Business goes from pretty good to not so hot, but investors go from flawless to hopeless
Investor Howard Marks argues that prices move far more than company values, because tolerance for risk soars and collapses.
Oaktree Capital · Cockroaches in the Coal MineHoward Marks, an investor who has spent 47 years in the market for risky, low-rated bonds known as high yield bonds, was watching investors react to a cluster of bankruptcies and fraud allegations in riskier lending.
After disclosures from regional banks and news that two small telecom firms had borrowed against invoices that were made up, the shares of several large firms that lend money outside the banking system fell 5 to 7% in a single day. To Marks, the reaction was outsized because defaults are routine in this corner of finance. He notes that, by value, more than 2% of these bonds default in a typical year, and he says applying that share to thousands of issuers works out to dozens of failures when times are ordinary.
What interests him is how quickly mood changes. “In real life, things fluctuate between pretty good and not so hot,” Marks says. “But in investors’ minds, they go from flawless to hopeless.”
Marks says the chapter he had not planned to write for his book on market cycles, which he titled “the cycle in attitudes toward risk,” “became the most important chapter in the book and one of the longest.” His point is that security prices move far more than the businesses themselves are actually worth, mainly because feelings about risk are so volatile.
In good times, when the economy is humming and profits are piling up, Marks says investors tell themselves, “Risk is my friend,” and, “The more risk I take, the more money I make.” Ambiguous news is read as positive, bad news is brushed aside, and the fear of missing out and falling behind rivals takes over. Investors check borrowers less carefully and compete harder to win deals, and lending standards slip.
Then the economy softens, profits slip, and losses appear. Now, he says, the refrain becomes “bearing risk is just a way to lose money,” and investors want out at any price. Negatives are exaggerated, positives are ignored, and caution replaces tolerance, so standards for lending rise.
For Marks, that swing in feeling is why prices swing so much more than business values themselves.
Questions people ask
Do riskier bonds really default that often in normal times?
Yes. In U.S. high yield bonds, annual defaults have historically averaged a few percent in nonrecession years, with higher losses in recessions. That regular risk of loss is why investors demand extra yield over safer government bonds. Owning many different bonds is meant to absorb those expected losses.
Why do prices swing more than the businesses themselves?
Prices reflect both expected earnings and how much investors will pay for each dollar of those earnings, and that willingness shifts with interest rates and mood. When fear rises, investors demand a bigger cushion for taking risk, so valuations can fall even if earnings have barely changed. Economists sometimes call the extra movement excess volatility, explained in part by crowd behavior, meaning people copy each other, and loss aversion, meaning losses feel worse than equal gains feel good.