

In a supreme irony, the April week in which Robertson announced his departure turned out to be one of the best of his career, but the damage had already been done. I often think about the corrosive effect of being on the wrong side of a market judgment for prolonged periods, and the phenomenon through which those who resist trends the longest can finally capitulate at just the wrong time.

[…]

Last week saw a pullback from risk on the part of George Soros, head of the remarkable Quantum Fund (up 32%/year after fees for 30 years), and the resignation of Stanley Druckenmiller, its portfolio manager since 1989. Why? Druckenmiller had resisted tech stocks until mid-1999, but then he invested and made a bundle in the second half. When he held on to most of them in 2000, they brought him heavy losses. […]

An analyst who dealt with both Robertson and Soros summed up aptly for the Times:

The moral of this story is that irrational markets can kill you. Julian said, “This is irrational and I won’t play,” and they carried him out feet first. Druckenmiller said “This is irrational and I will play,” and they carried him out feet first.”

My thoughts: This is a good reminder that even the best in the business can fail. Also, it serves as a reminder that investing is hard, especially during crazy times when the  pressure to give in / give up will be hard to evade. On that note, I argue that non-professional/retail investors have some form of an edge since they are not simultaneously  exposed to the performance pressure from the individuals whose money they manage.

2.

“There are two main reasons why stocks fall when rates rise. I’ll discuss them below and offer my explanation for their failure to gain traction this time:

First, stocks dip because higher interest rates mean stiffer competition from fixed income investments. […]

Second, higher rates make it more expensive for consumers to buy houses and cars and for businesses to hold inventories, invest in machinery and build buildings. […] But if the investors setting stock prices don’t know (or care) how the economy and business cycle work, policy increases can be slow to impact the equity market.

Rate increases depress stocks in the short run when people understand how they work and anticipate the longer-term effects described above. That is, they work because people agree they will work. If this requirement isn’t met, then rate rises deserve the description that First Boston’s Al Wojnilower (“Dr. Doom”) applied in the 1970s to manipulating the money supply: “turning on and off a light switch to which no wires are attached.””

My thoughts: I thought this was an interesting and unique view about the relationship between stock prices and interest rates. I had not come across this explanation before. I will try to remind myself of this extract when (if?) interest rates starts to rise again.

3.

“Why did stocks rise so rapidly in 1999? Because people were rabid to buy and no one wanted to sell to them. The result was explosive appreciation. Those gains actually signaled great illiquidity (which is measured as the percentage price change that results from buying or selling a certain dollar value of stock). However, an imbalance of buyers over sellers is never called illiquidity; it’s called profit and doesn’t worry anyone.

In the last six weeks, however, the imbalance has been on the sell side. This time, investors’ inability to find others willing to trade with them has forced prices down drastically, and they are calling it illiquidity. In other words, radical upward movement was greeted warmly, but radical downward movement is being attributed somewhat to a failing on the part of the market.

Certainly the behavior of stocks in 1999 was viewed more benignly than it should have been. Momentum investors irrationally planned to get out when the music stopped, but the market wasn’t able to accommodate all of them.”

My thoughts: This should be a warning for all momentum investors. I’m quite sure H. Marks can use the exact same extract à la copy-paste in a future memo. First level thinking, as it relates to momentum investing, hasn’t changed.

4.

“In my opinion, the market for many stocks is highly efficient. […] But what does that mean?

When I say efficient, I mean “speedy,” not “right.” My formulation is that analysts and investors work hard to evaluate all of the available information such that:

  • the price of a stock immediately incorporates that information and reflects the consensus view of its significance, and
  • thus, it is unlikely that anyone can regularly outguess the consensus and predict a stock’s movement.

That is, the market may often misvalue stocks, but it’s not easy for anyone person – working with the same information as everyone else and subject to the same psychological influences – to consistently know when and in which direction. That’s what makes the mainstream stock market awfully hard to beat – even if it isn’t always right.”

My thoughts: The distinction between speedy and right is extremely important to understand as it relates to the definition of market efficiency. Applying H. Marks definition you will develop a humility-opportunistic-mindset towards investing. This will lower your expectations to a realistic level (i.e. investing is hard) while simultaneously pointing out the importance of focusing on finding pockets of slow. Reading the final sentence in the extract above, “the mainstream stock market” is probably not one of those pockets.

5.

“I listed some of the elements that have been at the foundation of prudent investing during my time in the business and more:

  • pursuing both appreciation and income,
  • balancing growth and value investments,
  • balancing the desire for gain and the fear of loss,
  • buying companies with a history of profitability,
  • caring about valuation parameters,
  • emphasizing cheap stocks,
  • taking profits and reallocating capital,
  • rotating industries, groups and themes,
  • diversifying,
  • hedging,
  • owning some bonds, and
  • holding some cash.”

My thoughts: This is a great checklist if one want’s to apply a prudent investing philosophy. However, during certain market environments (e.g. 1999) this list will also make you look like a fool and underperform as H. Marks points out in the memo.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s