Hemlines and Investment Styles (Howard Marks - September 2010)

This article is a guest contribution by Howard Marks, Chairman, Oaktree Capital.

Memo to: Oaktree Clients
From: Howard Marks
Re: Hemlines and Investment Styles

While the details change, the pendulum-like fluctuation of investment styles is a constant. Fear versus greed, pursuit of safety versus aggressiveness, stocks versus bonds, and growth versus value are just a few examples of the areas in which we see this take place. In this way, the investment world proves the wisdom of Mark Twain's observation that, "History doesn't repeat itself, but it does rhyme."

The limits of the pendulum's swing are fixed, and it tends to move back and forth over the territory between them. This occurs because (a) people tend to take trends to extremes, (b) neither extreme of the pendulum's arc represents a perfect or permanent solution, and (c) there's no place else to go in these regards. Thus the best way to view investment trends may be through an analogy to hemlines: all they can do is go up and down, and so they do. The style mavens call for short skirts, and people fall into line, raising hemlines until they're as high as they can go. And then they drop (and so forth).

The reasons behind the rise and fall of investment fashions rarely repeat exactly, in that the details, timing and effects vary from instance to instance. But the underlying process is a recurring one. For example:

An idea is born when an undervalued asset is discovered.

Its undervaluation attracts attention, as do pioneering investors' early gains.

• Its popularity rises, attracting more and more adherents, even as undervaluation moves to fully valued.
• It turns into a mania or "bubble," and price becomes immaterial.
• Eventually, the last potential buyer becomes convinced and comes on board.
• With no one else left to convert to the trend, the bubble of overvaluation is ripe for bursting.
• When followers experience the first price declines, disillusionment sets in.
• One-time devotees flee en masse, and the bubble turns into a crash.

This cycle of discovery, mania and crash is best summed up by the most useful of all investment adages: "What the wise man does in the beginning, the fool does in the end." This memo will be about recurring patterns, the history of stocks and bonds as I know it, and the adage's applicability to that history.

A Brief History of Stocks

A significant milestone occurred in October 2008, attracting a lot of attention. For the first time in almost fifty years, it was reported, the dividend yield on the Standard and Poor's 500 stock index was equal to the yield to maturity on the U.S. 10-year Treasury Note. People knew this meant stocks had cheapened, but it took an understanding of history to grasp the real significance. The truth is that stocks, like other investment media, tend to go in and out of style, and this was just one more example of the latter.

Prior to the 1950s, common stocks were viewed as a speculative, inferior (i.e., junior) asset class. For that reason, stocks had to pay higher yields than bonds in order to attract buyers; of course a riskier asset should yield more. In fact, most states had laws restricting holdings of stocks in fiduciary portfolios. This attitude toward stocks largely traced from the speculative stock bubble in the 1920s – featuring high-margin buying, bucket shops and shoe shine boys sharing stock tips – which collapsed in the Crash of '29. Poor economic and market performance stretching from 1929 to the end of World War II further contributed to the skepticism toward stocks.

It was only after WW II that economic performance began to support optimism. Brokerage firms led by Merrill, Lynch, Pierce, Fenner and Smith trumpeted the merits of stocks. Equity investing became widespread, and "customers' men" in local brokerage offices delivered stock investing to a great many households: I remember my mother buying 10 shares of Columbia Gas and 15 shares of Chock Full of Nuts around 1959.

I also remember a brochure on "growth stock investing" that Merrill put out in the mid-1960s, touting the desirability of rapid earnings growth and the strength of companies like IBM, Xerox, Avon, Coke, Texas Instruments and Johnson & Johnson. This idea grew into "nifty-fifty" investing, a true mania adopted by many of the large banks, among others. Ballyhoo took over from logic – excitement from value-consciousness – and these growth stocks' prices reached 80 and 90 times earnings.

The nifty-fifty stocks were tested – and found wanting – when the tide went out in the 1970s. Prosperity shifted to recession. The Arab oil embargo, a period of strong cost-push, and self- reinforcing cost-of-living adjustments created hyperinflation to which few people saw a chance for an end. Those growth stock p/e ratios went from 80 or 90 to 8 or 9. And stocks, Wall Street and the general economy went through a truly dreary decade, culminating in a Business Week cover story entitled "The Death of Equities," in August 1979. For evidence of the cyclicality of attitudes toward stocks, consider its final paragraph:

Today, the old attitude of buying stocks as a cornerstone for one's life savings and retirement has simply disappeared. Says a young U.S. executive: "Have you been to an American stockholders meeting lately? They're all old fogies. The stock market is just not where the action is."

In the investment world, lows in sentiment usually coincide with lows in price, and the late Seventies were no exception. Because of the dreadful environment, you could buy an existing company in the stock market for less than it would cost to start one. I was fortunate to become a portfolio manager in mid-1978, and thus to benefit from the subsequent recovery of investor psychology from its nadir.

In general (albeit with some prominent exceptions), the last half of the twentieth century was marked by the rise of a cult of equities, and the last quarter century was probably the best ever. From 1979 through 1990, the S&P 500 averaged an annual return of 15.4% and showed losses in only two years (4.8% in 1981 and 3.1% in 1990). Economic prosperity, rising corporate profits, a trend among consumers toward borrowing to spend, and the subsidence of inflation and interest rates all made for a most hospitable environment.

When the stock market's performance improved even further in 199 1-99, with an average return of 20.6% and no down years, the fawning kicked up a notch. From the low of 7 reached in 1980, the p/e ratio on the S&P 500 eventually exceeded 33 in 1999. The market's dramatic performance led to steady increases in the capital allocated to equities, and eventually to the tech stock bubble. It culminated in books such as the fact-based Stocks for the Long Run and the more fanciful Dow 36,000. If you asked institutional investors what return they expected from stocks going forward, I think just about all would have said 11%.

An aside: investors consistently seize upon above average returns as an encouraging sign and extrapolate them, and the 17.6% compound return on the S&P 500 from 1979 through 1999 was certainly a case in point. But rarely do they ask what gave rise to those good returns, or what it implies for the future. In essence, stock ownership conveys the benefits of owning a corporation, and stock appreciation should be powered by increases in profits. Thus long-run returns should reflect corporate growth. But as Warren Buffett has pointed out, ". . . people get into trouble when they forget that in the long run, stocks won't appreciate faster than the growth in corporate profits." Although that growth is the underlying source of equity profits, it is often overshadowed and obscured in the short run by trends in valuation. People took that 17.6% gain as an encouraging sign, overlooking the fact that it stemmed primarily from the rise of p/e ratios described above and thus was unlikely to continue unabated. Rather than healthy performance that could be extrapolated, this swollen return should have come as a warning that valuations were unsustainable and likely to regress toward the mean. But investors consistently fail to recognize that past above average returns don't imply future above average returns; rather they've probably borrowed from the future and thus imply below average returns ahead, or even losses. The tendency on the part of investors toward gullibility rather than skepticism is an important reason why styles go to extremes.