Memo to: Oaktree Clients
From: Howard Marks
Re: How Quickly They Forget
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In January 2004 I received a letter from Warren Buffett (how’s that for name dropping?) in which he wrote, “I’ve commented about junk bonds that last year’s weeds have become this year’s flowers. I liked them better when they were weeds.”
Warren’s phrasings are always the clearest, catchiest and most on-target, and I thought this Buffettism captured the thought particularly well. Thus for Oaktree’s 2004 investor conference we used the phrase “Yesterday’s Weeds . . . Today’s Flowers” as the title of a slide depicting the snapback of high yield bonds. It showed the 45% average yield at which a sample of ten bonds could have been bought during the Enron-plus-telecom meltdown of 2002 and the 6% average yield at which they could have been sold in 2003; on average, the yields had fallen by 87% in just thirteen months. The idea went full-circle in 2005, when Warren used our slide at the Berkshire Hathaway annual meeting to illustrate how rapidly things can change in the world of investing.
And that’s the point of this memo. Asset prices fluctuate much more than fundamentals. This happens because, rather than applying moderation and balancing greed against fear, euphoria against depression, and risk tolerance against risk aversion, investors tend to oscillate wildly between the extremes. They apply optimism when things are going well in the world (elevating prices beyond reason) and pessimism when things are going poorly (depressing prices unreasonably). Shortness of memory plays a major part in abetting these swings. If investors remembered past bubbles and busts and their causes, and learned from them, the swings would moderate. But, in short, they don’t. And they may be forgetting again.
High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.
The Importance – and Shortcomings – of Investment Memory
A number of my favorite quotations are on the subject of history and memory, and I’ve used them all in past memos. Humorist and author Mark Twain talked about the relevance of the past:
History doesn’t repeat itself, but it does rhyme.
The philosopher Santayana stressed the penalty for failing to attach sufficient importance to history:
Those who cannot remember the past are condemned to repeat it.
And economist John Kenneth Galbraith described the shabby way investors treat history and those who consider it important:
Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
String together these three pearls of wisdom and you get a pretty accurate picture of investment reality. Past patterns tend to recur. If you ignore that fact, you’re likely to fall prey to those patterns rather than benefit from them. But when markets get cooking, the lessons of the past are readily dismissed. These are nothing short of eternal verities, and their collective message is indispensible.
Why Does Investment Memory Fail?
Think back to the emotions you felt so strongly during the recent financial crisis, and the terrifying events that brought them on. You swore at the time that you’d never forget, and yet their memory has receded and nowadays has relatively little influence on your decisions. Why does the collective memory of investment experiences – and especially the unpleasant ones – fade so thoroughly? There are a number of reasons.
- First, there’s investor demographics. When the stock market declined for three straight years in 2000-02, for example, it had been almost seventy years since that had last happened in the Great Depression. Clearly, very few investors who were old enough to experience the first such episode were around for the second.
For another example, I believe a prime contributor to the powerful equity bull market of the 1990s and its culmination in the tech bubble of 1999 was the fact that in the quarter century from 1975 through 1999, the S&P 500 saw only three minor annual declines: 6.4% in 1977, 4.2% in 1981, and 2.8% in 1990. In order to have experienced a bear market, an investor had to have been in the industry by 1974, when the index lost 24.3%, but the vast majority of 1999’s investment professionals doubtless had less than the requisite 26 years of experience and thus had never seen stocks suffer a decline of real consequence.
- Second, the human mind seems to be very good at suppressing unpleasant memories. This is unfortunate, because unpleasant experiences are the source of the most important lessons. When I was in army basic training, I was sure the memories would remain vivid and provide material for a great book. Two months later they had disappeared. After the fact, we may remember intellectually but not emotionally: that is, the facts but not their impact.
- Finally, the important lessons of the past have to fight an uphill battle against human nature, and especially greed. Memories of crises tell us to apply prudence, patience, moderation and conservatism. But these things seem decidedly outdated when the market’s in a bull phase and risk bearing is paying off, and if practiced they appear to yield nothing but opportunity costs.
Charlie Munger contributed a great quote to my recent book, from Demosthenes: “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” In other words, there’s a powerful tendency to believe that which could make one rich if it were true.
I’ve tried to spend the last 42 years with my eyes open and my memory engaged. As a result, a lot of what I write is based on recognition of past patterns. It’s time to put my recollections to work, because I’m definitely seeing a trend in the direction of Galbraith’s “same or closely similar circumstances.”
The Not-So-Distant Past
It seems it was impossible – unless you were John Paulson – to escape entirely unscathed from the financial crisis of 2007-08. Most investors could only hope to have turned cautious in the run-up to the crisis, sold assets, increased the defensiveness of their remaining holdings, reduced or eschewed leverage, and secured capital with which to buy at the bottom in order to benefit from the subsequent recovery.
What might have prompted investors to do these things in advance of the mid-2007 onset of the crisis? Almost no one fully foresaw the impending subprime meltdown, and few macro-forecasts and market analyses were sufficiently pessimistic. Rather, I think investors would have been most likely to take the appropriate actions if they were aware of the pro-risk behavior taking place around them.
