Howard Marks (Trades, Portfolio)' latest memo contains some interesting food for thought. In the letter, Marks comments on the current market and economic situation, as well as the fiscal and monetary response from the U.S. government and Federal Reserve.
Marks' comments revolve around the Fed's actions and the impact they've had on equity and debt prices. The distressed debt investor noted that since the Fed decided to slash interest rates to near zero, asset prices have increased substantially, which has reduced the risk-reward ratio for investors.
This poses a dilemma, he went on to explain. Investors now have one of two options: either accept 0% returns in cash or risk further volatility by acquiring assets at high prices in hopes of receiving at least some sort of return.
Even the return potential of the latter option is miserable, Marks noted. He went on to add that the "prospective returns on everything are about the lowest they've ever been."
With this being the case, and considering the uncertain outlook for the economy, investors have to carefully balance aggressiveness and defensiveness. But how aggressive or defensive should investors be? Marks offerred the following thoughts:
"In my view, when uncertainty is high, asset prices should be low, creating high prospective returns that are compensatory. But because the Fed has set rates so low, returns are just the opposite. Thus the odds aren't on the investor's side, and the market is vulnerable to negative surprises. This is how I described the prior years, and I'm back to saying it again. The case isn't extreme -- prices aren't grievously high (assuming interest rates stay low, which they're likely to do for several years). But it's hard in this context to find anything mouth-watering."
This perspective isn't incredibly helpful, in my view. However, it does highlight the main risks investors face today.
After the recent market performance, many stocks are priced to perfection. This is a problem. Even a slight deterioration in fundamental performance or economic outlook could result in a big decline in the stock price.
Overpaying for an asset is one of the biggest mistakes an investor can make. It is very easy to overpay for assets today, simply because there are just so many companies trading at elevated levels compared to their growth and profit potential.
When all is said and done, how you interpret Marks' advice will depend on your own personal risk preference. For example, aggressive investors might be quite happy to take an aggressive stance in the current market. Following an aggressive investment approach, in general, requires a high level of risk and loss tolerance.
But if you're easily scared and tend to worry about small declines in market value, this might not be the right approach for you. There's no sense trying to achieve a higher return rate if you're going to sell the stock at the first sign of trouble. This could end up costing a lot of time, money and wasted resources.
To put it another way, it is perfectly acceptable to follow any investment strategy and be overly aggressive or defensive, as long as you are comfortable with it. Marks is a very successful distressed investor. This is a niche style that some might be uncomfortable following. Just because he does not think there are any attractive opportunities in the market right now does not necessarily make it true.
However, his thoughts on the topic are still relevant, particularly regarding markets' return potential in the future. If you're comfortable taking that risk, then fine. If not, it might be better to adopt a more defensive stance.
Disclosure: The author owns no share mentioned.
Read more here:
- Value Investing Is Not Dead, but It Has Changed
- Illiquidity, Psychology and Charlie Munger
- A Look Back at Warren Buffett's Gen Re Mistake
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