12 Insightful Thoughts from “The Most Important Thing” by Howard Marks

1. People usually expect the future to be like the past and underestimate the potential for change.

2. When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.

3. In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, there are two concepts we can hold to with confidence: • Rule number one: most things will prove to be cyclical. • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

4. Very early in my career, a veteran investor told me about the three stages of a bull market. Now I’ll share them with you. • The first, when a few forward-looking people begin to believe things will get better • The second, when most investors realize improvement is actually taking place • The third, when everyone concludes things will get better forever

5. Investors hold to their convictions as long as they can, but when the economic and psychological pressures become irresistible, they surrender and jump on the bandwagon.

6. Even when an excess does develop, it’s important to remember that “overpriced” is incredibly different from “going down tomorrow.” • Markets can be over- or underpriced and stay that way—or become more so—for years.

7. If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.

8. Our goal isn’t to find good assets, but good buys. Thus, it’s not what you buy; it’s what you pay for it.

9. There are two kinds of people who lose money: those who know nothing and those who know everything.

10. One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value

11. Surprisingly good returns are often just the flip side of surprisingly bad returns. One year with a great return can overstate the manager’s skill and obscure the risk he or she took. Yet people are surprised when that great year is followed by a terrible year.

12. Psychological and technical factors can swamp fundamentals. In the long run, value creation and destruction are driven by fundamentals such as economic trends, companies’ earnings, demand for products and the skillfulness of managements. But in the short run, markets are highly responsive to investor psychology and the technical factors that influence the supply and demand for assets. In fact, I think confidence matters more than anything else in the short run. Anything can happen in this regard, with results that are both unpredictable and irrational.

Source:  “The Most Important Thing”, Howard  Marks, 2011


Banks Need Higher Interest Rates to Start Making Money

It is a public secret that Fed’s attempt to sustain interbanking lending during the last financial crisis has led to ginormous increase to gynormous increase in banks’  excess reserves (the a part of capital above the minimum required reserves that it is not loaned). At the beginning of 2007, the excess reserves in the U.S. financial system were $1.5 billion. Today, they stay at $1.5 trillion – a 1000-fold increase in 4 years.

Banks have three major options to allocate those excess reserves:

– keep them and continue to receive money from the FED. Yes, they are getting paid for money they initially received from the FED and they are getting paid well: 0.25% compared to 0.21% for 2yr treasury notes and 0.03% for 3-month notes;

– buy short-term U.S. Treasuries and earn interest, which at this point is close to zero;

– lend it to the private sector at higher interest rates.

In normal circumstances, all banks would choose option number three, because it is the most lucrative for them. The thing is that the circumstances are not normal and there simply isn’t demand for this money at this point of time, so banks keep hoarding and earning the little percentage that the Fed and Treasuries pay them.

The exorbinant amount of excess reserves has many people worried that once demand for leverage from the private sector picks up, the final result will be accelerating inflation that the Fed won’t be able to stop. It turns out that one of Fed’s plans to fight this potential development is through raising the interest it pays for excess reserves in order to discourage banks from further lending. I am curious to see how this will work out.

Anyway, it looks like that the shortest way to rising profits for the banks is rising inflation expectations, which should encourage loan demand. Maybe this is one of the explanations behind the recent appreciation in U.S banks’ stocks. It is not only a result of short squeeze and “January effect”.

Todd Keister and James McAndrew from the NY Fed explain in details how everything works. I encourage you to read their paper from the summer of 2009 in its entirety in order to get better understanding of the mechanism of the U.S financial systems and the potential consequences for the future.

When the economy begins to recover, firms will have more profitable opportunities to invest, increasing their demands for bank loans. Consequently, banks will be presented with more lending opportunities that are profitable at the current level of interest rates. As banks lend more, new deposits will be created and the general level of economic activity will increase. Left unchecked, this growth in lending and economic activity may generate inflationary pressures. Under a traditional operating framework, where no interest is paid on reserves, the central bank must remove nearly all of the excess reserves from the banking system in order to arrest this process. Only by removing these excess reserves can the central bank limit banks’ willingness to lend to firms and households and cause short-term interest rates to rise.

Paying interest on reserves breaks this link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves.

This logic applies equally well when financial conditions are normal. A central bank may choose to maintain a high level of reserve balances in normal times because doing so offers some important advantages, particularly regarding the operation of the payments system. For example, when banks hold more reserves they tend to rely less on daylight credit from the central bank for payments purposes. They also tend to send payments earlier in the day, on average, which reduces the likelihood of a significant operational disruption or of gridlock in the payments system. To capture these benefits, a central bank may choose to create a high level of reserves as a part of its normal operations, again using the interest rate it pays on reserves to influence market interest rates.

Source: NY Fed

Five Indicators to Gauge Risk Appetite

Capital constantly moves from one sector to another, from one asset class to another. While your major attention should be focused on price action of the assets you own or trade, the ratios below help to look below the obvious surface and gauge the underlying market themes. You can tell a lot about capital markets’ confidence  and direction of money flow.

1) Small cap ($IWM) vs Large Cap($SPY)

Small caps are more volatile as they are easier to move. They tend to outperform in periods of rising confidence and drastically underperform during corrections, when the bids for them simply disappear.

2) Emerging Markets ($EEM) vs $SPY

Emerging markets are synonymous to higher growth and higher yield. When the the fear of missing out is bigger than the fear of losing, emerging markets tend to outperform.

3) Consumer Discretionary ($XLY) vs Staples($XLP)

When the stock market is in a process of discounting potential economic slowdown, staples tend to outperform as money chases recession-proof, dividend paying companies like tobacco and healthcare, for example. Consumer discretionary stocks are cyclical plays and tend to outperform during periods of increased optimism.

4) Basic Materials ($XLB) vs Utilites ($XLU)

The ultimate leading indicator of rising inflation is price action in commodities. Highly leveraged, high dividend paying utilites tend to outperform in period of pessimism and deflationary expectations, and severely underperform during “risk-on” market periods.

5) $SPY vs Long-term Treasuries ($TLT)

When the return of principle is more important that the return on investment, U.S. Treasuries are considered the ultimate safe haven and capital flows to perceived security. When money is chasing return and market mood is improving, capital tends to favor equities.

For example, curently the 5-year U.S. Treasury note yields less than 1%, the 30-year treasuries yield 3.15%. No hedge fund  could justify its fees or pension fund reach its annual target by investing in these vehicles. Once the fear of losing principle subsides and inflation expectations kick in, equities tend to outperform.

How Cheap is Apple?

Apple, the stock and the company, is everything but not typical

Most momentum stocks go through 3 main stages:

1) Earnings growth leads price growth. There is sudden acceleration in earnings growth that starts a process of repricing, but most investors are still cautious with the new name. They either don’t trust the sustainability of the story yet or haven’t heard about it. This period could continue anywhere from 6 months to 2 years. (think in terms of Hansen Natural in 2004 – 2005)

2) Price growth leads Earnings growth. At this stage the stock and its story are widely known and understood. The market projects the current levels of growth into infinity and it proactively discounts the best case scenario. This stage typically continues anywhere from 6  to 18 months. (think in terms of $MNST in 2006 – 2007 or $NFLX mid 2010 to mid 2011)

3) Either price growth and earnings growth start to go hand in hand or price growth drops below earnings growth ( as it is often the situation with ex- momentum leaders)

As you can see from the chart above, $AAPL is not following this pattern. While its market cap has increased 46 times for the past 10 years, its earnings per share growth has been even more impressive – 130 times. The EPS growth was offset by a 60% decline in the P/E multiple that the market is willing to pay. P/E often reflects investors’ expectations for near-term growth. As Nicholas Darvas liked to point out:

It is the anticipation of growth rather than the growth itself that leads to great profits in growth stocks. The biggest factor in stock prices is the lure of future earnings. The dream of the future is what excites people, not the reality

Walmart’s shareholders have experienced that personally. Over the past 10 years, $WMT’s EPS have more than doubled, while the market cap of the giant retailer fell 21%

The law of big numbers’ effect is commonly known and it is already discounted

For more than three years, investors have been pointing out that the gigantic size of Apple will limit the pace of its growth. Apple has proved them wrong, but Apple has been an exception. Historically, size has been an enemy of fast growth. Eventually, the naysayers will be right, but this might not matter.

Everyone and his grandmother has heard of this thesis and it is already discounted by the market in some form. How else would you explain the fact that $AAPL is trading at 15 times P/E while it is growing its earnings at 50%. The market clearly anticipates slowdown in earnings and if there is a surprise, it is likely to be on the upside.

Should Apple Pay Dividends – Not Today

There have been many discussions lately about the money hoarding by the big U.S. tech companies. The common denominator is that $AAPL  and $GOOG should start paying dividends. At this point, this suggestion is ill-advised and doesn’t make any sense.

Apple’s current ROE is 41%, which means that it makes 41 cents for every $1 of its capital. Logic says that if Apple’s shareholders cannot find an investment with higher than 41% return, they should not want to get paid dividends. Apple is still using their capital wisely.

Expectations Going Forward

Over the past few quarters, it has become a tradition  for $AAPL to appreciate in front of its earnings report, reflecting general expectations for positive surprise. The price action after the report hasn’t been that inspiring as “buy the rumor, sell the news” effect has dominated. I don’t expect this quarter to be any different, but anything is possible.

Disclosure: At this point of time, I don’t have a position in $AAPL

Embrace the Uncertainty

There are two types of forecasts – lucky and wrong.

Acting like you know everything is more dangerous than accepting your limitations.

Macro forecasting is not critical for investment success.

The only constants in capital markets are change and uncertainty

Being on the crossroad between the risk of losing money and the risk of losing opportunities

These are some of the tidbits from Howard Marks’s latest investors letter, which is among my favorite reads. There is always something insightful to learn.

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