Howard Marks Sea Change
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The past 4-weeks I’ve been teaching a Portfolio Management & Trading class to students.
Teaching them to think about the markets and investing that is outside of the retail trading inversion narrative.
That narrative is day-trading, made up indicators, looking for magical win ratios and not understanding how anything in financial markets work other than patterns.
That might work with futures trading or even some day trading but even then you need to understand the foundations of how those particular markets operate.
Most investors, and let’s get real here, put more time into researching where to eat dinner than they do on a stock investment.
In this post I am going to cover a bit of the Absolute Return Mindset then I am going to talk about the Howard Marks Sea Change note.
If you don’t know who he is, he’s the co-founder of Oaktree Capital Management.
It’s worth your time to research him because what I am going to get into regarding his Sea Change notes is relevant to investing, for anyone, everywhere, regardless of your experience and I’ll explain how.
Absolute Return Investing
If you type in Google “What is absolute return strategy” this is the first thing that will pop up.
This is from Morgan Stanley:
The Global Multi-Asset team Absolute Return Strategy uses a global macro and thematic approach, and invests across equities, fixed income, currencies and commodities. The Strategy seeks to generate a low beta to broad asset classes by taking the majority of risk in uncorrelated, hedged positions. Directional positions are also taken, but on a tactical and opportunistic basis. Rather than individual security selection, the Strategy invests in opportunities at the asset class, country, sector and thematic levels. The research and decision-making process is fundamentally-driven and discretionary.
If you type in Google “What is absolute return strategy” this is the first thing that will pop up.
This is from Morgan Stanley:
The Absolute Return Strategy uses a top-down global macro and thematic approach, and invests across equities, fixed income, currencies and commodities. The Strategy seeks to generate a low beta to broad asset classes by taking the majority of risk in uncorrelated, hedged positions. Directional positions are also taken, but on a tactical and opportunistic basis. Rather than individual security selection, the Strategy invests in opportunities at the asset class, country, sector and thematic levels. The research and decision-making process is fundamentally-driven and discretionary.
- Long/Short across all assets
- Structured with equity/derivatives/credit
- Fundamentally & Macro driven
The last part is important and I am going to show you why in this post how Howard Marks Sea Change note applies.
Top-Down Approach
Most investors, when they look at the markets, have pre conceived notions. They rarely realize that the companies and commodities that make up the markets are all affected by central bank policy.
I don’t care what you do, where it’s at you are affected by policy.
It drive earnings growth, M&A activity, customer acquisition….all of it starts and ends there.
It also drives where money flows.
Large firms, like Oaktree (and others) who control billions in assets look at the world from this approach.
Their portfolio managers allocate based on this understanding which, in turns, drives capital into and OUT of sectors and companies.
That in turn either:
- Creates volatility and lack of trend
- A trend you can count on
Here is a note from Sea Change, Howard Marks –
The low interest rates that prevailed in 2009-21 made it a great time for asset owners – lower discount rates make future cash flows more valuable – and for borrowers. This in turn made asset owners complacent and potential buyers eager. And FOMO became most people’s main concern. The period was correspondingly challenging for bargain hunters and lenders.
That environment creates how assets trade.
From micro-caps, to small-caps to high beta to the ShitCos like $AMX and $GME, among others, traded in 2020-2021.
If you’re still not tying this together at this point in the post then maybe consider another line of work.
Capital chases risk-adjusted returns, especially large capital.
So if that capital is uncertain of future times then you are going to have an environment that is vastly different than 2009-2021.
Howard Marks Sea Change
There are too many great lines in the memo for me to breakdown in a post so what I am going to do is highlight a few of them in this post then make a video discussing my take on them.
1. On Fed Policy staying too low for too long creating bad investments:
Rather than letting economic and market forces determine the rate of interest, the Fed has been unusually active in setting interest rates, greatly influencing the economy and the markets.
Importantly, this distorts the behavior of economic and market participants. It causes things to be built that otherwise wouldn’t have been built, investments to be made that otherwise wouldn’t have been made, and risks to be borne that otherwise wouldn’t have been accepted. There’s no doubt that this is true in general, and I’m convinced it accurately describes the period in question.
2. Easy Money is Gone, a reversion to the mean.
If the declining and/or ultra-low interest rates of the easy-money period aren’t going to be the rule in the years ahead, numerous consequences seem probable:
economic growth may be slower;
profit margins may erode;
default rates may head higher;
asset appreciation may not be as reliable;
the cost of borrowing won’t trend downward consistently (though interest rates raised to fight inflation likely will be permitted to recede somewhat once inflation eases);
investor psychology may not be as uniformly positive; and
businesses may not find it as easy to obtain financing.
In other words, after a long period when everything was unusually easy in the world of investing, something closer to normalcy is likely to set in.
3. Equity Investors may face a rude awakening
I’ve been thinking lately about the fact that being an investor requires a person to be somewhat of an optimist. Investors have to believe things will work out and that their skill will enable them to wisely position capital for the future. Equity investors have to be particularly optimistic, as they have to believe someone will come along who’ll buy their shares for more than they paid. My point here is that optimists surrender their optimism only grudgingly, and phenomena such as cognitive dissonance and self-delusion permit opinions to be held long after information to the contrary has arrived. This is among the reasons why they say of the stock market: “Things can take longer to happen than you thought they would, but then they happen faster than you thought they could.” Today’s sideways or “range-bound” market tells me investors possess a good amount of optimism despite the worries that have arisen. In the coming months, we’ll find out if the optimism was warranted.
Final Word.
Here is my take on this (and I don’t think it’s much off his) and how it relates to both:
- How retail investors ‘trade the markets’
- How money management changes
For retail investors:
- The era of small-cap/mid-cap pump and dumps will be slower or just non existent.
- Volatility will suppress in certain sectors (high beta options trading)
- Buy and hold in equities is a thing of the past – expect lower returns
For money management
- Credit & Fixed income strategy likely to increase
- Active management will be required
- Potentially (and I hope – Howard does not agree) the return of hedge fund golden years
- Maybe an increase in activist investing to return?
Next Lesson
Patience Pays and Stock Market Sentiment
GXO Logistics and Stock Market Sentiment
Ready for Take Off or Jet Lagged?
About the Author
Daniel Bustamante is the founder, managing partner, and CIO of Bustamante Capital L.L.C., a multi-strategy hedge fund management firm based in San Juan, Puerto Rico. He has over 10 years of experience in the financial industry, specializing in equities, futures, and event-driven trading strategies.
He is also the founder of TheLongVol.com, a blog and newsletter that shares his insights on his investing process, travel, and other private investments. He has been featured in Bloomberg, Arizona Business Journal, Business Insider, Yahoo! Finance, Forbes, Seeking Alpha, and other publications over his career on Wall Street.
