Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

The prevalence of risk-tolerance (or risk-obliviousness) in the late 1990s was clear. I personally heard a prominent brokerage house strategist say, “Stocks are overpriced, but not enough to keep them from being a buy.” And we all heard the man on the street say, “I’m up so much in my 401(k), it wouldn’t bother me if it fell by a third.” (Where was that guy two or three years later?) No, those risk-tolerant attitudes will not persist forever. Eventually, something will intrude, exposing securities’ imperfections and too-high prices. Prices will decline. Investors will like them less at $60 than they did at $100. Fear of losing the remaining $60 will overtake the urge to make back the lost $40. Risk aversion eventually will reassert itself (and usually go to excess). How about some quantification of this cycle? In mid-1998, just before the collapse of Long-Term Capital Management brought investors other than techies to their senses, only $12.5 billion of non-defaulted bonds yielded more than 20% (one possible threshold for the label “distressed debt”). Because investors weren’t very worried about risk, they demanded ultra-high returns from relatively few non-defaulted bonds; the word “blithe” might best describe their attitude. But Long-Term’s demise awakened investors to the existence of risk, and a year later, the amount of bonds yielding more than 20% had more than tripled to $38.7 billion. By mid-2002, when the corporate scandals held the debt market in a grip of terror...