Howard Marks Memo Breakdown: "The Limits to Negativism"

The Limits to Negativism

This memo was written in October of 2008, about a month after Lehman Brothers’ bankruptcy. It starts with Marks detailing the panic in the markets he had observed for the past few weeks. The panic, Marks says, was the greatest he has ever seen.

Self-Perpetuating Pessimism

The first important detail is that during this panic, most of the large declines in asset prices were not associated with true “weakness in the depreciating assets or the companies behind them,” but rather with a self-perpetuating pessimistic attitude that no potential outcome was too negative and that any optimism was disregarded. While nothing is impossible in financial markets, especially during the financial crisis, there are two factors to consider when predicting the future: what might happen and the probability that it does.

Because of the pessimistic attitude that prevailed during the crisis, people thought many bad things could happen. But just because something could happen doesn’t mean that it will. When pessimism prevailed as it did during the crisis, investors failed to understand that. For investors, especially during a crisis, it is impossible to know exactly what the future holds. However, it is possible to decide which outcome is more likely to be profitable or less likely to be wrong.

In 2008, Marks had 40 years of experience with the cycles of emotions investors have. Following the majority of the investors at each point in those cycles, i.e. following the herd, will only give you average performance and heavy losses at the extremes. An important distinction Marks highlights is that of the prevailing attitudes in 2008 and in 2005-2007. In 2005-2007, investors were optimistic and took large amounts of risk, as the previous memo explained. There was no scenario that was too optimistic. Compared to 2008, the attitude was the exact opposite: there was no scenario that was too negative. The optimistic attitude in 2005-2007 was one that didn’t encourage skeptics who believed the conventional wisdom was wrong to present their case. If they were encouraged, then perhaps the crisis wouldn’t have been as destructive.

The Importance of Skepticism

The importance of skepticism ties into The Black Swan, a book whose main message is that extremely unlikely and unpredictable events still can occur. An event that everyone believes has a 0% chance of occurring can actually occur. That ties into how crucial skepticism, which Marks says is one of “the most important requirements for successful investing” and which he defines as “not believing what you’re told or what ‘everyone’ considers true.”

If an investor isn’t skeptical, then they’ll conform to the herd of investors. This is the same herd that is buying high, selling low, losing at extremes, and missing out when markets recover.

Being skeptical means looking at the inner workings of a company to see if it is truly performing how people say it is. A skeptical investor will separate “the things that sound good and are from the things that sound good and aren’t.”

In other words, a skeptical investor will be able to correctly judge the claim that something is good. Therefore, they can find opportunities to truly grow their money.

Skepticism was ineffective in the euphoria of the pre-crisis years. That euphoria called for pessimism, but that pessimism was dismissed immediately. But that doesn’t mean that skepticism is the same as pessimism, as Marks emphasizes. In the extreme optimism that encouraged investors to use more and more leverage in the years prior to the crisis, skepticism would have introduced pessimism. After the crisis, with extreme pessimism and negativity that encourages a downward spiral of asset prices, skepticism would introduce optimism. So, as Marks simply summarizes, “skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.”

Contrarianism

Skepticism ties into contrarianism, or doing the opposite of what others do. Marks is one of the most well-known contrarian investors and says contrarianism is “essential for investment success.”

During the crisis, pessimism prevailed and caused a self-sustaining downward spiral in prices, and that cheapened asset prices. That should lead to more buying as prices were attractive and cheap, but because people thought conditions were going to deteriorate further, buying at the cheap prices didn’t happen and prices kept falling. Very few people were skeptical, and even fewer thought to buy assets now that their prices were so low.

Being skeptical of the conventional belief could have led to profits. Marks walks us through a potential skeptical way of thinking that could have led to buying depressed assets. In summary, if the negative event did come to pass, the price would change little. This is because the market has already priced in negative events. Therefore, an investor wouldn’t gain or lose that much money. But, if the negative event did not come to pass, then the asset it affects would increase dramatically in price from its current depressed price. It’s the positive outcome that held the potential for greater returns in an environment where negativity ruled.

Predictions

Breaking from his usual subjects of discussion, Marks discusses his short-term and long-term future outlook. For his short-term prediction, Marks thinks that “governments and central banks will do everything they can to resolve the credit crisis.”

This was spot-on, as the government did get involved by bailing out the big banks. The government was throwing around hundreds of billions, adding up to trillions, in order to solve the crisis. They indicated that they would do anything to rejuvenate the world economy. He cites Walter Wriston, who led Citibank from 1967 to 1984, who said that “countries don’t go bust,” referring to a government’s ability to print their own currency.

Short-Term Outlook

So, printing the money needed to jumpstart the world economy wasn’t going to be a problem. So in the short term, Marks believes the governments of the world will provide the money to get the global economy back on its feet, no matter how the amount it needs to print. But printing enough money isn’t the end of the solution. Liquidity and credit also need to be encouraged in the economy. Banks can get the money cheaply to loan out. But, if people don’t repay loans, then it’s back to square one because banks lose their money. The money will have to circulate through the economy, not just be printed and given to financial institutions.

Money of the Mind

Liquidity and credit, as Jim Grant describes, can be categorized as “money of the mind” because it increases and decreases based on people’s attitudes. The more willing people are willing to trade and take out loans, the more liquidity and credit increases, so those liquidity and credit are constantly changing based. There needs to be a reason for financial institutions to provide liquidity and credit for money the Fed gives them. The Fed also has seen an increase in deposits from banks. But, in order to get credit flowing again in the economy, the Fed needs to reloan those deposits to banks in order for more money to be loaned by those banks.

Even with all-out efforts by the government to revive the economy, Marks doubts that “things will return immediately to their old pace” because of the immense financial losses and damaged confidence among investors, lenders, and consumers. The same kind of expansive growth that was present before the crisis won’t be present in the recovery.

Long-Term Outlook

In the longer-term, Marks wonders about the effects that all the newly printed money will have globally. The immediate consequence that of the glut of newly printed money is higher inflation and lower purchasing power. Marks uses the Weimar Republic, which was Germany’s government from 1918 to 1933 that is known for its hyperinflation of its currency, as an example of what could happen if governments cheapen their money too much, reducing its purchasing power drastically, causing hyperinflation. While Marks doesn’t know if hyperinflation will happen or not, he doesn’t give it a big enough chance of happening. But, he acknowledges that it may cause investors to rethink investing in low-yielding investments. Additionally, Marks knows that the government isn’t a cure-all. A few actions from it won’t solve all the problems the crisis created.

Government’s Role

In the aftermath of the crisis, questions were asked about the role the government should have in controlling the economy. Marks was asked what his thoughts on government ownership on banks was, or, more broadly, what his thoughts on the way the government should interact with the economy. While in the short-term, government ownership may be good, Marks’s long-term preference is for free enterprise with some government supervision.

Marks questions what a new financial order with government ownership the banks would look like. The underlying question he asks is “if the government’s equity is non-voting, will that be enough to keep it out of the banks’ affairs?” which refers to the extent the government has influence in the bank. The question could be reworded as follows: if the government simply owns the banks, how far will their influence extend to how the bank operates? According to Marks, it’s too soon to say anything about that.

Marks believes that the financial sector will be “less leveraged, less risk-prone, less profitable, slower growing and more regulated” in the future which makes it “less exciting” and “less glamorous”. He was quite accurate with that statement, as the sector has become more regulated with Dodd-Frank and other legislation, and bank profits today aren’t as high as they were before the crisis. Significantly less leverage is used now as well. Marks believes that in a free-market system, “success carries within itself the seeds of failure” and “so does failure carry the seeds of success.”

If banks are going to become more risk-averse, then they won’t make as many loans. That allows new firms to enter the market to fill in the hole the banks are leaving. They end up serving the people the banks can no longer afford to serve.

Conclusion

Marks ends with the quote about prudence by Warren Buffett, but with a somewhat different meaning this time. When other people are excessively negative in their outlook, it’s time to think positively. When investors are saying conditions are going to keep getting worse, it’s time to think about the positive outcomes because those have greater profit potential. The flip side is also true. When investors are saying conditions are going to keep getting better, it’s time to think about the negative outcomes. When in the deep throes of a bear market, when more negative thinking is present and positive outlooks are lacking, the “greater long-term risk probably lies in not investing.”

Marks was, again, spot-on in this as the market indeed rebounded from the crisis. Marks’s ability to think positively when pessimism permeated the world earned him great returns.