Memo to: Oaktree Clients

From: Howard Marks

Re: Ruminating on Asset Allocation

When I travel to see clients and spend entire days discussing investing and the markets, memo ideas often
pop up. Last month’s visit with clients in Australia is a case in point. We talked about the “sea change” I
believe is taking place in interest rates and about the role of credit in portfolios, and in a few cases, this
led to the general topic of asset allocation. The result wasn’t a lot of new ideas on the subject, but rather a
new way to combine old ideas into a unified theory.

Before I proceed, I want to mention that, from time to time in this memo, I’llll say “generally,”
“generally, “usually,”
or “everything else being equal.” These caveats are likely applicable to many more sentences and ideas
herein, but for the sake of readability, I’m not going to repeat them ad nauseum
nauseum. In addition, I’m going to
use a lot of graphics, as I truly believe one picture is worth a thousand words. Please bear in mind that
these representations are intended to be notional, not technically correct.

Asset Classes

From my vantage point, “asset allocation” is a relatively new thing. No one used that phrase when I
joined the industry 55 years ago. Structuring portfolios was a pretty simple matter, generally following
the classic “60/40” split. Most U.S. investors limited themselves to investing in U.S. stocks and bonds,
and there was a time-honored
honored notion that something like 60% equities and 40% bonds represented
reasonable diversification.

Today,
oday, investors are presented with so many choices – and there’s so much emphasis on getting the
decision right – that the term “asset
asset allocation
allocation” is very prominent, and there are individuals and whole
departments dedicated to doing just that. ItIt’s their job to decide how to weight the asset classes to be held
in a portfolio, meaning asset allocators spend their time on decisions like these:

How
ow much in equities and how much in debt?
How much in stocks and bonds and how much in “alternatives”?
How much in public securities and how much in private assets?
How much in one’s home country and how much abroad?
How much of the latter in the developed world and how much in emerging markets?
How much in high quality assets and how much in low quality?
How much in more volatile “high beta” assets and how much in steadier ones?
How much in levered strategies and how much unlevered?
How much in “real assets”?
How much in derivatives?

It’s enough to make your head spin. Many investors use computer models to help with these decisions,
but the models require inputs regarding expected return, risk, and correlation, and most of these are based
on history and thus of questionable relevance to the future. Correlation between asset classes is
particularly difficult to predict. It’s often a case of garbage in, garbage out (but with the added comfort
that comes from using mathematical models).

© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Ever since coming up with my sea change thesis regarding interest rates two years ago, I’ve been talking
about the increased utility of credit investments. And the more I’ve done so, the more I’ve thought about
the difference between credit investments and equities. Thus, the first thing I want to mention about
my “Australian epiphany” is the unconventional idea that, at bottom, there are only two asset
classes: ownership and debt. If someone wants to participate financially in a business, the essential
choice is between (a) owning part of it and (b) making a loan to it.

When I moved from Citibank’s equity research department to its bond department in 1978, I learned
firsthand that this is a matter of night and day. On my new desk, I found a machine called a Monroe
360/65 Bond Trader. If you typed in a bond’s interest rate, maturity date, and market price, it would tell
you the yield to maturity . . . in other words, what your return would be if you bought the bond at that
price and held it to maturity (and it paid). This was revolutionary to me. On the equity side I’d come
from, there was no place you could look to find out what your return would be.

This highlighted for me something I’ve always felt most investors don’t grasp viscerally
viscerally: the essential
difference between stocks and bonds . . . that is, between ownership and lending. Investors seem to think
of stocks and bonds as two things that fall under the same heading. But the difference is enormous. In
fact, ownership and lending have nothing in common:

Owners put their money at risk with no promise of a return. They acquire a piece of a business or
other asset and are entitled to their proportional share of any residual that remains after the
necessary payments have been made to employees, providers of raw materials, landlords, tax
authorities, and, of course, lenders. If there’ss something left over, it’s
it called profit or cash flow,
and the owners have the right to sharee in whatever part of it is paid out. And if there
there’s profit or
cash flow (or the potential
ential for it in the future), the business will have “enterprise value,” in which
the owners also share.
Lenders typically provide funds to help owners purchase or operate businesses or other assets
and, in exchange, are promised periodic interest and the repayment of principal at the end. The
relationship between borrower and lender is contractual, and the resulting return is known in
advance as described above, again assuming the borrower makes the promised payments when
due. That’ss why this kind of investing is called “fixed income” – the income is fixed. For the
purposes of this memo, however, iit might help to think of it as “fixed outcome” investing.

This isn’tt a difference in degree; it

it’s a difference in kind. Ownership assets (things like common
stocks, whole companies, real estate, private equity, and real assets) and debt (bonds, loans, mortgage
backed securities, and other streams of promised payments) should be thought of as entirely different, not
variations
ions on a theme. They have different characteristics and potential, and the choice between them is
one of the most basic things investors must decide.

The Essential Choice

At the outset of this memo, I listed some of the decisions that comprise the asset allocation process. But
how can those decisions be approached? What’s the framework for making them?

The next piece that clicked into place in my thinking “down under” was with regard to the basic
characteristics of a portfolio. In my opinion, one decision matters more than – and should set the
basis for – all the other decisions in the portfolio management process. It’s the selection of a
targeted “risk posture,” or the desired balance between aggressiveness and defensiveness. The
essential decision in investing is how much emphasis one should put on preserving capital and how much
on growing it. These two things are mostly mutually exclusive:

2
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Insistence on preserving capital – or, secondarily, on limiting the portfolio’s volatility – calls for
an emphasis on defense, which precludes pursuing maximum growth.
Correspondingly, a decision to strive to maximize growth requires an emphasis on offense,
meaning preservation of capital and steadiness must be sacrificed to some degree.

It’s one or the other. You can’t simultaneously emphasize both preservation of capital and
maximization of growth, or defense and offense. This is the fundamental, inescapable truth in
investing. The questions listed on page one are just details, the options available for reaching your
targeted risk posture.

If you think about portfolio construction in this sense – looking for the right balance between offense and
defense – it becomes clear that the goal should be optimization, not maximization. To my mind, it
shouldn’t be “wealth,” but “wealth pursued in an appropriate way, taking into account the investor’s
wants and needs.”

Many people think the proper goal in investing is achieving the highest return.
return. More sophisticated
thinkers understand – either intellectually or intuitively – that the goal should be to achieve the best
relationship between return and risk.. If you follow that latter mandate, it it’ll hopefully lead you to
it’
assets whose expected return is more than sufficient to compensate for their risk, and thus to a portfolio
with the potential for an attractive risk-adjusted return. But that’s
’s not enough.

The absolute level of risk in a portfolio shouldn’tt be an unwitting consequence of the asset
allocation process described above, or of the search for superior risk
risk-adjusted returns. The
absolute risk level must be consciously targeted. In fact, in my vie
view, it’s the most important thing.
For an investment program to be successful, the level of risk in the portfolio must be well
compensated and fall within the desired range . . . neither too much nor too little.
little

The Shape of the Curves

In the last few months, I’ve

ve been drawing probability distributions to illustrate the fundamental difference
between the potential returns from ownership assets and debt (or “fixed income,” “credit,” or whatever
you want to call it). Here’ss the general shape of the curve describing the potential return on a portfolio of
ownership assets (Figure 1):

And following on page four is the shape of the curve describing the potential return on a portfolio of debt
(Figure 2):

3
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Ownership assets typically have a higher expected return, greater upside potential, and greater
downside risk. Everything else being equal, the expected returns from debt are lower but likely to
fall within a much tighter range. There’s generally no upside on debt – no one should buy an 8% bond
expecting to make more than 8% per year over the long term. But there’ss also relatively little downside –
you’ll
ll get your 8% if the borrower pays, and relatively few fail to pay. For this reason, offense is usual
usually
better played through ownership assets, and defense is usually better played through debt. (I hasten to
add that investing isn’tt a matter of either/or. The two can be combined, meaning the operative question
surrounds the right mix.)

In the low-interest-rate
rate environment that prevailed from 2009 through 2021, the expected return from
debt was extremely low in the absolute and far below the historical return on equities, rendering debt
relatively unattractive (Figure 3).

But today, it’ss considerably higher than it was and closer to that of equities (Figure 4). That
That’s why I’ve
been urging increased investment in credit.

Obviously, the relationship between the two curves at a point in time has a very direct bearing on the
appropriate asset allocation at that time.

4
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Which of the two is “better,” ownership or debt? We can’t say. In a market with any degree of
efficiency – that is, rationality – it’s just a tradeoff. A higher expected return with further upside
potential, at the cost of greater uncertainty, volatility, and downside risk? Or a more dependable
but lower expected return, entailing less upside and less downside? The choice between the two is
subjective, largely a function of the investor’s circumstances and attitude toward bearing risk. That
means the answer will be different for different investors.

Choosing the Offense/Defense Balance

I’ve previously expressed my view that, as a starting point, every investor or their investment manager
should identify their appropriate normal risk posture or offense/defense balance. For each individual or
institution, this decision should be informed by the investor’s investment horizon, financial condition,
income, needs, aspirations, responsibilities, and, crucially, intestinal fortitude, or their ability to stomach
ups and downs.

Once investors have specified the normal risk posture that’ss right for them, they face a choice: they can
maintain that posture all the time, or they can opt to depart from it on occasion in response to the
movements of the market and thus changes in the attractiveness
ttractiveness of the offerings it provides, increasing
their emphasis on offense when the market is beaten down and on defense when it it’s riding high.

Regardless of whether one’ss risk posture is fixed or variable, however, the next question is how one gets
there. This question led me to think about another old idea: the relationship between risk and return. II’ve
described a million times the way this was taught at the University of Chicago, beginning when I was
there in the 1960s. It’ss a graphical presentation we’ve all seen ever since, in which, as we move from left
to right, increasing the expected risk, the expected return also increases (Figure 5):

As readers know, I always felt this representation was highly inadequate, since the linearity of the
relationship in the graph makes it appear too certain that increased risk will lead to increased
return. This obviously belies the nature of risk. So, in a memo in 2006, I took the same line and
superimposed on it some bell-shaped curves representing probability distributions turned on their side. I
did this to indicate the uncertain nature of returns from riskier assets (Figure 6):

5
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Now, we see that as the thing called “risk” increases (that is, as we move from left to right on the
graph), not only does the expected return increase, but the range of possible outcomes becomes
wider and the bad outcomes become worse. That’ss risk! (I hope this way of presenting risk will be
considered a lasting contribution to the investment industry when I’m gone.)

Doodling one day, I took the black and green curves describing ownership asset returns and debt returns
from Figure 4 and added some intermediate positions in blue and red to indicate various combinations of
the two. Thus, the blue curve is 2/3 debt and 1/3
/3 ownership, and the red is 1/3 debt and 2/3 ownership
(Figure 7):

In Australia, as I was showing this diagram, it struck me that Figure 7 is just another way to represent the
idea presented in Figure 6. Again, as we move from left to right (more ownership assets, less debt), the
expected return increases and the expecte
expected risk increases (that is, just as in Figure 6, the range of possible
outcomes grows wider and the left
left-hand tail stretches further into undesirable territory). This way of
presenting the options might be more intuitively clear.

Someone who believes in “more risk, more return” as portrayed in Figure 5 should logically adopt a high-
risk posture. But if they understand the real implications of increased risk, as suggested by Figures 6 and
7, then they might opt for something more moderate.

The Role of Alpha and Beta

All the foregoing assumes markets are efficient:

As risk increases in an efficient market, expected return increases proportionally. Or maybe that’s
better stated the other way around: as expected return increases, so does the accompanying risk
(the uncertainty surrounding the outcome and the likelihood of a bad one). Thus, no position on
the risk continuum (for example, in Figure 6) is “better” than any other. It’s all just a matter of
where you want to come out in terms of absolute riskiness, or what absolute level of return you

6
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 want to aim for. The ratio of return to risk is similar at all points on the continuum – less of
both toward the left, and more of both toward the right. Said another way, there’s no free lunch.
Also, looking at each position on the risk continuum, the symmetricalness of the vertical
distribution of possible returns around the expected return is similar from one position to
the next. That means the ratio of upside potential to downside risk at one position on the
continuum isn’t markedly better than it is at other positions – again no free lunch.
Finally, if you want to move further out on the risk continuum, you can do so by either (a)
investing in riskier assets or (b) applying leverage to the same assets (magnifying both the
expected return and risk). Again, in a fully efficient market, neither tactic is preferable to the
other.

The above three statements capture some of the important implications of supposed market efficiency.

Looked at this way, the only thing that matters is getting to the right risk position for you
you; under an
assumption of market efficiency, there’ss nothing to be gained in terms of return at a given level of
risk. All ways of getting to a certain risk level will produce the same expected return.

The reason for this is the academic view that, in an efficient market, (a) all assets are priced fairly relative
to each other, such that there are no bargains or over-pricings
pricings to take advantage of and (b) there’s
there no such
thing as alpha, which I define as “gains
gains resulting from superior individual skill.”
skill. As a result, there’s
nothing to be gained from active decision making: no asset class, strategy, security or manager is
“better” than any other. They merely vary in terms of risk and resulting return.

Also in the academic view, since there’ss no such thing as alpha, the only thing that differentiates assets is
their beta, or their relative volatility, the extent to which they reflect market movements. In the theory, it
it’s
beta that expected returns are proportional to.

Now it’ss time for me to assert strenuously that, in reality, markets are not efficient in the academic
sense of always being “right.” Markets may do an efficient job of (a) rapidly incorporating new
information and (b) accurately reflecting the resulting consensus opinion concerning the right price for
each asset given the totality of information, but that opinion can be far from correct. For that reason,
gains can be achieved by choosing skillfully among the options:

some assets, markets or strategies can offer a better risk/return bargain than others, and
some managers can operate within a market or strategy to produce superior risk-adjusted
risk returns.

This last idea raises one of the key questions in asset allocation: should you consider departing from your
“sweet spot” in terms of risk level in order to invest in a riskier asset class with a manager believed to
possess alpha? There’s no easy answer to this question, especially given that many managers who are
believed to possess alpha turn out not to.

To conclude, I’ll recap the key points:

Fundamentally speaking, the only asset classes are ownership and debt.
They differ enormously in terms of their fundamental nature.
Ownership assets and debt assets should be combined to get your portfolio to the position on the
risk/return continuum that’s right for you. This is the most important decision in portfolio
management or asset allocation.
The other decisions are merely a matter of implementation.

7
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Of course, your asset allocation process will be informed by how you rate your ability to identify
and access superior strategies and superior managers, recognizing that doing so isn’t easy.

* * *

Moving on to the real world, I want to make some important observations regarding one of Oaktree’s key
sectors, non-investment grade credit (defined as performing non-government debt):

The prospective returns in this area today are much higher than they were in the 2009-21 period.
These returns, starting at roughly 7% on public credit and 10% on private credit, are competitive
with the historical returns on equities and capable of helping many investors toward their overall
return targets.
Because of their contractual nature, the returns from credit are likely to prove much more
dependable than ownership returns.

In my view, the thought process set forth in this memo leads to the conclusion that investors
should increase their allocations in this area if they are (a) attracted by returns of 7-10% or so, (b)
desirous of limiting uncertainty and volatility, and (c) willing to forgo upside potential beyond today’s
yields to do so. For me, that should include a lot of investors, even if not everyone.

My recommendation at this time is that investors do the research required to increase their allocation to
credit, establish a “program” for doing so, and take a partial step to implement it. While today
today’s potential
returns are attractive in the absolute, higher returns were available on credit a year or two ago, and we
could see them again if markets come to be less ruled by optimism. I believe there will be such a time.

Thank you for indulging me in this foray into investment philosophy. I hope you
you’ve found it of value.

October 22, 2024

8
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

9
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Shall We Repeal the Laws of Economics?

For months, I’ve been saving up clippings for a memo on the above topic, but favorite subjects such as
risk, debt, and uncertainty repeatedly jumped the queue, delaying my intended memo until the U.S.
election season got into full swing, making it compelling.

Like me, you’ve undoubtedly noticed that politicians ranging from former President Trump and Vice
President Harris to down-ballot
ballot candidates are back to making promises that ignore economic reality.
Trump’s call for tariffs and Harris’s attack on grocery profiteering are merely two examples of proposals
that would impose costs the candidate ignores (in Trump’ss case) or that fail to reflect a meaningful
understanding of the problem (in Harris’ss case). My purpose, of course, is not to promote or dismiss
either candidate, but rather to illustrate that there is no “free lunch” in economics, despite candidates
candidates’
assertions to the contrary.

The Background

Inn 2016, with an unusually clamorous presidential election in full swing, I published two memos that
strayed from investing into the world at large, called Economic Reality and Political Reality. The first
explained that economics is largely the study of how we make choices – how people allocate finite
resources among the available options. The second stated that in politics – and especially in the land of
campaign promises – there’s no such thing
ing as finiteness. As I wrote in Political Reality:

I’ve
ve always gotten a kick out of oxymorons – phrases that are internally contradictory –
such as “jumbo shrimp”” and ““common
common sense.”
sense. I’ll add “political reality” to the list. The
world of politics has its own, altered reality, in which economic reality of
often seems not to
impinge. No choices need be made: candidates can promise it all. And there are no
consequences. If something might have negative consequences in the real world,
politicians seem to feel free to ignore them.

I followed those two memos with one in 2019 entitled Political Reality Meets Economic Reality. Its
main thrust was that politicians can promise whatever they want regarding the economy, but they
won’t be able to deliver if their promises fly in the face of economic reality because, ultimately, the
laws of economics are incontrovertible. Free economies are driven by self-interested decisions made
by millions of producers and consumers, employers and employees, and savers and investors.
Governments can pass laws designed to encourage or even compel behavior, but in general they
can’t mandate economic outcomes. There are so many moving pieces and second-order
consequences that governments generally can’t engineer both prosperity and the specific economic
outcomes that policymakers may seek.

History is littered with command economies that didn’t succeed. There’s proof for this that includes the
“control group” required by the scientific method. Eighty years ago, Korea was a single country. Then,
following World War II, it was split in two, obviously with similar people, geography and resources:
South Korea (under U.S. influence), and North Korea (under Soviet influence). Since then, South Korea
has operated as a capitalist democracy and North Korea as a communist dictatorship. There’s little

© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
reliable economic data regarding North Korea, but according to the CIA’s Worldbook, its GDP in
purchasing power terms is estimated at $2,000 per person versus $50,000 in South Korea. North Korea’s
citizens are described as impoverished, but at least it doesn’t have a border problem, since nobody’s
trying to sneak in. There are political differences (democracy versus dictatorship) in addition to the
economic ones, but I think it’s fair to say capitalism has won.

In discussions of economic systems, I usually ask people what they think has been responsible for the
economic preeminence the U.S. has enjoyed since the end of World War I, and thus for its citizens’ higher
average standard of living. Are Americans smarter? Harder working? More deserving? None of the
above. I’m confident it’s because of our historical embrace of the free-market system and capitalism.

The incentives provided by free markets efficiently direct capital and other resources where they’ll
be most productive. They prompt producers to make the goods people want most and workers to
take the jobs where they’ll be most productive in terms of the value of their output. And they
encourage hard work and risk taking. The result is a higher standard of living for society in general,
but certainly not everyone benefits to the same degree. Thanks to the way incentives interact with
people’s different abilities, some people do considerably better than others. Some also prosper thanks to
good luck and/or inherited advantage, rather than innate ability. The free-
free-market
free -market system doesn
doesn’t
necessarily produce “fair” outcomes in all circumstances, but economic systems designed to do so
generally don’tt provide the incentives needed to encourage economic productivity for the collective
good. That’s what accounts for their record of failure.

On August 15, the media reported that the next day, Vice President Harris would announce her economic
policies. The bulk of the attention went to her promise to ban price gouging in the grocery industry.
“Grocery prices … have jumped 26 percent since 2019, according to Elizabeth Pancotti, director of
special initiatives at the Roosevelt Institute, a left
left-leaning
leaning think tank”
tank (The Washington Post, August 15),
and many voters say inflation is their greatest concern. For this combination of reasons, Harris
Harris’s targeting
of grocery prices is entirely predictable. (Ironically, August 15 was also the day U.S. inflation was
reported to have fallen below 3% for the first time since March 2021.) I’m I certain, however, that this
falls under the heading of simplistic economic solutions that are designed to appeal to voters but are
unsoundly based and likely to fail.

What Is Price Gouging?

Price gouging is generally defined as sellers taking advantage of market power or temporary
supply/demand imbalances to raise prices to levels that otherwise wouldnwouldn’t prevail. And food prices
did rise significantly in 2021 and 2022, leading to suspicion of food retailers. But might there be reasons
for the price increases other than a malevolent decision to gouge on the part of sellers? Here are a few
possibilities:

When the pandemic began in March 2020, most people stayed home and cooked their own meals,
significantly increasing the demand for groceries and depleting inventories.
The production system was disrupted, with inputs in short supply or in the wrong places relative
to the needs. This led to the much-discussed “supply-chain problems.” Too few goods – when
coupled with too much money chasing them – constitute the classic reason for inflation.
The federal government sent taxpayers massive amounts of Covid-19 relief. Many more people
received benefits than had been hurt financially by the pandemic. Those people came out ahead,
capturing trillions of dollars for future spending.

2
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 When the Delta variant of Covid popped up in mid-2021, people again stayed home and shrunk
from contact with others, spending more on goods and less on services than they otherwise might
have. Demand for goods was strong as a result, outstripping the limited supplies and causing
prices to rise.

Profit margins in the supermarket industry are low – about 1% to 2% of sales – and that changed only a
little in 2021-22. So, was there gouging? And if gouging is the explanation for the price increases, why
did it occur in those years, rather than sooner? Again, might today’s high prices be explained by
something other than gouging? The New York Times, rarely a defender of capitalism, wrote the following
on August 15:

Researchers from the Federal Reserve Bank of Kansas City reported last year that rapid
job growth in the U.S. economy, and the wage increases that came with it, were major
contributors to rising grocery prices.

A number of factors contributed to the increase in food prices, many of them linked to the macro
economy. But the bottom line is that conditions allowed food sellers to raise prices, and they did so.

Is Raising Prices Wrong?

The above is the key question. Definitions of price gouging invariably include words like “unfair,”
“excessive,” and “exorbitant.” These are subjective terms that are open to judgment and debate.
The propriety of behavior with regard to these words is usually in the eye of the beholder. The seller
seller’s
highly reasonable price increase is the customer’ss gouging. The difficulty of defining gouging reminds
me of those who say, “we’re not out to soak thee rich; we just want to make them pay their fair share in
taxes.” I’m
m far from saying the rich shouldn’t
shouldn t pay their ““fair share,” but what’s the standard for a fair
share, and who gets to set it? In the same way, who determines whether prices are fair, and how?

When a supermarket raises the price of a necessity like bread, is that gouging? The answer is that it
it’s
complicated, and that’ss what makes it hard to regulate prices fairly.

If the farmer pays more for fertilizer and labor and then charges the baker more for wheat, can the
baker fairly pass that on to the supermarket in the form of a higher price for bread?
If the baker raises the price he charges the supermarket for bread, is it wrong for the supermarket
to pass on the increase to the consumer?
If the supermarket’s
supermarket employees demand higher pay, can it offset the increase by raising the prices
of the things it sells?
If demand increases because a hit TV show popularizes sandwiches, is it wrong for people in the
supply chain to take advantage and charge more for bread?

In a free market, prices are determined by supply and demand. Is it wrong per se for providers of goods
and services to raise prices in response to reduced supply or increased demand? A few examples should
make clear the complex nature of this question.

Uber applies “surge pricing” during rush hour, when more people want rides. Is that an unfair
practice? If the government says Uber mustn’t do so, that will make rides available at prices
below what some people would pay and deprive drivers of the full fare they could otherwise
collect. And the rate the drivers would then receive might not be high enough to justify the time

3
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 they’d spend stuck in traffic, meaning fewer drivers would be available to handle the peak
demand and people needing rides would remain unserved. Is that preferable?
If 1,000 tickets for a Taylor Swift concert are put on sale at $100 and 3,000 people line up to buy
them, what’s the message? Simple: they’re too cheap! Would it be unfair for the concert
promoter to raise the price until there are just 1,000 people in line? Few people would say so.
But if instead the price remains at $100 and the first 1,000 people buy them all, that leaves unmet
demand, in which case those who bought the tickets would be able to resell them for more than
$100. The profit would go to the resellers, who got their tickets at a price that was too low. Is
that fair? Wouldn’t it be fairer if the ticket prices were raised and the increment went to Tay
Tay, reflecting the full value her fans put on her labor?
In 2021, when people wanted to leave their city apartments, and homes and building materials
were in short supply, home prices shot upward. If you owned a home worth $400,000 in 2019
and asked $500,000 for it in the post-pandemic environment, was your behavior immoral?
Should the government prosecute people who asked more for their homes?
Lastly, when the economy sprung back to life in 2021 and there were multiple job openings per
unemployed worker, making higher salaries attainable, workers were able to tell the boss, “I can
get a higher salary down the road. If you don’t give me a raise, I’m leaving.
leaving.” Should the
government limit wage increases at a time when employees have an edge in negotiations? In the
fall of 2023, the United Auto Workers union took advantage of the bargaining power caused by
the tight labor conditions to extract from Ford “an 11% wage increase in the first year, and total
25% increase in wages over the 4.5 year contract, a $5,000 ratification bonus and a cost
cost-of-living
adjustment.” (Wikipedia) This was a huge package. Did it represent gouging?

Each of these examples shows one party taking advantage of supply/demand conditions to charge
more for the thing they have to offer. But certainly, their actions aren
aren’t illegitimate. They’re simply
examples of how markets work.

The alternative would be to have the government decide who should prevail in each case. Should it be the
Uber driver or the passenger; the concertgoer or the performer; the homeowner or the homebuyer; the
worker or the employer? Many have a knee-jerk
knee-jerk ten
tendency to sympathize with the passenger, concertgoer,
homebuyer, and worker, as it’ss easy to care less about the person who
who’s profiting: the driver, popstar,
homeowner, and employer. But if the government puts its thumb on the scale in favor of one party o or
the other, it distorts the workings of the free market and keeps it from functioning efficiently on
behalf of society overall. More on this later.

There are forms of seller behavior that are clearly wrong. These include collusion, price fixing, and
predatory pricing designed to drive competitors out of the market. But laws prohibiting these behaviors
are already on the books. Additional laws desig
designed to prohibit and punish price increases that someone
views as unfair, excessive or exorbitant – as opposed to being the result of improper conduct – are sure to
prove difficult to enforce and counter-productive.

Would a Law Against Price Gouging Work?

Just as history is full of failed command economies, it also shows the ineffectiveness of attempts to
regulate prices. In 1974, when the OPEC oil embargo set off inflation that made life difficult for millions,
the U.S. government countered by distributing “WIN” buttons, standing for Whip Inflation Now. I still
have mine, but neither it nor the voluntary consumer actions that were supposed to follow were enough to
keep inflation from reaching 13.5% in 1980. The buttons were derided, with some skeptics wearing them
upside down, according to Wikipedia. “Worn that way, ‘NIM’ stood for ‘No Immediate Miracles,’
‘Nonstop Inflation Merry-go-round,’ or ‘Need Immediate Money.’ ’’
4
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
There’s more recent experience with price controls, in Venezuela. Here’s what I said about it in Economic
Reality:

A case in point is the price controls, which have expanded to apply to more and
more goods: food and vital medicines, yes, but also car batteries, essential
medical services, deodorant, diapers, and, of course, toilet paper. The
ostensible goal was to check inflation and keep goods affordable for the
poor, but anyone with a basic grasp of economics could have foreseen the
consequences: When prices are set below production costs, sellers can’t afford
to keep the shelves stocked. Official prices are low, but it’s a mirage: The
products have disappeared. (Atlantic Monthly, May 12, 2016, emphasis added)

Here’s a shocker: you can set prices for goods, but you can’t make people produce
them. That sounds a lot like economic reality.

This is an example of the fact that officials may believe they can control economic developments with a
stroke of the pen, but they’ll be thwarted by second-order
order consequences that complicate the effort.

There’ss nothing wrong with trying to bring down the cost of necessities. However, the best way to do this
is to encourage additions to supply. Another way is to not overstimulate demand by injecting excessive
liquidity into the economy. Mandating lower prices is generally the least effective way to get them.

This is a good time for me to cite the economist’ss adage that “the best solution for high prices is
high prices.” This isn’tt a joke; far from it. In general, high prices mean demand is strong relative to
supply. Eventually, those high prices will encourage producers to produce more and consumers to
consume less, and the depressant impact on prices from both direct
directions is obvious. We see this all the
time in the oil market, for just one example.

A government bureaucracy set up to regulate the price of food is very unlikely to succeed and almost
certainly would have adverse effects. So, are there no benefits we can count on from price controls? I
can think of one: thousands of new (albeit unprodu
unproductive) jobs in that new bureaucracy. As Jason Furman,
a relatively liberal economist, said of Harris
Harris’s anti-gouging efforts, “This is not sensible policy, and I
think the biggest hope is that it ends up being a lot of rhetoric and no reality.
reality.”

Another Case in Point: Rent Control

The issue that first suggested this memo several months ago was rent control, something II’ve had
personal experience with, having lived in an apartment that rented for $92 a month in 1956, when I was
ten.

The federal government implemented rent control during World War II so that, with few new apartment
buildings being built and breadwinners away fighting the war rather than earning their normal wages,
families wouldn’t be priced out of their apartments. Rents on New York City apartments were frozen at
1943 levels. This was probably a good idea under the unusual circumstances of wartime, but the program
wasn’t dismantled afterwards, and it still governs some apartments that were built more than 80 years ago.
And rent regulation still plays havoc with the supply and demand for New York City apartments.

In general, New York City rent control limits rent increases on apartments so long as they’re occupied by
people who were tenants in 1971 or relatives who lived with them. The law was enacted to protect the
occupants at the time, but apartments have been passed down at controlled rents to people who didn’t

5
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
necessarily live in them in 1971. Fewer and fewer people are still around who satisfy the above criterion,
so this form of rent regulation is winding down.

Newer regulations continue in force under the rubric of “rent stabilization.” One example is Mandatory
Inclusionary Housing, which has been explained to me as follows: if you want to build an apartment
building and need some zoning relief – and virtually all projects do – you must agree as follows:

A percentage of the apartments will be “affordable.”

Tenants for affordable apartments must earn incomes well below the average in the area.
The maximum allowable rent will be set based on a percentage of tenants’ income.
Rent increases upon lease renewal will be regulated, usually at a few percent per year.

Most would agree that it’s laudable to encourage the creation of new affordable apartments, but this
particular method of doing so has the related effect of increasing the cost of apartment construction.
Probably everyone would be better off if there were simply more new apartments built every year.

The bottom line is that rents for the majority of New York City apartments remain subject to one form of
control or another and are unlikely to ever become fully deregulated. As a result, the incentives to build
new apartments are limited, and between 2002 and 2017, for example, the growth in the number of rental
apartments in New York City was only 0.3%, per year.

Improvements in regulated apartments are also regulated. Expenditures on improvements are limited to a
very small amount in any 15-year
year period, and the investment can be recouped only through an increase in
the monthly rent equal to a tiny percentage of the cost of the improvement
improvements. Thus, making improvements
is generally uneconomic:

Many landlords do not fill their vacant rent stabilized units, as the operational and
renovation costs may exceed the legal maximum rent. As of 2022, there are roughly
20,000 vacant rent stabilized apartments in New York City. (Wikipedia)

Might there be something wrong with a system where (a) there

there’s strong demand for apartments but (b) it’s
more profitable to keep apartments vacant than rent them out? Apartments aren’t much different from
bread or toilet paper. Officials can limit the price people have to pay, which is popular with
consumers, but other than in the most dictatorial jurisdictions, they can
can’t force suppliers to
produce goods for sale at the
the regulated prices.

As I’ve
ve tried this year to keep up with articles about New York
York’s apartment situation, I’ve noticed that the
following factors are usually listed as discouraging apartment creation: (a) a lack of tax incentives and
subsidies, (b) resistance to construction of affordable apartment buildings in the suburbs, and (c) high
interest rates (albeit the last one can’t be used to explain the low level of apartment construction in the
2010s). What struck me most was the absence of any mention of the impact of rent regulations.

A February 9 article in The New York Times particularly piqued my interest. The article reported that the
percentage of New York City rental apartments that were “vacant and available” had fallen to 1.4%, the
lowest since 1968. It went on to say, “Housing experts consider a healthy vacancy rate to be somewhere
around 5 to 8 percent.” So why are so few apartments vacant? It comes down to supply and demand:

a) As in the example of Taylor Swift tickets, they’re simply too cheap. That means demand is
strong and apartments don’t sit vacant.

6
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 b) Also, because rents are kept too low, would-be builders can’t achieve attractive returns,
meaning there are few additions to supply. (I also imagine that if apartment builders could earn
an acceptable return on investment, they’d have to worry about new regulations expropriating it.)

As mentioned earlier with regard to prices in general, if demand for apartments is strong and
supply is restricted, the result should be rents that rise, encouraging landlords to add to supply.
But market forces aren’t allowed to freely function in New York City; the laws of economics have
been blunted by regulation. The February 9 article included the following statements (and this is from
The New York Times, again usually not the capitalist’s friend):

The answer is that developers generally can’t make returns for building apartments that are
competitive with the returns on other forms of investment. . . .

Housing experts estimate that the number of homes the city needs to build is in the
hundreds of thousands.

So far, however, the city and state have not made moves that could accelerate enough
housing development to solve the crisis. . . .

[Governor Kathy] Hochul said in a statement that the survey was “the latest reminder that
we can only build our way out of this crisis.”

But it’s interesting to note that the “moves” that are described as having the potential to lead to
“building our way out of this crisis” always emphasize government-provided
government subsidies and
incentives, never allowing the free market to set rents.

A person in favor of this arrangement would argue that it maintains affordability and diversity. What it
means in purely economic terms is that some people who couldncouldn’t afford to live in New York City if
rents were set by free-market
market forces are able to live there if they
they’re lucky enough to secure an
apartment with regulated rent. But other people who would like to live in New York City and can
afford higher rents can’tt do so because there are no apartments for them. And lastly, landlords that
have apartments that are somehow unregulated can command higher rents than would be the case if
additions to the supply of apartments weren
weren’t being discouraged. It’s a matter of personal philosophy
whether this is good or bad. But clearly, the laws of economics and the actions of free markets aren’t at
work in New York City. Someone in government is making the decisions.

I’ll
ll end this discussion with a comment Jason Furman made about grocery prices:

Mr. Furman . . . said . . . if prices do not rise in response to strong demand, new
companies may not have as much inclination to jump into the market to ramp up supply.
(The New York Times, August 15)

By the way, as part of her August 16 economic package, Harris said she would prohibit landlords who
own more than 50 apartments from raising rents by more than 5% for two years. That may or may not be
a good idea, but it’s certainly not going to encourage increased investment in apartments.

Regulatory Miscellany

There are so many examples of governmental attempts to ignore or override the laws of economics that
it’s daunting to think of cataloging them, but I must discuss a few here, and their shortcomings:

7
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Another component of Harris’s economic program is a plan to give first-time homebuyers
$25,000 to help with down payments. Certainly, it’s hard these days for young people to come
up with the cash needed to become homeowners. The problem here is that giving a million
would-be buyers $25,000 each, or $25 billion in all, would almost certainly result in an
immediate increase in home prices, eliminating much of the hoped-for benefit from the program.
Easy: that can be prevented by passing a law that prohibits current sellers from raising home
prices in response to enactment of the program. But what about homes that will come onto the
market in the future? Simple: enact another law that says you can’t ask more for your home than
you would have if the program didn’t exist. Try enforcing that one.

When he was president, Donald Trump enacted tariffs on goods from China to counter trade
practices he considered unfair. Now, he promises a 10% across-the-board tariff on imports.
Those tariffs might discourage imports, stimulate domestic production, and reduce the U.S.’s
chronic trade deficit. But they’d
d likely be paid by consumers of imported goods, as
manufacturers and exporters are unlikely to absorb a tariff if they can pass
pass it on. For many years
low-cost imports have held down inflation in the U.S.. and enabled Americans to enjoy an
attractive standard of living. Broad new tariffs are likely to be the equivalent of price increases
for American consumers. And the tariffs – and those imposed by other nations in retaliation –
would hamper globalization,on, which benefits the global economy by letting people in each nation
do for the world what they’re best at.

Trump’s policy proposals also include extension of his expiring 2017 tax cuts and a panoply of
new ones. There’ss something for everyone, with tax cuts for corporations and individuals,
including ending the taxation of tips, Social Security benefits, and overtime pay. The Penn
Wharton Budget Model estimates that in 2026, the plan would reduce taxes by $320 for the
average person in the bottom income quintile and $47,220 for those in the top percentile. Even
without factoring in the latest proposals, like exempting overtime pay, these
t actions are projected
to increase the national deficit by $5.8 trillion over the next decade, or $4.1 trillion after
incorporating their potential stimulative impact on the overall economy (so (so-called “trickle-down
effects”). Other than that possibility, there
there’s no suggestion the cuts would be paid for.

California is a Petri dish for so-

so-called
so -called “progressive” economic ideas. In 2022, the state legislature
passed a bill creating a council comprised of industry representatives and restaurant workers to
set wages in the fast-food
fast food industry. Faced with a threatened
threa industry-financed referendum to
repeal the law, legislators modified it to mandate a minimum hourly wage of $20 for fast food
chains of more than 60 restaurants
restaurants. The new law only took effect in April, so it’s too early to
assess its impact. Press aaccounts, however, are replete with accounts of restaurants closing,
employees being laid off or having their hours reduced, employers investing in labor
labor-saving
technologies, and substantial price increases for the consumer. Although “mom and pop”
restaurants are not required to pay the new minimum wage, predictably many have been forced to
match the mandated rate to retain their employees, meaning the protection legislators intended for
small restaurants may be illusory. That’s how the laws of economics work.

Similarly, California passed a law mandating a $25-an-hour minimum wage for workers in the
healthcare industry. But more recently, according to The Wall Street Journal of May 27,
officials realized that it “would cost the state $4 billion more a year owing to higher Medicaid
costs and compensation for workers at state-owned facilities” and so they delayed the benefit of
the law with respect to those workers. Shocking here is the idea that you can’t give money to
someone without getting it from someone else, and California taxpayers might not enjoy the state
directing more of it to healthcare workers, especially given the current budget deficit.

8
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 If there’s one thing both parties agree on, it’s “hands off Social Security!” Retirees present and
future want their monthly payments, and they want the rules left as they are. The leaders of both
parties have agreed to this. It’s just that it can’t work. Social security is a contributory program
analogous to insurance, and it works through a trust fund. Workers pay in via taxes and retirees
get checks. But the number of retirees drawing benefits has been growing relative to the number
of active workers paying in, and, if nothing is changed, the fund is sure to become insolvent
through an inexorable mathematical process. There are many levers that could be pulled to
restore Social Security to health, but nobody wants to pull them, since doing so would displease
someone (that is, displease some voters). The options include (a) raising the Social Security tax
rate, (b) raising the ceiling on the earnings on which tax is paid, (c) reducing benefits, (d) limiting
cost-of-living adjustments, (e) raising the retirement age, (f) limiting the number of years for
which retirees can collect, and (g) means testing would-be recipients. None of these is considered
acceptable. Everyone just wants their checks as promised.

It doesn’tt take a degree in economics to know what happens when people spend more than they
bring in. (Only in political reality might someone expect a different outcome.) However, we
don’tt hear a word from politicians or elected officials about making tthe changes that are
necessary to keep the Social Security trust fund from insolvency. The government can switch
Social Security from a self-funded
funded program to a government-funded
government-funded benefit, of course, and at first
government-
glance, the change appears to be mainly semantic.
ntic. But depleting the trust fund and paying
benefits from the Treasury would add further to the already
already-troublesome deficit, the national debt,
and the annual debt service, which would feed back to further increase the deficit and debt.

That leads me to a topic I’m

m asked about all around the world: the U.S. government
government’s deficit and debt. I
answer that they’re
re an embarrassment. Oaktree is privileged to manage money for several countries that
have sovereign wealth funds, not national debt.
debt. Some countries put windfalls into a lockbox, like
Norway’ss oil revenues or the proceeds from the privatization of Australia
Australia’s telephone company. And
many other countries live within their means simply because they have to – they don’t have the luxury of
printing unlimited amounts of money without precipitating a devaluation. But the U.S. habitually runs
deficits, spending more than it takes in. Our last surplus came in 2000, at the end of the Clinton
administration. Today, for the first time, simply the annual interest on our national debt exceeds the
Defense Department budget. Yet neither party is willing to address the deficit or stand for balanced
budgets. Our congress rarely submits a budget at all, no less a balanced one. This is irresponsible
behavior we wouldn’tt tolerate in our own organizations.

The U.S. acts as if it has a credit card with no limit on the balance and no requirement to pay it
down. It does so because it it’s been able to get away with it thus far, and our governing officials lack
the will to spend less than they can. We don’t hear much these days about Modern Monetary Theory,
the view popularized in 2020 that “for countries in control of their currencies, deficits and debts don’t
matter.” Nevertheless, our government still acts as if this theory is valid.

In the 1930s, John Maynard Keynes posited that when an economy is growing too slowly to produce the
needed jobs, the government should increase spending to stimulate demand, even if that means running a
deficit and covering it by borrowing. And then, when prosperity resumes and the jobs are there, it should
spend less than it takes in, running a surplus and using it to repay the debt. All good, except for that last
bit: the part about surpluses and debt repayment has been forgotten.

The truth is, deficits encourage the economic growth that most people enjoy, and spending more than the
government takes in permits officials to give away “free stuff,” thereby gaining votes. But doing this

9
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
perpetually requires ignoring the laws of economics, running up debts in the apparent belief that
they’ll never have to be paid. Can it go on without end? We’ll see, but I would think not.

What Are the Common Threads?

The actions and proposed actions described above, like the questions beginning at the bottom of page
three, all have certain elements in common.

The goals usually seem commendable on the surface: cheaper goods and services, and more equal
outcomes. But, given the way things work in economics, they usually have second-order
consequences that are uncontrollable and unhelpful.
At their core, they’re all questions of “who gets what?” There’s no possibility of money appearing
from out of the ether; there are just choices regarding who pays in and who gets something out. It It’s a
zero-sum game.
The goals are often populist, with legislators and regulators picking winners and losers. They usually
fashion their actions as protecting the downtrodden little guy from the rapacious big guy. Most anti anti-
free-market regulations incorporate size criteria, meaning they only apply to supermarkets, not corner
grocery stores; landlords with a lot of apartments; medical facilities of a certain size
size; and restaurant
chains, not independents. In this context, we should note what President Biden said at the DemocrDemocratic
National Convention in August: “I’m m proud to have been the first president to walk a picket line
and be labeled the most pro-union
union president in history.”” Are employees per se more deserving of
protection than employers? Without employers, where would people get jobs? Regardless, they do
serve as convenient targets for politicians.
The rhetoric surrounding these matters is often alarmingly classist and divisive. Here
Here’s part of a
typical note I received from a candidate last month: “Even
“ with inflation lowering [sic], food prices
still seem sky-high. It’ss another sign of corporate greed
greed hurting . . . consumers. CEOs shouldn
shouldn’t be
lining their pockets with record profits while families struggle to put food on the table or pay for
medications.” In this kind of environment, “profit
“profit” is a dirty word, and “greedy corporations” are
ripe for suspicion and regulation.
Finally, elected officials have a habit of exempting themselves from impact. Thus, it it’s interesting to
observe that California’ss minimum fast-food
fast wage doesn’t apply to restaurants in government
facilities. What official wants to suffer the wrath of an eemployee forced to pay more for lunch?

One of the most important characteristics of the laws of economics is that they apply to everyone. On the
other hand, attempts to negate those laws are usually designed to affect some parties differently from
others. Whenever this is the case, those in ccharge are picking would-be winners and losers. Not a great
idea in a “free society.”

Fundamentally, government subsidies and economic regulations amount to encouraging actions

that people wouldn’t take on their own. In other words, these actions wouldn’t happen in a free
market. Mandates like these should be examined critically. Some may stem from officials’ Solomonic
decisions and desire for a fair society. Others are probably the result of a philosophic bias in favor of
redistribution. And still others are just a matter of currying favor with voters.

For many career politicians, the first order of business is getting elected and reelected. Elected officials’
tinkering with the economy is often designed to appeal to voters. Then there’s the added benefit of
getting officials off the hook, since they can redirect blame for politically undesirable developments to
“bad actors,” such as powerful corporations and greedy landlords. Finally, economic regulations can

10
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
provide temporarily palliative outcomes, with the negative side effects coming only in later years, when
the officials who enacted them have left the political stage.

Free Markets or Controlled Markets? That Is the Question

Governments don’t make a product, create value over and above the cost of the inputs they employ
or – other than through their spending – contribute to GDP. They collect (or print) money with one
hand and distribute money and services with the other. They collect taxes from taxpayers and incur debts
in the name of future taxpayers. Then they pay out money for benefit programs, salaries, capital
expenditures, and subsidies. Policymaking is about who will pay in and who will receive the benefits.

Governments don’t strive for profits, meaning the people who run governments get a free pass on
efficiency. Corporate management teams that fail to produce a product worth more than the inputs – aka
make a profit – won’t last long. But governments aren’t expected to do so, and as a result, there
there’s no easy
yardstick for quantifying a government’ss effectiveness, like profits do for a business.

Governments do play essential roles that may have nothing to do with profits or value added.

They provide things people can’tt provide for themselves, such as defense, healthcare, police and
fire services, education, infrastructure, and response to emergencies, both physical (floods,
tornados, and pandemics) and economic (recessions and hyperinflat
hyperinflation).
They also provide safety nets for those who would otherwise suffer. There are extensive
differences of opinion over how much of this governments should do, and those differences
underly one of the biggest disagreements between the U.S. political parties.

Beyond necessities, how far should a government go to even out its citizens
citizens’ incomes and quality of life?
Doing so is one of the reasons why governments take from some to give to others as described above.
But it must be acknowledged that each step in this direction – as opposed to requiring people to
fend for themselves – is a step in contravention of free
free-market forces, with consequences.

Darwin described the way species are strengthened through what is known as “survival of the
fittest.” It works, and species evolve upward. But this is, by definition, a cold-blooded
cold process
through which the strong thrive and the weak perish. Good for tthe whole of the species, but not
for every member.
Likewise, the collective economic welfare of a society is maximized by the operation of the free
market. In the process, some people do better than others – preferably, but certainly not always,
the most talented, hardest working, and most deserving. Onl
Only in the most rose-colored (and ill-
fated) systems is it not accepted that some people will do better than others. But the differential
has expanded a great deal of late, and there is a growing debate as to “how much better” is fair
and acceptable.

The choice is clear based on the evidence provided by history: (a) efficient free market economies
with their incentives and uneven outcomes or (b) command economies with their uniform outcomes
and sub-par performance. On page two, I wrote the following:

The incentives provided by free markets direct capital and other resources where they’ll
be most productive. They prompt producers to make the goods people want most and
workers to take jobs where they’ll be most productive in terms of the value of their
output. And they encourage hard work and risk taking.

11
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
In contrast, if markets are made less free – that is, if they’re forced to follow government edicts rather
than the laws of economics:

capital and raw materials will be directed to places other than where they’ll be most productive;
producers will fail to make the things people want most, and instead will make things the
government thinks people should have;
workers will be assigned to work where they’ll produce less than they otherwise might; and
hard work and risk taking won’t take place as much, since the rewards for doing those things will
be capped and, in some cases, redirected to people who didn’t do the work or take the risk but
whom those in control deem deserving.

Incentives and free markets are essential for a high-functioning economy, but their existence
assures that some members of the economy will do better than others. You can’t have one without
the other.

China

At this point you might ask, “But

But what about China? The Chinese economy isn isn’t free to operate pursuant
to the laws of economics, but it’s doing well.” We think of China as a ““communist country,” replete with
state-owned enterprises, industrial policy, and five-year
year plans. And yet, China’s GDP has grown at nearly
9% per annum for the last 45 years, and in 2010 it became the world
world’s second-largest economy. How
could that be?

As it turns out, much of China’ss economic success is attributable to a vibrant private sector. II’ve been
visiting China for nearly 20 years and, especially during my early visits, I struggled to comprehend the
logic that permits the coexistence of the collective
lective ideology with private enterprise. Certainly, those are
“strange bedfellows.” A visit to Xiamen, China earlier this month for the China International Fair for
Investment & Trade reminded me of this conundrum. Regardless of the explanation, the fa fact is that
China’ss economy relies heavily on the dynamic private sector. In the summer of 2022, Edward
Cunningham of the Harvard Kennedy School used a popular formulation to describe it:

China’ss private sector is often summed up with a combination of four numbers:

60/70/80/90. Private firms contribute 60% of China
China’s GDP, 70% of its innovative
capacity, 80% of its urban employment and 90% of new jobs.

And the government recognizes this. On March 13, 2023, CNN reported on a statement from Chinese
Premier Li Qiang:

“For a period of time last year, there were some incorrect discussions and comments in
the society, which made some private entrepreneurs feel worried,” Li said Monday.
“From a new starting point, we will create a market-oriented, legalized and
internationalized business environment, treat enterprises of all types of ownership
equally, protect the property rights of enterprises and the rights and interests of
entrepreneurs.”

Certainly, this represents a triumph of pragmatism over ideological purity. It’s a clear example of
accommodating to economic reality rather than trying to override it.

12
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 * * *

My first step toward understanding the workings of the various economic systems came in junior high
school in the late 1950s, when I read George Orwell’s Animal Farm. Orwell wrote it in 1945 as a thinly
veiled critique of Russia and communism/socialism. That book taught me most of what I needed to know
about free markets versus command economies. If you haven’t read it, or if you read it so long ago that
you can’t remember what it says, I suggest you pick it up.

In the allegory of Animal Farm, the animals took over the running of the farm. For me, the key lesson
emanates from the motto they painted on the barn wall, borrowed from Karl Marx: “From each according
to his ability; to each according to his needs.”

What an idealistic statement! It would be great if everyone produced all they could, with the more able
members of society producing more. And it would be great if everyone got what they need, with needier
individuals getting more. But, as the animals onn the farm soon learned, if workers only get to keep what
they need, there’ss no incentive for the more able among them to put in the additional effort required to
produce a surplus from which to fill the needs of the less able. The great challenge, of cou
course, is to
strike the proper balance: to take enough from the successful in the form of taxes to fund services,
government programs, and wealth transfers without eroding their incentive to work or encouraging
them to seek out low-tax jurisdictions.

What I discuss above are the economic facts of life, and some of their ramifications may be less than
ideal. But idealists’ wishes don’tt govern economies; these realities do. Foremost among them are
the power of incentives and the influence of supply and demand. The rules must be respected; they
can’tt be ignored, wished away, or overridden without consequences.

Anyone who thinks it’ss better to live in a centrally planned economy that prefers evenly distributed
benefits over free markets hasn’tt studied history (or read Animal Farm). It may sound good in theory, but
it has never worked. The laws of economics will always win out eventually. Nations can respect them
and reap the associated benefits, or they can try to contravene them and pay the price in terms of
underperformance. In the world of politics, there can be limitless benefits and something for
everyone.. But in economics, there are only tradeoffs.

September 19, 2024

13
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

14
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Mr. Market Miscalculates

In his book The Intelligent Investor, first published in 1949, Benjamin Graham, who was Warren Buffett’s
teacher at Columbia Business School, introduced a fellow he called Mr. Market:

Imagine that in some private business you own a small share that cost you $1,000. One
of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what
he thinks your interest is worth and furthermore offers either to buy you out or to sell you
an additional interest on that basis. Sometimes his idea of value appears plausible and
justified by business developments and prospects as you know them. Often, on the other
hand, Mr. Market lets his enthusiasm or his fears run away with him,
im, and the value he
proposes seems to you a little short of silly.

Of course, Graham intended Mr. Market as a metaphor for the market as a whole. Given Mr. Market’s Market
inconsistent behavior, the prices he assigns to stocks each day can diverge – sometimes wildly – from
their fair value. When he’ss overenthusiastic, you can sell to him at prices that are intrins
intrinsically too high.
And when he’ss overly fearful, you can buy from him at prices that are fundamentally too low. Thus, his
miscalculations provide profit opportunities to investors interested in taking advantage of them them.

* * *

There’ss a great deal to be said about investors’

investors’ foibles, and II’ve shared much of it over the years. But the
rapid market decline we saw in the first week of August – along with the rapid rebound – compels me to
pull together what I’ve
ve said previously on the subject, along with some priceless investing cartoons from
my collection, and add a few new observations.

To set the scene, let’s

’ss review recent events. As a result of the Covid-19
Covid pandemic, soaring inflation, and
the U.S. Federal Reserve’ss rapid interest rate increases, 2022 was one of the worst years ever for the
combination of stocks and bonds. Sentiment rreached its low around the middle of 2022, with investors
depressed by the universally negative outlook: “We have inflation, and that’s bad. And the rate increases
to fight it are sure to bring on a recession, and that’s bad.” Investors could think of few positives.

Then the mood lightened and, late in 2022, investors coalesced around a positive narrative: the slow
economic growth would cause inflation to decline, and that would permit the Fed to start lowering rates in
2023, leading to economic vigor and market gains. A significant stock market rally began and continued
nearly uninterrupted until this month. Although the rate cuts anticipated in 2022 and 2023 still haven’t
materialized, optimism has been in the ascendency in the stock market. The S&P 500 stock index rose by
54% (not counting dividends) in the 21 months which ended on July 31, 2024. That day, Fed Chair
Jerome Powell confirmed that the Fed was moving closer to a rate cut, and things appeared to be on track
for economic growth and further stock market appreciation.

But that same day, the Bank of Japan announced its biggest increase in its short-term interest rate in over
17 years (to a whopping 0.25%!). This shocked the Japanese stock market, to which people had been

© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
warming for over a year. In addition, and importantly, the announcement played havoc with investors
who had engaged in “the carry trade.” For years, Japan’s infinitesimal – and often negative – interest
rates have meant that people could borrow cheaply in Japan and invest the borrowed funds in any number
of assets, there and elsewhere, that promised to return more, for a “positive carry” (aka “free money”).
This led to the establishment of highly levered positions. It seems odd that a quarter-point increase in
interest rates could require some of these positions to be unwound. But it did, leading to motivated
selling in a variety of asset classes as those who had engaged in the practice moved to cut their leverage.

Starting the next day, the U.S. announced mixed economic news. On August 1, we learned that the
Manufacturing Purchasing Managers’ Index had dipped and initial jobless claims had risen. On the other
hand, corporate profit margins continued to look good, and gains in productivity surprised to the upside.
A day later, we learned that employment gains had moderated, with hiring rising less than had been
expected. The unemployment rate stood at 4.3% at the end of July, up from a low of 3.4% in April 2023.
This was still very low by historical standards, but, according to the suddenly popular “Sahm Rule” (don’t
complain to me; I’d never heard of it either), since 1970, an increase in the three-month average
unemployment rate of 0.5 percentage points or more from the low of the prior 12 months has never
occurred without the economy already being in recession. Around the same time, Warren Buffett’s
Buffett
Berkshire Hathaway announced that it had sold off a good part of its massive holding of Apple shares.

In all, this news constituted a triple whammy. The resulting flip-flop

flop from optimism to pessimism set off
a significant stock market rout. The S&P 500 fell on three consecutive trading days – August 1, 2, and 5
– by a total of 6.1%. The replay of the mistakes I’ve
ve witnessed for decades was so obvious that I can’t
can
resist cataloging them below.

What’s Behind the Market’s Volatility?

On the first two days of August, I was in Brazil, where people often asked me to explain the sudden
collapse. I referred them to my 2016 memo On the Couch
Couch. Its key observation was that in the real
world, things fluctuate between ‘pretty
pretty good’
good and ‘not so hot,’ but in investing, perception often
swings from ‘flawless’ to ‘hopeless.’
hopeless.’ That says about 80% of what you need to know on the subject.

If reality changes so little, why do estimates of value (that

(that’s what security prices are supposed to be)
change so much? The answer has a lot to do with changes in mood. I wrote over 33 years ago, in only
my second memo:

The mood swings of the securities markets resemble the movement of a pendulum. . . .
between euphoria and depression, between celebrating positive developments and
obsessing over negatives, and thus between overpriced and underpriced. This oscillation
is one of the most dependable features of the investment world, and investor psychology
seems to spend much more time at the extremes than it does at a “happy medium.” (First
Quarter Performance, April 1991)

Mood swings do a lot to alter investors’ perception of events, causing prices to fluctuate madly. When
prices collapse as they did at the start of this month, it’s not because conditions have suddenly become
bad. Rather, they become perceived as bad. Several factors contribute to this process:

heightened awareness of things on one side of the emotional ledger,

a tendency to overlook things on the other side, and
similarly, a tendency to interpret things in a way that fits the prevailing narrative.

2
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
What this means is that in good times, investors obsess about the positives, ignore the negatives, and
interpret things favorably. Then, when the pendulum swings, they do the opposite, with dramatic
effects.

One important idea underpinning economics is the theory of rational expectations, described by
Investopedia as follows:

The rational expectations theory . . . posits that individuals base their decisions on three
primary factors: their human rationality, the information available to them, and their past
experiences.

If security prices were really the result of the rational, dispassionate evaluation of data, presumably one
piece of negative information would move the market down a little, and the next such piece would move
it down a bit more, and so forth. But instead, we see that an optimistic market is capable of ignoring
individual pieces of bad news until a critical mass of bad news builds up, at which time a tipping point is
reached, the optimists surrender, and a rout begins. Rudiger Dornbush’ss great quote about economics is
highly applicable here: “. . . things take longer to happen than you think they will, and then they happen
faster than you thought they could.” Or as my partner Sheldon Stone says, “The air goes out of the
balloon much faster than it went in.”

The non-linear
linear nature of this process suggests something very different from rationality is at work. In
particular, as in many other aspects of life, cognitive dissonance plays a big part in investors
investors’ psyches.
The human brain is wired to ignore or reject incoming data that is at odds with prior beliefs, and
investors are particularly good at this.

While we’re on the subject of irrationality, I’ve

ve been waiting for an opportunity to share the following
screenshot from June 13, 2022:

3
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
This was a tough day in the markets: interest rates were rising thanks to the actions of the Fed and other
central banks, and asset prices were under significant pressure as a result. But take a look at the table.
Every country’s equity index was down significantly. Every currency was down relative to the dollar.
Every commodity was down. Only one thing was up: bond yields . . . meaning bond prices were down,
too. Wasn’t there one asset or country whose value didn’t decline that day? What about gold, which is
supposed to do well in difficult times? My point here is that, during big market moves, no one performs
rational analysis or makes distinctions. They just throw out the baby with the bathwater, primarily
because of psychological swings. As the old saying goes, “in times of crisis, all correlations go to 1.”

Further, the data in the table exhibit an additional phenomenon that’s often present during extreme moves:
contagion. Something goes wrong in the U.S. market. European investors take that as a sign of trouble,
so they sell. Asian investors detect that something negative is afoot, so they sell overnight. And when
U.S. investors come in the next morning, they’re spooked by the negative developments in Asia, which
confirm their pessimistic inclinations, so they sell. This is a lot like the game of telephone we played
when I was little: the message may be miscommunicated as it’s passed down the chain, but it still
encourages ill-founded actions.

When psychology is swinging radically, meaningless statements can be given weight. Thus, during the
three-day
day decline earlier this month, it was observed that foreigners sold more Japanese stocks than they
bought, and investors reacted as if this meant something.
mething. But if foreigners sold on balance, Japanese
investors must have bought on balance. Should either of these phenomena be treated as more significant
than the other? If so, which one?

Further complicating things in terms of rational analysis is the fact that most developments in the
investment world can be interpreted both positively and negatively, depending on the prevailing
mood.

4
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Another classic cartoon sums up this ambiguity in fewer words. It’s highly applicable to the market
tremor that inspired this memo.

One more source of miscalculation is investors’ tendency toward optimism and wishful thinking.
Investors in general – and equity investors in particular – must,
must by definition, be optimists. Who other
than people with positive expectations (and/or a strong desire for increased wealth) would be willing to
part with money today based on the possibility of getting back more in the future?

Charlie Munger, Warren Buffett’ss late partner, routinely quoted the ancient Greek statesman
Demosthenes, who said, “Nothing
Nothing is easier than self
self-deceit. For what each man wishes, that he also
believes to be true.” One great example is “Goldilocks thinking”:
thinking the belief that the economy will be
neither strong enough to bring on inflation nor weak enough to lapse into recession. Things sometimes
work out that way – as may be the case right now – but not nearly as often as investors posit.
Expectations that incline toward the positive encourage aggressive behavior on the part of investors. And
if this behavior is rewarded in good times, still more aggressiveness usually ensues. Rarely do investors
realize that (a) there can be a limit to the run of good news or (b) an upswing can be so strong as to
be excessive, rendering a downswing inevitable.

For years, I quoted Buffett as having warned investors to temper their enthusiasm: “When investors lose
track of the fact that corporate profits grow at 7% on average, they tend to get into trouble.” In other
words, if corporate profit growth averages 7%, shouldn’t investors begin to worry if stocks appreciate by
20% a year for a while (as they did throughout the 1990s)? I thought it was such a good quote that I
asked Buffett when he said it. Unfortunately, he answered that he hadn’t. But I still think it’s an
important warning.

That inaccurate recollection reminds me of John Kenneth Galbraith’s trenchant reference to one of the
most important causes of financial euphoria: “the extreme brevity of the financial memory.” It’s this trait
that allows optimistic investors to engage in aggressive behavior, untroubled by knowledge of what such
behavior led to in the past. Further, it makes it easy for investors to forget past errors and invest blithely
on the basis of the newest miraculous development.

5
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Finally, the investment world might be less unstable if there were immutable rules – like the one
governing gravity – that could be counted on to always produce the same results. But there are no such
rules, since markets aren’tt built on natural laws, but rather the shifting sands of investor
psychology.

For example, there’ss a long-

long
long-running
-running adage that says we should “buy on rumor and sell on news.” That is,
the introduction of favorable expectations is a buy signal, because expectations often continue to rise.
That ends when the news arrives, however, bec because the impetus for gains has been realized and no further
good news remains to take the market higher. But in the carefree environment of a month ago, I told my
partner Bruce Karsh that maybe the prevailing attitude had become “buy on rumor and buy on news.” In
other words, investors were acting as though it was always a good time to buy. Rationally, one shouldn’t
price in the possibility of a favorable event twice: both when the possibility of the event is introduced and
when the event occurs. But euphoria can get the better of people.

Another example of the absence of meaningful guidelines can be seen in this excerpt from one of the
oldest clippings in my file:

A continuing pattern of consolidation and group rotation suggests that increasing

emphasis should be placed on buying stocks on relative weakness and selling them on
relative strength. This would be a marked contrast to some earlier periods where
emphasizing relative strength proved to be effective. (Loeb, Rhoades & Co., 1976)

6
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
In short, sometimes the things that have gone up the most should be expected to continue to go up
the most, and sometimes the things that have gone up the least should be expected to go up the
most. To which many of you might respond “duh.” Bottom line: there are few effective rules for
investors to follow. Superior investing always comes down to skillful analysis and superior insight, not
adherence to formulas and guidelines.

* * *

Volatile psychology, skewed perception, overreaction, cognitive dissonance, rapid-fire contagion,

irrationality, wishful thinking, forgetfulness, and the lack of dependable principles. That’s quite a
laundry list of ills. Together, they constitute the main cause of extreme market highs and lows and are
responsible for the volatile swings between them. Ben Graham said that, in the long run, the market is a
weighing machine that assesses the merit of each asset and assigns an appropriate price. But in the short
term, it’s merely a voting machine, e, and the investor sentiment that moves it swings wildly, incorporating
little rationality and assigning daily prices that often reflect little in terms of intelligence.

Rather than try to reinvent the wheel, I’ll repeat some of what I’ve
ve said in two past memos:

Especially during downdrafts, many investors impute intelligence to the market and look
to it to tell them what’ss going on and what to do about it. This is one of the biggest
mistakes you can make. As Ben Graham pointed out, the day day-to-day market isn’t a
fundamental analyst; it’ss a barometer of investor sentiment. You just can’t can take it
too seriously. Market participants have limited insight into what
what’s really happening in
terms of fundamentals, and any intelligence that could be behind their buys and ssells is
obscured by their emotional swings. It would be wrong to interpret the recent worldwide
drop as meaning the market “knows”” tough times lay ahead. (It’s( Not Easy, September
2015)

My bottom line is that markets don

don’t
don’’t assess intrinsic value from day to day, and certainly
they don’tt do a good job during crises. Thus, market price movements don’t
don say much
about fundamentals. Even in the best of times, when investors are driven by
fundamentals rather than psychology, markets show what the participants think
value is, rather than what value really is. Value is something the market doesn’t know
any more about than the average investor. And advice from the average investor
obviously can’tt help you be an above average investor.

Fundamentals – the outlook for an economy, company or asset – don’t change much from
day to day. As a result, daily price changes are mostly about (a) changes in market
psychology and thus (b) changes in who wants to own something or un-own
something. These two statements become increasingly valid the more daily prices
fluctuate. Big fluctuations show that psychology is changing radically. (What Does the
Market Know?, January 2016)

The market fluctuates at the whim of its most volatile participants: those who are willing (a) to buy
at a big premium to the former price when the news is good and enthusiasm is riding high and (b)
to sell at a big discount from the former price when the news is bad and pessimism is rampant.
Thus, as I wrote in On the Couch, every once in a while, the market needs a trip to the shrink.

7
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
It’s important to note that, as my partner John Frank points out, in comparison to the total number who
own each company, it takes relatively few people to drive prices up during bubbles or down during
crashes. When shares in a company that was worth $10 billion a month ago trade at prices implying a
valuation of $12 billion or $8 billion, it doesn’t mean the whole company would change hands at these
prices; just a tiny sliver. Regardless, a few emotional investors can move prices much more than
should be the case.

The worst thing you can do is join in when other investors go off on these irrational jags. It’s far better to
watch with bemusement from the sidelines, buttressed by an understanding of how markets work. But
better still to see Mr. Market’s overreactions for what they are and accommodate him, selling to
him when he’s eager to buy regardless of how high the price is, and buying from him when he
desperately wants out. Here’s how Ben Graham followed the introduction of Mr. Market that I included
on page 1:

If you are a prudent investor or a sensible businessman will you let Mr. Market’s daily
communication determine your view of the value of your $1,000 interest in the
enterprise? Only in case you agree with him, or in case you want to trade with him. You
may be happy to sell out to him when he quotes you a ridiculously
diculously high price, and equally
happy to buy from him when his price is low. But the rest of the time you will be wiser
to form your own ideas of the value of your holdings, based on full reports from the
company about its operations and financial position.

In other words, it’ss the primary job of the investor to take note when prices stray from intrinsic value and
figure out how to act in response. Emotion? No. Analysis? Yes.

August 22, 2024

8
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

9
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: The Folly of Certainty

The impetus for my memos can come from a wide variety of sources. This one was inspired by an article
in The New York Times on Tuesday, July 9. What caught my eye were a few words in the sub-headline:
“She doesn’t have any doubt.” The speaker was Ron Klain, a former Biden chief of staff. The subject
was whether President Biden should continue to run for reelection. And the “she” was Jen O’Malley
Dillon, Biden’s campaign chair. The article went on to quote her as having said, “Joe Biden is going to
win, period,” in the days just before his June 27 debate against former President Donald Trump.

And, with that, I had the subject of this memo: not whether Biden will continue campaigning or
drop out – or whether he’ll win if he continues – but rather how anyone can be without doubt. It’ll
be another of my “shortie” memos given the uncertain shelf life of the Biden candidacy.

This choice of subject calls to mind another time I heard a highly credentialed person express absolute
certainty. In that case, an acknowledged expert in foreign affairs told a group I was part of there was “a
100% probability that the Israelis would ‘take out’ Iran’ss nuclear capability before year-end.”
year He seemed
like a genuine insider, and I had no reason to doubt his word. Yet, that was 2015 or ’16, and I’m still
waiting for “before year-end” to come around (in his defense, he didn
didn’t say which year).

As I indicated in my memo The Illusion of Knowledge (September 2022), there there’s no way a macro-
forecaster can produce a forecast that correctly incorporates all the many variables that we know will
affect the future as well as the random influences about which little or nothing can be known. It’sIt for this
reason, as I’ve
ve written in the past, that investors and others who are subject to the vagaries of the macro-
macro
future should avoid using terms such as “will,”
“will,” “won’t,”
“ “has to,” “can’t,” “always,” and “never.”

Politics

When the 2016 presidential election rolled around, there were two things about which almost everyone
was certain: (a) Hillary Clinton would win but (b) if by some quirk of fate Donald Trump were to win, the
stock market would collapse. The least certain ppundits said Clinton was 80% likely to win, and the
estimates of her probability of victory ranged upward from there.

And yet, Trump won, and the stock market rose more than 30% over the next 14 months. The response of
most forecasters was to tweak their models and promise to do better next time. Mine was to say, “if that’s
not enough to convince you that (a) we don’t know what’s going to happen and (b) we don’t know how
the markets will react to what actually does happen, I don’t know what is.”

Even before the much-discussed presidential debate of three weeks ago, no one I know expressed much
confidence regarding the outcome of the coming election. Today, Ms. O’Malley Dillon would likely
soften her position regarding the certainty of a Biden victory, explaining that she was blindsided by the
debate result. But that’s the point! We don’t know what’s going to happen. Randomness exists.

Sometimes things go as people expected, and they conclude that they knew what was going to
happen. And sometimes events diverge from people’s expectations, and they say they would have

© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
been right if only some unexpected event hadn’t transpired. But, in either case, the chance for the
unexpected – and thus for forecasting error – was present. In the latter instance, the unexpected
materialized, and in the former, it didn’t. But that doesn’t say anything about the likelihood of the
unexpected taking place.

Macro Economics

In 2021, the U.S. Federal Reserve held the view that the bout of inflation then underway would prove
“transitory,” which it has subsequently defined as meaning temporary, not entrenched, and likely to self-
correct. I think the Fed might have been proved right, given enough time. Inflation might have retreated
of its own accord in three or four years, after (a) the Covid-19 relief funds that caused the surge in
consumer spending were spent down and (b) the global supply chain returned to its normal operations.
(However, not slowing the economy would have brought the risk that inflationary psychology might take
hold in those 3-44 years, necessitating even stronger action.) But because the Fed’s view wasn
wasn’t borne out
in 2021 and waiting longer was untenable, the Fed was forced to embark on one of the fastest programs of
interest rate increases in history, with profound implications.

In mid-2022, there was near certainty that the Fed’ss rate increases would precipitate a recession. It made
sense that the dramatic increase in interest rates would shock the economy. Further, history clearly
showed that major central bank tightening has almost always led to economic contraction rather than a
“soft landing.” And yet, no recession has materialized.

Instead, late in 2022, the consensus among market observers shifted to the view that (a) inflation was
easing, and this would permit the Fed to start cutting interest rates, and (b) rate cuts would enable the
economy to avoid recession or ensure that any contraction
contraction would be mild and short
short-lived. This optimism
ignited a stock market rally in late 2022 that persists today.

And yet, the anticipated rate reductions in 2023 that undergirded the rally didn
didn’t transpire. Then, in
December 2023, when the “dot plot”” of Fed officials
officials’ views called for three interest rate cuts in 2024, the
optimists driving the market doubled down, pricing in an expectation of six. Inflation
Inflation’s stubbornness has
precluded any rate cuts thus far, with 2024 more than half over. Now the consensus has coalesced around
the idea of a first cut in September. And the stock market keeps hitting new highs.

The optimists today would likely say, “We were right. Look at those gains!” But, regarding interest rate
cuts, they were simply wrong. For me, all this does is serve as another reminder that we don
don’t know
what’ss going to happen or how markets will react to what does happen.

Conrad DeQuadros of Brean Capital, my favorite economist (how’s that for an oxymoron?), has supplied
an interesting tidbit for this memo on the subject of economists’ conclusions:

I use the Philly Fed’s Anxious Index (the probability of a decline in real GDP in the
upcoming quarter) as an indicator that a recession has ended. By the time more than
50% of the economists in the survey project a decline in real GDP in the coming
quarter, the recession is over or close to being over. (Emphasis added)

In other words, the only thing worthy of certainty is the conclusion that economists shouldn’t be
expressing any of it.

2
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Markets

The rare person who in October 2022 correctly predicted that the Fed wouldn’t cut interest rates over the
next 20 months was absolutely right . . . and if that prediction kept them out of the market, they’ve missed
out on a gain of roughly 50% in the Standard & Poor’s 500 index. The rate-cut optimist, on the other
hand, was absolutely wrong about rates but is likely much richer today. So, yes, market behavior is very
tough to gauge correctly. But I’m not going to take time here to catalog the errors of market savants.

Instead, I’d like to focus on why so many market forecasts fail. The performance of economies and
companies might tend toward predictability given that the forces governing them are somewhat . . . shall I
say . . . mechanical. In these areas, one might say “if A, then B” with some degree of confidence.
Predictions here might, therefore, have some chance of being correct, albeit that’s mostly the case when
trends continue unabated and extrapolation works.

But markets swing more than economies and companies. Why? Because of the importance and
unpredictability of market participants’ psyches or emotions. Thanks to further help from Conrad
DeQuadros, I can illustrate the greater variability of markets, as follows:

40-Year
Year Standard Deviation of Annual Percentage Changes

GDP 1.8%
Corporate profits 9.4
S&P 500 price 13.1

Why is it that stock prices rise and fall so much more than the economies and companies that underlie
them? And why is it that market behavior is so hard to predict and often seems unconnected to economic
events and company fundamentals? The financial “sciences
“sciences” – economics and finance – assume that
each market participant is a homo economicus: someone who makes rational decisions designed to
maximize their financial self-interest.
interest. But the crucial role played by psychology and emotion oftenoft
causes this assumption
ssumption to be mistaken. Investor sentiment swings a great deal, swamping the short short-run
influence of fundamentals. It’ss for this reason that relatively few market forecasts prove correct, and
fewer still are “right
right for the right reason.”
reason.”

* * *

Today, pundits are making all sorts of predictions about the upcoming presidential election. Many of their
conclusions seem well-reasoned and even persuasive. We hear and read statements from those who
believe Biden should and shouldn’t drop out; those who think he will and won’t; those who think he can
win if he stays in the race; and those who think he’s sure to lose. Obviously, intelligence, education,
access to data, and powers of analysis can’t be sufficient to produce correct forecasts. Many of
these commentators possess these attributes, but clearly, they won’t all be right.

Over the years, I’ve often cited the wisdom of John Kenneth Galbraith. It’s he who said, “There are two
kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” I find myself
using this quote all the time. Another of my favorite Galbraith quotes is from his book A Short History of
Financial Euphoria. In describing the reasons for “speculative euphoria and programmed collapse,” he
discusses two factors “little noted in our time or in past times. One is the extreme brevity of the financial
memory.” I often cite this factor, too.

3
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
But I don’t remember ever writing about his second factor, which Galbraith says is “the specious
association of money and intelligence.” When people get rich, others take that to mean they’re smart.
And when investors succeed, it’s often assumed their intelligence can lead to similarly good results in
other fields. Further, successful investors often come to believe in the strength of their own intellect and
opine about fields with no connection to investing.

But investors’ success can be the result of a string of lucky breaks or a propitious environment, rather than
any special talents. They may or may not be intelligent, but often they don’t know any more than most
others about subjects outside of investing. Nevertheless, many are unsparing with their opinions, and
those opinions often are highly valued by the general populace. That’s the specious part. And today we
find some of them speaking with conviction on all sides of the issues related to the election.

A lot has been said about those who express certainty. We all know people we’d describe as “often wrong
but never in doubt.” This reminds me of another of my favorite quotes, one that’ss attributed (perhaps
tenuously) to Mark Twain: “It ain’t what you don’tt know that gets you into trouble. It’s
It what you know
for sure that just ain’t so.”

Back in mid-2020,
2020, when the pandemic seemed to have become a more or less understood phenomenon, I
slowed the pace of my memo writing from the one-a-week week pattern of March and April. In May, I took the
opportunity for two non-Covid-related memos titled Uncertainty and Uncertainty II II, in which I devoted a
significant amount of space to the subject of intellectual humility. While these memos were on one of my
favorite topics, they generated little response. So, I’ll
ll quote a bit from Uncertainty and hopefully give
you reason to look back at them.

Here’ss part of the article that first brought the subject of intellectual humility to my
attention:

As defined by the authors, intellectual humility is the opposite of intellectual

arrogance or conceit. In common parlance, it resembles open
open-mindedness.
Intellectually humble people can have strong beliefs, but recognize their
fallibility and are willing to be proven wrong on matters large and small.
(Alison Jones, Duke Today,
Today, March 17, 2017)

. . . To put it simply, intellectual humility means saying “I’m not sure,” “The other
person could be right,”
right, or even “I might be wrong.” I think it’s an essential trait for
investors; I know it is in the people I like to associate with. . . .

No statement that starts with “I don’t know but . . .” or “I could be wrong but . . .” ever
got anyone into big trouble. If we admit to uncertainty, we’ll investigate before we
invest, double-check our conclusions and proceed with caution. We may sub-optimize
when times are good, but we’re unlikely to flame out or melt down. On the other hand,
people who are sure may dispense with those things, and if they’re sure and wrong,
as the Twain quote suggests, the outcome can be catastrophic. . . .

. . . maybe Voltaire said it best 250 years ago: Doubt is not a pleasant condition, but
certainty is absurd.

There simply is no place for certainty in fields that are influenced by psychological fluctuations,
irrationality, and randomness. Politics and economics are two such fields, and investing is another. No
one can predict reliably what the future holds in these fields, but many people overrate their ability and

4
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
attempt to do so nevertheless. Eschewing certainty can keep you out of trouble. I strongly
recommend doing so.

P.S.: Last summer’s Grand Slam tennis tournaments provided the inspiration for my memo Fewer Losers,
or More Winners? Similarly, this past Saturday’s women’s final match at Wimbledon has provided a
snippet for this memo. Barbora Krejcikova prevailed over Jasmine Paolini to win the women’s
title. Before the tournament, bettors considered Krejcikova a 125-to-1 shot. In other words, they were
sure she wouldn’t win. The bettors may have been right to doubt her potential, but it seems they
shouldn’t have been quite so certain in making their predictions.

And speaking of the unpredictable, I can’t fail to mention the recent attempt on Donald Trump’s life, an
event that could well have had a more grave and impactful result. Even now that it has happened and
President Trump has escaped serious injury, no one can state with certainty
ainty how it will impact the election
(though at present it appears to bolster Trump’s prospects) or the markets.. So, if anything, it reinforces
my bottom line: making predictions is largely a loser’s game.

July 17, 2024

5
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

6
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: The Impact of Debt

My partner Bruce Karsh recently supplied me with a newspaper article about chess that inspired me to
write a brief memo called The Indispensability of Risk. The response to the memo was favorable,
hopefully because people found the content valuable, but quite possibly because it was only three pages
long versus the usual ten to twelve. Thus encouraged, I’m following up with another short memo.

One of my more interesting sources for readings on practical philosophy – including investment
philosophy – is the blog from the Collaborative Fund to which Morgan Housel,, a fund partner, is a
regular contributor. As I read Housel’s musings, I often find myself saying,, “that’
“that
“that’s right in line with what
I think.” And at other times, I say,, as I hope others say after reading my memos, “I never thought of it
that way.”

I found Housel’s April 30 article, entitled “How

How I Think About Debt,”
Debt ” particularly interesting
interesting. The
subject is the impact of debt on longevity,, and it really boils down to a discussion of risk, one of my
favorite topics.

Housel
ousel starts by discussing the 140 businesses in Japan that are still operating more than 500 years after
they were founded and the few that are purportedly more than 1,000 years old.

It’ss astounding to think what these businesses have endured – dozens of wars, emperors,
catastrophic earthquakes, tsunamis, depressions, on and on, endlessly. And yet they keep
selling, generation after generation.

These ultra-durable
durable businesses are called “shinise,” and studies of them show they tend to
share a common characteristic: they hold tons of cash, and no debt. That’s part of how
they endure centuries of constant calamities.

Clearly,
learly, all else being equal, people and companies that are indebted are more likely to run into trouble
than those that aren’t.
’t.
t. And it goes without saying that a home or car that hasn’t
hasn been used as collateral for
a loan can’tt be foreclosed on or repossessed. It
It’s the presence of debt that creates the possibility of
default, foreclosure, and bankruptcy.

Does that mean debt is a bad thing and should be avoided? Absolutely not. Rather, it’s a matter of
whether the amount of debt is appropriate relative to (a) the size of the overall enterprise and (b) the
potential for fluctuations in the enterprise’s profitability and asset value.

Housel frames the issue by introducing the idea of potential volatility over one’s lifetime: “Not just
market volatility, but . . . world and life volatility: recessions, wars, divorces, illness, moves, floods,
changes of heart, etc.” With no debt, he postulates, we’re likely to survive all but the most infrequent,
most volatile events. But in a succession of illustrations, Housel shows that as the level of one’s
indebtedness increases, the range of volatility one can withstand narrows, until at a very high level of
debt, only the tamest of environments are survivable. As Housel puts it, “as debt increases, you narrow
the range of outcomes you can endure in life.”

© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Housel’s approach to thinking about debt – and especially his illustrations – reminded me of my
December 2008 memo, Volatility + Leverage = Dynamite. (Unless otherwise indicated, this memo is the
source of the quotations that follow; in all cases, emphasis is in the original.) In that memo, I used a
series of simple graphics to show that the lower a company’s debt load is, the greater the decline in
fortune it could survive. And I made the following observation about the root cause of the Global
Financial Crisis, which was in full force at the time of the memo:

. . . the amount of borrowed money – leverage – that it’s prudent to use is purely a
function of the riskiness and volatility of the assets it’s used to purchase. The more
stable the assets, the more leverage it’s safe to use. Riskier assets, less leverage. It’s that
simple.

One of the main reasons for the problem today at financial institutions is that they
underestimated the risk inherent in assets such as home mortgages and, as a result,
bought too much mortgage-backed
backed paper with too much borrowed moneymoney.

Portfolios, Leverage, and Volatility

The reason for taking on debt – i.e., using what investors call “leverage”
“leverage – is simple: to increase so-called
capital efficiency. Debt capital is usually cheap relative to the expected returns that motivate equity
investments and thus relative to the imputed cost of equity capital. Thus, it’s efficient to use it in lieu of
equity. In casinos, I’ve heard the pit boss say, “The
The more you bet, the more you win when you win. win.”
Likewise, for a given amount of equity capital, (a) the more debt capital you use, the more assets
you can own and (b) the more assets you own, the greater your profits will be . . . when things go
well.

But few people talk about the downside. The pit boss never says, “. . . and the more you lose when you
lose.” Likewise, when your assets decline in value, the more leverage you’ve
you employed, the more equity
loss you’ll suffer.

The magnification of gains and losses stemming from leverage is typically symmetrical: a given amount
of leverage amplifies gains and losses similarly. But levered portfolios face a downside risk to which
there isn’tt a corresponding upside: the risk of ru
ruin. The most important adage regarding leverage
reminds us to “never
never forget the six-foot-tall
six person who drowned crossing the stream that was five
feet deep on average.” ” To survive, you have to get through the low points, and the more leverage you
carry (everything else being equal), the less likely you are to do so.

. . . it’s important to recognize the role of volatility. Even if losses aren’t permanent, a
downward fluctuation can bring risk of ruin if a portfolio is highly leveraged and (a) the
lenders can cut off credit, (b) investors can be frightened into withdrawing their equity, or
(c) the violation of regulatory or contractual standards can trigger forced selling.

Obviously, the greatest leverage-related losses occur when the potential for downward fluctuations has
been underestimated for a meaningful period of time and thus the use of leverage has become excessive.
Generally speaking, “normal levels of volatility” – those seen on a regular basis and documented through
historical statistics – are used in investors’ calculations and reflected in the amounts of leverage they
employ. It’s the isolated “tail events” that saddle levered investors with the greatest losses:

2
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 The problem is that extreme volatility and loss surface only infrequently. And as
time passes without that happening, it appears more and more likely that it’ll never
happen – that assumptions regarding risk were too conservative. Thus, it becomes
tempting to relax rules and increase leverage. And often this is done just before the risk
finally rears its head. As Nassim Nicholas Taleb wrote in Fooled by Randomness:

Reality is far more vicious than Russian roulette. First, it delivers the fatal
bullet rather infrequently, like a revolver that would have hundreds, even
thousands of chambers instead of six. After a few dozen tries, one forgets
about the existence of a bullet, under a numbing false sense of security . . .
Second, unlike a well-defined precise game like Russian roulette, where the
risks are visible to anyone capable of multiplying and dividing by six, one does
not observe the barrel of reality. . . . One is thus capable of unwittingly playing
Russian roulette – and calling it by some alternative “low risk” name.

. . . In all aspects of our lives, we base our decisions on what we think probably will
happen. And, in turn, we base that to a great extent on what usually happened in
the past. We expect results to be close to the norm most ost of the time, but we know it
it’s
not unusual to see outcomes that are better or worse. Although we should bear in mind
that, once in a while, a result will be outside the usual range, we tend to forget about the
potential for outliers. And importantly, as illustrated by recent events, we rarely consider
outcomes that have happened only once a century . . . or never.

Cycles in the Use of Leverage

In my second book, Mastering the Market Cycle:

Cycle: Getting the Odds on Your Side,
Side one of the longest
chapters, and probably the most important, is one I hadn
hadn’t planned when I first sat down to write: “The
Cycle in Attitudes Toward Risk.” Investor psychology has a dominant influence on the market in the
short run, and the attitudes that
at motivate investment decisions are often cyclical in nature, driving markets
to irrational extremes and then correcting in the opposite direction . . . to the opposite extreme.

Attitudes that govern the use of debt capital are examples of this cyclical process. When things have been
going well for a while – asset prices have been rising, investment returns have been positive, and the use
of leverage has paid off in the form of h
higher returns – investors view leverage as benign. As a result:

the favorable aspects of leverage become well

well-recognized,
the negative potential is overlooked,
investors become interested in employing more,
lenders become willing to provide more, and
regulations and mores governing the use of leverage tend to become more permissive.

But when events turn negative, this process goes into reverse. Leverage is penalized, not rewarded.
Thus, its use declines. And importantly, lenders provide less and try to demand repayment of outstanding
leverage if they can, leading to negative consequences for borrowers. In this way, as we so frequently
see, psychology often strays from the “happy medium” and moves toward extreme highs that presage
painful losses when extreme lows are reached.

The source of losses from excessive use of leverage might be best understood through an adaptation of
my favorite new quote, from Edward Chancellor’s book The Price of Time, which I cited in this past

3
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
January’s memo Easy Money:

The Manchester Banker John Mills commented perceptively [in 1865] that “as a rule,
panics do not destroy capital; they merely reveal the extent to which it has previously
been destroyed by [the taking on of excessive leverage in good times].”

Using Debt Prudently

As with so many aspects of investing, determining the proper amount of leverage has to be a
function of optimizing, not maximizing. Given that leverage magnifies gains when there are gains and
that investors only invest when they expect there to be gains, it can be tempting to think the right amount
of leverage is “all you can get.” But if you bear in mind (a) leverage’s potential to magnify losses when
there are losses and (b) the risk of ruin under extreme negative circumstances, investors should usually
use less than the maximum available. Successful investments, perhaps enhanced by the moderate use of
leverage, should usually provide a good-enough return – something few people think about in good times.

Here’s how I summed it up in Volatility + Leverage = Dynamite:

Clearly, it’ss difficult to always use the right amount of leverage, because it’s
it difficult to
be sure you’re re allowing sufficiently for risk. Leverage should only be used on the basis
of demonstrably cautious assumptions. And it should be noted that if you’re doing
something novel, unproven, risky, volatile, or potentially life life-threatening, you
shouldn’tt seek to maximize returns. Instead, err on the side of caution. The key to
survival lies in what Warren Buffett constantly harps on: margin of safety. Using
100% of the leverage one’ss assets might justify is often incompatible with assuring
survival when adverse outcomes materialize. . . .

The riskier the underlying assets, the less leverage should be used to buy them.
Conservative assumptions on this subject will keep you from maximizing gains but
possibly save your financial life in bad times.

The right way to think about debt may be best captured by one of the oldest maxims: “There are old
investors, and there are bold investors, but there aren
aren’t many old bold investors.” Using a moderate
amount of borrowed capital balances the desire for enha
enhanced gains against the awareness of the potential
negative consequences. It’s
It only in this way that one can hope to attain the longevity of Morgan Housel
Housel’s
500-year-old
old success stories.

May 8, 2024

4
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

5
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: The Indispensability of Risk

Oftentimes, we’re best able to understand something we’re interested in through analogies that clarify the
matter by establishing connections between it and other parts of life. That’s why I’ve written a memo
comparing investing to sports in each of the four decades I’ve been writing memos and one connecting
investing and card playing in 2020.

The motivation for this memo comes from an article in The Wall Street Journal of April 12 that my
partner Bruce Karsh sent me entitled “Chess Teaches the Power of Sacrifice” by Maurice Ashley, a chess
grandmaster who has been inducted into the U.S. Chess Hall of Fame. Few people know that Bruce is a
chess player, and I hadn’t thought about this fact for years, but the article provided a good reminder and
moved me to dash off this memo.

As is obvious from the article’s title, the piece is mostly about the role of sacrifice. Ashley says, “Many
positions cannot be won or saved without something of value being given away, from a lowly pawn all
the way up to the mighty queen.” Intentionally losing a piece as part of one’s gameplan is the sacrifice
that Ashley is referencing.

He describes some sacrifices as “shams,” (a term coined by chess master Rudolf Spielmann in his
book The Art of Sacrifice in Chess) where “. . . one can easily see that the piece being given up
will return concrete benefits that can be clearly calculated.” In other words, I put a piece in clear
jeopardy, but I do this so that I’ll be able to take one of yours of greater value.
Others are deemed “real” sacrifices, where “. . . giving away a piece offers gains that are neither
immediate nor tangible. The return on investment might be controlling more space, creating an
assailable weakness in the opponent’s position, or having more pieces in the critical sector of
attack.”

The analogy to investing begins to become clear. Buying a 10-year U.S. Treasury note is a modest or
“sham” sacrifice. You give up the use of your money for ten years, but that’s only an opportunity cost,
and accepting it brings the certainty of interest income. Most other investments involve real sacrifices,
though, where the risk of loss is borne in pursuit of “gains that are neither immediate nor tangible.”

Ashley goes on to speak of sacrifice in risk/return terms that are familiar to investors. He describes his
mother’s decision to leave him (at age two) and his two siblings in Jamaica and travel to the U.S. in
search of a better life for herself and for them. She reached her goal a decade later and was able to bring
her kids to the U.S., where they would find success in a variety of fields:

It did not have to turn out that way. It did because she was willing to stomach the key
aspect of making real sacrifices: the willingness to take risks. For a chess player, risk is
as much intuited as it is calculated. Due to the inherent complexity of the game, it is
virtually impossible to assess with certainty whether a risky move will pay off in the end.
It’s up to the player to decide if sufficient conditions have been met to take the
chance on a risky move. . . .

© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 What we do know, however, is that the famous saying “No risk, no reward” is true in
many cases. A skilled adversary is normally able to handle solid, conservative play and
therefore able to rob us of opportunities that may be inherent in our position. As [five-
time world chess champion] Magnus Carlsen put it, “Not being willing to take risks is an
extremely risky strategy.” (Emphasis added)

And there you have it: the indispensability of risk.

The Risk of Not Taking Risk

Because the future is inherently uncertain, we usually have to choose between (a) avoiding risk and
having little or no return, (b) taking a modest risk and settling for a commensurately modest return, or (c)
taking on a high degree of uncertainty in pursuit of substantial gain but accepting the possibility of
substantial permanent loss. Everyone would love a shot at earning big gains with little risk, but the
“efficiency” of the market – meaning the fact that the other participants in the market aren’t dummies –
usually precludes this possibility.

Most investors are capable of accomplishing “a” and most of “b.” The challenge in investing lies in the
pursuit of some version of “c.” Earning high returns – in absolute terms or relative to other
investors in a market – requires that you bear meaningful risk – either the possibility of loss in the
pursuit of absolute gain or the possibility of underperformance in the pursuit of outperformance.
In each case, the two are inseparable. As Ashley says, no risk, no reward. No pain, no gain.

The risk inherent in not taking enough risk is very real. Individual investors who eschew risk may end up
with a return that is insufficient to support their cost of living. And professional investors who take too
little risk may fail to keep up with their clients’ expectations or their benchmarks.

Like chess (and most card games), backgammon requires the calculation of when to take risk and when to
avoid it. In backgammon, two players move their checkers around the board based on throws of a pair of
dice. One player moves clockwise and the other counterclockwise. When players’ checkers come near
each other, the player who’s moving often has a choice between (a) landing on one of the other player’s
checkers, sending it back to the start (but at the risk of leaving the moving checker in a vulnerable
position), and (b) avoiding doing so to play it safe. No one wants to be exposed and get hit. But most
beginners play it too safe, and because they put so much emphasis on avoiding getting hit, they rarely
win.

Relevant lessons from sports (included in past memos) are easily accessed and also very helpful:

“You miss 100% of the shots you don’t take.” – Wayne Gretzky, NHL Hall of Famer
“You have to give yourself a chance to fail.” – Kenny “The Jet” Smith, two-time NBA champion

I’ll sum up with a paragraph from my memo of last September, Fewer Losers, or More Winners? The
final sentence says a great deal about sacrifice and risk:
. . . not having any losers isn’t a useful goal. The only sure way to achieve that is by not
taking any risk. But … risk avoidance is likely to result in return avoidance. There’s
such a thing as the risk of taking too little risk. Most people understand this
intellectually, but human nature makes it hard for many to accept the idea that the
willingness to live with some losses is an essential ingredient in investment success.

2
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
How to Think About Risk-Taking

The paradox of risk-taking is inescapable. You have to take it to be successful in competitive, high-
aspiration arenas. But taking it doesn’t mean you’ll be successful; that’s why they call it risk.

Equally paradoxical, earning a high rate of return over a long time period doesn’t have to – and usually
doesn’t – connote a record of consistent success. More often it results from having made a lot of well-
reasoned investments, some subset of which worked out well. Here’s how I described the basis for the
success of Berkshire Hathaway in Fewer Losers, or More Winners?:
I believe the ingredients of Warren [Buffett]’s and Charlie [Munger]’s great performance
are simple: (a) a lot of investments in which they did decently, (b) a relatively small
number of big winners that they invested in heavily and held for decades, and (c)
relatively few big losers. No one should expect to have – or expect their money
managers to have – all big winners and no losers.
Investors must accept that success is likely to stem from making a large number of investments, all
of which you make because you expect them to succeed, but some portion of which you know won’t.
You have to put it all out there. You have to take a shot. Not every effort will be rewarded with high
returns, but hopefully enough will do so to produce success over the long term. That success will
ultimately be a function of the ratio of winners to losers, and of the magnitude of the losses relative to the
gains. But refusal to take risk in this process is unlikely to get you where you want to go.

I’ll conclude with another good paragraph from Ashley:

Taking a chance doesn’t mean there will be a successful outcome, nor does it require it.
If the reasons are sound, the risk should be taken almost reflexively. The more often we
trust our judgment, the more confidence we gain in our decision-making capacity. The
courage to take risks becomes a worthwhile end in itself.

The bottom line on the quest for superior investment returns is clear: You shouldn’t expect to make
money without bearing risk, but you shouldn’t expect to make money just for taking risk. You
have to sacrifice certainty, but it has to be done skillfully and intelligently, and with emotion under
control.

April 17, 2024

3
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

4
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Easy Money

The backstory: I began writing these memos in 1990 and continued to do so for ten years despite never
receiving a single response. Then, on the first business day of 2000, I published bubble.com, a memo with
warnings about excesses in the tech sector that turned out to be timely. The inspiration for the memo
came from a book I’d read the preceding autumn: Devil Take the Hindmost: A History of Financial
Speculation, by Edward Chancellor, an account of speculative excesses starting with the South Sea
Bubble of the early 1700s. The book’s description of behavior surrounding the mania for the South Sea
Company jibed with what I was seeing in the tech/media/telecom bubble that was underway. I received
excellent feedback on the memo from clients – encouragement that prompted the many memos that have
followed.

I consider it highly coincidental that 24 years later, I devoted another autumn to reading another
Chancellor book, The Price of Time: The Real Story of Interest,, his history of interest rates and central
bank behavior. I thank Zach Kessler, a regular memo reader, for sending it. The relevance of The Price
of Time to the trends I’ve been discussing for the last year occasions this memo.

* * *

In December 2022, I published Sea Change

Change,, a memo that primarily discussed the 13 13-year period from the
end of 2008, when the U.S. Federal Reserve cut the fed funds rate to zero to counter the effects of the
Global Financial Crisis, to the end of 2021, when the Fed abandoned the idea that inflation was transitory
and readied what turned out to be a rapid-fire
rapid-fire succession of interest rate increases. The memo
rapid-
concentrated on the impact that this lengthy period of unusually low interest rates had on the economy,
the financial markets, and investment outcomes. I followed this up with the memo Further Thoughts on
Sea Change, which Oaktree released to clients in May 2023 and to the public in October. In the latter
memo and subsequent conversations with clients, II’ve emphasized the significant impact of low interest
rates on the behavior of participants in the economy and the markets.

Easy Times

In Sea Change, I likened the effect of low interest rates to the moving walkway at the airport. If you walk
while on it, you move ahead faster than you would on solid ground. But you mustn’t attribute this rapid
pace to your physical fitness and overlook the contribution from the walkway.

In much the same way, declining and ultra-low interest rates had a huge but underrated influence on the
period in question. They made it:

easy to run a business, with the stimulated economy growing unabated for more than a
decade;
easy for investors to enjoy asset appreciation;

© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 easy and cheap to lever investments;
easy and cheap for businesses to obtain financing; and
easy to avoid default and bankruptcy.

In short, these were easy times, fueled by easy money. Like travelers on the moving walkway, it was
easy for businesspeople and investors to think they were doing a great job all on their own. In particular,
market participants got a lot of help in this period as they rode the 10-year-plus bull market, the longest in
U.S. history. Many disregarded the benefits that ensued from low interest rates. But as one of the oldest
investment adages says, we should never confuse brains with a bull market.

As I’ve continued to think and talk about the switch from declining and/or ultra-low interest rates
to more normal, stable ones, I’ve emphasized the fact that low rates alter investor behavior,
distorting it in ways that have serious consequences.

Thinking about the change in interest rates sensitized me to media mentions of low rates, and II’ve noticed
many. This was particularly true following Silicon Valley Bank’ss meltdown last March, which many
articles attributed to faulty managerial decisions made “during
during the preceding period of easy money.”
money.
More recently, there’s been much discussion of the less-favorable
favorable outlook for private equity, usually
related to expectations that interest rates aren’tt going to return to the low levels of the recent past
past.

The effects of low interest rates are multi-faceted

faceted and ubiquitous, yet frequently overlooked. I became
more conscious of them as I read The Price of Time,, and I want to catalog them here:

i. Low interest rates stimulate the economy

Everyone knows that when central banks want to stimulate their countries
countries’ economies, they cut
interest rates. Lower rates reduce costs for businesses and put money into the hands of
consumers. For example, since most people buy cars on credit or lease them, lower interest rates
make cars more affordable, increasing demand. The result is typically good for automakers, their
suppliers, and their workers, and thus for the economy in general.

It’ss important to realize that easy money keeps the economy aloft, at least temporarily. But low
interest rates can make the economy grow too fast, bringing on higher inflation and
increasing the probability that rates will have to be raised to fight it, discouraging further
economic activity. This oscillation of interest rates between extremes can have effects and
encourage behavior that natural/neutral rates (see p. 13) would be less likely to induce.

ii. Low interest rates reduce perceived opportunity costs

Opportunity cost is a major consideration in most financial decisions. But in low-interest-rate

environments, the rate earned on cash balances is minimal. Thus, you don’t forgo much interest
by withdrawing money from the bank to buy a house or boat (or make an investment), which
makes doing so seem painless. For example, if someone’s thinking about taking $1 million out of
savings for a purchase at a time when savings accounts pay 5% interest, they’re likely to
understand that doing so will cost them $50,000 per year in forgone income. But when the rate
is zero, there is no opportunity cost. This makes the transaction more likely to occur.

iii. Low interest rates lift asset prices

In finance theory, the value of an asset is defined as the discounted present value of its future cash
flows. We discount future cash flows when calculating present value because we must wait to
2
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 receive them, so they’re less valuable than cash flows received today. The lower the rate at which
future cash flows are discounted, the higher the present value, as investors have noted for
centuries:

In the [18th] century, Adam Smith described how the price of land depended on
the market rate of interest. In The Wealth of Nations (published in 1776) Smith
noted that land prices had risen in recent decades, as interest rates declined. (The
Price of Time, or “TPOT”)

By placing too low a discount on the future earnings of companies, investors [in
the 1920s] ended up paying too much. (TPOT)

In real life, investments are evaluated primarily on a relative basis. The return demanded on each
investment is largely a function of the prospective returns on other investments and differences in
these investments’ respective levels of risk. Low interest rates lower the ““relative bar,”
bar,
making the higher returns offered on riskier assets appear relatively attractive even if
they’re low in the absolute.

In this vein, The Price of Time describes the thought process that made “iffy” loans to the
government of Argentina acceptable in the low-rate
rate environment of the late 1880s:

Buenos Aires “took

took advantage of the low rate of interest and the abundance of
money in Europe to contract as many loans as possible, new loans often being
made in order to pay the interest on former ones.
ones.” Some Argentine loans paid as
little as 5 percent – low in absolute terms or relative to their risk but still a
couple of points above the measly yield on [[consols, or perpetual British
government debt] . . . (TPOT,
TPOT,, emphasis added)
TPOT

When bond yields decline, bonds present less competition for riskier assets. Thus, low yields on
bonds lead to lower demanded returns – and higher valuations – on other asset classes, such as
equities, real estate, and private equity. For these reasons, low interest rates lead to asset
inflation and sometimes asset bubbles like those we saw in late 2020 and throughout 2021.

iv. Low interest rates encourage risk taking, leading to potentially unwise investments

Low interest rates create a “low-return world” marked by paltry prospective returns on safe
investments. At the same time, investors
investors’ required returns or desired returns typically don’t
decline (or they decline by much less), meaning investors face a shor
shortfall. The ultra-low returns
on safe assets cause some investors to take additional risks to access higher returns. Thus,
these investors become what my late father-in-law called “handcuff volunteers” – they move
further out on the risk curve not because they want to, but because they believe it’s the only
way to achieve the returns they seek.

In this way, capital moves out of low-return, safe assets and in the direction of riskier
opportunities, resulting in strong demand for the latter and rising asset prices. Riskier
investments perform well for a while under these conditions, encouraging further risk
taking and speculation:

In his 1844 book On the Regulation of Currencies [banker John Fullarton]

observed that at times of low interest, “everything in the nature of value puts on
an aspect of bloated magnitude,” and every article becomes an object of

3
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 speculation. Long periods of easy money, wrote Fullarton, engender “a wild
spirit of speculation and adventure.” Fullarton noted that financial euphoria
occurred after a period of falling interest rates: “From the Bubble year [i.e., the
South Sea Bubble of 1720] downwards, I question much if an instance could be
shown of any great or concurrent speculative movement on the part of capitalists,
which had not been preceded by a marked decline of the current rate of interest.”
(TPOT)

The risk-free rate is the point of origin, or jumping-off point, for returns and risk premia. When a
central bank cuts the risk-free rate:

the rest of the yield curve usually follows;

the capital market line governing asset-class returns also shifts downward, especially if
the desire for higher returns in the low-return
return environment causes riskier investments to
be aggressively pursued as described above;
in addition to moving lower, the capital market line also can flatten
flatten, reducing risk premia,
if investors are paying little heed to fundamental/credit risk; and
the liquidity premium – the increment in expected return for owning illiquid rather than
readily saleable assets – can also shrink, as return-seeking
seeking investors embrace illiquid
investments.

In all these ways, the return increments associated with longer

longer-term, riskier, or less-liquid
assets can become inadequate to fully compensate for the increase in risk. Nevertheless, the
low prospective returns on safe securities cause investors to look p
past these factors and
lower their standards, encouraging speculation and causing questionable investments to be
made in pursuit of higher returns:

For [Austrian-school
school economist Friedrich] Hayek, it was axiomatic, but all too
often overlooked, that “all
all economic activity is carried out through time.
time.” When
interest rates decline, he said, businesses are inclined to invest in projects with
more distantt payoffs – in Hayek
Hayek’s terminology, the “structure of production”
lengthens. If interest rates are kept below their natural level [see p. 113],
misguided investments occur: too much time is used in production, or, put
another way, the investment returns do don’t justify the initial outlay.
“Malinvestment”,
Malinvestment to use a term popularized by Austrian economists, comes
in many shapes and sizes. It might involve some expensive white white-elephant
project, such as constructing a tunnel under the sea, or a pie pie-in-the-sky
technology scheme with no serious pr prospect of ever turning a profit. (TPOT,
emphasis added; the quotation is from 1928)

I’ll provide a few examples of imprudent investments made during the recent easy money period:

In the low-return environment of 2017, Argentina once again became the poster child for
questionable investment opportunities, when it offered 100-year bonds. As I asked at the
time in my memo There They Go Again . . . Again (July 2017), “Is Argentina, a country
that defaulted five times in the last hundred years (and once in the last five), likely to get
through the next hundred without a rerun?” Argentina’s checkered history as a borrower
was ignored in the low-return environment, and the bonds were oversubscribed thanks to
their having a yield of 7.85% at a time when 30-year Treasurys offered only 2.77%. It
took less than a year for Argentina to request a loan from the International Monetary

4
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Fund and less than three years for it to default on the bonds. When the 100-year bonds
were restructured in 2020, holders received new bonds with an expected recovery value
of roughly 54.5 cents on the dollar, according to The Wall Street Journal of August 31,
2020. Aptly, that same Journal article quoted Piotr Matys of Rabobank Group NV, as
saying, “Treasury yields are so low, it’s forcing investors into risk. That’s why
people are buying crazy stuff.”
In the 2010s, investors eagerly snapped up leveraged buyout loans bearing historically
low yields of around 6%. The buyers included CLOs, which are structured to give
relatively high yields to the investors in their lower-rated tranches, as well as private
credit lenders that levered up the prospective returns to roughly 9%.
While “zombie” companies that burn cash haven’t historically been considered
creditworthy, many were able to borrow easily in the pro-risk times through 2021. But as
financial conditions have tightened, these companies have seen their cost to borrow rise
and/or the amounts they can borrow shrink.
The craving for good returns in low-return
return times can enable scams. Theranos (the
medical technology company) and FTX (the cryptocurrency exchange) were the most
prominent examples in recent years. Such scandals are less likely to happen in times of
economic and capital market stringency, when investors are less eager and more careful.

Under easy-money conditions, long-dated

dated bonds may appear particularly desirable; since the
yield curve usually slopes upward, they typically offer higher yields. It should be noted,
however, that long bonds are more rate-sensitive
sensitive than short ones, meaning their prices change
more in response to a given change in interest rates. As a result,
result the higher yields on more-
volatile long bonds can attract capital in times of low rates, just when the odds usually favor a
subsequent increase in yields (and thus a rapid
rapid declin
decline in long bond prices).

It seems to me that there’ss often a similar movement of capital toward “long stocks” when interest
rates are low. By this I mean the stocks of companies believed to have many years of rapid
growth ahead. For these companies, more of the projected cash fl flows are, by definition, in the
distant future. Yet, investors may become more attracted to these stocks when rates are low
because they want the higher returns that such rapid growth would bring, and there
there’s less
opportunity cost associated with the long wait for the relevant cash flows. (These sound like
Hayek’s “projects
projects with more distant payoffs.
payoffs.” See the quote on the previous page.) Just as the
prices of longer bonds fluctuate more in response to a given change in interest rates, so-called
“growth
growth stocks”
stocks” usually rise more than others in times of easy money and fall more when money
dries up. The former was certainly the case in late 2020 and in 2021 . . . and the latter in 2022.

I love Hayek’ss word “malinvestment,” because of the validity of the idea behind it: in low-
return times, investments are made that shouldn’t be made; buildings are built that
shouldn’t be built; and risks are borne that shouldn’t be borne. People with money feel they
must put it to work, since cash yields little or nothing. They drop their risk aversion and, as
discussed below, compete spiritedly for lending or investing opportunities with higher potential
returns. The investment process becomes all about flexibility and aggressiveness, rather
than thorough diligence, high standards, and appropriate risk aversion.

Skimpy return prospects on safe assets lead to elevated risk taking – sometimes abetted by
widespread optimism and/or the suspension of disbelief – and thus to the approval of investments
that would likely be greeted with skepticism in normal times. Many of the risky assets people
invest in out of presumed necessity are deemed less palatable and less valuable under tougher
market conditions, when they can only be sold at lower prices.

5
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 v. Low rates enable deals to be financed readily and cheaply

Related to the above, low rates make people more willing to lend for risky propositions.
Providers of capital vie to be the one who gets the deal. To compete for deals, the “winner” must
be willing to accept low returns from possibly questionable projects and reduced safety, including
weaker documentation. For this reason, it’s often said that “the worst of loans are made at
the best of times.”

The availability of capital fluctuates radically. Whereas in times of stringency, capital may
not be available even to quality borrowers for valid purposes, in periods of easy money,
capital typically becomes available to weaker borrowers, in large amounts, for almost any
purpose. Things that couldn’t be financed in tighter times are deemed acceptable.

For one example, consider the shifting perception of high-tech tech companies. Prior to roughly 2005,
they were usually considered too undependable to be creditworthy, since outcomes for tech
investments are generally asymmetric. If the company succeeds, the equity owners get rich. If it
fails, there’ss little asset value for creditors to recover. But in the years following
followi the
tech/media/telecom meltdown of 2000-02,, when interest in public equities declined and large
sums flooded into private equity funds, tech ech companies began to be bought out, often with
financing from the newly popular field of private credit.

vi. Low interest rates encourage greater use of leverage, increasing fragility

Borrowed money – leverage – is the mother’ss milk of rapid expansion and speculation. In my
memo It’s All Good (July 2007), I compared leverage to ketchup: “I was a picky eater when I was
a kid, but I loved ketchup, and my pickiness could be overcome with ketchup.
ketchup.” Ketchup got me
to eat food I otherwise would have considered inedible. In much the same way, lever leverage can
make otherwise unattractive investments investible. Let Let’s say you’re offered a low-rated loan
yielding 6%. “No way,” you say, “I “I’dd never buy a security that risky at such a low yield.
yield.” But
what if you’rere told you can borrow the money to buy it aat 4%? “Oh, that’s a different story. I’ll
take all I can get.” But it must be noted that cheap leverage doesn
doesn’t make investments better; it
merely amplifies the results.

In times of low interest rates, absolute prospective returns are low and leverage is cheap.
Why not use a lot of leverage to increase expected returns? In the late 2010s, money flowed
to both private equity, given its emphasis on leveraged returns from company ownership, and
private credit, which primarily provides debt capital to private equity deals. These trends
complemented
mented each other and led to a significant upswing in levered investing.

But in the last decade, some companies acquired by private equity funds were saddled with
capital structures that failed to anticipate the increase in interest rates of 400-500 basis-
points. Having to pay interest at higher rates has reduced these companies’ cash flows and
interest coverage ratios. Thus, companies that took on as much debt as possible – based on their
former levels of earnings and the prevailing low interest rates – may now be unable to service
their debt or roll it over in a higher-rate environment.

Finally, all else being equal, the more leverage that’s piled on a company, the lower the
probability it’ll be able to survive a rough patch. This is one of the foremost reasons for the
adage “never forget the six-foot-tall man who drowned crossing the stream that was five feet deep
on average.” Heavy leverage can render companies fragile and make it hard for them to get
through the proverbial low spots in the stream. Take, for example, Signa, a large privately owned

6
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 property company in Europe, which announced in November of last year that it was beginning
insolvency proceedings:

The decision to go all-out during the era of cheap money left Signa
dangerously exposed to the sharp rise of interest rates this year. . . . And
rising interest rates have hammered commercial property values across the
market, reducing the value of the assets used to secure Signa’s loans. (FT
Asset Management Newsletter, December 11, 2023, emphasis added)

vii. Low interest rates can lead to financial mismatches

Easy-money episodes make it particularly attractive to borrow short at low rates in order to make
long-term investments or loans with higher prospective returns. This is the other classic reason
why, in the investment world, proverbial six-footers often drown.
rown. (Investors with liability
maturities that match the duration of their assets make it across the river much more regularly.)
In tougher times, if lenders demand their money back or decline to roll over existing debt when it
comes due, debtors can find themselves holding discounted or illiquid assets – just when cash is
needed. This is a familiar theme that frequently marks the turn of the cycle from benign to nasty.
Chancellor provides an example from 1866 in connection with the failure of Overend Gurney, a
London broker:

Lending against long dated and illiquid collateral was not a suitable business for
Overend, which normally discounted three-
three-month
three -month commercial paper financed
with daily cash calls on the money market. The Times [of London] described
how Overend had erred:

A Discount Company which had forsaken the business of discount

brokers for that of “financing
“financing”,
financing”, which had locked up its assets in
securities promising to repay a high rate of interest, but incapable of
conversion into cash on an emergency, had found its resources too
limited to meet the calls upon them except at a ruinous sacrifice of
its property, and had, therefore, suspended payment. ((TPOT)

viii. Low interest rates give rise to expectations of continued low rates

It’ss common for people to conclude that the environment they’ve

they lived through for a while is
“normal,” and that the future will entail more of the same. For this reason, people who have
gotten used to low interest rates may think rates will always be low and make decisions based on
that assumption. As a result, investor due diligence or corporate planning may assume that
the cost of capital will remain low. This can become a source of trouble if rates are higher
when financing is actually sought.

For example, in recent months, I’ve noted a number of lots in midtown Manhattan that have been
cleared for the construction of new buildings. Given the lengthy planning and approval process
involved with such projects, these buildings were undoubtedly greenlit in the low-interest-rate
environment that preceded 2022. Will they be built if the actual financing costs are higher than
those that were assumed? Or will they be abandoned at significant cost?

When the pandemic year of 2020 came to a close, the recovering economy, rallying stock market,
and low interest rates put investors in a good mood, and there was widespread belief that the Fed
would keep rates “lower for longer,” supporting the economy and stock market for years to come.

7
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 However, investors learned a lesson that has been repeated throughout financial history: catalysts
for interest rate increases inevitably pop up, and thus perpetual prosperity and “the end of cycles”
turn out to be nothing but wishful thinking. Consider another example from Chancellor:

One of the aims of U.S. monetary policy in the 1920s was to dampen the
seasonal fluctuations of interest rates caused by the agricultural cycle, which led
to money being tight at certain times of the year. The Fed was so successful at
this that Treasury Secretary Andrew Mellon went so far as to hail an end to the
cycle of boom and bust. “We are no longer the victim of the vagaries of business
cycles. . . . As economist Perry Mehring writes [in The New Lombard Street]:
“Intervention to stabilize seasonal and cyclical fluctuations produced low
and stable money rates of interest, which supported the investment boom
that fueled the Roaring Twenties but also produced an unstable asset price
bubble.” (TPOT, emphasis added)

ix. Low interest rates bestow benefits and penalties, creating winners and losers

Importantly, low interest rates subsidize borrowers at the expense of savers and lenders.
Does it make sense to reduce the revenues of lenders so that investors can lever their investments
cheaply?

[In the mid-17th century,]] Thomas Manley added that lowering the rate of
interest would involve robbing Peter (the creditor) to pay Paul (the borrower).
(TPOT)

Doing so is a policy decision, or more likely the consequence of a decision to stimulate the
economy. But it can have many other effects.

When the rate of interest on savings is 4%, a retiree fortunate enough to have saved up $500,000
will earn $20,000 per year on her bank balance
balance. But when the interest rate on a savings account
is near zero, as we saw for much of the last 14 years, she gets essentially nothing. Is it good for
society to make her settle for zero? Or would it be better if she put the money into the stock
market in an effort to make more?

While discussing the ramifications of policy decisions, let’s

let consider the impact of low rates on
the distribution of income and wealth.

. . . because assets like stocks and real estate are disproportionately held by
the rich, ZIRP [the “zero interest-rate policy” that was introduced in
December 2008] helped produce the largest spike in wealth inequality in
postwar American history. From 2007 to 2019, . . . the wealthiest 1 percent of
Americans saw their net worth increase by 46 percent, while the bottom half saw
only an 8 percent increase. A report from McKinsey Global Institute, not exactly
known as a bastion of economic populism, calculated that from 2007 to 2012, the
Fed’s policies created a benefit for corporate borrowers worth about $310 billion,
whereas households that tried to save money were penalized by about $360
billion. (The Atlantic, December 11, 2023, emphasis added)

The yawning economic gap is one of the biggest problems the U.S. faces, and it’s probably
responsible for a fair bit of the extreme divisiveness we see every day in the media and in

8
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 politics. A central bank’s decision to set rates that subsidize some and penalize others
clearly has consequences.

x. Low rates induce optimistic behavior that lays the groundwork for the next crisis

Elevated risk taking, underestimating future financing costs, and increased use of leverage
often lie behind investments that fail when tested in subsequent periods of stringency,
bringing on the next crisis and perhaps the need for the next rescue. In this way, excesses in
one direction typically precede excesses in the other direction.

In October 1889, the Governor of the Bank of England, William Lidderdale,

delivered a stern warning to the City:

The present tendency of finance . . . is distinctly in the direction of

danger, too much capital is being forced into industrial
developments, financiers are taking larger & larger risks in securities
which require prosperity & easy money to carry without becoming a
burden, & an increased number of investments have been driven up
in price by the combined efforts of a long period of cheap money &
depression in trade . . . we have most of the elements of a Crisis.
(TPOT)

The Never-Ending Story

One of the quotes I return to most frequently is Mark Twain’s

Twain purported observation that “history doesn’t
repeat itself, but it often rhymes.” For investors, cycles, along with their causes and effects, are
among the influential matters that invariably rhyme from one period to the next.

Roughly 30 years ago – largely thanks to my involvement with my partner Bruce Karsh and his distressed
debt funds – I became much more conscious of the importance of fluctuations in the availability and cost
of money. Thus, I wrote as follows in my memo You Can’t Predict. You Can Prepare. (November 2002):

The longer I’mm involved in investing, the more impressed I am by the power of the credit
cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in
the availability of credit, with great impact on asset prices and back on th
the economy
itself.

I reused that paragraph in my 2018 book Mastering the Market Cycle: Getting the Odds on Your Side,
adding this:

. . . the credit cycle can be easily understood through the metaphor of a window. In short,
sometimes it’s open and sometimes it’s closed. And, in fact, people in the financial world
make frequent reference to just that: “the credit window,” as in “the place you go to
borrow money.” When the window is open, financing is plentiful and easily obtained,
and when it’s closed, financing is scarce and hard to get. . . .

9
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
In the book I made three foundational observations about cycles in general:

The events that make up each cyclical progression don’t merely follow each other. Much
more importantly, each event in the progression is caused by those that went before. This
causality must be appreciated if one is to fully understand cycles and navigate them successfully.
Cyclical oscillation isn’t best thought of as consisting merely of “ups and downs,” but rather as
(a) an excessive departure from the midpoint, secular trend or norm in one direction, and (b) a
correction of that excess, which often ends up in (c) an excessive continuation of the correction in
the opposite direction. “Excesses and corrections” is a much more useful way to think about
cycles than “ups and downs.”
Cycles don’t have an obvious beginning and end. The only requirement for something to
correctly be considered a full cycle is that it must include four components: (1) a movement from
a norm to a high, (2) a move away from that high back toward the norm, (3) a move from the
norm to a corresponding low, and (4) a movement from that low back toward the norm. Any of
these can be labeled the start of a cycle, providing it goes on to include all four.

While there’ss no fixed point that represents the official start or end of a cycle, most economic cycles can
be described as follows. Notably, each step in the cycle causes the next.

First, stimulative rate cuts bring on easy money and positive market developments;
which reduce prospective returns;
which leads to willingness to bear increased risk;
which results in unwise decisions and, eventually, investment losses;
which bring on a period of fear, stringency, tight money, and economic contraction;
which leads to stimulative rate cuts, easy money, and positive market developments.

Here’ss an especially trenchant observation on the cyclical process:

The Manchester banker

anker John Mills commented perceptively [in 1865] that “as a rule,
panics do not destroy capital; they merely reveal the extent to which it has
previously been destroyed by its betrayal into hopelessly unproductive works.
works.”
(TPOT, emphasis added)
added)

As readers know, I believe investors can gain an advantage by studying cycles, understanding their
causes, and watching for excesses in one direction that are likely to lead to corrections in the opposite
direction. Walter Bagehot, the editor of The Economist in the 1860s, is described as having demonstrated
an exceptional understanding of cycles and cycle
cycle-related behavior:

. . . our modern monetary mandarins never stop to consider Bagehot’s warnings about the
adverse consequences of easy money – how interest rates set at 2 per cent or less fuel
speculative manias, drive savers to make risky investments, encourage bad lending and
weaken the financial system. (TPOT)

What I so enjoy about Chancellor’s books is the way they illustrate the tendency of financial history
themes to rhyme, as Twain would say, and thus how behavior that took place 200 or 400 years ago is
being repeated today and is sure to reappear again and again in the future. What he tells is a never-
ending story.

10
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Easy Money Observed

The behavior brought on by low rates takes place in plain sight. Some people take note of it, and a subset
of them talk about it rather than let it pass unremarked. Fewer still understand its real implications. And
almost no one alters their investment approach to take them into account.

The low-rate period that immediately preceded the Global Financial Crisis of 2008-09 was marked by the
kind of spirited competition to make investments and provide financing described above. It was in this
climate that Chuck Prince, then CEO of Citi, made the statement for which he is remembered:

When the music stops, in terms of liquidity, things will be complicated. But as long as
the music is playing, you've got to get up and dance. (July 14, 2007)

When money is easy, few people opt to sit out the dance, even though the adverse results described
above can reasonably be anticipated. When faced with the choice between (a) maintaining high
standards and missing deals and (b) making risky investments,, most people will choose the latter.
Professional investment managers especially may fear the consequences of idiosyncratic behavior that’s
that
bound to look wrong for a while. Abstaining demands uncommon strength when doing so means
departing from herd behavior.

And this gives me a great opportunity to reference one of my favorite quotations from John Kenneth
Galbraith’s wonderful book on market excesses:

Contributing to and supporting this euphoria are two further factors little noted in our
time or in past times. The first is the extreme brevity of the financial memory. In
consequence, financial disaster is quickly forgotten. . . . There can be few fields of
human endeavor in which history counts for so little as in the world of financ
finance. (A Short
History of Financial Euphoria)

The lessons from past periods of easy money usually fall on deaf ears since they come up against (a)
ignorance of history, (b) the dream of profit, (c) the fear of missing out, and (d) the ability of
cognitive dissonance to make people dismiss information that is inconsistent with their beliefs or
perceived self-interest.
interest. These things are invariably enough to discourage prudence in times of low
interest rates, despite the likely consequences.

As you no doubt know, Charlie Munger passed away on November 28 at the age of 99. I want to pay a
small tribute to Charlie’s
Charlie’s life and wisdom by sharing something he wrote me in 2001: “Maybe we have a
new version of Lord Acton
Acton’s law: easy money corrupts, and really easy money corrupts absolutely.”

Will We Go Back to Easy Money?

Before I turn to the above question, I want to answer the one I’m asked most often these days: “Are you
saying interest rates are going to be higher for longer?” My answer is that today’s rates aren’t high.
They’re higher than we’ve seen in 20 years, but they’re not high in the absolute or relative to history.
Rather, I consider them normal or even on the low side.

In 1969, the year I started work, the fed funds rate averaged 8.2%.
Over the next 20 years, it ranged from 4% to 20%. Given this range, I certainly wouldn’t
describe 5.25-5.50% as high.

11
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Between 1990 and 2000, which I would consider the last roughly normal period for rates, the fed
funds rate ranged from 3% to 8%, suggesting a median equal to today’s 5.25-5.50%.

So no, today’s interest rates aren’t high. Having disposed of that question, I’ll move to the subject of this
section: the outlook for rates.

Many of my reasons for believing we’re not going back to ultra-low rates are rooted in my thoughts on
how the Fed should think about the issue. But the Fed could decide to lower rates to stimulate economic
growth or reduce the cost of servicing the national debt, even if doing so might be deemed imprudent.
Thus, I have no idea what the Fed will do. But I’m sticking with the thinking that follows.

In my original Sea Change memo, I listed a number of reasons why we weren’t likely to go back to ultra-
low interest rates anytime soon. The most salient are these:

Globalization has been a strong disinflationary influence, and it’ss likely on the decline. For this
reason – and because the bargaining power of labor seems to be on the rise – I believe inflation
may tend to be higher in the near future than it was pre-2021.
021. If true, this will, all else being
equal, mean interest rates will be kept higher to prevent inflation from accelerating.
Rather than be in a perpetually stimulative posture, the Fed may want to maintain the neutral rate
most of the time. This rate, which is neither stimulative nor restrictive, has most recently been
estimated to be 2.5%.
The Fed might want to get out of the business of controlling rates and let supply and demand set
the price of money, which hasn’tt been the case for a quarter century.
Having had a taste of inflation for the first time in decades, the Fed might keep the fed funds rate
high enough to avoid encouraging another bout. To control inflation, one would think the rate
would need to be kept positive in real terms. If inflation will be, say, 2.5%, the fed funds rate
would by definition have to be above that.
Perhaps most importantly, one of the Fed Fed’s essential jobs is to enact stimulative monetary
Fed’
policy if the economy falls into recession, largely by cutting rates. It can’t do that effectively
if the rate is already zero or 1%.

To this list, I would add a few more reasons for not returning to ultra-low interest rates, including the
tendency of easy money to (a) induce risk taking and “malinvestment”; (b) encourage increased use of
leverage; (c) produce asset bubbles; and (d) create economic winners and losers. Finally, cutting rates to
stimulative territory as soon as inflation hits 2% could cause it to reaccelerate. Instead, the plan
should be to get inflation to 2% and then keep rates at a level that is neither stimulative nor
restrictive.

After listing the above bulleted arguments against renewed low rates, I went on in Sea Change to say the
following (despite my strong aversion to predictions):

These are the reasons why I believe that the base interest rate over the next several
years is more likely to average 2-4% (i.e., not far from where it is now) than 0-2%.
Of course, there are counterarguments. But, for me, the bottom line is that highly
stimulative rates are likely not in the cards for the next several years, barring a serious
recession from which we need rescuing . . .

Most people – other than lenders and savers – want low interest rates: people (and businesses) with
floating-rate mortgages and other debt, consumers in general, homebuilders, car and boat dealers, private
equity firms and their LPs, investors using leverage, and the people charged with paying the interest on

12
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
our national debt. But when you consider the reasons for not keeping rates permanently low, as
enumerated above, I think the economic merits favor setting rates low only as an emergency
measure to rescue the economy from prolonged or severe contractions.

When I attended graduate school at the University of Chicago, the leading intellectual light was
economist Milton Friedman, who argued strenuously that the free market is the best allocator of
resources. In this same vein, I’m convinced that so-called “natural” interest rates lead to the best overall
allocation of capital. This is why I so like Chancellor’s decision to title his book The Price of Time.
That’s what interest rates are: the price borrowers pay to rent lenders’ money for a period of time.
Natural rates reflect supply and demand for money, and they’re found at the intersection of (a) the price
suppliers of money ask for parting with it temporarily and (b) the price borrowers are willing to pay to use
it. Like Chancellor, I think it’s clearly best when interest rates are naturally occurring.

A consensus emerged among [17th-century] English practitioners of “political

political
arithmetick” that interest – defined by one writer as “aa Reward for forbearing the use of
your own Money for a Term of Time agreed upon” – was much like any other price,
whose level should be determined by buyers rs and sellers in the market, rather than
government fiat. (TPOT)

Even though it cannot be known with certainty, it is useful to hold in mind how the world
would look if the natural rate held sway; . . . a rate that accurately reflects society
society’s time
preference; which ensures that we neither borrow too much nor save too little; which
ensures capital is used efficiently, and puts an accurate value on land and other assets; a
rate which provides savers with a fair return and is not so low as to subsidize bankers and
their financial friends, nor so high as to bite borrowers. (TPOT)

Or as the central bank head of Germany said in 1927, a time when his counterparts in the U.S. and Great
Britain were arguing for easy money, “Don’t
Don’tt give me a low rate, give me a true rate, and then I shall
know how to keep my house in order.” ((TPOT
(TPOT)
TPOT))
TPOT

Natural rates seem to me to be related to but not quite the same thing as “neutral rates,” which are rates
that are neither stimulative nor restrictive. Neutral rates are less likely than administered rates to be
super-high or super-low,
low, and thus less likely to encourage extreme behavior. As Swedish economist Knut
Wicksell said in 1936:

. . . if the rate of interest was too low, credit would expand rapidly, and inflation would
appear. On the other hand, if the rate was kept too high, credit would contract and prices
would decline. (TPOT((TPOT)

In my view we haven’t had a free market in money since the late 1990s, when I believe the Fed became
“activist,” eager to head off problems real and imagined by injecting liquidity. Given that activism,
investors have become preoccupied with central bank actions and their consequences. For years, that’s all
investors have talked about.

If I ran the Fed (to be clear, I don’t expect to be offered the job), I think I would (a) lower rates to
stimulate the economy when it’s growing too slowly to produce needed jobs; (b) raise rates to cool off the
economy when it’s overheating, to head off rising inflation; and (c) keep my hands off rates the rest of
time, allowing market forces to determine their level. Under this construct, we certainly wouldn’t see
rates perpetually near zero, as we did much of the time from 2009 to 2021. (I estimate the fed funds rate
averaged roughly 0.5% over that stretch).

13
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Finally, what will we see moving forward? It now appears that sometime in 2024, the Fed will declare
victory against inflation and begin to reduce the fed funds rate from today’s somewhat restrictive 5.25-
5.50%. The current “dot plot,” which summarizes the views of Fed officials, shows three 25-bps rate cuts
in 2024, bringing the rate to 4.60%, and then more cuts in 2025, taking it to the mid-3s. However, today’s
consensus thinking among investors seems to be considerably more optimistic than that, anticipating
more/earlier/bigger rate cuts.

While on the subject of consensus thinking, I’ll point out the following:

Eighteen months ago, it was near-universally accepted that the Fed’s aggressive program of rate
increases would result in a recession in 2023. That was wrong.
Twelve months ago, the optimists who launched the current stock market rally were motivated by
their belief that the Fed would pivot to dovishness and start cutting rates in 2023. That was
wrong.
Six months ago, there was a consensus that there would be one more rate increase in late 2023.
That was wrong.

I find it interesting that the current stock market rally began as a result of optimism powered by consensus
thinking that was generally off target. (See the second bullet point just above.)

At present, I believe the consensus is as follows:

Inflation is moving in the right direction and will soon reach the Fed
Fed’s target of roughly 2%.
As a consequence, additional rate increases won’t be necessary.
As a further consequence, we’llll have a soft landing marked by a minor recession or none at all.
Thus, the Fed will be able to take rates back down.
This will be good for the economy and the stock market.

Before going further, I want to note that, to me, these five bullet points smack of “Goldilocks thinking”:
the economy won’tt be hot enough to raise inflation or cold enough to bring on an economic slowdown.
I’ve seen Goldilocks thinking in play a few times over the course of my career, and it rarely holds for
long. Something usually fails to operate as hoped, and the economy moves away from perfection. One
important effect of Goldilocks thinking is that it creates high expectations among investors and th thus
room for potential disappointment (and losses). FT Unhedged recently expressed a similar view:

Yesterday’ss letter suggested that we think the market’s

market current expectation of solid
growth and six rate cuts seemed likely to be wrong in one direction or the other: either
strong growth will limit the Fed to close to the three rate cuts it currently forecasts, or
growth will be weak and there will be as many cuts as the market expects. In this sense,
the market does look to be pricing in too much good news. (December 20, 2023)

I don’t have an opinion as to whether the consensus described above is correct. However, even
granting that it is, I’ll still stick with my guess that rates will be around 2-4%, not 0-2%, over the
next few years. Do you want more specificity? My guess – and that’s all it is – is that the fed funds rate
will average between 3.0% and 3.5% over the next 5-10 years. If you think I’m wrong, ask yourself
whether you’d put your money on a different half-point range. (Before readers protest my
uncharacteristic descent into forecasting, I’ll point out that, at Oaktree, we say it’s okay to have opinions
on the macro; it’s just not okay to bet clients’ money on them. We invest with an awareness of current
macro conditions, but our investment decisions are always based on bottom-up analysis of companies and
securities, not macro forecasts.)

14
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 * * *

The upshot of my sea change thesis is simple:

1. The period from 1980 through 2021 was generally one of declining and/or ultra-low interest rates.
2. This had profound ramifications in many areas, including determining which investment
strategies would be the winners and losers.
3. That changed in 2022, when the Fed was forced to begin raising interest rates to combat inflation.
4. We’re unlikely to go back to such easy money conditions, other than temporarily in response to
recessions.
5. Therefore, the investment environment in the coming years will feature higher interest rates
than those we saw in 2009-21. Different strategies will outperform in the period ahead, and
thus a different asset allocation is called for.

Bullet points one through three above are statements of fact and not controvertible. Consequently,
the conclusion – number five – depends exclusively on whether number four is correct. The
question is simple: do you agree with it or don’t you? If you agree, we have a host of solutions to
propose.

January 9, 2024

15
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

16
© 2024 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Further Thoughts on Sea Change

In May, I wrote a follow-up memo to Sea Change (December 2022) that was shared exclusively with
Oaktree clients. In Further Thoughts on Sea Change, I argued that the trends I had highlighted in the
original memo collectively represented a sweeping alteration of the investment environment that called
for significant capital reallocation. This memo was originally sent to Oaktree clients on May 30, 2023.1

This Time It Really Might Be Different

On October 11, 1987, I first came across the saying “this time it’ss different.” According to an article in
The New York Times by Anise C. Wallace, Sir John Templeton had warned that when investors say times
are different, it’s usually in an effort to rationalize valuations that appear high relative to history – and it’s
usually done to investors’ ultimate detriment. In 1987, it was high equity prices in general; the article I
cite was written just eight days before Black Monday, when the Dow Jones Industr Industrial Average declined
by 22.6% in a single day. A dozen years later, the new thing people were excited about was the prospect
that the Internet would change the world. This belief served
served to justify ultra
ultra-high prices (and p/e ratios of
infinity) for digital and e-commerce
commerce stocks, many of which went on to lose more than 90% of their value
over the next year or so.

Importantly, however, Templeton allowed that things might really be different 20% of the time. On rare
occasions, something fundamental does change, with significant implications for investing. Given the
pace of developments these days – especially in technology – I imagine things might genuinely be
different more often than they were in Templeton
Templeton’s day.

Anyway, that’s all preamble.

reamble. My reason for writing this memo is that, while most people I speak with
seem to agree with many of my individual observations in Sea Change, few have expressly agreed with
my overall conclusion and said, “I think you’re
you right: We might be seeing a significant and possibly
lasting change in the investment environment.
environment.” This memo’s main message is that the changes I
described in Sea Change aren
aren’t just usual cyclical fluctuations; rather, taken together, they
represent a sweeping alteration of the investment environment, calling for significant capital
reallocation.

The Backdrop

I’ll start off by recapping my basic arguments from Sea Change:

In late 2008, the Federal Reserve took the fed funds rate to zero for the first time ever in order to
rescue the economy from the effects of the Global Financial Crisis.

1
All market data cited in this memo is as of May 30, 2023.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Since that didn’t cause inflation to rise from its sub-2% level, the Fed felt comfortable
maintaining accommodative policies – low interest rates and quantitative easing – for essentially
all of the next 13 years.
As a result, we had the longest economic recovery on record – exceeding ten years – and “easy
times” for businesses seeking to earn profits and secure financing. Even money-losing businesses
had little trouble going public, obtaining loans, and avoiding default and bankruptcy.
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.
The massive Covid-19 relief measures – combined with supply-chain snags – resulted in too
much money chasing too few goods, the classic condition for rising inflation.
The higher inflation that arose in 2021 persisted into 2022, forcing the Fed to discontinue its
accommodative stance. Thus, the Fed raised interest rates dramatically – its fastest tightening
cycle in four decades – and ended QE.
For a number of reasons, ultra-low or declining interest rates are unlikely to be the norm in the
decade ahead.
Thus, we’re likely to see tougher times for corporate profits, for asset appreciation, for borrowing,
and for avoiding default.
Bottom line: If this really is a sea change – meaning the investment environment has been
fundamentally altered – you shouldn’t assume the he investment strategies that have served you best
since 2009 will do so in the years ahead.

Having supplied this summary, I’m

m going to put flesh on these bones and share some additional insights.

A Momentous Development

To promote discussion these days, I often start by asking people, “What do you consider to have been the
most important event in the financial world in recent decades?
decades?” Some suggest the Global Financial Crisis
and bankruptcy of Lehman Brothers, some the bbursting of the tech bubble, and some the Fed/government
response to the pandemic-related
related woes. No one cites my candidate: the 2,000-basis-point
2,000 decline in
interest rates between 1980 and 2020. And yet, as I wrote in Sea Change, that decline was probably
responsible for the lion’s
’ss share of investment profits made over that period. How could it be overlooked?

First, I suggest the metaphor of boiling a frog. It’s said that if you put a frog in a pot of boiling water, it’ll
jump out. But if you put ut it in cool water and turn on the stove, it’ll just sit there, oblivious, until it boils to
death. The frog doesn’t detect the danger – just as people fail to perceive the significance of the interest
rate decline – because of its gradual, long-term nature. It’s not an abrupt development, but rather a drawn
out, highly influential trend.

Second, in Sea Change, I compared the 40-year interest rate decline to the moving walkway at an airport.
If you stand still on the walkway, you’ll move effortlessly; but, if you walk at your normal pace, you’ll
move ahead rapidly – perhaps without being fully conscious of why. In fact, if everyone’s walking on the
moving walkway, doing so can easily go unnoted, and the walkers might conclude that their rapid
progress is “normal.”

Finally, there’s what John Kenneth Galbraith called “the extreme brevity of the financial memory.”
Relatively few investors today are old enough to remember a time when interest rates behaved differently.
Everyone who has come into the business since 1980 – in other words, the vast majority of today’s

2
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
investors – has, with relatively few exceptions, only seen interest rates that were either declining or
ultra-low (or both). You have to have been working for more than 43 years, and thus be over 65, to have
seen a prolonged period that was otherwise. And since market conditions made it tough to find
employment in our industry in the 1970s, you probably had to get your first job in the 1960s (like me) to
have seen interest rates that were either higher and stable or rising. I believe the scarcity of veterans from
the ’70s has made it easy for people to conclude that the interest rate trends of 2009-21 were normal.

The Relevance of History

The 13-year period from the beginning of 2009 through the end of 2021 saw two rescues from financial
crises, a generally favorable macro environment, aggressively accommodative central bank policies, a
lack of inflation worries, ultra-low and declining interest rates, and generally uninterrupted investment
gains. The question, of course, is whether investors should expect
pect a continuation of those trends.

Recent events have shown that the risk of rising inflation can’tt be ignored in perpetuity
perpetuity.
Moreover, the reawakening of inflationary psychology will probably make central banks less
likely to conclude that they can engage in continuous monetary stimulation without
consequences.
Thus, interest rates can’t be counted on to stay “lower
lower for longer”
longer and produce perpetual
prosperity, as many thought was the case in late 2020.
Also in late 2020, Modern Monetary Theory was accepted by some as meaning deficits and
national debt could be disregarded in countries “with control of their currencies.”
currencies (We no longer
hear anything about this notion.)

In Sea Change,, I listed several reasons why I don’tt think interest rates are going back to that period’s
lows on a permanent basis, and I still find these arguments compelling.
compelling In particular, I find it hard to
believe the Fed doesn’tt think it erred by sticking with ultra-low
ultra interest rates for so long.

As noted above, too fight the GFC, the Fed took the ffed funds rate to roughly zero for the first time in late
2008. Macro conditions
onditions were frightening, as a vicious cycle capable of undermining the entire financial
system appeared to be underway. For this reason, aggressive action was certainly called for. But I was
shocked when I looked at the data and saw that the Fed kept the rate near zero for nearly seven years.
Setting interest rates at zero
zero is an emergency measure, and we certainly didn
didn’t have a continuous
emergency through late 2015. To To me, those
t sustained low rates stand out as a mistake not to be repeated.

Further, by 2017-18,
18, with the fed funds rate around 1%, it had become clear to many that there wasn’t
room for the Fed to reduce rates if necessary to stimulate the economy during a recession. But when the
Fed attempted to raise rates to create that room, it encountered pushback from investors (see the fourth
quarter of 2018). I find it hard to believe the Fed would want to reimpose that limitation on its toolkit.

A recurring theme of mine is that, even though many people agree that free markets do the best job of
allocating resources, we haven’t had a free market in money in roughly the last two decades, a period of
Fed activism. Instead, Fed policy has been accommodative almost the entire time, and interest rates have
been kept artificially low. 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

3
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
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.

Many articles about the problems at Silicon Valley Bank and First Republic Bank cite errors that were
made in the preceding “easy-money” period. Rapid growth, unwise inducements to customers, and lax
financial management were all encouraged in a climate with accommodative Fed policy, uniformly
positive expectations, and low levels of risk aversion. This is just one example of a time-worn adage in
action: “The worst of loans are made in the best of times.” I don’t think the Fed should return us to an
environment that has been distorted to encourage universal optimism, belief in the existence of a Fed put,
and thus a dearth of prudence.

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
(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;
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
kely to set in.

Please note that I’m

m not saying interest rates, having declined by 2,000 basis points over the last 40 or so
years, are going back up to the levels seen in the 1980s.
1980s In fact, I see no reason why short-term interest
rates five years from now should be appreciably higher than they are today. But still, I think the easy
times – and easy money – are largely over. How can I best communicate what I’m I talking about? Try
this: Five years ago, an investor went to the bank for a loan, and the banker said, “We’ll give you
$800 million at 5%.” Now the loan has to be refinanced
refinanced, and the banker says, “We’ll give you $500
million at 8%.” That means the investor’s
investor cost of capital is up, his net return on the investment is
down (or negative), anand
d he has a $300 million hole to fill.

What Strategies Will Work Best

Best?

It seems obvious that if certain strategies were the best performers in a period with a given set of
characteristics, it must be true that a starkly different environment will produce a dramatically
altered list of winners.

As mentioned above in the recap of Sea Change, the 40 years of low and declining interest rates
were hugely beneficial for asset owners. Declining discount rates and the associated reduction in
the competitiveness of bond returns led to substantial asset appreciation. Thus, asset ownership –
whether related to companies, pieces of companies (equities), or properties – was the place to be.
Falling interest rates brought down the cost of capital for borrowers. As this occurred, any
borrowing automatically became more successful than originally contemplated.
And, as I also mentioned in Sea Change, the combined result of the above for investors who
bought assets on borrowed money was a double bonanza. Think back to the first of the sea

4
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 changes I mentioned in that memo: the advent of high yield bonds in 1977-78, which brought
about the trend toward bearing risk for profit and the emergence of levered investment strategies.
It’s very notable that almost the entire history of levered investment strategies has been
written during a period of declining and/or ultra-low interest rates. For example, I would
venture that nearly 100% of capital for private equity investing has been put to work since interest
rates began their downward move in 1980. Should it come as a surprise that levered investing
thrived in such salutary conditions?
At the same time, declining interest rates rendered lending – or buying debt instruments – less
rewarding. Not only were prospective returns on debt low throughout the period, but investors
who were eager to get away from the ultra-low yields on safer securities like Treasurys and
investment grade corporates competed spiritedly to deploy capital in higher-risk markets, and this
caused many to accept lower returns and reduced lender protections.
Finally, conditions in those halcyon days created tough times for bargain hunters. Where do the
greatest bargains come from? The answer: the desperation of panicked holders.
holders When times are
untroubled, asset owners are complacent, and buyers are eager, no one has any urgency to exit,
making it very hard to score significant bargains.

Investors who profited in this period from asset ownership and levered investment strategies may
overlook the salutary effect of interest rates on asset values and borrowing costs and instead think the
profits stemmed from the inherent merit of their strategies, perhaps with some help from their own skill
and wisdom. That is, they may have violated a basic rule in investing
investing: “Never confuse brains and a bull
market.” Given the benefits of being on the “moving
moving walkway”
walkway” during this period, it seems to me it
would have required really bad decision-making
making or really bad luck for a purchase of assets made with
borrowed money to have been unsuccessful.

Will asset ownership be as profitable in the years ahead as in the 20092009-21 period? Will leverage
add as much to returns if interest rates don’tt decline over time or if the cost of borrowing isn’t
much below the expected rate of return on the assets purchased? Whatever the intrinsic merits of
asset ownership and levered investment, one would think the benefits will be reduced in the years
ahead. And merely riding positive trends by buying and levering may no longer be sufficient to produce
success.. In the new environment, earning exceptional returns will likely once again require skill in
making bargain purchases and,, in control strategies, adding value to the assets owned.

Lending, credit, or fixed income investing should be correspondingly better off. As I mentioned in
my December memo, the 13 years in question were a ddifficult, dreary, low-return period for credit
investors, including Oaktree.
Oaktree. Most of the asset classes we operate in were offering the lowest prospective
returns any of us had ever seen. The options were to (a) hold and accept the new lower returns, (b) reduce
risk to prepare for the correction that the demand for higher returns would eventually bring, or (c)
increase risk in pursuit of higher returns. Obviously, all of these had drawbacks. The bottom line was
that it was quite challenging to safely and dependably pursue high returns in a low-return world like the
one we were experiencing.

But now, higher prospective returns are here. In early 2022, high yield bonds (for example) yielded in the
4% range – not a very useful return. Today, they yield more than 8%, meaning these bonds have the
potential to make a great contribution to portfolio results. The same is generally true across the entire
spectrum of non-investment grade credit.

5
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Asset Allocation Today

My thinking about the sea change materialized mostly as I was visiting clients last October and
November. When I got home, I wrote the memo and began to discuss its thesis. And at the December
meeting of a non-profit investment committee, I said the following:

Sell off the big stocks, the small stocks, the value stocks, the growth stocks, the U.S.
stocks, and the foreign stocks. Sell the private equity along with the public equity, the
real estate, the hedge funds, and the venture capital. Sell it all and put the proceeds into
high yield bonds at 9%.

This institution needs to earn an annual return of 6% or so on its endowment, and I’m convinced that if it
holds a competently assembled portfolio of 9% high yield bonds, it would be overwhelmingly likely to
exceed that 6% target. But mine wasn’t a serious suggestion, more a statement designed to evoke
discussion of the fact that, thanks to the changes over the last year and a half, investors today can get
equity-like returns from investments in credit.

The Standard & Poor’s 500 Index has returned just over 10% per year for almost a century, and
everyone’s very happy (10% a year for 100 years turns $1 into almost $14,000).
$14,000 Nowadays, the ICE
BofA U.S. High Yield Constrained Index offers a yield of over 8.5%,
8.5%, the CS Leveraged Loan Index
offers roughly 10.0%,, and private loans offer considerably more. In other words, expected pre-tax
yields from non-investment grade debt investments now approach or exceed the historical returns
from equity.

And, importantly, these are contractual returns. When I shifted from equities to bonds in 1978, I was
struck by a major difference. With equities, the bulk of your return in the short or medium term depends
on the behavior of the market. If Mr. Market’s ’s in a good mood, as Ben Graham put it, your return will
benefit,, and vice versa. With credit instruments, on the other hand, your return comes overwhelmingly
from the contract between you and the borrowers. You give a borrower money up front; they pay you
interest every six months; and they give you your money back at the end. And, to greatly oversimplify, if
the borrower doesn’tt pay you as promised, you and the other creditors get ownership of the company via
the bankruptcy process, a possibility that gives the borrower a lot of incentive to honor the contract. Th
The
credit investor isn’tt dependent on the market for returns
returns; if the market shuts down or becomes illiquid, the
return for the long-term
term holder is un
unaffected.
affected. The difference between the sources of return on stocks and
bonds is profound, something many inve investors may understand intellectually but not fully appreciate.

It’ss been years since prospective returns on credit were competitive with those on equities. Now it’s the
case again. Should the non-profit
non whose board I sit on put all its money into credit instruments? Perhaps
not. But Charlie Munger exhorts us to “invert,” or flip questions like this. To me, this means allocators
should ask themselves, “What are the arguments for not putting a significant portion of our capital
into credit today?”

Here I’ll mention that, over the years, I’ve seen institutional investors pay lip service to developments in
markets and make modest changes in their asset allocation in response. When the early index funds
outperformed active management in the 1980s, they said, “We’ve got that covered: We’ve moved 2% of
our equities to an index fund.” When emerging markets look attractive, the response is often to move
another 2%. And from time to time, a client tells me they’ve put 2% in gold. But if the developments I
describe really constitute a sea change as I believe – fundamental, significant, and potentially long-
lasting – credit instruments should probably represent a substantial portion of portfolios . . .
perhaps the majority.

6
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
What’s the downside? How could this be a mistake?

First, individual borrowers can default and fail to pay. It’s the main job of the credit manager to
weed out the non-payers, and history shows it can be done. Isolated defaults are unlikely to
derail a well-selected and well-diversified portfolio. And if you’re worried about a wave of
defaults hitting your credit portfolio, think about what the implications of that environment
would be for equities or other ownership assets.
Second, by their nature, credit instruments don’t have much potential for appreciation. Thus, it’s
entirely possible that equities and levered investment strategies will surprise on the upside and
outperform in the years ahead. There’s no denying this, but it should be borne in mind that the
“downside risk” here consists of the opportunity cost of returns forgone, not failing to achieve
the return one sought.
Third, bonds and loans are subject to price fluctuations, meaning having to sell in a weak period
could cause losses to be realized. But credit instruments are far from alone in this regard, and the
magnitude of the fluctuations on “money-good” bonds and loans is constrained significantly by
the magnetic “pull to par” exerted by the promise of repayment
payment upon maturity.
Fourth, the returns I’ve
ve been talking about are nominal returns. If inflation isn
isn’t brought under
control, those nominal returns could lose significant value when they
they’re converted into real
returns, which are what some investors care about most.. Of course, real returns on other
investments could suffer as well. Many people think of stocks and real estate as potentially
providing inflation protection, but my recollection from the 1970s is that the protection typically
takes hold only after prices have declined so as to provide higher prospective returns.
Finally, the sea change could end up being less long
long-lasting
lasting than I expect, meaning the Fed takes
take
the fed funds rate back down to zero or 1% and the yields on credit recede accordingly.
Fortunately, by buying multi-year
year credit instruments, an investor can tie up the promised return
for a meaningful period (assuming the investment provides some degree of call protection).
Reinvesting will have to be dealt with upon maturity or call,
call but once you’ve made the credit
investments I’mm suggesting, you will at least have secured the promised yield – perhaps minus
losses on defaults – for the term of the instruments.

* * *

The overarching theme of my sea sea-change thinking is that, largely thanks to highly accommodative
monetary policy, we went through unusually easy times in a number of important regards over a
prolonged period,, but that time is over. There clearly isn’t much room for interest rate declines from
today’s levels, and I don’t think short-term interest rates will be as low in the coming years as in the
recent past. For these and other reasons, I believe the years ahead won’t be as easy. But while my
expectations may prove correct, there’s no evidence yet on which I can hang my hat. Why not? My
answer is that the economy and markets are in the early stages of a transition that’s far from complete.

Asset prices are established through a tug-of-war between buyers who think prices will rise and sellers
who think they’ll fall. There’s been an active one over the last year or so as sentiment has waxed and
waned regarding the outlook for inflation, recession, corporate profits, geopolitics, and especially a Fed
pivot back to accommodation. The tug-of-war is ongoing, and, as a result, the S&P 500 is within a half
percent of where it was a year ago.

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

7
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
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.

The positive forces that shaped the 2009-21 period began to change around 18 months ago. The higher
inflation turned out not to be transitory. This brought on interest rate increases, concern that a recession
would result, some resurrection of worry over the possibility of loss, and thus insistence on greater
compensation for bearing risk. But while most people no longer see an outlook that’s flawless, few think
it’s hopeless either. Just as optimism abetted a positive cycle in those 13 years, I believe a lessening
of optimism will throw some sand into the financial gears in a variety of ways, some of which may
be unforeseeable.

In this latter regard, it’s essential to acknowledge that since we haven’tt lived through times exactly like
the years that lie ahead – and since changes in the economic/financial environment limit the applicability
of history – we’rere likely to encounter surprises. And if the environment is less favorable, the surprises are
likely to be on the downside.

Please note, as mentioned earlier, that I’m

m absolutely not saying interest rates are going back to the high
levels from which they’veve come. I have no reason to believe that the recession most people believe lies
ahead will be severe or long-lasting.
lasting. And with valuations high, bbut not terribly so, I don’t think a stock
market collapse can reasonably be predicted. This isn’t
isn a call for dramatically increased defensiveness.
Mostly I’mm just talking about a reallocation of capital, away from ownership and leverage and toward
lending.

This isn’t a song I’ve sung often over the course of my career. This is the first sea change II’ve remarked
on and one of the few calls I’ve
ve made for substantially increas
increasing investment in credit. But the bottom
line I keep going back to is that credit investors can access returns today that:

are highly competitive versus the historical returns on equities,

exceed many investors’
investors required returns or actuarial assumptions, and
are much less uncertain than equity returns.

Unless there are serious holes in my logic, I believe significant reallocation of capital toward credit
is warranted.

October 11, 2023

8
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.
This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written con
consent of Oaktree.

9
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Fewer Losers, or More Winners?

My memos got their start in October 1990, inspired by an interesting juxtaposition between two events.
One was a dinner in Minneapolis with David VanBenschoten, who was the head of the General Mills
pension fund. Dave told me that, in his 14 years in the job, the fund’s equity return had never ranked
above the 27th percentile of the pension fund universe or below the 47th percentile. And where did those
solidly second-quartile annual returns place the fund for the 14 years overall? Fourth percentile! I was
wowed. It turns out that most investors aiming for top-decile performance eventually shoot themselves in
the foot, but Dave never did.

Around the same time, a prominent value investing firm reported terrible results, causing its president to
issue an easy rationalization: “If
If you want to be in the top 5% of money managers, you have to be willing
to be in the bottom 5%, too.” My reaction was immediate: “Myy clients don’t
don care whether I’m in the top
5% in any single year, and they (and I) have absolutely no interest in me ever being in the bottom 5%.”

These two events had a strong influence on me and helped define my – and what five years later became
Oaktree’s – investment philosophy, which emphasizes risk control and consistency above all. Here’s how
I put it 33 years ago in that first memo, titled The Route to Performance
Performance:

I feel strongly that attempting to achieve a superior long

long-term record by stringing
together a run of top-decile
decile years is unlikely to succeed. Rather, striving to do a little
better than average every year – and through discipline to have highly superior relative
results in bad times – is:

less likely to produce extreme volatility,

less likely to produce huge losses which can
can’t be recouped and, most
importantly,
more likely to work (given the fact that all of us are only human).

Simply
imply put, what [General Mills’s]
Mills record tells me is that, in equities, if you can avoid
losers (and losing years), the winners will take care of themselves. I believe most
strongly that this holds true in my group’s opportunistic niches as well – that the best
foundation for above-average long-term performance is an absence of disasters.

As you can see, my dinner with Dave was a seminal event; his approach was clearly the one for me.
(Incidentally, I want to share that after decades of not having been in touch, Dave was among the many
kind people who wrote in recent months to encourage me vis-à-vis my health issue. This is a great
example of the many personal dividends my career has paid.)

Putting It in Brief

That first memo, and the bit cited above, include a phrase you’ve likely heard from Oaktree: If we avoid
the losers, the winners will take care of themselves. My partners and I considered this phrase so fitting

© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
that we adopted it as our motto when Oaktree was formed in 1995. Our reasoning was simple: If we
invest in a diversified portfolio of bonds and are able to avoid the ones that default, some of the non-
defaulters we buy will benefit from positive events, such as upgrades and takeovers. That is, the winners
will materialize without our having explicitly sought them out.

We thought that phrase was innovative. But in 2005, while working with Seth Klarman to update the
1940 edition of Benjamin Graham and David Dodd’s Security Analysis – the “bible of value investing” –
I read something that indicated we were late by about 50 years. In the section Seth asked me to edit, I
came across Graham and Dodd’s description of “fixed-value” (or fixed-income) investing as “a negative
art.” What did they mean?

At first, I found their observation cynical, but then I realized what they were saying. Let’s assume there
are one hundred 8% bonds outstanding. Let’s further assume that ninety will pay interest and principal as
promised and ten will default. Since they’re all 8% bonds, all the ones that pay will deliver the same 8%
return – it doesn’t matter which ones you bought. The only thing that matters is whether you bought any
of the ten that defaulted. In other words,, bond investors improve their performance not through what they
buy, but through what they exclude – not by finding winners, but by avoiding losers. There it is: a
negative art.

One more anecdote concerning the origin of the phrase: I’ve ve always been interested in old books. A few
years ago, while walking through a Las Vegas convention center on the way to meet with a client, I came
upon a rare book fair. I stopped at the booth of a book dealer I know, and my eye immediately fell on a
book he had for sale: How to Trade in Stocks, by Jesse Livermore. Here
Here’s the quote the dealer had
highlighted: “Winners
inners take care of themselves; losers never do.”
do. You may be tempted to believe
Livermore
rmore borrowed my idea . . . until you realize that, like Graham and Dodd, he published these lines in
1940. So much for my innovation.

At the time I adopted that saying, my partners and I were primarily high yield bond investors. And since
non-convertible bonds have little upside potential beyond their promised yield to maturity, it truly was the
case that our main job was to avoid the non
non-payers,
-payers,
payers, with the assumption that some subset of the payers
would likely give us exposure to positive developments that occurred.
occurred It was an appropriate way to sum
up our approach as bond investors.
investors.

But fortunately, I joined up with Bruce Karsh in 1987, and in 1988 we organized our first distressed debt
fund. Now we were investing in bonds that had defaulted or seemed likely to do so. We thought we
might be able to buy them at bargain prices because of the cloud they were under, giving us the possibility
of capital appreciation. Bruce has since become well known for his investing acumen, and, certainly, his
returns since 1988 can’t’tt be attributed to the mere avoidance of losses. When you aspire to returns well
above those available on bonds, it’s not enough to avoid losers; you actually have to find (or create)
winners from time to time. The returns generated by Bruce and his group show that they’ve done so.

Oaktree now has a number of what I call “aspirational strategies,” meaning they need winners. So why
do we still use the above phrase as our motto, and why is “the primacy of risk control” still the first
tenet of our investment philosophy? The answer is we want the concept of risk control to always be top
of mind for our investment professionals. When they review a security, we want them to ask not only
“How much money can I make if things go well?” but also “What will happen if events don’t go as
planned? How much could I lose if things get bad? And how bad would things have to get?”

Risk control is still number one at Oaktree. Seventy-plus years ago, UCLA football coach Henry
Russell “Red” Sanders said, “Winning isn’t everything, it’s the only thing.” (The saying is also attributed
to Vince Lombardi, legendary football coach of the Green Bay Packers.) While I haven’t figured out

2
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
exactly what that phrase means, I’m firmly convinced that for Oaktree, risk control isn’t everything; it
is the only thing.

Not Risk Avoidance

Understanding the distinction between risk control and risk avoidance is truly essential for
investors. Risk avoidance basically consists of not doing anything where the outcome is uncertain and
could be negative. And yet, at its heart, investing consists of bearing uncertainty in the pursuit of
attractive returns. For this reason, risk avoidance usually equates to return avoidance. You can avoid risk
by buying Treasury bills or putting your money into government-insured deposits, but there’s a reason
why the returns on these are generally the lowest available in the investment world. Why should you be
well paid for parting with your money for a while if you’re sure to get it back?

Risk control, on the other hand, consists of declining to take risks that (a) exceed th the quantum of
risk you want to live with and/or (b) you wouldn’t be well rewarded for bearing. I’ve written in the
past about what I call “the intelligent bearing of risk for profit.” Here’ss the backstory:

I got my start managing money in 1978, when Citi asked me to run portfolios of convertibles
convertible and high
yield bonds. The former were mostly non-investment
investment grade securities issued by companies that had no
alternative when seeking to raise capital,, and the latter were, according to the terminology of the day
day,
low-rated “junk bonds.” Clearly, they both entailed significant credit risk. Around 1980, a reporter from
one of the first financial news networks asked me a provocative question: “How can you buy high yield
bonds when you know some of the issuers are going to default?
default?” My response captured the essence of
intelligent risk bearing: “How
How can life insurance companies insure people’s
people lives when they know they’re
all going to die?”

The point is simple: These functions can both be performed in an intellige

intelligent, risk-controlled way. For
that to be the case, the risk has to be:

risk you’re aware of,

risk you can analyze,
risk you can diversify, and
risk you’re
re well paid to assume.

Risks like this needn’tt be avoided. If you have real insight, such risks can be borne prudently and
profitably.

I know several investors who take much more risk than Oaktree does and whose bad years are much
worse than ours. But the few who possess genuine skill – what I call “alpha” (more on that later) –
produce jumbo returns in their good years, such that their long-term returns are exceptional. Their clients
are well rewarded . . . assuming they have enough intestinal fortitude to hang in through the bad years.
Thus, risk-taking isn’t unwise per se, and risk avoidance is appropriate only for investors who feel they
can’t survive tough times.

Building a Good Record

Since (a) all but the most cautious investing entails risk and (b) the presence of risk means results will be
unpredictable and inconsistent, very few (if any) investors are able to have only good years or to assemble

3
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
portfolios that contain only winners. The question isn’t whether you’re going to have losers, but
rather how many and how bad relative to your winners.

Warren Buffett – arguably the investor with the best long-term record (and certainly the longest long-term
record) – is widely described as having had only twelve great winners in his career. His partner Charlie
Munger told me the vast majority of his own wealth came not from twelve winners, but only four. I
believe the ingredients of Warren’s and Charlie’s great performance are simple: (a) a lot of investments in
which they did decently, (b) a relatively small number of big winners that they invested in heavily and
held for decades, and (c) relatively few big losers. No one should expect to have – or expect their money
managers to have – all big winners and no losers.

In fact, not having any losers isn’t a useful goal. The only sure way to achieve that is by not taking any
risk. But, as I said earlier, risk avoidance is likely to result in return avoidance. There’s such a thing as
the risk of taking too little risk. Most people understand this intellectually, but human nature makes
it hard for many to accept the idea that the willingness to live with some losses is an essential
ingredient in investment success.

Having watched some great tennis this summer – right through the U.S. Open this past weekend – I’ll
recycle a tennis analogy I first suggested in my memo Dare to Be Great II (April 2014). What if I went
out to play tennis and said, “Today, I’m not going too commit any service faults
faults”? My serves would have
to be so meek that my opponent would likely destroy them. Tennis players have to take some risk if
they hope to succeed (see below). If none of your serves fall outside the service box, you’re probably
serving too cautiously to win. The same is true of investing.
investing
ing.. As my long-time
long partner Sheldon Stone puts
it, “If you don’t experience any defaults, you’re
re probably not taking enough credit risk.”

Winners’ Stats

Looking back, it turns out I devoted an entire memo to analogies between investing and sports once per
decade in the 1990s, the 2000s, and the 2010s. This time, in my fourth decade of memo
memo-writing, I’m
going to devote a few more paragraphs to tennis.

As mentioned
entioned above, tennis makes for very apt comparisons to investing. Hit safely and get blasted? Or
try for shots you can’tt make consistently and beat yourself? Charles
Charl D. Ellis’s article “The Loser’s
Game” (The Financial Analysts JournalJournal, July/August 1975) was truly seminal in my development as an
investor.. He pointed out that there are two kinds of tennis players . . . actually, two different types of
tennis games. Professionals play a winner
winner’s game: They win by hitting winners (in tennis, that means
shots the opponent can’t ’tt return).
return Since their game is so much within their control, they can usually
produce the shots they want, the best of which win points. But amateur tennis is a loser’s game: The
winner is usually the person who hits the fewest losers. If you can just keep the ball in play long
enough, eventually your opponent will hit it off the court or into the net. The amateur doesn’t have to hit
winners to win, and that’s a good thing, because he or she generally is incapable of doing so dependably.

A quick look at some statistics from this year’s Wimbledon provides a great deal of food for thought. I’ll
look first at the men’s quarterfinal match between Daniil Medvedev, the #3 seed in the tournament, and
unseeded Christopher Eubanks. Eubanks, 6’7” and highly athletic, surprised everyone with his rush to
the quarterfinals. But, in Medvedev, he was playing someone who’s spent years trailing just behind the
“big three” of men’s tennis: Novak Djokovic, Rafael Nadal, and Roger Federer.

As a pronounced underdog, Eubanks probably recognized that he wasn’t likely to outlast or out-steady
Medvedev. Thus, he had to go for winners. If that was Eubanks’s plan, he succeeded in executing it. He

4
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
achieved 74 winners to Medvedev’s 52, and he aggressively rushed the net 67 times (for 44 winners)
compared to Medvedev’s 8 (for 4 winners). These are great offensive stats.

The problem is that – as I’ve experienced firsthand many times – if you’re up against a player who’s
better than you are, you have to attempt shots that aren’t firmly within your competence in order to have a
hope of winning. Thus, along with his 74 winners, Eubanks was guilty of 55 unforced errors (mistakes
that aren’t forced by good shots from one’s opponent; the easy way to make an unforced error is to go for
a winner and miss). In comparison, Medvedev committed only 13 unforced errors.

Bottom line: Eubanks had considerably more winners than Medvedev, but he had three unforced errors
for every four winners, whereas Medvedev had only one per four. Medvedev won 53% of the points
played versus Eubanks’s 47%, and thus he won the match. The lesson is that it’s not enough to have
more winners. To win – in tennis as in investing – you have to have a favorable relationship between
winners and losers. You can win by having a few winners but fewer losers or by having a lot of
losers but more winners. Neither maximizing winners nor minimizing losers is necessarily enough.
It’s all in the balance.

And that leads me to the Wimbledon men’ss final. This exciting match pitted Djokovic, who had won the
most Grand Slam championships in history (23 combined at Wimbledon, the U.S. Open, the Fre French
Open, and the Australian Open), against up-and-coming 20-year-old old Carlos Alcaraz, who had a grand
total of one. Like Eubanks, Alcaraz plays a big, athletic game and goes for a lot of winners. You can see
that in his serving: Alcaraz had seven double faults, more than twice Djokovic’s
Djokovic three. But, again, a
single statistic tells us very little, since Alcaraz’ss attempts at big serves gave him nine aces (serves his
opponent couldn’tt even get his racquet on), more than four times Djokovic’s
Djokovic two. This is an indication of
the players’ respective styles. In the end, Alcaraz won the match with 66 winners, whereas Djokovic had
only 32.

So, Alcaraz beat Djokovic with a “bigger,”” high

high-risk
risk game, while Medvedev beat Eubanks with his
steadier, risk-controlled style. Neither approach is better than the other per se. Style alone never
determines outcome; it’ss a matter of style plus execution
execution. My tennis teacher, Jordi Ballester, explains:
“Alcaraz
Alcaraz plays a more aggressive game. Given his high level of talent, as he showed at Wimbledon, if he
has a good day, he can beat Djokovic (or any other opponent). If he
he’s off, he may well lose.”

It’ss interesting to note that tennis’s

tennis big three presided over an incredible era. In the 19 years leading up to
Wimbledon 2023, they won a combined 65 – or 87% – of the 75 Grand Slam championships. Notably,
none of them was a “big big hitter”
hitter in Alcaraz’s mold. Their ability to hit at a fabulous level for four or
five hours without committing many errors was usually enough.

The Need for Winning Stocks

There have been several times over the course of my career when a small number of stocks have
accounted for a disproportionately large share of the market’s gains. In this regard, a lot has been written
about the so-called “magnificent seven”: Apple, Microsoft, Alphabet (owner of Google), Amazon,
Nvidia, Tesla, and Meta (owner of Facebook). At various points in time this year, these seven stocks
accounted for most or all of the gains of various equity indices. Here’s how the Financial Times put it in
June:

Seven of the biggest constituents . . . have ripped higher, gaining between 40 per cent and
180 per cent this year. The remaining 493 companies [in the Standard & Poor’s 500
stock index] are, in aggregate, flat.

5
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Big tech companies dominate the index to an unprecedented degree. Just five of those
seven stocks represent nearly a quarter of the market capitalisation of the entire index.
(“The seven companies driving the US stock market rally,” Financial Times, June 14,
2023.)

The extent of these stocks’ outperformance for much of this year may be unique, but the phenomenon is
not. It was also the case in 2017 that a few stocks were largely responsible for carrying the market
upward. Then it was the “FAANGs”: Facebook, Amazon, Apple, Netflix, and Google/Alphabet. The
Financial Times highlighted this history as well:

Top-heaviness, particularly in US markets, is not new. “The big tech stocks in the S&P
now are the same situation as oil companies were in the past, or the Nifty 50 in the
1960s,” says Frédéric Leroux, head of the cross-asset team at Carmignac in Paris – a nod
to the craze that swept shares in a small number of fast-growing
growing companies such as IBM,
Kodak and Xerox higher before a heavy decline set in. “It’ss a problem, but it
it’s a
recurring problem.” (Ibid.)

For as long as most of us can remember, active investors have had a tough time keeping up with the
equity indices. For this reason, in recent decades, passive investing has taken a substantial
substant share of equity
capital invested. Active investing’ss shortfall has been attributed primarily to the combination of market
efficiency, management fees, and investor error. I think there’s another reason: active investors
investors’ need for
winners.

What if you didn’t own the magnificent seven earlier this year? Clearly, you’d
you be far behind the indices.
What if you owned them, but in smaller proportions than their weightings in the indices? You’d still lag,
but by a smaller amount. So, by definition, keeping up with the indices requires having exposure to
the big winners that is at least equal to their representation in the indices. That much seems clear.

Now, think about that representation. Let’ss say you started off 20 years ago – in the summer of 2003 –
with an index-sized
sized helping of Apple at a split-adjusted
split price of $0.37. The key question is simple:
Would you have held on as it rose?

As I described in my memo Selling Out ((January 2022), most investors subscribe to the conventional
wisdom of “taking
taking profits,” “taking
taking some money off the table,”
table, or “topping the trees.” After all, as the
old saying goes, “Noo one ever went broke taking profits.”
profits. Investors often sell off some of their winners
for the simple reason that they’re
they afraid to watch as they give up their gains, which can lead to regret,
criticism from clients, and/or lost accounts.

Most people would have sold part or all of their Apple holding by the time the price reached $15 in the
summer of 2013. What would you have done when it hit 40 times your original cost after 10 years?

Today, another 10 years later, Apple is around $180 1 – up 12x since 2013 and up by almost 500x since
2003. The point is, in the face of these gains, very few investors would still hold all they’d originally
bought. But if they sold Apple stock when the constructors of the index didn’t, they’ve probably
failed to keep up with the index. The situation can be summed up as follows:

1
This reflects the price as of September 8, 2023.

6
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 The performance of the equity indices is often dominated by a few stocks or groups of stocks.
The gains of the leaders can make them seem expensive, arguing for profit-taking.
Human nature – especially the desire to avoid regret – adds to the motivation to sell.
By definition, if you reduce your holdings of the winners relative to their representation in the
indices and these winners continue to outperform, you’ll have a tough time keeping up.

In my memo Liquidity (March 2015), I included an insight from my son Andrew. To paraphrase, he said,
“If you look at the chart of a stock that’s been up for 25 years and say, ‘Man, I wish I’d owned that stock,’
think about all the days you would have had to talk yourself out of selling.” I doubt many people watched
Apple go from $0.37 to $180 without selling any. How many active investors would allow Apple shares
to constitute nearly 8% of their portfolios, which was its weight in the S&P 500 at the recent peak? But –
to oversimplify – if they sold Apple, they’ve lagged.

The bottom line is that winners aren’t entirely dispensable. If you hope to at least keep up with the
indices, you probably have to have an average representation in them. (This isn’t ’t entirely inescapable.
You might also achieve that goal by holding fewer of the losers.)

The Role of Risk Bearing

I’m
m going to conclude this memo using my favorite graph. When I attended graduate school at the
University of Chicago 55 (!) years ago, I was taught to view the relationship between risk and return as
follows:

Risk

But the more I thought about it, the more unhappy I was with the way the linear presentation of the
purported relationship tells investors that they can count on achieving higher returns as a result of taking
more risk. After all, if that were really the case, risky investments wouldn’t
wouldn be riskier. Thus, in my
memo Risk (January 2006), I suggested a different way of depicting the relationship by superimposing on
the line a series of bell-shaped probability distributions turned on their side:

7
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Risk

Rather than implying that taking more risk – moving from left to right in the graph – assures higher
returns, this new way of looking at the relationship suggests that as you take more risk, (a) the expected
return increases, as per the original version above; (b) the range of possible outcomes becomes wider; and
(c) the
he bad possibilities become worse. In other words, riskier investments introduce the potential for
higher returns, but also the possibility of other less-desirable side effects. That
That’s why they’re described as
being riskier. Since writing that memo, I’ve concluded that this way of thinking about things has a great
many applications. Here are a few:
Investing

Risk

Bonds Equities Venture

Capital

Fixed Income

Risk

Treasurys Corporates High Yield Bonds

8
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Equities

Risk

U.S. Non-U.S. Emerging

Markets

There are also applications for this way of seeing things outside the investment world. For example:
ex

Tennis Strategies

Risk

Djokovic’s
Djokovic Alcaraz’s Eubanks’s
Game Game Game

And that brings me back to the subject of this memo:

Investment Styles

Risk

Avoiding Losers Going for Winners

9
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
As the above graphs indicate, a high-risk approach introduces the potential for huge returns . . . as
well as the possibility of loss.
So, where’s the right place to be on this spectrum? Where can one find the best risk/return bargains? The
short answer is that, according to investment theory – particularly the Efficient Market Hypothesis – there
are no better (or worse) places to be. The EMH says markets price securities such that (a) their price
equals their intrinsic value and (b) bearing incremental risk is rewarded fairly. Thus, bargains and
over-pricings can’t exist. This is why, according to the theory, “you can’t beat the market.”

The theory also suggests that if a market is at “equilibrium,” each change in prospective return is fair
relative to the change in risk borne, such that all positions on the curve are equivalent in attractiveness.
Move to the left, and you avoid some risk, but your prospective return drops. Move to the right, and your
prospective return increases, but so does your risk. No position on the spectrum is superior to any other.
It’s like a coin toss (which the EMH suggests active investing is): Neither heads nor tails is the smarter
call.

What About in Practice?

One of my favorite quotes is attributed to Albert Einstein and Yogi Berra, amo
among others: “In theory, there
is no difference between theory and practice. In practice, there is.” If markets are efficient and securities
are always priced correctly, there can be no value in active investing. The truth is that many active
managers, especially
pecially in developed market equities, have failed to demonstrate the ability to add value, or
to add enough value to justify their management fees. This is largely why index funds were created and
why a significant amount of equity capital has migrated tto index and passive investing in recent decades.

And yet, I firmly believe there are times when the markets are overpriced and times when they they’re
underpriced. There are also times when particular markets or sectors are overpriced or underpriced
relative too others. In these instances, some securities can be priced too high or too low, and thus some
positions on the risk curve can offer better bargains than others.

The theory assumes investors are rational and objective, but psychological excesses violate tthat
assumption. Take, for example, the investment environment during the Global Financial Crisis. As I
described in my July memo Taking the Temperature
Temperature, in late 2008, investors were so worried about a
financial sector meltdown that they panicked and sold securities aggr
aggressively as their prices collapsed.
Excessive risk aversion causes the risk/return line to steepen (increasing the return for each incremental
unit of risk borne)) and perhaps even to curve upward (rendering the compensation for making
investments at the risky
isky end of the spectrum disproportionately generous). Thus, in periods of excessive
risk aversion, the riskier part of the curve can be the smarter place to be (and in periods when risk bearing
is too eagerly embraced, the safer part can offer a superior proposition).

10
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
The last element I want to touch on is what I call “alpha,” or individual investing skill. The reason the
EMH disdains efforts to beat the market is its conviction that since securities are always priced correctly,
the ability to identify bargains to buy and over-pricings to avoid can’tt exist. Theory’s
Theory assertion that
there’s no such thing as mastery of markets implies that no one has the skill to assemble portfolios that
outperform. This is why I depict the bell-shaped
shaped curves above as symmetrical: In an efficient market,
investors can only take what the market gives them.

But I’m convinced the potential to improve on that through skill does exist in some markets and some
people. Investors who possess alpha have the ability to alter the shape of the distribution
distributions in the
graphs above so that they’re not symmetrical,, in that the portion of the distribution representing
the less desirable outcomes is smaller than the portion representing the better ones. In fact, that’s
what alpha really means: Investors
nvestors with alpha can go into a market and, by applying their skill,
access the upside potential
ntial offered in that market without taking on all the downside risk. In my
memo What Really Matters? (November 2022), I said the key characteristic of superior investing is
asymmetry – having more upside than downside. Alpha A enables exceptional investors to modify the
probability distributions such that they are biased toward the positive, resulting in superior risk-adjusted
returns.

If alpha is the ability to earn return without taking fully commensurate risk, investors possessing it
can do so by either reducing risk while giving up less return or by increasing potential return with
a less-than-commensurate increase in risk. In other words, skill can enable some investors to
outperform by emphasizing aggressiveness and some by emphasizing defensiveness. The choice between
these approaches depends on the type of alpha an investor possesses: Is it the ability to produce stunning

11
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
returns with tolerable risk, or the ability to produce good returns with minimal risk? Almost no investors
possess both forms of alpha, and most possess neither. Investors who lack alpha shouldn’t expect to be
able to produce either version of asymmetry – that is, to be able to generate superior risk-adjusted
returns. However, most believe they do have it.

The proper choice between the two approaches – fewer losers or more winners – depends on each
investor’s skill, return aspiration, and risk tolerance. As with many of the things I discuss, there’s no
right answer here. Just a choice.

September 12, 2023

12
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.
This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written con
consent of Oaktree.

13
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Taking the Temperature

In preparation for my interview for “Lunch with the FT” last fall, I sent the reporter, Harriet Agnew, five
memos I had written between 2000 and 2020 that contained market calls. How were they chosen? First, I
felt the memos accurately conveyed my thinking at the key turning points in that 20-year period. And
second, my calls turned out to be right.

Five Calls

I’ve
ve written before about the time in 2017 when I was working on my book Mastering the Market Cycle
and batting ideas back and forth with my son Andrew. I said, “You You know, looking back, I think my
market calls have been about right.” His response was dead d on target as usual: “Yeah, Dad, that’s
because you did it five times in 50 years.” It struck me like an epiphany: He was 100% correct correct. In
those five instances – around the publication of the respective memos – the markets were either crazily
elevated or massively depressed, and as a result, I was able to recommend becoming more defensive or
more aggressive with a good chance of being right. (Before I go further, let me make it clear that while
hindsight shows that the logic behind those calls was corre
correct, that doesn’t mean I made them without
great trepidation.)

Too illustrate how one might approach making market calls, I’mI going to briefly summarize what led me
to make those five calls. (I’m
m not going to go into detail, since the contemporaneous memos I cite in each
section will supply more than enough for those who
who’re interested.) As you read the description of each
event, look closely at how the forces that contributed to – and resulted from – each episode led to the next
one. You’ll be able to appreciate
reciate why I’ve
I long stressed the role of causality in market cycles.

January 2000

Inn the fall of 1999, against the backdrop of the massive gains being achieved in tech, media, and telecom
stocks, I read Edward Chancellor
Chancellor’s excellent book Devil Take the Hindmost. I was struck by the
similarities between the TMT boom and the historical bubbles that are the subject of that book. The lure
of easy profits, the willingness to leave one’s day job to cash in, the ability to invest blithely in money-
losing companies whose business models one can’t explain – all these felt like themes that had rhymed
over the course of financial history, leading to bubbles and their painful bursting. And all of them were
visible in investor behavior as 1999 came to an end.

While I wasn’t involved directly in equities and Oaktree’s investments had little if any exposure to
technology at the time, I observed many market narratives that I thought were too good to be true. Thus, I
said so in the memo bubble.com, which was published as 2000 began. The memo described how tech
investors were buying the stocks of young companies at astronomical prices set in many cases as a
multiple of current revenues, as the companies often had no profits. In fact, many had no revenues, in
which case the price was based on little more than a concept and hope. I define a bubble as an irrationally

© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
elevated opinion of an asset or sector, and the TMT craze of the late 1990s exemplified this definition.
Thus, I wrote as follows:

In short, I find the evidence of an overheated, speculative market in technology, Internet

and telecommunications stocks overwhelming, as are the similarities to past manias. . . .

To say technology, Internet and telecommunications stocks are too high and about to
decline is comparable today to standing in front of a freight train. To say they have
benefited from a boom of colossal proportions and should be examined very skeptically
is something I feel I owe you.

In my opinion, the TMT bubble burst in early 2000 for no reason other than that stock prices had become
unsustainably high. The Standard & Poor’s 500 Index fell by 46% from its 2000 high to the low in 2002,
and the tech-heavy NASDAQ Composite declined by 80% during this period. Many tech stocks lost
much more, and many young companies in fields such as e-commerce
commerce ended up becoming worthless.
And the word “bubble” became part of everyday speech for a new generation of investors.

Late 2004 to Mid-2007

The aftermath of the TMT bubble led to an environment in the mid

mid-aughts that felt to me like a slow-
developing trainwreck, with an emphasis on “slow-developing.”
developing.” I started complaining too soon . . . or
maybe my timing was reasonable but the negative consequences just took longer to develop than they
should have.

In summary, the Federal Reserve was engaging in accommodative monetary policy – taking the fed funds
rate to new lows – to battle the potential ramifications of the TMT bubble’s
bubble bursting. Thus, in my memo
Risk and Return Today from late 2004, 4, I observed that (a) prospective returns on most asset classes were
unusually low and (b) risk-seeking
seeking on the part of investors looking to improve on those low returns had
led them to embrace higher-risk
risk and “alternative
“alternative”
alternative investments.

I identified somee of these alternatives in the memo There They Go Again (May 2005), spending most of
my time discussing residential real estate, as that was where investors were embracing the most glaring
fallacy: the belief that home prices only go up up. I also discussed the tendency of investors to (a) ignore
the lessons of past cycles, (b) fall for new developments, and (c) pile into risky investm
investments, guided by
time-honored
honored platitudes such as “it’s different this time,” “higher risk means higher returns,” or “if it
stops working, I’ll
ll just get out.
out.” Many of these logical errors were being committed by investors in the
housing market.

The driving force behind Oaktree’s behavior in that period wasn’t any of the above. Rather, it was the
fact that my Oaktree co-founder Bruce Karsh and I were spending much of each day trudging to each
other’s offices to complain about the crazy deals – characterized by low returns, high risk for investors,
and a lot of optionality for issuers – that were easily being brought to market. “If deals like this can get
done,” we agreed, “there’s something wrong with the market.” Few people, we thought, were
demonstrating prudence, discipline, value consciousness, or the ability to resist the fear of missing out.
Investors are supposed to act as disciplinarians, preventing undeserving securities from being issued, but
in those days, they weren’t performing that function. This signaled a worrisome state of affairs.

These observations – along with an awareness of the generally high prices and low prospective returns
that prevailed at the time – convinced us to dramatically increase our usual emphasis on defensiveness. In

2
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
response, we sold off large amounts of assets, liquidated large funds, organized small funds (or none at all
in certain strategies), and significantly raised the bar against which potential new investments would be
evaluated.

In July 2007, I published the memo It’s All Good, in which I was more emphatic (and had better timing):

Where do we stand in the cycle? In my opinion, there’s little mystery. I see low levels of
skepticism, fear and risk aversion. Most people are willing to undertake risky
investments, often because the promised returns from traditional, safe investments seem
so meager. This is true even though the lack of interest in safe investments and the
acceptance of risky investments have rendered the slope of the risk/return line quite flat.
Risk premiums are generally the skimpiest I’ve ever seen, but few people are responding
by refusing to accept incremental risk. . . .

Eight months after I wrote It’s All Good,, Bear Stearns melted down under the weight of funds that had
invested in subprime mortgages. Then, in mid-September we saw – in rapid succession – the rescue of
Merrill Lynch by Bank of America, the bankruptcy
ankruptcy of Lehman Brothers, and the bailout of AIG. The
S&P 500 Index fell to a low of 735 in February 2009, down 53% from its high of 1,549 reached in 2007
(and down 39% from its level around the time I put out the way-too-early
early Risk and Return Today).

Importantly, Oaktree had essentially no involvement with subprime mortgages or mortgage

mortgage-backed
securities. Moreover, those assets were traded in a relatively remote corner of the investment world, and
we had little appreciation for what was taking place there. In other words, our cautious conclusions
weren’t reached on the basis of subject-matter
matter expertise but rather on an unusually good example
of what I call “taking
taking the temperature of the market” (see pages 9-10).

Late 2008

The world seemed relatively tranquil as September 2008 began, but then Lehman Brothers
Brothers’ bankruptcy
filing, mentioned above, took place mid
mid-month.
-month. The markets promptly fell apart, based on an apocalyptic
view that Lehman’ss failure was part of a logical progression
pro that had started when Bear Stearns ceased to
exist as an independent entit
entity
y and could eventually lead to a meltdown of the worldwide financial system.
Complacency gave way to panic, and the Global Financial Crisis – in capital letters – was upon us.

Anticipating that the reckless behavior we were witnessing (see the previous section) would ultimately
create significant buying opportunities for our distressed debt strategy, Oaktree organized an $11 billion
“reserve fund” for distressed debt between
betw January 2007 and March 2008. The fund was created to give
us capital to invest if things reached crisis proportions, which by mid-2008, they had not. Because its
predecessor fund had only just become fully invested, we started to slowly invest the reserve fund prior to
Lehman’s bankruptcy. In the market panic that followed Lehman’s collapse, our first job was to figure
out how best to proceed. Should we continue to invest the fund’s capital or hold it in reserve? Or should
we step on the gas? Was this the bottom? How could we determine what lay ahead? There was no
history of financial sector meltdowns to rely on and no informed way to approach these questions given
the uniqueness of the circumstances and the many unknowns. With the future unknowable, we applied
the only analytical framework we could think of (simplistic though it was):

I think the outlook has to be viewed as binary: will the world end or won’t it? If you
can’t say yes, you have to say no and act accordingly. In particular, saying it will end
would lead to inaction, while saying it’s not going to will permit us to do the things that
always have worked in the past.

3
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 We will invest on the assumption that it will go on, that companies will make money, that
they’ll have value, and that buying claims on them at low prices will work in the long
run. What alternative is there? . . .

No one seems able to imagine how the current vicious circle will be interrupted. But I
think we must assume it will be.

It must be noted that, just like two years ago, people are accepting as true something that
has never held true before. Then, it was the proposition that massively levered balance
sheets had been rendered safe by the miracle of financial engineering. Today, it’s the
non-viability of the essential financial sector and its greatest institutions. . . . (Nobody
Knows, September 19, 2008)

The above reasoning led us to conclude that if we invested and the financial world melted down, it
wouldn’t matter what we had done. But if we didn’t invest and it didn’tt melt down, we wouldn wouldn’t
have done our job. So, we made the unsupportable assumption that the financial world would continue
to exist and concluded that this meant we should invest aggressively. Bruce Karsh
Karsh’s team plunged in,
investing an average of $400 million a week from September 18, 2008 through year year-end – a total of $6
billion in, essentially, a single quarter. Purchases by the rest of Oaktree brought the total invested over
that period to $7.5 billion.

We ran into very few people outside Oaktree who were putting money to work or willing to grant that we
might be doing the right thing. I told a reporter friend we were buying, and he said – incredulously –
“You are!?!”

Around the same time, I met with thehe CIO of a client institution as part of our efforts to raise equity to
delever a fund that was perilously close to receiving a margin call, and although I had good responses to
all the increasingly negative scenarios she posited, we never got to a poi point where she would grant
that “it can’t be that bad.” This demonstration of unbridled pessimism – which appeared to be
widespread at the time – convinced me that little optimism was embodied in the prices of the assets we
were buying and thus that there was little chance of losing money. Here
Here’s how I put it in a memo I wrote
that day:

Skepticism
pticism and pessimism aren
aren’t synonymous. Skepticism calls for pessimism when
optimism is excessive. But it also calls for optimism when pessimism is excessive
excessive. . . .

In the third stage of a bear market . . . everyone agrees things can only get worse. The
risk in that – in terms of opportunity costs, or forgone profits – is equally clear. There’s
no doubt in my mind that the bear market reached the third stage last week. That
doesn’t mean it can’t decline further, or that a bull market’s about to start. But it
does mean the negatives are on the table, optimism is thoroughly lacking, and the
greater long-term risk probably lies in not investing.

The excesses, mistakes and foolishness of the 2003-2007 upward leg of the cycle were
the greatest I’ve ever witnessed. So has been the resulting panic. The damage that’s
been done to security prices may be enough to correct for those excesses – or too much or
too little. But certainly it’s a good time to pick among the rubble. (The Limits to
Negativism, October 15, 2008)

4
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Importantly, our confidence in investing the reserve fund’s capital was enhanced by the fact that (a) we
were buying the senior-most debt of high-quality companies that had been the subject of recent buyouts
and (b) we were buying at prices so low that our debt holdings would do fine even if the companies ended
up being worth only one-quarter or one-third of what the buyout funds had just paid for them.

Episodes like the visit with the apprehensive CIO told me the post-Lehman temperature of the market was
too low. There was too much fear and too little greed, too much pessimism and too little optimism, and
too much risk aversion and too little risk tolerance. Negative possibilities were being accepted as fact.
When these things are true, it stands to reason that (a) investor expectations are low; (b) asset
prices probably aren’t excessive; (c) there’s little possibility of investors being disappointed; and (d)
thus there’s little likelihood of lasting loss and a good chance prices will work their way higher. In
other words, this was the epitome of a buying opportunity.

March 2012

After the TMT bubble burst in mid-2000,

2000, the S&P 500 dropped in 2000, 2001, and 2002, the first three
three-
year stretch of negative returns since 1939. These declines caused many investors to lose interest in
equities. Just a few years earlier, there had been widespread faith that stocks could never perform poorly
for a meaningful period. Now, all of a sudden, such a time seemed to be at hand. Stocks delivered
disillusionment, which
hich can be one of the strongest forces in markets, and investors turned against them.

During the first few years of the aughts, the lack of appetite for equities – and for bonds, given how low
the Fed had driven yields – caused many investors to conclude
conclude they couldn’t
couldn earn their targeted returns
through traditional asset classes. This, in turn, caused capital to flow to alternative investments, first
hedge funds and then private equity. Soon investors were confronted by the Global Financial Crisis an and
the fear of financial-sector
sector meltdown described above, which added to their negativity. These
developments weighed heavily on investor psychology, and as a result, the S&P 500 was essentially flat
from 2000 through 2011, returning an average of only 0.55% a year for the 12 years.

This is how things stood in March 2012, when I wrote the memo Déjà Vu All Over Again. My inspiration
arrived when, sleepless while on a business trip in Chile, I reached into my Oaktree bag for something to
read and came up with an old article I had wanted to revisit because I was sensing parallels between the
current environment and the one the article described. It was “The Death of Equities,” one of the most
important magazine articles on investing of all time. It had appeared in Businessweek on August 13,
1979, following years of raging inflation, dreary economic news, and poor stock mar
market performance.

In short, the article’ss theme was that no one would ever invest in stocks again because they had done so
badly for so long. Here are a few of the article’s observations:

Whatever caused it, the institutionalization of inflation – along with structural changes in
communications and psychology – have killed the U.S. equity market for millions of
investors. . . .

For investors . . . low stock prices remain a disincentive to buy. . . .

For better or for worse, then, the U.S. economy probably has to regard the death of
equities as a near-permanent condition – reversible some day, but not soon. . . .

It would take a sustained bull market for a couple of years to attract broad-based investor
interest and restore confidence.

5
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
In other words, poor performance had led to investor disinterest, and disinterest had perpetuated
the poor performance, creating one of the supposedly unstoppable vicious cycles we see in the
markets from time to time. In the author’s view, this negative state was likely to prevail for years.

Like many arguments in the world of investing, the assertions in “The Death of Equities” may have
seemed sensible on the surface. But if you drilled down a bit – and, in particular, if you thought like
a contrarian – the logical flaws became readily apparent. What if the lows in optimism and
enthusiasm for equities meant things couldn’t get any worse? Wouldn’t that mean they could only
get better? And in that case, wouldn’t it be reasonable to assume that low stock prices presaged
future gains, not continued stagnation?

The above paragraph captures in brief the difference between the thinking of the average investor and
what I call “second-level thinking.” The latter doesn’tt rely on first impressions; rather, it’s
it deeper, more
complex, and more nuanced. In particular, second-level
level thinkers understand that the convictions of the
masses shape the market, but if those convictions are based on emotion instead of sober analysis, they
should often be bet against, not backed. Here’s how I put it in Déjà Vu All Over Again
Again:

The negative factors are clear to the average investor. And from there he draws negative
conclusions. But the person who applies logic and insight, rather than superficial views
and emotion, sees something very different.

Thus, it would not have come as a surprise to the more sophisticated investor that “The Death of
Equities” – perhaps the most sweepingly dour article ever written about the stock market –
preceded one of (if not the) most positive periods in market history. In the 21 years from 1979 (when
the article was written) through 1999 (just before the TMT bubble burst), the S&P 500’s average annual
return was 17.9%. That was nearly double its long
long-term
term average and enough to turn $1 in 1979 into $32
in 1999!! Once more from Déjà Vu All Over Again:
Again:

Importantly, the stage had been set for this rise in 1979 by the accumulation and
excessively pessimistic discounting of negatives. . . . The extrapolator threw in the
towel on stocks, just as the time was right for the contrarian to turn optimistic. AAnd
it will always be so. . . .

The great irony here is that the extrapolator actually thinks he he’s being respectful of
history: he’s
’ss assuming continuation of a trend that has been underway. But the history
that deserves his attention isn
isn’t the recent rise or fall of an asset’s price, but rather the fact
that most things eventually prove to be cyclical and tend to swing back from the extreme
toward the mean.

Rereading “The Death of Equities” in 2012 allowed me to immediately see parallels between the then-
present day and the environment in which that article was written. Recent events had been highly
negative, performance had been poor, and investor sentiment was depressed. That was enough to allow
me – benefiting from the lessons of history – to adopt a positive stance:

The story [in 2012] isn’t as hopeless as it was in 1979, but it is uniformly negative. Thus,
while I don’t expect an equity rally anything like what followed on the heels of “The
Death of Equities,” I don’t find it hard to conjure up positive scenarios.

The result: From 2012 – the year of Déjà Vu All Over Again – through 2021, the S&P 500 returned 16.5%
a year. Once again, excessively negative sentiment had resulted in major gains. It’s as simple as that.

6
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
March 2020

The last of the five calls – recent enough for readers to recall the context – came in the early days of the
Covid-19 pandemic. The disease began to enter most people’s consciousness in February 2020, and from
mid-February to mid-March, the S&P 500 fell by approximately one-third.

In Nobody Knows II (March 2020), my first memo during the pandemic, I cited Harvard epidemiologist
Marc Lipsitch, who said on a podcast that when trying to understand the disease, there were (a) facts, (b)
informed extrapolations from analogies to other viruses, and (c) opinion or speculation. But it was clear
to me at the time that there were no “facts” regarding the pandemic’s future course and no “history of
other viruses” of comparable magnitude to extrapolate from. Thus, we were left with “opinion or
speculation.”

The bottom line of the above – simply put – is that we didn’tt know anything about what the future held.
But whereas some people think ignorance regarding the future means they mustn’t take any action,
someone who thinks the matter through logically and unemotionally should recognize that
ignorance doesn’t mean the position they’re in is necessarily the position
tion they should remain in.
(This is very much along the lines of Oaktree’s post-Lehman
Lehman thinking.)

Two weeks later, on March 19, 2020, I ended my client-only

only memo Weekly Update in a similar vein:

I’ll sum up my views simply – since there’s nothing sophisticated to say:

“The bottom” is the day before the recovery begins. Thus it it’s absolutely impossible
to know when the bottom has been reached . . . ever. Oaktree explicitly rejects the
notion of waiting for the bottom; we buy when we can ac access value cheap.
Even though there’ss no way to say the bottom is at hand, the conditions that make
bargains available certainly are materializing.
Given the price drops and selling we’
we’ve seen so far, I believe this is a good time to
we
invest, although of course it may prove not to have been the best time.
No one can argue that you should spend all your money today . . . but equally,
no one can argue that you shouldn
shouldn’t spend any. (Emphasis added)

Whereas some of the market calls described earlier relied oon knowledge of history and/or logical analysis,
this recommendation was based primarily on acknowledgment of ignorance. All we knew for sure was
that (a) there was a pandemic underway and (b) the U.S. stock market was down oneone-third. Doesn’t it
stand to reason, though, that however much money long
long-term investors had in stocks when the S&P 500
peaked at 3,386 in February, they should have considered adding to their positions when it hit 2,237
roughly a month later? That was the essence of my reasoning. Here’s how I built up to the conclusion
cited above:

It’s easy to say that something approaching panic is present in the markets. We’ve seen
record percentage declines several times within the last month (exceeded since 1940 only
by Black Monday – October 19, 1987 – when the S&P 500 declined by 20.4% in a day).
This week and last included down days as follows: -7.6%, -9.5%, -12.0%, and -5.2%
yesterday. These are enormous losses. . . .

. . . there has been a rush to cash. Both long positions and short positions have been
closed out – a sure sign of chaos and uncertainty. Cash in money market funds has

7
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 increased substantially. This doesn’t tell us anything about fundamentals, but the outlook
for eventual market performance is improved:

the more people have sold,

the less they have left to sell, and
the more cash they have with which to buy when they turn less pessimistic. . . .

[In the words of Justin Quaglia, one of our traders,] after two days of a basically stalled
but stressed [bond] market, we “finally had the rubber band snap.” Forced sellers
(needing to sell for immediate cash flow needs) brought the market lower in a hurry. We
opened 3-5 points lower, and the Street was again hesitant to take risk. . . .

We’re never happy to have the events that bring on chaos, and especially not the
ones that are underway today. But it’ss sentiment like Justin describes above that
fuels the emotional selling that allows us to access thee greatest bargains. (Weekly
Update, emphasis added)

While neither a historical foundation nor

or rigorous quantitative analysis was achievable, the above
paragraphs indicate that one could still logically determine an appropriate course of action. As I wr
wrote in
that same memo:

What do we know? Not much other than the fact that asset prices are well down, asset
holders’ ability to hold coolly is evaporating, and motivated selling is picking up.

But that was enough. Paralysis wasn’tt called for, but rathe
rather steps that could help us take advantage of
most investors’ panic and the resulting dramatic price declines. Sometimes it’s it as simple as that. When
the knee-jerk
jerk reaction of most investors is to stand pat or sell, a contrarian decision to buy might well be
called for. Doing so is never easy, though, and mid-
mid-March
mid -March 2020 was one of the most challenging
environments I’veve ever worked through. But the key, as Rudyard Kipling wrote in the poem “If,” is to
“keep
keep your head when all about you are losing theirs. . .”

How Can You Do It?

I spent the preceding pages describing these five calls not for purposes of self
self-congratulation but rather to
lay the groundwork for a discussion of how one can make useful observations regarding the status of the
markets. Hopefully
ully we learn from our experiences as we go through life. But to really learn from
them, we have to step back on occasion, look at an entire string of events, and figure out the
following: (a) what happened, (b) is there a pattern that has repeated, and (c) what are the lessons
to be learned from the pattern?

Once in a while – once or twice a decade, perhaps – markets go so high or so low that the argument for
action is compelling and the probability of being right is high. As my son helped me to recognize, I had
identified five of those, and they paid off. But what if I’d tried to make 50 market calls in my 50 years
. . . or 500? By definition, I would have been making judgments about markets that were closer to the
middle ground – perhaps a little high or a little low, but not so extreme as to permit dependable
conclusions. Investors’ records of success with calls in markets like these are poor, since even if they’re
right about asset prices being out of line, it’s very easy for something that’s a little overpriced to go on to
become demonstrably more so, and then to turn into a raging bubble, and vice versa. In fact, if we could
rely on small mispricings to always correct promptly, they would never grow into the manias, bubbles,
and crashes we see from time to time.
8
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
So, one key is to avoid making macro calls too often. I wouldn’t want to try to make a living predicting
the outcome of coin tosses or figuring out whether the favorite will cover the point spread in every
football game over the course of a season. You have to pick your spots – as Warren Buffett puts it, wait
for a fat pitch. Most of the time, you have nothing to lose by abstaining from trying to adroitly get in and
out of the markets: you merely participate in their long-term trends, and those have been very favorable.

My readers know I don’t think consistently profitable market calls can be manufactured out of
macroeconomic forecasts. Nor do I believe you can beat the market simply by analyzing company
reports. On both subjects, as Andrew puts it (see my memo Something of Value, January 2021), “readily
available quantitative data regarding the past and present” can’t hold the secret to superior performance
since it’s available to everyone.

When
hen markets are at extreme highs or lows, the essential requirement for achieving a superior view
of their future performance lies in understanding what’ss responsible for the current conditions.
Everyone
ryone can study economics, finance, and accounting and learn how the markets are supposed to work.
But superior investment results come from exploiting the differences between how things are supposed to
work and how they actually do work in the real world.. To do that, the essential inputs aren
aren’t economic
data or financial statement analysis. The key lies in understanding prevailing investor psychology.

For me, the things one must do fall under the general heading of “taking the temperature of the market.”
I’ll itemize the most essential components here:

Engage in pattern recognition. Study market history in order to better understand the
implications of today’ss events. Ironically, when viewed over the long term, investor psychology
and thus market cycles – which seem flighty and unpredictable – fluctuate in ways that approach
dependability (if you’rere willing to overlook their highly variable causality, timing, and
amplitude).
Understand that cycles stem from what I call “excesses and corrections” and that a strong
movement in one direction is more likely to be followed – sooner or later – by a correction in the
opposite direction than by a trend that “grows to the sky.”
Watch for moments when most people are so optimistic that they think things can only get
better,, an expression that usually serves to justify the dangerous view that “there’s no price too
high.” Likewise, recognize when people are so depressed that they conclude things can only get
worse, as this often means they think a sale at any price is a good sale. When the herd’s thinking
is either Pollyannaish or apocalyptic, the odds increase that the current price level and direction
are unsustainable.
Remember that in extreme times, because of the above, the secret to making money lie lies in
contrarianism, not conformity. When emotional investors take an extreme view of an asset’s
future and, as a result, take the price to unjustified levels, the “easy money” is usually made by
doing the opposite. This is, however, very different from simply diverging from the
consensus all the time. Indeed, most of the time, the consensus is as close to right as most
individuals can get. So to be successful at contrarianism, you have to understand (a) what the
herd is doing, (b) why it’s doing it, (c) what’s wrong with it, and (d) what should be done instead
and why.
Bear in mind that much of what happens in economies and markets doesn’t result from a
mechanical process, but from the to and fro of investors’ emotions. Take note of the swings
and capitalize whenever possible.
Resist your own emotionality. Stand apart from the crowd and its psychology; don’t join in!

9
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Be on the lookout for illogical propositions (such as “stocks have fallen so far that no one will
be interested in them”). When you come across a widely accepted proposition that doesn’t make
sense or one you find too good to be true (or too bad to be true), take appropriate action. See
something; do something.

Obviously, there’s a lot to grapple with when taking the temperature of the market. In my opinion,
it has more to do with clear-eyed observations and assessments of the implications of what you see
than with computers, financial data, or calculations.

I’ll go into additional depth on a couple of points:

On pattern recognition: You may have noticed that the first of the five calls described above was made
in 2000, when I had already been working in the investment industry for more than 30 years. Does this
mean there were no highs and lows to remark on in those earlier years? No,, I think it means it took me
that long to gain the insight and experience needed to detect the market’ss excesses.

Most notably, whereas I spent two pages above describing the profound error in “The Death of Equities,”
you may have noticed that I didn’t say ay anything about my having called out the article when it appeared
in Businessweek in 1979. The reason is simple: I didn’t. t. I had only been in this business for about a
decade at that point, so (a) I didn’tt have the experience needed to recognize the article’s
ar error and (b) I
had yet to develop the unemotional stance and contrarian approach needed to depart from the herd and
rebel against its thesis. The best I can say is that my eventual development of those attributes
enabled me to catch the same errorr when it arose again 33 years later. Pattern recognition is an
important part of what we do, but it seems to require time in the field – and some scars – rather than just
book learning.

On cycles: In my book Mastering the Market Cycle,Cycle, I defined cycles not as a series of up and down
movements, each of which regularly precedes the next – which I believe is the usual definition – but as a
series of events, each of which causes the next. This causality holds the key to understanding cycles. In
particular, I think economies, investor psychology, and thus markets eventually go too far in one direction
or another – they become too positive or too negative – and afterward they eventually swing back toward
moderation (and then usually toward excess in the oppos
opposite direction). Thus, in my opinion, these
cycles are best understood as stemming from “excesses and corrections.” Overlooking the details of
the individual episodes, it’ss clear from the descriptions
description of these five calls that the greatest opportunities
forr bargain purchases result from overly negative prevailing psychology and the greatest opportunities to
sell at too-high
high prices arise from excessive optimism.

Macro Calls and the Oaktree Culture

While on the subject of market calls, I want to touch on two questions I’ve received repeatedly since the
publication of my memo The Illusion of Knowledge (September 2022), which discussed why I believe
creating helpful macro forecasts is so challenging. How does making these market calls fit within
Oaktree’s investment approach? And how can we make “micro forecasts” concerning companies,
industries, and securities without predicting the macro context?

In 1995, when my four Oaktree co-founders and I decided to form a new firm, we’d already been working
together for nine years on average. To come up with an investment philosophy that would guide the new
entity, we only had to reflect on what had worked for us up to that point and what we believed in. This
led us to write down the six tenets that describe how we invest, and we haven’t changed a word in 28
years.

10
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Of the six tenets, two raise questions regarding how macro calls fit within Oaktree’s investment approach:

Number five: “We don’t base our investment decisions on macro forecasts.”
Number six: “We’re not market timers.”

How about the first of those? It’s easy to say you don’t invest on the basis of macro forecasts, and I’ve
been saying this for decades. But the truth is, if you’re a bottom-up investor, you make estimates
regarding future earnings and/or asset values, and those estimates have to be predicated on
assumptions regarding the macro environment. Certainly, you can’t predict a business’s results in a
given period without considering what’ll be going on in the economy at that point. So, then, what does
avoiding macro forecasting mean to us? My answer is as follows:

We generally assume the macro environment of the future will resemble past norms.
We then make allowance for the possibility that things will be worse than normal. Ensuring our
investments have a generous “margin of safety” makes es it more likely they’ll do okay even if
future macro developments disappoint somewhat.
What we never do is project that the macro environment will be distinctly better than
normal in some way, making winners out of particular investments. Doing so can llead to profits
if one is right, but it’ss hard to consistently make such forecasts correctly. Further, investments
reliant on favorable macro developments can expose investors to the possibility of
disappointment, leading to loss. It’ss our goal to construct
construct portfolios where the surprises will
be on the upside. Relying on optimistic underlying assumptions is rarely part of such a
process. We prefer to make assumptions I would describe as “neutral.”

So we do base our modeling on macro assumptions – by necessity – but rarely are those
assumptions boldly idiosyncratic or optimistic. We never base our investment decisions on the
mistaken belief that we (or anyone else) can predict the future. Thus, we recognize that the above average
results we seek must arise
ise from our ground-
ground
ground-up
-up insights and not from our ability to do a superior job of
forecasting unusual macro events.

You might ask here, “WhatWhat about the memo Sea Change and its assertion that we may be seeing a shift
toward a wholly different environment?”
environment? My answer is that I feel good about this memo because (a) it’s
mostly a review of recent history and (b) the important observations surround the unusual nature of the
2009-21 period, itss effect on investment outcomes, and the improbability of it repeating. (I(I’m particularly
comfortable saying interest rates aren
aren’t going to decline by another 2,000 basis points from here.) While
it’ss important to stick to guiding principles, it’s
it also essential to recognize and respond to real change
when it happens. Thus, I stand by Sea Change (my only expression of an opinion of this kind in my
entire working life) as an acceptable deviation from my standard practice. For me, the case for a sea
change has more to do with observing and inferring than it does with predicting.

And what about market timing? As I’ve written numerous times since developing my risk-posture
framework a few years ago, every investor should operate most of the time in the context of their normal
risk posture, by which I mean the balance between aggressiveness and defensiveness that’s right for them.
It makes perfect sense to try to vary that balance when circumstances dictate compellingly that you should
do so and your judgments have a high probability of being correct, like in the case of the five calls I’ve
discussed. But such occasions are rare.

So, we stay in our normal balance – which in Oaktree’s case implies a bias toward defensiveness –
unless compelled to do otherwise. But we are willing to make changes in our balance between

11
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
aggressiveness and defensiveness, and we have done so successfully in the past. In fact, I consider one of
my principal responsibilities to be thinking about the proper balance for Oaktree at any given time.

If we’re happy to vary our risk posture, then what does it mean when we say, “we’re not market timers”?
For me, it means the following:

We don’t sell things we consider attractive long-term holdings to raise cash in expectation
of a market decline. We usually sell because (a) a holding has reached our target price, (b) the
investment case has deteriorated, or (c) we’ve found something better. Our open-end portfolios
are almost always fully invested; that way we avoid the risk of missing out on positive returns. It
also means buying usually necessitates some selling.
We don’t say, “It’s cheap today, but it’ll be cheaper in six months, so we’ll wait.” If it’s
cheap, we buy. If it gets cheaper and we conclude the thesis is still intact, we buy more. We’re
much more afraid of missing a bargain-priced
priced opportunity than we are of starting to buy a good
thing too early. No one really knows whether something will get cheaper in the days and weeks
ahead – that’s a matter of predicting investor
or psychology, which is somewhere between
challenging and impossible. We feel we’re re much more likely to correctly gauge the value of
individual assets.

While on the subject of buying too soon, I want to spend a minute on an interesting question: Which is
worse, buying at the top or selling at the bottom? For me the answer is easy: the latter. If you buy at
what later turns out to have been a market top, you’ll ll suffer a downward fluctuation. But that isn’t
isn cause
for concern if the long-term thesisis remains intact. And, anyway, the next top is usually higher than the
last top, meaning you’rere likely to be ahead eventually. But if you sell at a market bottom, you render that
downward fluctuation permanent, and, even more importantly, you get off the th escalator of a rising
economy and rising markets that has made so many long long-term investors rich. This is why I describe
selling at the bottom as the cardinal sin in investing.

* * *

Thinking about the macro environment and how it influences our proper risk posture falls squarely
within our responsibilities as investment managers. But the bottom line is that, at Oaktree, we
approach these things with great humility, diverging from our neutral assumptions and normal
behavior only when circumstances leave us no other choice. “Five times in 50 years” gives you an
idea about our level of interest in being market timers. The fact is, we do so hesitantly.

July 10, 2023

12
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.
This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written con
consent of Oaktree.

13
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Lessons from Silicon Valley Bank

This isn’t going to be another history of the meltdown of Silicon Valley Bank. Dozens of those have
appeared in my inbox over the past month, as I’m sure they have in yours. Thus, rather than merely
recount the developments, I’m going to discuss their significance.
My sense is that the significance of the failure of SVB (and Signature Bank) is less that it portends
additional bank failures and more that it may amplify preexisting wariness among investors and lenders,
leading to further credit tightening and additional pain across a range of industries and sectors.

One-off or a Harbinger of Things to Come?

A number of things about SVB made it somewhat of a special case – which means it probably won’t
won turn
out to be the first of many:

The bank’ss business was heavily concentrated in a single sector – venture capital-backed startups
in tech and healthcare – and a single region – Northern
Northern California.
Californ Many regional banks’
businesses are similarly concentrated, but not usually in sectors and regions that are both highly
volatile.
The boom in its sector and region caused SVB’
SVB’s business to grow very rapidly.
SVB
In recent years, startups were a major destination
destination for investors
investors’ cash, a good deal of which they
deposited at SVB. This caused SVB’s
SVB deposits to triple, from $62 billion at the end of 2019 to
$189 billion at the end of 2021.
For the same reason, many of SVBSVB’s clients had so much capital that they had little need to
SVB’
borrow. As deposits piled up at SVB, there wasnwasn’t offsetting demand for loans. Few other banks
have customers with similar cash inflows and consequently so little need to borrow money.
Because SVB had few traditional banking uses for the cash that piled up, it instead invested $91
billion in Treasury bonds and U.S. government agency mortgage
mortgage-backed securities between 2020
and 2021. This brought SVB’s investments to roughly half its total assets. (At the average bank,
that figure is about
bout one-quarter.)
Presumably to maximize yield – and thus the bank’s earnings – in what was a low-return
environment, SVB bought securities with long-dated maturities. SVB designated these securities
as “hold to maturity” (HTM) assets, meaning they wouldn’t be marked to market on the bank’s
balance sheet since it had no intention of selling them.
When the Federal Reserve embarked on its program of interest rate increases last year, bond
prices fell rapidly, and, of course, the longer the tenor of the bonds, the greater the decline in
value. In short order, the market value of SVB’s bond holdings was down $21 billion.
Word of the bank’s losses caused depositors to start withdrawing their money. To meet the
withdrawals, SVB had to sell bonds. Consequently, the bonds could no longer be considered
HTM. Instead, they had to be categorized as “available for sale” (AFS), meaning (a) the bonds
were marked down on SVB’s financial statements and (b) actual sales caused the losses to be
crystalized.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 The recognized losses helped hasten the spread of negative rumors throughout the tight-knit
venture capital community, which led to further withdrawals. An unusually large percentage of
SVB’s deposits – 94% – exceeded $250,000 and thus weren’t fully insured by the FDIC. This
meant they were more “institutional” than “retail.” Additionally, SVB’s customers were highly
interconnected: They had many backers in common, lived and worked near each other, and could
exchange information almost instantaneously through social media.

The sum of the above rendered SVB particularly vulnerable to a bank run if adverse circumstances
developed – and they did. However, many of the above factors were peculiar to SVB. Thus, I don’t think
SVB’s failure suggests problems are widespread in the U.S. banking system.

What Did SVB Have in Common with Other Banks?

I talked above about some things that distinguished SVB from other banks. But it’s as important to
consider the elements they shared:

Asset/liability mismatch – Financial mismatches are dangerous, and banks are built on them.
Deposits are banks’ primary source of funds, and while some have longer terms, most can be
withdrawn on any day, without prior notice. On the other hand, making loans represents banksbanks’
main use of funds, and most loans have lives ranging from one year ((commercial loans) up to 10-
30 years (mortgages). So, while most depositors can demand their money back at any time, (a)
no banks keep enough cash on hand to pay back all their depositors, (b) their main assets don
don’t
pay down in a short timeframe, and (c) if they need cash, it can take them a long time to sell loans
– especially if they want a price close to par. Maintaining solvency requires bank managements
to be aware of the riskiness of the assets they acquire, among other things. But liquidity is a m
more
transient quality. By definition, no bank can have enough liquidity to meet its needs if
enough depositors ask for their money all at once. Managing these issues is a serious task,
since it’s a bank’ss job to borrow short (from its depositors) and lend
len long.

This
his mismatch, like most other mismatches, is encouraged by the upward slope of the typical
yield curve. If you want to borrow, youyou’ll find the lowest interest rates at the “short end” of the
curve. Thus, you minimize your costs by borrowing for a day or a month . . . but you expose
yourself to the risk of rising interest expense, since you haven
haven’t fixed your rate for long.
Similarly, if you want to lend (or invest in bonds), you maximize your interest income by lending
long . . . but that subjects you tto the risk of capital losses if interest rates rise. If you follow
the yield curve’s
curve’s dictates, you’ll
you always borrow short and lend long, exposing you to the
possibility of an SVB
SVB-type mismatch.

High leverage – Banks operate with skinny returns on assets. They pay depositors (or the Fed) a
low rate of interest to borrow the funds they need to operate, and they lend or invest those funds
at slightly higher rates, earning a modest spread. But they literally make it up on volume. They
employ heavy leverage, meaning they can do a lot of business based on little equity capital,
thereby translating a low return on assets into a high return on equity. However, having a high
ratio of total assets to equity capital means a modest decline in asset prices can wipe out a bank’s
equity, rendering it insolvent. There’s no source of meltdown – in any sector – as potentially
toxic as the combination of high leverage and an asset/liability mismatch. Banks have them
both.

2
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Reliance on trust – Since depositors put money in banks in pursuit of safety and liquidity and, in
exchange, accept a low return, faith in banks’ ability to meet withdrawals is obviously paramount.
Depositors ostensibly can get liquidity, safekeeping, and low interest from any bank – that is, one
bank’s offering is essentially undifferentiated from those of others. Thus, most depositors are
perfectly willing to change banks if given the slightest reason, and there’s no offsetting reason for
them to leave their money on deposit if a bank’s safety is questioned.

You may be familiar with one of my favorite sayings: “Never forget the six-foot-tall person who drowned
crossing the stream that was five feet deep on average.” Surviving on average is a useless concept; you
have to be able to survive all the time, including – no, especially – in bad times. Borrowing short to
invest long powerfully threatens that ability. Being highly levered is another reason why, metaphorically,
tall people sometimes drown in streams that are shallow on average. And for financial institutions,
customers’ loss of confidence is a third.

The bottom line is that banks are, essentially, highly levered fixed income investors. Any long-term,
fixed-rate loans or bonds they own (which for most banks aren’t a large percentage of total assets) are
subject to declines in economic value in a rising-interest-rate
rate environment. Banks dondon’t have to recognize
price declines on assets they intend to hold to maturity, but any bank that is forced to sell those assets to
meet withdrawals would ld have to show the declines on its financial statements.

Looked at this way, retaining depositors’ trust is an absolutely essential ingredient in a bank’s
bank activities,
and that means assets, liabilities, liquidity, and capital have to be skillfully manage
managed. In SVB’s case, its
equity went up in smoke when rising interest rates reduced the value of a good part of its assets.

In that vein, I’m

m going to share a personal anecdote. When our son, Andrew, went off to college in 2005,
Nancy and I concluded it woulduld be great to live outside the United States for a while, something neither
of us had ever done. We chose to live in the UK for four months of the year, during which I worked in
Oaktree’ss London office. To generate income to cover our living expenses, we moved cash to a UK bank
and asked that it be deposited in CDs at several building societies (what we in the U.S. call savings &
loans). One of those was Northern Rock. In September 2007, as the financial crisis was brewing,
Northern Rock had trouble securing
ecuring the financing it needed in the wholesale funding market on which it
traditionally had depended. That prompted depositors to queue up to close their accounts.

I called my banker on a Friday afternoon to ask whether I could move my funds elsewher
elsewhere, and he told
me there would be a 2% penalty for early withdrawal. It took me about one second to say, “please move
those funds first thing Monday morning.
morning.” A 2% penalty sounded like peanuts relative to risking my
entire principal at Northern Rock. Now imagine the thinking of SVB depositors who could withdraw
their money without any penalty. (As it happens, the UK government guaranteed Northern RockRock’s
deposits over the weekend in question, eliminating the need to move the funds. But that was my closest
brush with a bank failure.)

Another new trend that has added to banks’ precariousness is the emergence of digital communications,
including social media. Sixteen years ago, it took days for Northern Rock’s depositors to become aware
of its difficulties. And when they decided to move their money, they had to go to their branch during
banking hours (what a quaint notion), queue up, and submit a withdrawal request. In SVB’s case, word
of the bond losses traveled quickly, through unusually interconnected depositors who had the ability to
request withdrawals online. As a result, more than one-third of the bank’s deposits departed in a single
day. All banks have to contend with digital communication and online withdrawals these days, but
SVB’s depositors were particularly high flight risks, given the bank’s region and the nature of its
clientele.

3
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
About twenty years ago, my partner Sheldon Stone shared an interesting parable: Imagine you’re on a
boat crossing Lake Erie. The captain comes on the loudspeaker and says, “Everyone run to the left side
of the boat.” A minute later he says, “Everyone run to the right side.” And a minute after that he says,
“Run back to the left.” It would make for an unusually rocky crossing. Today the internet and social
media are the loudspeaker, which almost anyone can take over, disseminating any message they choose.
This “digital herding,” as Gillian Tett of The Financial Times has labeled it, can have a huge impact in
many fields, particularly those that run on information and trust.

Was SVB’s Collapse Inevitable?

To close the loop, I’m going to recap the interrelated factors that caused SVB to fail:

If the bank had made more loans relative to the size of its deposit base, it wouldn
wouldn’t have bought as
many potentially volatile bonds.
If the bonds the bank bought hadn’tt had such long maturities, it wouldn’t
wouldn have been as exposed to
price declines.
If the Fed hadn’tt raised interest rates as much as it did, the bonds wouldn’t
wouldn have lost so much
value.
If the depositors hadn’tt exited en masse, the bank wouldn’t have had to sell bonds and realize the
losses.

You wouldn’tt think a portfolio consisting of bank loans and high

high-quality Treasury and mortgage-backed
bonds could be vulnerable to a meltdown that would render
rende a bank insolvent. But the scale of SVB’s
SVB
bond investments, the length of the maturities, and the extent of the Fed
Fed’s interest rate hikes put SVB at
risk, and the rapidity of the withdrawals caused the problem to run far ahead of the solutions.

When looking at SVB’ss demise, the decision-

decision
decision-making
-making behind its bond purchases stands out as particularly
flawed and probably the primary cause of the bank bank’s failure. According to public reports, SVB
management “made a bet” that interest rates would hold steady or ffall. While that expectation is implicit
in its actions, I find it hard to believe it was a conscious, considered decision, as opposed to an example of
mindlessly chasing yield, perhaps abetted by wishful thinking. The bond purchases took place in 2020
and 2021. In that two-year year period, the yield on the 30
30-year Treasury ranged between 0.99% and 2.45%.
How could anyone have thought rates that low were more likely to hold steady or fall than rise?
Determining how to move forward is always challenging in eeconomics and investing. However, when the
Fed and Treasury flooded the economy with cash in 2020 and inflation began to rise in 2021, the one
thing that should have been obvious was that there was no good reason to hold long long-dated bonds at
pitifully low yields,
ields, which presented profound risk and miniscule potential for return.

Comparisons to the GFC

SVB’s failure – along with the collapse of Signature Bank, the rescue of First Republic Bank, and Credit
Suisse’s forced sale to UBS – roiled markets in March. This resulted from fear of bank failure contagion
along the lines of what we saw during the Global Financial Crisis of 2007-08, when Bear Stearns, Merrill
Lynch, Lehman Brothers, Wachovia Bank, Washington Mutual, and AIG either melted down or required
rescues. There were times in that span, particularly in the last four months of 2008, when investors were
forced to contemplate the possibility of an unstoppable series of failures that could have endangered the
entire financial system. Nobody wants to face that again.

4
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
While I want to state clearly that I’m not an expert on banks or their regulation, I think the
similarities between 2008 and 2023 are limited to the mere fact that, in both instances, problems
existed at a few financial institutions. I find the common elements mostly superficial. What follows
are the differences.

By far most importantly, the GFC occurred for the simple reason that investors and financial institutions
experienced temporary insanity with respect to residential mortgages. They:

accepted unquestioningly that mortgages’ low-default history could be extrapolated;

forced massive amounts of money into the mortgage market;
loaned lots of it to subprime borrowers who couldn’t or wouldn’t document income or assets;
built tranched and levered mortgage-backed securities using subprime mortgages; and
in many cases, invested their own capital in the riskiest tranches of the RMBS to enable the
formation process to be repeated.

These parties ignored the possibility that excessive faith in mortgages – and the resultant lowering of
lending standards – could precipitate massive numbers of mortgage defaults. Further, they ignored the
fragility of the structured securities built out of those mortgages. Investors,
Investors, bankers, and rating agencies
(which awarded AAA ratings to thousands of RMBS issues) naively trusted that people who were willing
to pay extra interest to obtain mortgages without disclosing their financial condition would repay those
mortgages, even if the prices of the homes they bought fell. This led them to conclude that mortgage
defaults wouldn’t be sufficient to jeopardize the mortgage-backed
backed securities
securities’ viability. Subprime
mortgages were totally lacking in substance, yet many of the world
world’s leading financial institutions were
happy to make those loans and invest in securities built out of them.

Looking at the current situation, I can’tt think of anything that

that’s highly analogous to the subprime
mortgages at the heart of the GFC. There are things here or there that have been overover-hyped or are
short on substance – some people will point to SPACs or cryptocurrencies – but they’re not as massive in
scale, perhaps not as lacking in substance, and certainly not held on the balance sheets of America
America’s key
financial institutions in amounts sufficient to endanger our financial system. Indeed, I think it’s safe to
say the most glaring market excesses were corrected in 2022 and aren aren’t hanging over us now.
(However, for a caveat, please see this memo
memo’s last few paragraphs.)

In addition, whereas the list of institutions that disappeared during the GFC included some that clearly
were systemically important, I don
don’t think that can be said of SVB. I doubt our financial system was
highly reliant on promises made
made by SVB and thus subject to extensive counterparty risk. The GFC
affected some truly large banks – household names – and most people believed it was on the way to
jeopardizing even bigger ones before the government stepped in. There’s no reason to think the failure of
SVB poses the same risk.

Finally, it should be borne in mind that even though huge banks appeared to be endangered in 2008, the
Fed and other economic policymakers were able to come up with rescue plans (for the institutions
and for the economy), and they worked! In that vein, it’s worth noting that the Fed’s response to SVB’s
problems included (a) guaranteeing all SVB deposits, (b) making additional liquidity available to banks,
(c) injecting extensive liquidity into the economy, and (d) letting its balance sheet grow, even though it’s
been in the process of winding it down from its post-pandemic high. Thus, I find it hard to believe that
SVB or the like can set off a chain reaction sufficient to trigger an irreversible financial crisis.

On the subject of the problem’s scale, I want to mention a new pet peeve of mine. Increasingly, we hear
the media say things like, “this was the best month in the stock market since 2020” or “we saw more new

5
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
daily lows today than on any day since October.” The media like this kind of dramatic-sounding
comparison, and the latest is that “SVB is the biggest bank to fail since the GFC.” But these comparisons
don’t always mean much. In the case of SVB, it should be noted that, while this is the second-biggest
bank failure in history, SVB was only two-thirds the size of Washington Mutual, the biggest. Further,
since the financial sector has expanded meaningfully in the last 15 years, WaMu’s $307 billion of assets
in 2008 were much more significant than SVB’s $209 billion today.

A Word on Regulation

In March 2011, in the aftermath of the GFC, I published a memo called On Regulation. Its basic thrust
was that financial regulation is highly cyclical. Crashes, meltdowns, and widespread misbehavior bring
on calls for increased regulation. They also make increased regulation palatable to most parties. But
when the new regulations succeed – and thus appear to make the financial environment safer and better
functioning – free marketeers and people with vested interests typically start to argue that such strong
regulation is no longer necessary and that it restricts the financial system’s effectiveness. For example, in
response to the Great Crash of 1929, massive new regulations were enacted between 1930 and 1940 to
constrain conduct in the wild, wild west of Wall Street. But by the 1990s, the pain of the Crash was long
forgotten, and belief
ief in the efficacy of the free market was riding high. As a result, multiple regulations
were dismantled, enabling conduct that contributed to very painful experiences in the GFC.

The GFC, in turn, inspired another round of regulation. One of the governing principles was that
financial institutions that are too big to fail – and thus will, by necessity, be bailed out if threatened –
shouldn’tt be permitted to engage in risky activities, as this creates a situation where “heads, the
shareholders and management
ement win; tails, the taxpayers lose.
lose.” That proposition seems reasonable on its
face and was implemented via the Dodd-Frank Frank Act and its Volcker Rule. In general, bank regulation was
significantly tightened.

As time passed, the normal pushback against regulation

regulation emerged. The aspect that’s
that most relevant here is
the regulatory threshold. Following the GFC, all banks with assets above $50 billion were subject to the
strictest standards. But in 2018, regulators were convinced to raise that figure to $250 bbillion (thanks in
part to the lobbying of SVB’ss chief executive officer). As a result, SVB – with assets around $50 billion
at the time the threshold was raised – faced a looser regulatory regime. This helped it expand massively –
until it failed in a matter
tter of days.

Nevertheless, thanks to the post

post-GFC rules, the major U.S. banks today are well capitalized and have
significant liquidity and healthy balance sheets. This makes it less likely that we
we’ll see a GFC-type round
of bank failures. I’ve
ve heard it
i argued that current regulations and the resultant financial condition of
banks aren’t robust enough, but I believe most banks – and especially the majors – are much stronger than
they were before and during the GFC and typically much stronger than SVB.

Interestingly, Canada, Australia, and Britain function very well with far fewer banks than the U.S.
Canada, for example, has $2 trillion of GDP and just 34 domestic banks (17 per $1 trillion of GDP), and it
seems to get by. In contrast, in 2021, the U.S. had 4,236 FDIC-insured commercial banks for its $20
trillion of GDP, or 212 banks per $1 trillion. Could regulators do a better job if there were fewer banks to
monitor? We’ll see what happens to the number of U.S. banks if big ones absorb smaller ones and
deposits become concentrated in the bigger ones. But given the role of private parties and their money in
our system of government, I don’t expect to see a major change.

6
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Moral Hazard

One problem with government solutions of any kind – like the so-called “Greenspan put” – is the
possibility that they’ll generate moral hazard. That is, players will conclude that they’ll be rescued if they
make a mistake. This suggests they can freely engage in high-risk, high-return behavior; if it works,
they’ll get rich, but if it fails, they’ll be bailed out. People sometimes refer to this as “privatizing profits
and socializing losses.”

On March 9, when SVB was hanging by a thread while experiencing massive withdrawals, people started
talking about a possible government guarantee of all deposits. One of the arguments against such a
bailout was that it would create moral hazard. If people know they’ll be protected from losses, they’ll
have no reason to examine the solidity of a bank before depositing money, meaning the diligence function
won’t be performed. Consequently, poorly run, poorly capitalized banks will be permitted to stay in
business and grow.

But we simply cannot expect depositors to perform that function. Since banks banks’ operations are
characterized by mismatched assets/liabilities and a dependence on depositors’ trust, it’s
it terribly hard to
assess their financial health from the outside (maybe sometimes from the inside, too, since SV
SVB
succumbed to what in retrospect seem to have been obvious managerial mistakes). In the 28 years that
Oaktree has been in business, we’ve invested in relatively few deposit-taking
deposit financial institutions. Other
than in cases where we’ve become insiders, we’ve ve generally avoided investing in banks because their
complex, often impenetrable financial disclosures and reliance on trust make them harder to evaluate than
we like.

Few people are capable of studying banks’ financial statements and determining whet
whether they’ll remain
solvent and liquid. Expecting depositors to do so could cause banking to grind to a halt. That’s why
deposit insurance was introduced during the Great Depression. For the same reason, the government
government’s
decision to fully guarantee SVB’s deposits was quite appropriate.

Notably,
otably, however, management and shareholders werenweren’t bailed out; rather, in today’s parlance, they
were “bailed in,” or left with their losses. We can hope their losses will encourage other investors and
bank managers to apply greater prudence in their future decision-making.
decision

AT1s

While
hile not at all related, SVB
SVB’s failure gives me a chance to discuss another topic involving financial
institutions that’ss recently been in the news: A
Additional Tier 1 bonds, or AT1s. On the heels of the GFC,
European regulators required banks to raise new equity capital (“tier 1 capital”) and delever. However,
given the risks surrounding the banks, potential providers of capital demanded inducements. With AT1s,
these came in the form of bond-like yields, a promise of repayment at maturity, and debtholder status. So
far, so good.

In UBS’s recent takeover/rescue of Credit Suisse, FINMA, the Swiss bank regulator, determined that (a)
shareholders would receive modest compensation and (b) the holders of the $17 billion of AT1s would
get nothing. There was an immediate outcry, along with threats of litigation.

Although AT1s are clothed as debt securities, it seems FINMA had the power to alter the AT1s’ priority
relative to the shareholders and even eliminate their value. In this case, they chose to put the AT1s
behind the shareholders, wiping out investors who thought they were creditors. As Bloomberg noted on
March 23, this shouldn’t have come as a surprise:

7
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 A prospectus for the Credit Suisse AT1s highlights from the very first page the possibility
of a wipeout when there is what’s known as a writedown event. In this scenario, interest
on the notes would stop accruing and the full outstanding amount of the bonds would be
automatically and permanently written down to zero. Finma has the power to decide that
a type of writedown event known as a “viability event” has occurred if a bank’s efforts to
improve capital adequacy are “inadequate or unfeasible,” or if there is “extraordinary
public support” to avoid a bankruptcy, insolvency or halt to regular business.

Bloomberg’s Matt Levine explained how this worked in Credit Suisse’s case:

If the bank’s common equity tier 1 capital ratio – a measure of its regulatory capital –
falls below 7%, then the AT1 is written down to zero: It never needs to be paid back; it
just goes away completely. . . .

These securities are, basically, a trick. To investors,, they seem like bonds: They pay
interest, get paid back in five years, feel pretty safe. To regulators, they seem like equity:
If the bank runs into trouble, it can raise capital by zeroing the AT1s.
AT1s. If investors think
they are bonds and regulators think they are equity, somebody is wrong. The
investors are wrong.

In particular, investors seem to think that AT1s are senior to equity, and that the common
stock needs to go to zero before the AT1s suffer any losses. But this is not quite right.
You can tell because the whole point of the AT1s is that they go to zero if the
common equity tier 1 capital ratio falls below 7%. (Bloomberg Opinion; Money Stuff,
March 20, 2023. Bolding added.)

Were the investors misled? To me, the answer is no. In this regard, let
let’s consider the way the prospectus
for one such Credit Suisse issuance – “aa $2 billion US dollar 7.5% AT1 issued in 2018” – was labeled
(per Matt Levine): “7.500 per cent. Perpetual Tier 1 Contingent Write
Write-down Capital Notes.” There
shouldn’tt have been much doubt about their riskiness when “write-down capital notes” was in the title.

I once wrote of Bernie Madoff that you can say you did thorough due diligence or you can say he passed
the test, but you can’tt say you did thorough due diligence and he passed the test. Likewise, in the case of
Credit Suisse’ss AT1s, you can say you read and understood the prospectus, or you can say you thought
they were like ordinary debt securities, but you can
can’t say both.

Maybe there’ss a third path; maybe you could say “I knew the regulators had the power to zero me out, but
I didn’tt think they ever would.”
would. It seems to me that if people can take value from you legally, and
especially if doing so isn’t unambiguously immoral, you shouldn’t be surprised if they do. Holders
of high yield bonds have for many years dealt with an analogous phenomenon called “event risk,” which
refers to actions undertaken by company management for the purpose of transferring value from
bondholders to stockholders. In the case of Credit Suisse, the regulators likely gained the cooperation of
shareholders by paying them a few francs per share while wiping out the AT1s. Under the circumstances,
that shouldn’t have come as a complete surprise. It’s all part of protecting banks, which – as noted
above – are risky by nature.

Psychological Ramifications of the SVB Collapse

As I previously mentioned, I don’t view SVB, Signature Bank, First Republic, and Credit Suisse as
having been connected other than by the fact that they were in the same general line of work. That did

8
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
give them one thing in common: Since they’re all financial institutions, events involving them can
broadly impact depositors’ and investors’ confidence (or lack thereof). People seem to have trouble
dealing with multiple problems at once, and the near-simultaneous challenges at four banks caused people
to string them all together like beads, crafting a narrative that included a potential systemic meltdown.

While they don’t seem to me to be connected in tangible ways, the four banks’ recent crises certainly had
the power to shake things up. And when participants in the economy or market are shaken up, the
implications can be serious. As President Franklin D. Roosevelt said in his 1933 inaugural address during
the Great Depression, “the only thing we have to fear is fear itself.” Things don’t have to be connected
physically or even economically. In the markets, a series of scary events can have a very powerful
impact.

The credit crises during which my partners and I have invested over the last 38 years generally have
resulted
sulted from some combination of (a) negative economic developments, (b) excesses in the markets, (c)
adverse exogenous events, and (d) rising fear among investors and finance industry professionals. The
failures of SVB and the other banks likely aren’t enough
ough to bring on a credit crisis, but they could
contribute to one. As a result, it seems inescapable that some financial institutions will reduce the amount
of credit they make available, causing some borrowers to be left out. In particular, SVB SVB’s failure could
mean the startup world will have a tougher time getting financing in the months ahead. Regional and
community banks are likely to undergo increased scrutiny and experience deposit flight as cash flows to
money market funds and larger banks perceived ved to be safer. Their importance as the main financers of
real estate makes it likely that the going will get tougher for property owners and developers, just as
office buildings, brick-and-mortar
mortar retail, and perhaps even multifamily are coming under pressure in
many regions.

Combine developments like these with the reality that (a) interest rates are no longer declining or near
zero; (b) the Fed can’t be as accommodative as it was in the last few crises, because of today’s elevated
inflation; and (c) negative
gative developments are popping up in portfolios, and I think the case made in my
previous memo, Sea Change (December 2022), has been bolstered. The easy easy-money environment of the
last few years has been blamed for – among other things – the difficulties at SVB and its peers. Their
failure is likely to bring stricter scrutiny to banking, meaning things are unlikely to be as easy in the
period ahead. And to paraphrase Warren Buffett, nnow that the tide has gone out a bit, we’ve caught a
glimpse of some who were swimming naked near shore. The remaining questions are, how many more
are out there, and will the tide go out far enough to expose them?

When investors think things are flawless, optimism rides high and good buys can be hard to find.
But when psychology swings in the direction of hopelessness, it becomes reasonable to believe that
bargain hunters and providers of capital will be holding the better cards and will have
opportunities for better returns. We consider the meltdown of SVB an early step in that direction.

* * *

While I don’t foresee widespread contagion – either psychological or financial – arising from the
SVB failure alone, I can’t end a memo on U.S. banks without mentioning one of the biggest worries
they face today: the possibility of problems stemming from loans against commercial real estate
(“CRE”), especially office buildings.

The following factors are influencing the CRE sector today:

9
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Interest rates are up substantially. While some borrowers benefit from having fixed interest rates,
roughly 40% of all CRE mortgages will need to be refinanced by the end of 2025, and in the case
of fixed-rate loans, presumably at higher rates.
Higher interest rates call for higher demanded capitalization rates (the ratio of a property’s net
operating income to its price), which will cause most real estate prices to fall.
The possibility of a recession bodes ill for rental rates and occupancy, and thus for landlords’
income.
Credit is likely to be generally less available in the coming year or so.
The concept of people occupying desks in office buildings five days a week is in question,
threatening landlords’ underlying business model. While workers may spend more time in the
office in the future, no one knows what occupancy levels lenders will assume in their refinancing
calculations.

Total U.S. bank assets exceed $23 trillion. Banks collectively are the biggest real estate lenders, and
while we only have rough ranges for the data, they’re
re estimated to hold about 40% of the $4.5 trillion of
CRE mortgages outstanding, or around $1.8 trillion at face value. Based on these estimates, CRE loans
represent approximately 8-9% of the average bank’ss assets, a percentage that is significant but not
overwhelming. (Total exposure to CRE may be higher, however, as any investments in commercial
mortgage-backed
backed securities have to be considered in addition to banks’ holdings of direct CRE loans.)

However, CRE loans aren’tt spread evenly among banks: Some banks concentrate on parts of the country
where real estate markets were “hotter” and thus could see bigger percentage declines; some loaned
against lower-quality
quality properties, which is where the biggest problems
p are likely to show up; some
provided mortgages at higher loan-to-value
value ratios; and some have a higher percentage of their assets in
CRE loans. To this latter point, a recent report from Bank of America indicates that average CRE loan
exposure is just
ust 4.5% of total assets at banks with more than $250 billion of assets, while it
it’s 11.4% at
banks with less than $250 billion of assets.

Since banks are so highly levered, with collective equity capital of just $2.2 trillion (roughly 9% of total
assets),
), the estimated amount the average bank has in CRE loans is equal to approximately 100% of its
capital. Thus, losses on CRE mortgages in the average loan book could wipe out an equivalent
percentage of the average bank’ss capital, leaving the bank underca
undercapitalized. As the BofA report notes,
the average large bank has 50% of its risk
risk-based capital in CRE loans, while for smaller banks that figure
is 167%.

Notable defaults on office building mortgages and other CRE loans are highly likely to occur. Some
already
lready have. But that doesn’t
doesn necessarily mean the banks involved will suffer losses. If loans were made
at reasonable LTV ratios, there could be enough owners’ equity beneath each mortgage to absorb losses
before the banks’ loans are jeopardized. Further, mortgage defaults generally don’t signal the end of the
story, but rather the beginning of negotiations between lenders and landlords. In many cases, the result is
likely to be extension of the loan on restructured terms.

No one knows whether banks will suffer losses on their commercial real estate loans, or what the
magnitude will be. But we’re very likely to see mortgage defaults in the headlines, and at a
minimum, this may spook lenders, throw sand into the gears of the financing and refinancing
processes, and further contribute to a sense of heightened risk. Developments along these lines
certainly have the potential to add to whatever additional distress materializes in the months ahead.

April 17, 2023

10
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources ces from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.
This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

11
© 2023 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Sea Change

sea change (idiom): a complete transformation, a radical change of direction in attitude,

goals . . . (Grammarist)

In my 53 years in the investment world, I’ve seen a number of economic cycles, pendulum swings,
manias and panics, bubbles and crashes, but I remember only two real sea changes.
changes I think we may
be in the midst of a third one today.

As I’ve
ve recounted many times in my memos, when I joined the investment management industry in 1969,
many banks – like the one I worked for at the time – focused their equity portfolios on the so-called
so
“Nifty Fifty.” The Nifty Fifty comprised the stocks off companies that were considered the best and
fastest-growing – so good that nothing bad could ever happen to them. For these stocks, everyone was
sure there was “no price too high.” But if you bought the Nifty Fifty when I started at the bank and held
them
hem until 1974, you were sitting on losses of more than 90% . . . from owning pieces of the best
companies in America. Perceived quality, it turned out, wasn’t
wasn’ synonymous with safety or with
wasn
successful investment.

Meanwhile, over in bond-land, a security with a rating of single

single-B was described by Moody’s as “failing
to possess the characteristics of a desirable investment.”
investment. Non-investment grade bonds – those rated
double-B and below – were off-limits
limits to fiduciaries, since proper financial behavior mandat
mandated the
avoidance of risk. For this reason, what soon became known as high yield bonds couldn couldn’t be sold as new
issues. But in the mid-1970s,
1970s, Michael Milken and a few others had the idea that it should be possible to
issue non-investment
investment grade bonds – and to invest in them prudently – if the bonds offered enough interest
to compensate for the risk of default. In 1978, I started investing in these securities – the bonds of
perhaps America’ss riskiest public companies – and I was making money steadily and safely.

In other words, whereas prudent bond investing had previously consisted of buying only
presumedly safe investment grade bonds, investment managers could now prudently buy bonds of
almost any quality as long as they were adequately compensated for the attendant risk. The U.S.
high yield bond universe amounted to about $2 billion when I first got involved, and today it stands at
roughly $1.2 trillion.

This clearly represented a major change in direction for the business of investing. But that’s not the end
of it. Prior to the inception of high yield bond issuance, companies could only be acquired by larger firms
– those that were able to pay with cash on hand or borrow large amounts of money and still retain their
investment grade ratings. But with the ability to issue high yield bonds, smaller firms could now acquire
larger ones by using heavy leverage, since there was no longer a need to possess or maintain an
investment grade rating. This change permitted, in particular, the growth of leveraged buyouts and what’s
now called the private equity industry.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
However, the most important aspect of this change didn’t relate to high yield bonds, or to private
equity, but rather to the adoption of a new investor mentality. Now risk wasn’t necessarily avoided,
but rather considered relative to return and hopefully borne intelligently. This new risk/return
mindset was critical in the development of many new types of investment, such as distressed debt,
mortgage backed securities, structured credit, and private lending. It’s no exaggeration to say today’s
investment world bears almost no resemblance to that of 50 years ago. Young people joining the
industry today would likely be shocked to learn that, back then, investors didn’t think in
risk/return terms. Now that’s all we do. Ergo, a sea change.

At roughly the same time, big changes were underway in the macroeconomic world. I think it all started
with the OPEC oil embargo of 1973-74, which caused the price of a barrel of oil to jump from roughly
$24 to almost $65 in less than a year. This spike raised the cost of many goods and ignited rapid
inflation. Because the U.S. private sector in the 1970s was much more unionized than it is now and many
collective bargaining agreements contained automatic cost-of-living
living adjustments, rising inflation triggered
wage increases, which exacerbated inflation and led to yet more wage increases. This seemingly
unstoppable upward spiral kindled strong inflationary expectations, which in many cases becam
became self-
fulfilling, as is their nature.

The year-over-year
year increase in the Consumer Price Index, which was 3.2% in 1972, rose to 11.0% by
1974, receded to the range of 6-9%9% for four years, and then rebounded to 11.4% in 1979 and 13.5% in
1980. There was great
reat despair, as no relief was forthcoming from inflation
inflation-fighting tools ranging from
WIN (“Whip Inflation Now”) buttons to price controls to a federal funds rate that reached 13% in 1974.
It took the appointment of Paul Volcker as Fed chairman in 1979 andan the determination he showed in
raising the fed funds rate to 20% in 1980 to get inflation under control and extinguish inflationary
psychology. As a result, inflation was back down to 3.2% by the end of 1983.

Volcker’s success in bringing inflation underer control allowed the Fed to reduce the fed funds rate to the
high single digits and keep it there over the rest of the 1980s, before dropping it to the mid
mid-single digits in
the ’90s. His actions ushered in a declining-
declining-interest-rate
declining -interest environment that prevailed for four
decades (much more on this in the section that follows). I consider this the second sea change I’ve
seen in my career.

The long-term
term decline in interest rates began just a few years after the advent of risk/return
thinking, and I view thee combination of the two as having given rise to (a) the rebirth of optimism
among investors, (b) the pursuit of profit through aggressive investment vehicles, and (c) an
incredible four decades for the stock market. The S&P 500 Index rose from a low of 102 in August
1982 to 4,796 at the beginning of 2022, for a compound annual return of 10.3% per year. What a period!
There can be no greater financial and investment career luck than to have participated in it.

An Incredible Tailwind

What are the factors that gave rise to investors’ success over the last 40 years? We saw major
contributions from (a) the economic growth and preeminence of the U.S.; (b) the incredible performance
of our greatest companies; (c) gains in technology, productivity and management techniques; and (d) the
benefits of globalization. However, I’d be surprised if 40 years of declining interest rates didn’t play
the greatest role of all.

2
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
In the 1970s, I had a loan from a Chicago bank, with an interest rate of “three-quarters over prime.” (We
don’t hear much about the prime rate anymore, but it was the benchmark interest rate – the predecessor of
LIBOR – at which the money-center banks would lend to their best customers.) I received a notice from
the bank each time my rate changed, and I framed the one that marked the high point in December 1980:
It told me the interest rate on my loan had risen to 22.25%! Four decades later, I was able to borrow at
just 2.25%, fixed for 10 years. This represented a decline of 2,000 basis points. Miraculous!

What are the effects of declining interest rates?

They accelerate the growth of the economy by making it cheaper for consumers to buy on credit
and for companies to invest in facilities, equipment, and inventory.
They provide a subsidy to borrowers (at the expense of lenders and savers).
They reduce businesses’ cost of capital and thus increase their profitability.
They increase the fair value of assets. (The theoretical value of an asset is defined as th
the
discounted
scounted present value of its future cash flows. The lower the discount rate, the higher the
present value.) Thus, as interest rates fall, valuation parameters such as p/e ratios and enterprise
values rise, and cap rates on real estate decline.
They reduce the prospective returns investors demand from investments they they’re considering,
thereby increasing the prices they’llll pay. This can be seen most directly in the bond market –
everyone knows it’s “rates down; prices up” – but it works rks throughout the investment world.
By lifting asset prices, they create a “wealth effect” that makes people feel richer and thus more
willing to spend.
Finally, by simultaneously increasing asset values and reducing borrowing costs, they produce a
bonanzaa for those who buy assets using leverage.

I want to spend more time on that last point. Think about a buyer who employs leverage in a declining
declining-
rate environment:

He analyzes a company,, concludes that he can make 10% a year on it, and decides to buy it.
Then he asks his head of capital markets how much it would cost to borrow 75% of the money.
When he’s told it’ss 8%, it’ss full speed ahead. Earning 10% on three-quarters of the capital that’s
borrowed at 8% would lever up the return on the other oneone-quarter (his equity) to 16%.
Banks compete to make the loan, and the result is an interest rate of 7% instead of 8%, making
the investment even more profitable (a 19% levered return).
The interest cost on his floating
floating-rate debt declines over time, and when his fixed-rate debt
matures, he finds he can roll it over at 5%. Now the deal is a home run (a 25% levered return, all
else being equal).

This narrative ignores the beneficial impact of declining interest rates on both the profitability of the
company he bought and the market value of that company. Is it any wonder then that private equity and
other levered strategies enjoyed great success over the last 40 years?

In a recent visit with clients, I came up with a bit of imagery to convey my view of the effect of the
prolonged decline in interest rates: At some airports, there’s a moving walkway, and standing on it makes
life easier for the weary traveler. But if rather than stand still on it, you walk at your normal pace, you
move ahead rapidly. That’s because your rate of travel over the ground is the sum of the speed at which
you’re walking plus the speed at which the walkway is moving.

3
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
That’s what I think happened to investors over the last 40 years. They enjoyed the growth of the
economy and the companies they invested in, as well as the resulting increase in the value of their
ownership stakes. But in addition, they were on a moving walkway, carried along by declining interest
rates. The results have been great, but I doubt many people fully understand where they came from. It
seems to me that a significant portion of all the money investors made over this period resulted
from the tailwind generated by the massive drop in interest rates. I consider it nearly impossible to
overstate the influence of declining rates over the last four decades.

The Recent Experience

The period between the end of the Global Financial Crisis in late 2009 and the onset of the pandemic in
early 2020 was marked by ultra-low interest rates, and the macroeconomic environment – and its effects –
were highly unusual.

An all-time low in interest rates was reached when the Fed cut the fed funds rate tot approximately zero in
late 2008 in an effort to pull the economy out of the GFC. The low rates were
were accompanied
aacco by
quantitative easing purchases of bonds undertaken by the Fed
ed to inject liquidity into the economy (and
perhaps to keep investors from panicking). The effects were dramatic:

The low rates and vast amounts of liquidity stimulated the economy and triggered explosive gains
in the markets.
Strong economic growth and lower interest costs added to corporate profits.
Valuation parameters rose, as described above, lifting asset prices. Stocks increase
increased non-stop for
more than ten years, except for a handful of downdrafts that each lasted a few months. From a
low of 667 in March 2009, the S&P 500 reached a high of 3,386 in February 2020, for a
compound return of 16% per year.
The markets’ strength encouragedraged investors to drop their crisis
crisis-inspired risk aversion and
return to risk taking much sooner than expected. It also made FOMO – the fear of missing
out – the prevalent emotion among investors. Buyers were eager to buy, and holders
weren’t motivated to sell.
Investors’ revived desire to buy caused the capital markets to reopen, making it cheap and easy
for companies to obtain financing. Lenders
Lenders’ eagerness to put money to work enabled borrowers
to pay low interest rates under less
less-restrictive documentation that reduced lender protections.
The paltry yields on safe investments drove investors to buy riskier assets.
Thanks to economic growth and plentiful liquidity, there were few defaults and bankruptcies.
The main exogenous influences were increasing globalization and the limited extent of armed
conflict around the world. Both influences were clearly salutary.

As a result, in this period, the U.S. enjoyed its longest economic recovery in history (albeit also one of its
slowest) and its longest bull market, exceeding ten years in both cases.

When the Covid-19 pandemic caused much of the world’s economy to be shut down, the Fed dusted off
the rescue plan that had taken months to formulate and implement during the GFC and put it into effect in
a matter of weeks at a much larger scale than its earlier version. The U.S. government chipped in with
loans and vast relief payments (on top of its customary deficit spending). The result in the period from
March 2020 to the end of 2021 was a complete replay of the post-GFC developments enumerated above,

4
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
including a quick economic bounce and an even quicker market recovery. (The S&P 500 rose from its
low of 2,237 in March 2020 to 4,796 on the first day of 2022, up 114% in less than two years.)

For what felt like eons – from October 2012 to February 2020 – my standard presentation was
titled “Investing in a Low Return World,” because that’s what our circumstances were. With the
prospective returns on many asset classes – especially credit – at all-time lows, I enumerated the principal
options available to investors:

invest as you previously have, and accept that your returns will be lower than they used to be;
reduce risk to prepare for a market correction, and accept a return that is lower still;
go to cash and earn a return of zero, hoping the market will decline and thus offer higher returns
(and do it soon); or
ramp up your risk in pursuit of higher returns.

Each of these choices had serious flaws, and there’s a good reason for that. By definitio
definition, it’s hard to
achieve good returns dependably and safely in a low-return world.

Regular
egular readers of my memos know that my observations regarding the investment environment are
primarily based on impressions and inferences rather than data. Thus, in rece
recent meetings, I’ve been using
the following list of properties to describe the period in question. (Think about whether you agree with
this description. I’ll return to it later.)

2009 to 2021

Fed behavior Highly stimulative

Inflation Dormant
Economic outlook Positive
Likelihood of distress Minimal
Mood Optimistic
Buyers Eager
Holders Complacent
Key worry FOMO
Risk aversion Absent
Credit window Wide open
Financing Plentiful
Interest rates Lowest ever
Yield spreads Modest
Prospective returns Lowest ever

The overall period from 2009 through 2021 (with the exception of a few months in 2020) was one in
which optimism prevailed among investors and worry was minimal. Low inflation allowed central
bankers to maintain generous monetary policies. These were golden times for corporations and asset

5
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
owners thanks to good economic growth, cheap and easily accessible capital, and freedom from distress.
This was an asset owner’s market and a borrower’s market. With the risk-free rate at zero, fear of
loss absent, and people eager to make risky investments, it was a frustrating period for lenders and
bargain hunters.

On recent visits with clients, I’ve been describing Oaktree as having spent the years 2009 through 2019
“in the wilderness” given our focus on credit and our heavy emphasis on value investing and risk control.
To illustrate, after raising our largest fund up to that time in 2007-08 and putting most of it to work very
successfully in the wake of the Lehman Brothers bankruptcy, we thought it appropriate, given the
investment environment, to cut the amount in half for its successor fund and halve it again for the fund
after that. Oaktree’s total assets under management grew relatively little during this period, and the
returns on most of our closed-end funds, although fine, were moderate by our standards. It felt like a
long slog.

That Was Then. This Is Now.

Off course, all of the above flipped in the last year or so. Most importantly, inflation began to rrear its head
in early 2021, when our emergence from isolation permitted too much money (savings amassed by people
shut in at home, including distributions from massive Covid-19 19 relief programs) to chase too few goods
and services (with supply hampered by the uneven restart of manufacturing and transportation). Because
the Fed deemed the inflation “transitory,” it continued its policies of low interest rates and quantitative
easing, keeping money loose. These policies further stimulated demand (especially for homes) at a time
when it didn’t need stimulating.

Inflation
nflation worsened as 2021 wore on, and late in the year, the Fed acknowledged that it wasn’t
wasn likely to be
short-lived.
lived. Thus, the Fed started reducing its purchases of bonds in November and began raising
ra interest
rates in March 2022, kicking off one of the quickest rate
rate-hiking cycles on record. The stock market,
which had ignored inflation and rising interest rates for most of 2021, began to fall around year-end.

From there, events followed a predictable

edictable course. As I wrote in the memo On the Couch (January
2016), whereas events in the real world fluctuate between “pretty good” and “not so hot,” investor
sentiment often careens from “flawless”
“flawless
“flawless to “hopeless” as events that were previously viewed as
benign come to be interpreted as catastrophic
catastrophic.

Higher
gher interest rates led to higher demanded returns. Thus, sstocks that had seemed fairly valued
when
hen interest rates were minimal fell to lower p/e ratios that were commensurate with higher
rates.
Likewise, the massive increase in interest rates had its usual depressing effect on bond prices.
Falling stock and bond prices caused FOMO to dry up and fear of loss to replace it.
The markets’ decline gathered steam, and the things that had done best in 2020 and 2021 (tech,
software, SPACs, and cryptocurrency) now did the worst, further dampening psychology.
Exogenous events have the ability to undercut the market’s mood, especially in tougher times,
and in 2022 the biggest such event was Russia’s invasion of Ukraine.
The Ukraine conflict reduced supplies of grain and oil & gas, adding to inflationary pressures.
Since the tighter monetary policies were designed to slow the economy, investors focused on the
difficulty the Fed would likely have achieving a soft landing, and thus the strong likelihood of a
recession.

6
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 The anticipated effect of that recession on earnings dampened investors’ spirits. Thus, the fall of
the S&P 500 over the first nine months of 2022 rivaled the greatest full-year declines of the last
century. (It has now recovered a fair bit.)
The expectation of a recession also increased the fear of rising debt defaults.
New security issuance became difficult.
Having committed to fund buyouts in a lower-interest-rate environment, banks found themselves
with many billions of dollars of “hung” bridge loans unsaleable at par. These loans have saddled
the banks with big losses.
These hung loans forced banks to reduce the amounts they could commit to new deals, making it
harder for buyers to finance acquisitions.

The progression of events described above caused pessimism to take over from optimism. The market
characterized by easy money and upbeat borrowers and asset owners disappeared; now lenders and buyers
held better cards. Credit investors became able to demand higher returns and better creditor protections.
The list of candidates for distress – loans and bonds offering yield spreads of more than 1,000 basis points
over Treasurys – grew from dozens to hundreds. Here’ss how the change in the environment looks to me:

2009 to 2021 Today

Fed behavior Highly stimulative Tightening

Inflation Dormant 40-year high
Economic outlook Positive Recession likely
Likelihood of distress Minimal Rising
Mood Optimistic Guarded
Buyers Eager Hesitant
Holders Complacent Uncertain
Key worry FOMO Investment losses
Risk aversion Absent Rising
Credit window Wide open Constricted
Financing Plentiful Scarce
Interest rates Lowest ever More normal
Yield spreads Modest Normal
Prospective returns Lowest ever More than ample

If the right-hand column accurately describes the new environment, as I believe it does, then we’re
witnessing a complete reversal of the conditions in the middle column, which prevailed in 2021 and late
2020, throughout the 2009-19 period, and for much of the last 40 years.

How has this change manifested itself in investment options? Here’s one example: In the low-return
world of just one year ago, high yield bonds offered yields of 4-5%. A lot of issuance was at yields in the
3s, and at least one new bond came to the market with a “handle” of 2. The usefulness of these bonds for
institutions needing returns of 6 or 7% was quite limited. Today these securities yield roughly 8%,

7
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
meaning even after allowing for some defaults, they’re likely to deliver equity-like returns, sourced from
contractual cash flows on public securities. Credit instruments of all kinds are potentially poised to
deliver performance that can help investors accomplish their goals.

The Outlook

Inflation and interest rates are highly likely to remain the dominant considerations influencing the
investment environment for the next several years. While history shows that no one can predict inflation,
it seems likely to remain higher than what we became used to after the GFC, at least for a while. The
course of interest rates will largely be determined by the Fed’s progress in bringing inflation under
control. If rates go much higher in that process, they’re likely to come back down afterward, but no one
can predict the timing or the extent of the decrease.

While everyone knows how little I think of macro forecasts, a number of clients have asked recently
about my views regarding the future of interest rates. Thus, I’ll ll provide a brief overview. (Oaktree’s
(Oaktree
investment philosophy doesn’tt prohibit having opinions, just acting as if they’re right.) In my view, the
buyers who’ve driven the S&P 500’s recent 10% rally from the October low have been motivated by their
beliefs that (a) inflation is easing, (b) the Fed will soon pivot from restrictive policy back toward
stimulative, (c) interest rates will return to lower levels, (d) a recession will be averted, or it will be
modest and brief, and (e) the economy and markets will return to halcyon days.

In contrast, here’s what I think:

The underlying causes of today’ss inflation will probably abate as relief

relief-swollen savings are spent
and as supply catches up with demand.
While some recent inflation readings have been encouraging in this regard, the labor market is
still very tight, wages are rising, and the economy is growing strongly.
Globalization is slowing or reversing. If this trend continues, we will lose its significant
deflationary influence. (Importantly, consumer durables prices declined by 40% over the years
1995-2020, no doubtt thanks to less-
less
less-expensive
-expensive imports. I estimate that this took 0.6% per year off
the rate of inflation.)
Before
efore declaring victory on inflation, the Fed will need to be convinced not only that inflation has
settled
ettled near the 2% target, but also that inflatio
inflationary psychology has been extinguished. To
accomplish
ccomplish this, the Fed will likely want to see a positive real fed funds rate – at present it’s
minus 2.2%.
Thus, while the Fed appears likely to slow the pace of its interest rate increases, it
it’s unlikely to
return to stimulative policies any time soon.
The Fed has to maintain credibility (or regain it after having claimed for too long that inflation
was “transitory”). It can’t appear to be inconstant by becoming stimulative too soon after having
turned restrictive.
The Fed faces the question of what to do about its balance sheet, which grew from $4 trillion to
almost $9 trillion due to its purchases of bonds. Allowing its holdings of bonds to mature and roll
off (or, somewhat less likely, making sales) would withdraw significant liquidity from the
economy, restricting growth.
Rather than be in a stimulative posture on a perpetual basis, one might imagine the Fed would
prefer to normally maintain a “neutral interest rate,” which is defined as neither stimulative nor
restrictive. (I know I would.) Most recently – last summer – that rate was estimated at 2.5%.

8
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 Similarly, although most of us believe the free market is the best allocator of economic resources,
we haven’t had a free market in money for well over a decade. The Fed might prefer to reduce its
role in capital allocation by being less active in controlling rates and holding mortgage bonds.
There must be risks associated with the Fed keeping interest rates stimulative on a long-term
basis. Arguably, we’ve seen most recently that doing so can bring on inflation, though the
inflation of the last two years can be attributed largely to one-off events related to the pandemic.
The Fed would probably like to see normal interest rates high enough to provide it with room to
cut if it needs to stimulate the economy in the future.
People who came into the business world after 2008 – or veteran investors with short memories –
might think of today’s interest rates as elevated. But they’re not in the longer sweep of history,
meaning there’s no obvious reason why they should be lower.

These are the reasons why I believe that the base interest rate over the next several years is more
likely to average 2-4% (i.e., not far from where it is now) than 0-2%. Of course, there are
counterarguments. But, for me, the bottom line is that highly stimulative rates are likely not in the cards
for the next several years, barring a serious recession from which we need rescuing (and that would have
ramifications of its own). But I assure you Oaktree isn’tt going to bet money on that belief.

What
hat we do know is that inflation and interest rates are higher today than they’ve
they been for 40 and 13
years, respectively. No one knows how long the items in the right-hand
right hand column above will continue to
accurately describe the environment. They’ll be influenced
luenced by economic growth, inflation, and interest
rates, as well as exogenous events, all of which are unpredictable. Regardless, I think things will
generally be less rosy in the years immediately ahead:

A recession in the next 12-1818 months appears to be a foregone conclusion among economists and an
investors.
That recession is likely to coincide with deterioration of corporate earnings and investor
psychology.
Credit market conditions for new financings seem unlikely to soon become as accommodative as
they were in recent years.
No one can foretell how high the debt default rate will rise or how long it’ll stay there. It’s worth
noting in this context that the annual default rate on high yield bonds averaged 3.6% from 1978
through 2009, but an unusually low 2.1% under the “just-right” conditions that prevailed for the
decade 2010-19.
19. In fact, there was only one year in that decade in which defaults reached
re the
historical average.
average.
Lastly,
astly, there is a forecast II’m confident of: Interest rates aren’t about to decline by another
2,000
,000 basis points from here.

As I’ve written many times about the economy and markets, we never know where we’re going, but
we ought to know where we are. The bottom line for me is that, in many ways, conditions at this
moment are overwhelmingly different from – and mostly less favorable than – those of the post-GFC
climate described above. These changes may be long-lasting, or they may wear off over time. But in my
view, we’re unlikely to quickly see the same optimism and ease that marked the post-GFC period.

We’ve gone from the low-return world of 2009-21 to a full-return world, and it may become more
so in the near term. Investors can now potentially get solid returns from credit instruments,
meaning they no longer have to rely as heavily on riskier investments to achieve their overall return
targets. Lenders and bargain hunters face much better prospects in this changed environment than

9
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
they did in 2009-21. And importantly, if you grant that the environment is and may continue to be
very different from what it was over the last 13 years – and most of the last 40 years – it should
follow that the investment strategies that worked best over those periods may not be the ones that
outperform in the years ahead.

That’s the sea change I’m talking about.

December 13, 2022

10
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This
his memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written co
consent of Oaktree.

11
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: What Really Matters?

I’ve gathered a few ideas from several of my memos this year – plus some recent musings and
conversations – to form the subject of this memo: what really matters or should matter for investors. I’ll
start by examining a number of things that I think don’t matter.

What Doesn’t Matter: Short-Term Events

In The Illusion of Knowledge (September 2022), I railed against macro forecasting, which in our
profession mostly concerns the next year or two. And in I Beg to Differ (July 2022)
2022), I discussed the
questions I was asked most frequently at Oaktree’s June 21 conference in London:
London How bad will inflation
get? How much will the Fed raise interest rates to fight it? Will those increases cause a recession? How
bad and for how long? The bottom line, I told the attendees,, was that these things all relate to the short
term, and this is what I know about the short term:

Most investors can’t do a superior job of predicting short

short-term phenomena like these.
Thus, they shouldn’tt put much stock in opinions on these subjects (theirs
( or those of others).
They’re unlikely to make major changes in their portfolios in response to these opinions.
The changes they do make are unlikely to be consistently right.
Thus, these aren’tt the things that matter.

Consider an example. In response to the first tremors of the Global Financial Crisis, the Federal Reserve
began to cut the fed funds rate in 3Q2007.
3Q2007
3Q 2007. The
They then lowered it to zero around the end of 2008 and left it
there for seven years.. In late 2015,
2015, virtually the only question I got was “When will the first rate increase
occur?” My answer was always the same: “Why do you care? If I say ‘February,’ what will you do?
And if I later change my mind and say ‘May,’ what will you do differently? If everyone knows rates are
about to rise, what difference does it make w which month the process starts?” No one ever offered a
convincing answer. Investors probably think asking such questions is part of behaving professionally, but
I doubt they could explain why.

The vast majority of investors can’t know for sure what macro events lie just ahead or how the markets
will react to the things that do happen. In The Illusion of Knowledge, I wrote at length about the way
unforeseen events make a hash of economic and market forecasts. In summary, most forecasts are
extrapolations, and most of the time things don’t change, so extrapolations are usually correct, but not
particularly profitable. On the other hand, accurate forecasts of deviations from trend can be very
profitable, but they’re hard to make and hard to act on. These are some of the reasons why most people
can’t predict the future well enough to repeatably produce superior performance.

Why is doing this so hard? Don’t most of us know what events are likely to transpire? Can’t we just buy
the securities of the companies that are most likely to benefit from those events? In the long run, maybe,
but I want to turn to a theme that Bruce Karsh has been emphasizing lately, regarding a major reason why
it’s particularly challenging to profit from a short-term focus: It’s very difficult to know which
expectations regarding events are already incorporated in security prices.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
One of the critical mistakes people are guilty of – we see it all the time in the media – is believing that
changes in security prices are the result of events: that favorable events lead to rising prices and negative
events lead to falling prices. I think that’s what most people believe – especially first-level thinkers – but
that’s not right. Security prices are determined by events and how investors react to those events,
which is largely a function of how the events stack up against investors’ expectations.

How can we explain the company that reports higher earnings, only to see its stock price drop? The
answer, of course, is that the reported improvement fell short of expectations and thus disappointed
investors. So, at the most elementary level, it’s not whether the event is simply positive or not, but how
the event compares with what was expected.

In my earliest working years, I used to spend a few minutes each day looking over the earnings reports
printed in The Wall Street Journal. But after a while, it dawned on me that since I didn’t know what
numbers had been expected, I had no idea whether an announcement from a company I didn didn’t follow was
good news or bad.

Investors can become expert regarding a few companies

ompanies and their securities, but no one is likely to know
enough about macro events to (a) be able to understand the macro expectations that underlie the prices of
securities, (b) anticipate the broad events, and (c) predict how those securities will react. Where can a
prospective buyer look to find out what the investors who set securities prices already anticipate in terms
of inflation, GDP, or unemployment? Inferences regarding expectations
xpectations can sometimes be drawn from
asset prices, but the inferred levels often aren’t proved correct when the actual results come in.

Further, in the short term, security prices are highly susceptible to random and exogenous events that can
swamp the impact of fundamental events. Macro events and tthe ups and downs of companies’ near-
term fortunes are unpredictable and not necessarily indicative of – or relevant to – companies’
long-term prospects. So little attention should be paid to them. For example, companies often
deliberately reduce current earnings by investing in the future of their business
businesses; thus, low reported
earnings can imply high future earnings,
earnings, not continued low earnings. To know the difference, you have to
have an in-depth understanding of the company.
company

No one should be fooled into thinking security pricing is a dependable process that accurately follows a
set of rules. Events are unpredictable;
unpredictable; they can be altered by unpredictable influences; and investors’
reactions to the events that occur are unpredictable. Due to the presence of so much uncertainty, most
investors are unable to improve their results by focusing on the short term.

It’ss clear from observation that security pprices fluctuate much more than economic output or company
profits. What accounts for this? It must be the fact that, in the short term, the ups and downs of
prices are influenced far more by swings in investor psychology than by changes in companies’
long-term prospects. Because swings in psychology matter more in the near term than changes in
fundamentals – and are so hard to predict – most short-term trading is a waste of time . . . or worse.

What Doesn’t Matter: The Trading Mentality

Over the years, my memos have often included some of my father’s jokes from the 1950s, based on my
strong belief that humor often reflects truths about the human condition. Given its relevance here, I’m
going to devote a bit of space to a joke I’ve shared before:

2
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 Two friends meet in the street, and Joe asks Sam what’s new. “Oh,” he replies, “I just
got a case of great sardines.”

Joe: Great, I love sardines. I’ll take some. How much are they?

Sam: $10,000 a tin.

Joe: What! How can a tin of sardines cost $10,000?

Sam: These are the greatest sardines in the world. Each one is a pedigreed purebred,
with papers. They were caught by net, not hook; deboned by hand; and packed
in the finest extra-virgin olive oil. And the label was painted by a well-known
artist. They’re a bargain at $10,000.

Joe: But who would ever eat $10,000 sardines?

Sam: Oh, these aren’t eating sardines; they’re trading sardines.

I include this old joke because I believe most people treat stocks and bonds like something to trade, not
something to own.

If you ask Warren Buffett to describe the foundation of his approach to investing, he’ll he probably
start by insisting that stocks should be thought
ught of as ownership interests in companies. Most people
don’tt start companies with the goal of selling them in the short term, but rather they seek to operate them,
enjoy profitability, and expand the business. Of course, founders do these things to ultimately
ult make
money, but they’rere likely to view the money as the byproduct of having run a successful business.
Buffett says people who buy stocks should think of themselves as partners of owners with whom they
share goals.

But I think that’s rarely the case. Most people buy stocks with the goal of selling them at a higher
price, thinking they’rere for trading, not for owning. This means they abandon the owner mentality and
instead act like gamblers or speculators
speculators who bet on stock price moves. The results are often unpleasant.

The DALBAR Institute 2012 study showed that investors receive three percentage points
less per year than the S&P 500 generated from 1992 to 2012, and the average holding
period for a typical investor is six months. Six Months!! When you hold a stock for less
than a year, you are not using the stock market to acquire business ownership positions
and participate in the growth of that business. Instead, you are just guessing at short-term
news and expectations, and your returns are based on how other people react to that news
information. In aggregate, that kind of attitude gets you three percentage points less per
year than you’d get from doing nothing at all beyond making the initial investment in the
index fund of the S&P 500. (“Fidelity’s Best Investors Are Dead,” The Conservative
Income Investor, April 8, 2020)

To me, buying for a short-term trade equates to forgetting about your sports team’s chances of winning
the championship and instead betting on who’s going to succeed in the next play, period, or inning.

Let’s think about the logic. You buy a stock because you think it’s worth more than you have to pay for
it, whereas the seller considers it fully priced. Someday, if things go well, it’ll become fully priced, in

3
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
your opinion, meaning you’ll sell it. The person you sell it to, however, will buy it because he thinks it’s
worth still more. We used to talk about this process as being reliant on the Greater Fool Theory: No
matter what price I pay for a stock, there will always be someone who will buy it from me for more,
despite the fact that I’m selling because I’ve concluded that it has reached full value.

Every buyer is motivated by the belief that the stock will eventually be worth more than today’s price (a
view the seller presumably doesn’t share). The key question is what type of thinking underlies these
purchases. Are the buyers buying because this is a company they’d like to own a piece of for years?
Or are they merely betting that the price will go up? The transactions may look the same from the
outside, but I wonder about the thought process and thus the soundness of the logic.

Each time a stock is traded, one side is wrong and one is right. But if what you’re doing is betting
on trends in popularity, and thus the direction of price moves over the next month, quarter, or
year, is it realistic to believe you’ll be right more often than the person on the other side of the
trade? Maybe the decline of active management can be attributed to the many active managers who
placed bets on the direction of stock prices in the short term, instead of picking companies they wanted to
own part of for years. It’s all a matter of the underlying mentality.

I had a long debate on this topic with my father back in 1969, when I lived with him during my first
months at First National City Bank. (It’s amazing for me to think back to those days;
days he was so much
younger than I am today.) I told him I thought buying a stock should be motivated by something other
than the hope that the price would rise, and I suggested this might be the expectation that dividends would
increase over time. He countered that no one buys stocks for the dividends – they buy because they think
the price will go up. But what would trigger the rise?

Wanting to own a business for its commercial merit and long-term

long earnings potential is a good reason to
be a stockholder, and if these expectations are borne out, a good reason to believe the stock price will rise.
In the absence of that, buying in the hope of appreciation merely amounts to trying to guess which
industries and companies investors will favor in the future
future. Ben Graham famously said, “In the short run,
the market is a voting machine, but in the long run, it is a weighing machine.
machine.” While none of this is
easy, as Charlie Munger once told me, carefully weighing long-term merit should produce better
results than trying to guess at short
short-
short-term
-term swings in popularity.

What Doesn’tt Matter: Short

Short-Term
Term Performance

Given the possible contributors to short-term investment performance, reported results can present a
highly misleading picture,
ture, and here I’m
I talking mostly about superior gains in good times. I feel there are
three ingredients for success during good times – aggressiveness, timing, and skill – and if you have
enough aggressiveness at the right time, you don’t need that much skill. We all know that in good times,
the highest returns often go to the person whose portfolio incorporates the most risk, beta, and correlation.
Having such a portfolio isn’t a mark of distinction or insight if the investor is a perma-bull who’s always
positioned aggressively. Finally, random events can have an overwhelming impact on returns – in either
direction – in a given quarter or year.

One of the recurring themes in my memos is the idea that the quality of a decision cannot be determined
from the outcome alone. Decisions often lead to negative outcomes even when they’re well-reasoned and
based on all the available information. On the other hand, we all know people – even occasionally
ourselves – who’ve been right for the wrong reason. Hidden information and random developments can

4
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
frustrate even the best thinkers’ decisions. (However, when outcomes are considered over a long period
of time and a large number of trials, the better decision maker is overwhelmingly likely to have a higher
proportion of successes.)

Obviously, no one should attach much significance to returns in one quarter or year. Investment
performance is simply one result drawn from the full range of returns that could have materialized,
and in the short term, it can be heavily influenced by random events. Thus, a single quarter’s
return is likely to be a very weak indicator of an investor’s ability, if that. Deciding whether a
manager has special skill – or whether an asset allocation is appropriate for the long run – on the basis of
one quarter or year is like forming an opinion of a baseball player on the basis of one trip to the plate, or
of a racehorse based on one race.

We know short-term performance doesn’t matter much. And yet, most of the investment committees I’ve
sat on have had the latest quarter’s performance as the first item on the agenda and devoted a meaningful
portion of each meeting to it. The discussion is usually extensive, but it rarely leads to significant action.
So why do we keep doing it? For the same reasons investors pay attention to forecasting, as described in
The Illusion of Knowledge: “everyone does it,” and “itit would be irresponsible not to.”
to

What Doesn’t Matter: Volatility

I haven’tt written much about volatility, other than to say I strongly disagree with people who consider it
the definition or essence of risk. I’vee described my belief that the academics who developed the Chicago
School theory of investment in the early 1960s (a) wanted to examine the relationship between investment
returns and risk, (b) needed a number quantifying risk that they could put into their
thei calculations, and (c)
undoubtedly chose volatility as a proxy for risk for the simple reason that it was the only quantifiable
quant
metric available. I define risk ass the probability of a bad outcome, and volatility is, at best, an indicator of
the presence of risk. But volatility is not risk. That’s
That all II’m going to say on that subject.

What I want to talk about here is the extent to which thinking and caring about volatility has
warped the investing world over the 50- 50
50-plus
-plus years that II’ve been in it. It was a great advantage for
me to have attended the Graduate School of Business at the University of Chicago in the late ’60s and to
have been part of one of the very first classes tthat was taught the new theories. I learned about the
efficient market hypothesis,
hesis, the capital asset pricing model, the random walk, the importance of risk
aversion, and the role of volatility as risk. While volatility wasn’t a topic of conversation when I got into
the real world of investing in 1969
1969, practice soon caught up with theory.

In particular, the Sharpe ratio was adopted as the measure of risk-adjusted return. It’s the ratio of a
portfolio’s excess return (the part of its return that exceeds the yield on T-bills) to its volatility. The more
return per unit of volatility, the higher the risk-adjusted return. Risk adjustment is an essential concept,
and returns should absolutely be evaluated relative to the risk that was taken to achieve them. Everyone
cites Sharpe ratios, including Oaktree, because it’s the only quantitative tool available for the job. (If
investors, consultants, and clients didn’t use the Sharpe ratio, they’d have no metric at all, and if they tried
to substitute fundamental riskiness for volatility in their assessments, they’d find that there’s no way to
quantify it.) The Sharpe ratio may hint at risk-adjusted performance in the same way that volatility
hints at risk, but since volatility isn’t risk, the Sharpe ratio is a very imperfect measure.

Take, for example, one of the asset classes I started working with in 1978: high yield bonds. At Oaktree,
we think moderately-above-benchmark returns can be produced with substantially less risk than the

5
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
benchmark, and this shows up in superior Sharpe ratios. But the real risk in high yield bonds – the one
we care about and have a history of reducing – is the risk of default. We don’t much care about reducing
volatility, and we don’t take conscious steps to do so. We believe high Sharpe ratios can result from –
and perhaps are correlated with – the actions we take to reduce defaults.

Volatility is particularly irrelevant in our field of fixed income or “credit.” Bonds, notes, and loans
represent contractual promises of periodic interest and repayment at maturity. Most of the time when
you buy a bond with an 8% yield, you’ll basically get the 8% yield over its life, regardless of
whether the bond price goes up or down in the interim. I say “basically” because, if the price falls,
you’ll have the opportunity to reinvest the interest payments at yields above 8%, so your holding-period
return will creep up. Thus, the downward price volatility that so many revile is actually a good thing – as
long as it doesn’t presage defaults. (Note that, as indicated in this paragraph, “volatility” is often a
misnomer. Strategists and the media often warn that “there may be volatility ahead.” What they really
mean is “there may be price declines ahead.” No one worries about, or minds experiencing
experiencing, volatility to
the upside.)

It’s essential to recognize that protection from volatility generally isn’t ’t a free good. Reducing
volatility for its own sake is a suboptimizing strategy: It should be presumed
presum that favoring lower-
volatility assets and approaches will – all things being equal – lead to lower
low returns. Only managers
with superior skill, or alpha (see page 11), will be able to overcome this negative presumption and reduce
return less than they reduce volatility.

Nevertheless, since
ince many clients, bosses, and other constituents are uncomfortable with radical ups and
downs (well, mostly with downs), asset managers often take steps to reduce volatility. Consider what
happened after institutional investors
ors began to pile into hedge funds follow
following the three-year decline of
stocks brought on by the bursting of the tech bubble in 2000
2000. (This was the first three-year decline since
1939-41.) Hedge funds – previously members of a cottage industry where most funds had a few hundred
million dollars of capital from wealthy individuals – did much better than stocks in the downdraft.
Institutions were attracted to these funds’ low volatility, and thus invested billions in them.

The average hedge fund delivered the stability the institutions wanted. But somewhere in the shuffle, the
idea of earning high returns with low volatility got lost. Instead, hedge fund managers pursued low
volatility as a goal in itself,, since the
theyy knew it was what the institutions were after. As a result, over
roughly the last 18 years, the average hedge fund delivered the low volatility that was desired, but it was
accompanied by modest single-
single
single-digit
-digit returns. No miracle there.

Why do I recite all this? Because volatility is just a temporary phenomenon (assuming you survive
it financially), and most investors shouldn’t attach as much importance to it as they seem to. As I
wrote in I Beg to Differ, many investors have the luxury of being able to focus exclusively on the long
term . . . if they will take advantage of it. Volatility should be less of a concern for investors:

whose entities are long-lived, like life insurance companies, endowments, and pension funds;
whose capital isn’t subject to lump-sum withdrawal;
whose essential activities won’t be jeopardized by downward fluctuations;
who don’t have to worry about being forced into mistakes by their constituents; and
who haven’t levered up with debt that might have to be repaid in the short run.

6
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
Most investors lack some of these things, and few have them all. But to the extent these characteristics
are present, investors should take advantage of their ability to withstand volatility, since many
investments with the potential for high returns might be susceptible to substantial fluctuations.

Warren Buffett always puts it best, and on this topic he usefully said, “We prefer a lumpy 15%
return to a smooth 12% return.” Investors who’d rather have the reverse – who find a smooth
12% preferable to a lumpy 15% – should ask themselves whether their aversion to volatility is
mostly financial or mostly emotional.

Of course, the choices made by employees, investment committee members, and hired investment
managers may have to reflect real-world considerations. People in charge of institutional portfolios can
have valid reasons for avoiding ups and downs that their organizations or clients might be able to stomach
in financial terms but would still find unpleasant. All anyone can do is the best they can under their
particular circumstances. But my bottom line is this: In many cases, people accord volatility far more
importance than they should.

An Aside

While I’m on the subject of volatility, I want to turn to an area that hasn
hasn’t reported much of it of late:
private investment funds. The first nine months of 2022 constituted one of the worst periods on record
for both stocks and bonds. Yet many private equity and private debt funds are reporting only small losses
for the year to date. I’m often asked what this means, and whether it reflects reality.

Maybe the performance of private funds is being reported accurately. (I know we believe ours is.) But I
recently came across an interesting Financial Times
imes article provocatively titled, “The volatility
laundering, return manipulation and ‘phoney
phoney happiness’
happiness of private equity
equity,” by Robin Wigglesworth.
Here’s some of its content:

The widening performance gap between public and private markets is a huge topic tthese
days. Investors are often seen as the gormless [foolish] dupes falling for the “return
manipulation” of cunning private equity tycoons. But what if they are co-conspirators? . . .

That’ss what a new paper from three academics at the University of Florida
Fl argues. Based
on nearly two decades worth of private equity real estate funds data
data, Blake Jackson,
David Ling and Andy Naranjo conclude that “private equity fund managers manipulate
returns to cater to their investors
investors.”

. . . Jackson, Ling and Naranjo’s . . . central conclusion is that “GPs do not appear
to manipulate interim returns to fool their LPs, but rather because their LPs want
them to do so”.

Similar to the idea that banks design financial products to cater to yield-seeking
investors or firms issue dividends to cater to investor demand for dividend
payments, we argue that PE fund managers boost interim performance reports
to cater to some investors’ demand for manipulated returns.

. . . If a GP boosts or smooths returns, . . . investment managers within LP

organizations can report artificially higher Sharpe ratios, alphas, and top-

7
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 line returns, such as IRRs, to their trustees or other overseers. In doing so,
these investment managers, whose median tenure of four years often expires
years before the ultimate returns of a PE fund are realized, might improve their
internal job security or potential labor market outcomes. . . .

This probably helps explain why private equity firms on average actually reported gains
of 1.6 per cent in the first quarter of 2022 and only some modest mark downwards since
then, despite global equities losing 22 per cent of their value this year. (November 2,
2022. Emphasis added)

If both GPs and LPs are happy with returns that seem unusually good, might the result be suspect? Is the
performance of private assets being stated accurately? Is the low volatility being reported genuine? If the
current business climate is challenging, shouldn’t that affect the prices of public and private investments
alike?

But there’s another series of relevant questions: Mightn’t it be fair for GPs to decline to mark down
private investments in companies that have experienced short-term term weakness but whose long-term
prospects remain bright? And while private investments might not have been marked down enough this
year, isn’t it true that the prices of public securities are more volatile than they should be,
be overstating the
changes in long-term value? I certainly think public security prices reflect psychological swings that are
often excessive. Should the prices of private investments emulate this this?

As with most things, any inaccuracy in reporting will event

eventu
eventually
ually come to light. Eventually, private debt
will mature, and private equity holdings will have to be sold
sold. If the returns being reported this year
understate the real declines in value, performance from here
he on out will likely look surprisingly poor.
And I’m sure this will lead plenty of academics (and maybe a few regulators) to question whether the
pricing of private investments in 2022 was too high.
high. We’ll
We see.

What Doesn’t Matter: Hyper-Activity

ctivity

In Selling Out (January 2022),, I expressed my strong view that most investors trade too much. Since it’s
hard to make multiple consecutive decisions correctly, and trading costs money and is often likely to
result from an investor’ss emotional swings
swings, it’s better to do less of it.

When I was a boy, there was a popular saying:say Don’t just sit there; do something. But for
investing, I’d invert it: Don’t
Don just do something; sit there. Develop the mindset that you don’t make
money on what you buy and sell; you make money (hopefully) on what you hold. Think more. Trade
less. Make fewer, but more consequential, trades. Over-diversification reduces the importance of each
trade; thus it can allow investors to take actions without adequate investigation or great conviction. I
think most portfolios are overdiversified and over-traded.

I devoted a good portion of The Illusion of Knowledge and Selling Out to warning investors about how
difficult it is to improve returns through short-term market timing, and I quoted the great investor Bill
Miller: “Time, not timing, is key to building wealth in the stock market.”

On this subject, I was recently asked by a consultant, “If you don’t try to get in and out of the market as
appropriate, how do you earn your fees?” My answer was that it’s our job to assemble portfolios that will
perform well over the long run, and market timing is unlikely to add to the outcome unless it can be done

8
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
well, which I’m not convinced is usually the case. “What about you?” I asked. “If you help a client
establish an appropriate asset allocation, does it follow that you’re not earning your fees if you don’t
change it a month later?”

Likewise, the day The Illusion of Knowledge came out, an old friend asked me, “But you have to take a
position [on short-run events], don’t you?” My answer, predictably, was, “No, not if you don’t have an
advantage when doing so. Why would you bet on the outcome of a coin toss, especially if it cost money
to play?”

I’ll end my discussion of this subject with a wonderful citation:

A news item that has gotten a lot of attention recently concerned an internal performance
review of Fidelity accounts to determine which type of investors received the best returns
between 2003 and 2013. The customer account audit revealed that the best investors were
either dead or inactive – the people who switched jobs and “forgot” about an old 401(k)
leaving the current options in place, or the people who died and the assets were frozen
while the estate handled the assets. (“Fidelity’s Best Investors
rs Are Dead
Dead,” The
Conservative Income Investor, April 8, 2020)

Since the journalists have been unable to find the Fidelity study, and apparentl
apparently so has Fidelity, the story
is probably apocryphal. But I still like the idea, since the conclusion is so much in line with my thinking.
I’m not saying it’s worth dying to improve investment performance, but it might be a good idea for
investors to simulate that condition by sitting on their hands.

So What Does Matter?

What really matters is the performance of your holdings over the next five or ten years (or more)
and how the value at the end of the period compares to the amount you invested and to your needs.
Some people say the long run is a series of short runs, and if you get those right, you
you’ll enjoy success in
the long run. They might think the
he route to success consists of trading often in order to capitalize on
relative value assessments, predictions regarding swings in popularity, and forecasts of macro events. I
obviously do not.

Most individual investors and anyone who understands the limitations regarding outperformance would
probably be best off holding index funds over the long run. Investment professionals and others who feel
they need or want to engage in active management might benefit from the following suggestions.

I think most people would be more successful if they focused less on the short run or macro trends and
instead worked hard to gain superior insight concerning the outlook for fundamentals over multi-year
periods in the future. They should:

study companies and securities, assessing things such as their earnings potential;
buy the ones that can be purchased at attractive prices relative to their potential;
hold onto them as long as the company’s earnings outlook and the attractiveness of the price
remain intact; and
make changes only when those things can’t be reconfirmed, or when something better comes
along.

9
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
At the London conference mentioned on page one – while I was discussing (and discouraging)
paying attention to the short run – I said that at Oaktree we consider it our job to (a) buy debt that
will be serviced as promised (or will return the same amount or more if not) and (b) invest in
companies that will become more valuable over time. I’ll stick with that.

The above description of the investor’s job is quite simple . . . some might say simplistic. And it is.
Setting out the goals and the process in broad terms is easy. The hard part is executing better than most
people: That’s the only route to market-beating performance. Since average decision-making is
reflected in security prices and produces average performance, superior results have to be based on
superior insight. But I can’t tell you how to do these things better than the average investor.
There’s a lot more to the process, and I’m going to outline some of what I think are key elements to
remember. You’ll recognize recurring themes here, from other memos and from earlier pages in this one,
but I make no apology for dwelling on things that are important:

Forget the short run – only the long run matters. Think of securities as interests in companies, not
trading cards.
Decide whether you believe in market efficiency. If so, is your market sufficiently inefficient to
permit outperformance,, and are you up to the task of exploiting it?
Decide whether your approach will lean more toward aggressiveness or defensiveness. Will you
try to find more and bigger winners or focus on avoidinging losers, or both? Will you try to make
more on the way up or lose less on the down, or both?? (Hint: “both” is much harder to achieve
than one or the other.) In general, people’s investment styles
style should fit their personalities.
Think about what your normal risk posture should be – your normal balance between
aggressiveness and defensiveness – based on your or your clients
clients’ financial position, needs,
aspirations, and ability to live with fluctuations. Consider whether you’ll vary your balance
depending on what happens in the market.
Adopt a healthy attitude toward return and risk. Understand that “the more return potential, the
better” can be a dangerous rule to follow given that increased return potential is usually
accompanied by increased risk. On the other hand, completely avoiding risk usually leads to
avoiding return as well.
Insist on an adequate margin of safety, or the ability to weather periods when things go less well
than you expected.
Stop trying to predict the macro; study the micro like mad in order to know
kno your subject better
than others. Understand that you can expect to succeed only if you have a knowledge advantage,
and be realistic about whether you have it or not. Recognize that trying harder isn’t enough.
Accept my son Andrew’s
Andrew view that merely possessing “readily available quantitative information
regarding the present
present” won’t give you above average results, since everyone else has it.
Recognize that psychology swings much more than fundamentals, and usually in the wrong
direction or at the wrong time. Understand the importance of resisting those swings. Profit if you
can by being counter-cyclical and contrarian.
Study conditions in the investment environment – especially investor behavior – and consider
where things stand in terms of the cycle. Understand that where the market stands in its cycle
will strongly influence whether the odds are in your favor or against you.
Buy debt when you like the yield, not for trading purposes. In other words, buy 9% bonds if you
think the yield compensates you for the risk, and you’ll be happy with 9%. Don’t buy 9% bonds
expecting to make 11% thanks to price appreciation resulting from declining interest rates.

10
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
Of critical importance, equity investors should make their primary goals (a) participating in the
secular growth of economies and companies and (b) benefiting from the wonder of compounding.
Think about the 10.5% yearly return of the S&P 500 Index (or its predecessors) since 1926 and the fact
that this would have turned $1 into over $13,000 by now, even though the period witnessed 16 recessions,
one Great Depression, several wars, one World War, a global pandemic, and many instances of
geopolitical turmoil.

Think of participating in the long-term performance of the average as the main event and the active
efforts to improve on it as “embroidery around the edges.” This might be the reverse of most active
investors’ attitudes. Improving results through over- and underweighting, short-term trading, market
timing, and other active measures isn’t easy. Believing you can do these things successfully requires
the assumption that you’re smarter than a bunch of very smart people. Think twice before
proceeding, as the requirements for success are high (see below).

Don’t mess it up by over-trading. Think of buying and selling as an expense item

item,, not a profit center. I
love the idea of the automated factory of the future, with its one man and one dog;
dog The dog’s job is to
keep the man from touching the machinery, and the man’ss job is to feed the dog. Investors should find a
way to keep their hands off their portfolios most of the time.

A Special Word in Closing: Asymmetry

“Asymmetry” is a concept I’ve been conscious of for decades and consider more important with
every passing year. It’s my word for the essence of investment excellence and a standard against
which investors should be measured.

First, some definitions:

I’m
m going to talk below about whether an an investor has “alpha.” Alpha is technically defined as
return in excess of the benchmark return, but I prefer to think of it as superior investing skill. It’s
the ability to find and exploit inefficiencies when they’re present.
Inefficiencies – mispricings or mistakes – represent instances when an asset’s price diverges from
its fair value. These divergences can show up as bargains or the opposite, overover-pricings.
Bargains will dependably perform better than other investments over time after adjustment for
their riskiness. Over-
Over-pricings
Over-pricings will do the opposite.
“Beta” is an investor’s
investor or a portfolio’s relative volatility, also described as relative sensitivity or
systematic risk.

People who believe in the efficient market hypothesis think of a portfolio’s return as the product of the
market’s return multiplied by the portfolio’s beta. This is all it takes to explain results, since there are no
mispricings to take advantage of in an efficient market (and so no such thing as alpha). Thus, alpha is
skill that enables an investor to produce performance better than that which is explained purely by
market return and beta. Another way to say this is that having alpha allows an investor to enjoy profit
potential that is disproportionate to loss potential: asymmetry. In my view, asymmetry is present when an
investor can repeatedly do some or all of the following:

make more money in good markets than he gives back in bad markets,
have more winners than losers,
make more money on his winners than he loses on his losers,

11
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 do well when his aggressive or defensive bias proves timely but not badly when it doesn’t,
do well when his sector or strategy is in favor but not badly when it isn’t, and
construct portfolios so that most of the surprises are on the upside.

For example, most of us have an inherent bias toward either aggressiveness or defensiveness. For this
reason, it doesn’t mean much if an aggressive investor outperforms in a good year or a defensive investor
outperforms in a bad year. To determine whether they have alpha and produce asymmetry, we have to
consider whether the aggressive investor is able to avoid the full loss that his aggressiveness alone would
produce in a bad market and whether the defensive investor can avoid missing out on too much of the
gain when the market does well. In my opinion, “excellence” lies in asymmetry between the results in
good and bad times.

As I see it, if inefficiencies are present in an investor’s market, and she has alpha, the impact will
show up in asymmetrical returns. If her returns show no asymmetry, the investor doesn’t have
alpha (or perhaps there are no inefficiencies for her to identify). Flipping that over,
over if an investor
doesn’t have alpha, her returns won’t be asymmetrical. It’s as simplee as that.

To simplify, here’s how I think about asymmetry. This discussion is based on material I included in my
2018 book Mastering the Market Cycle: Getting the Odds on Your Side.
Side While I may appear to be talking
about one good year and one bad one, these observations can only be considered valid if these patterns
hold over a meaningful number of years.

Let’s consider a manager’s performance:

Market performance +10% -10%

Manager A +10% -10%

The above manager clearly adds no value. You might as well invest in an index fund (probably at a much
lower fee).

These two managers also add no value:

value:

Market performance +10% -10%

Manager B +5% -5%

Manager C +20% -20%

Manager B is just a no-alpha manager with a beta of 0.5, and manager C is a no-alpha manager with a
beta of 2.0. You could get the same results as manager B by putting half your capital in an index fund
and keeping the rest under your mattress and in the case of manager C, by doubling your investment with
borrowed capital and putting it all in an index fund.

12
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
These two managers, however, do have alpha, as they exhibit asymmetry:

Market performance +10% -10%

Manager D +17% -12%

Manager E +9% -3%

Both managers’ returns reflect more of the market’s gain in good times than they do its loss in bad ones.
Manager D might be described as an aggressive manager with alpha; she achieves 170% of the market’s
return when the market rises but suffers only 120% of the loss when it falls. Manager E is a defensive
manager with alpha; his returns reflect 90% of the gain in an up market but only 30% of the loss in a
down market. These asymmetries can only be attributed to the presence of alpha. Risk-tolerant clients
will prefer to invest with D, and risk-averse ones will prefer E.

This manager is truly exceptional:

Market performance +10% -10%

10%

Manager F +20% -5%

She beat the market in both directions: She’s up more than the market when it rises and down less when it
falls. She’ss up so much in a good market that you might be tempted to describe her as aggressive. But
since she’s down less in a down market, that description won
won’
won’t hold. Either she doesn’t have a bias in
terms of aggressiveness versus defensiveness, or her alpha is great enough to offset it.

Finally, here’s one of the greatest managers of all time:

Market performance +10% -10%

Manager G +20% +5%

Manager G is up in good and bad markets alike. He clearly doesn’t have an aggressiveness/defensiveness
bias, since his performance is exceptional in both markets.
markets His alpha is sufficient to enable him to buck
the trend and achieve a positive return in a down year. When you find Manager G, you should (a) do
extensive due diligence regarding his reported performance, (b) if the numbers hold up, invest a lot of
money with him, (c)) hope he won’t
won accept so much money that his edge goes away, and (d) send me his
number.

* * *

What matters most? Asymmetry.

In sum, asymmetry shows up in a manager’s ability to do very well when things go his way and
not too bad when they don’t.

13
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 A great adage says, “Never confuse brains and a bull market.” Managers with the skill needed to
produce asymmetry are special because they’re able to fashion good gains from sources other
than market advances.
When you think about it, the active investment business is, at its heart, completely about
asymmetry. If a manager’s performance doesn’t exceed what can be explained by market
returns and his relative risk posture – which stems from his choice of market sector, tactics,
and level of aggressiveness – he simply hasn’t earned his fees.

Without asymmetry (see Managers A, B, and C on page 12), active management delivers no value and
deserves no fees. Indeed, all the choices an active investor makes will be for naught if he doesn’t
possess superior skill or insight. By definition, average investors and below-average investors don’t
have alpha and can’t produce asymmetry.

The big question is how to achieve asymmetry. Most of the things people focus on – the things I describe
on pages one through nine as not mattering – can’t provide it. As I’ve
ve said before, the average of all
investors’ thinking produces market prices and, obviously, average performance.
performance Asymmetry can only
be demonstrated by the relatively few people with superior skill and insight.
insight The key lies in finding
them.

November 22, 2022

14
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third-party
third sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished,
published, or posted in whole or in part, in any form without the prior written consent of Oaktree.

15
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: The Illusion of Knowledge

I’ve been expressing my disregard for forecasts for almost as long as I’ve been writing my memos,
starting with The Value of Predictions, or Where’d All This Rain Come From in February 1993. Over the
years since then, I’ve explained at length why I’m not interested in forecasts – a few of my favorite quotes
echoing my disdain head the sections below – but I’ve never devoted a memo to explaining why making
helpful macro forecasts is so difficult. So here it is.

Food for Thought

There are two kinds of forecasters: those who don’tt know, and those who don’t
don know
they don’t know.

– John Kenneth Galbraith

Shortly after putting the finishing touches on I Beg to Differ in July, I attended a lunch with a number of
experienced investors, plus a few people from outside the investment industry. It wasnwasn’t organized as a
social occasion but rather an opportunity for those present
present to exchange views regarding the investment
environment.

Att one point, the host posed a series of questions: What

What’s your expectation regarding inflation? Will
there be a recession, and if so, how bad? How will the war in Ukraine end? What do you think is going
to happen in Taiwan? What’ss likely to be the impact of the 2022 and ’24 U.S. elections? I listened as a
variety of opinions were expressed.

Regular
egular readers of my memos can imagine what went through my mind: “Not one person in this room is
an expert on foreign affairs or politics. No one present has particular knowledge of these topics, and
certainly not more than the average intelligent person who read this morning
morning’s news.” None of the
thoughts expressed, even on economic matters, seem
seemed much more persuasive than the others, and I was
absolutely convinced that none were capable of improving investment results. And thatthat’s the point.

It was that lunch that started me thinking about writing yet another memo on the futility of macro
forecasting. Soon thereafter a few additional inputs arrived – a book, a piece in Bloomberg Opinion, and
a newspaper article – all of which supported my thesis (or perhaps played to my “confirmation bias” –
i.e., the tendency to embrace and interpret new information in a manner that confirms one’s preexisting
views). Together, the lunch and these items inspired this memo’s theme: the reasons why forecasts are
rarely helpful.

In order to produce something useful – be it in manufacturing, academia, or even the arts – you must have
a reliable process capable of converting the required inputs into the desired output. The problem, in
short, is that I don’t think there can be a process capable of consistently turning the large number of
variables associated with economies and financial markets (the inputs) into a useful macro forecast (the
output).

© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
The Machine

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

– Daniel J. Boorstin

In my first decade or so working at First National City Bank, a word was in vogue that I haven’t heard in
a long time: econometrics. This is the practice of looking for relationships within economic data that can
lead to valid forecasts. Or, to simplify, I’d say econometrics is concerned with building a mathematical
model of an economy. Econometricians were heard from a great deal in the 1970s, but I don’t believe
they are any longer. I take that to mean their models didn’t work.

Forecasters have no choice but to base their judgments on models, be they complex or informal,
mathematical or intuitive. Models, by definition, consist of assumptions: “IfIf A happens, then B will
happen.” In other words, relationships and responses. But for us to willingly employ a model’s
model output,
we have to believe the model is reliable. When I think about modeling an economy, my first reaction is to
think about how incredibly complicated it is.

The U.S., for example, has a population of around 330 million. All but the very youngest and perhaps the
very oldest are participants in the economy. Thus, there are hundreds of millions of consumers, plus
millions of workers, producers, and intermediaries (many
many people fall into more than one category). To
predict the path of the economy, you have to forecast
orecast the behavior of these people – if not for every
participant, then at least for group aggregates.

A real simulation of the U.S. economy would have to deal with billions of interactions or nodes, including
interactions with suppliers, customers, andnd other market participants around the globe. Is it possible to do
this? Is it possible, for example, to predict how consumers will behave (a) if they receive an additional
dollar of income (what will be the “marginal
marginal propensity to consume
consume”?); (b) if energy prices rise,
squeezing other household budget categories; (c) if the price for one good rises relative to others (will
there be a “substitution effect”?); or (d) if the geopolitical arena is roiled by events continents away?

Clearly, this level of complexity necessitates the frequent use of simplifying assumptions. For example, it
would make modeling easier to be able to assume that consumers won won’t buy B in place of A if B isn’t
either better or cheaper (or both). And it would help to assume that producers won’t price X below Y if it
doesn’tt cost less to produce X than Y. But what if consumers are attracted to the prestige of B despite (or
even because of) its higher price? And what if X has been developed by an entrepreneur who who’s willing to
lose money for a few years to gain market share? Is it possible for a model to anticipate the consumer’s
consumer
decision to pay up and the entrepreneur
entrepreneur’s decision to make less (or even lose) money?

Further, a model will have to predict how each group of participants in the economy will behave in a
variety of environments. But the vagaries are manifold. For example, consumers may behave one way at
one moment and a different way at another similar moment. Given the large number of variables
involved, it seems impossible that two “similar” moments will play out exactly the same way, and thus
that we’ll witness the same behavior on the part of participants in the economy. Among other things,
participants’ behavior will be influenced by their psychology (or should I say their emotions?), and their
psychology can be affected by qualitative, non-economic developments. How can those be modeled?

How can a model of an economy be comprehensive enough to deal with things that haven’t been seen
before, or haven’t been seen in modern times (meaning under comparable circumstances)? This is yet
another example of why a model simply can’t replicate something as complex as an economy.

2
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Of course, a prime example of this is the Covid-19 pandemic. It caused much of the world’s economy to
be shut down, turned consumer behavior on its head, and inspired massive government largesse. What
aspect of a pre-existing model would have enabled it to anticipate the pandemic’s impact? Yes, we had a
pandemic in 1918, but the circumstances were so different (no iPhones, Zoom calls, etc. ad infinitum) as
to render economic events during that time of little or no relevance to 2020.

In addition to the matter of complexity and the difficulty of capturing psychological fluctuations and
dynamic processes, think about the limitations that bear on an attempt to predict something that can’t be
expected to remain unchanged. Shortly after starting on this memo, I received my regular weekly edition
of Morgan Housel’s always-brilliant newsletter. One of the articles described a number of observations
from other arenas that have relevance to our world of economics and investing. Here are two, borrowed
from the field of statistics, that I think are pertinent to the discussion of economic models and forecasts
(“Little Ways the World Works,” Morgan Housel, Collaborative Fund, July 20, 2022):

Stationarity: An assumption that the past is a statistical guide to the future, based on the
idea that the big forces that impact a system don’tt change over time. If you want to know
how tall to build a levee, look at the last 100 years of flood data and assume the next 100
years will be the same. Stationarity is a wonderful, science-based
based concept that works
right up until the moment it doesn’t. It’ss a major driver of what matters in economics and
politics. [But in our world,] “Things
Things that have never happened before happen all the
time,” says Stanford professor Scott Sagan.

Cromwell’s rule:: Never say something cannot occur . . . . If something has a one-in-a-
one
billion chance of being true, and you interact with billions of things during your lifetime,
you are nearly assured to experience some astounding surprises, and should always leave
openn the possibility of the unthinkable coming true.

Stationarity might be fairly assumed in the realm of the physical sciences. For example, thanks to the law
of universal gravitation, under given atmospheric conditions, the speed at which an object fall
falls can
always be counted on to accelerate at the same rate. It always has, and it always will. But few processes
can be counted on to be stationary in our world, especially given the role played by psychology, emotion,
and human behavior, and their propensity to vary over time.

Take, for example, the relationship between unemployment and inflation. For roughly the last 60 years,
economists relied on the Phillips curve, which holds that wage inflation will rise as the unemployment
rate declines, because when there are fewer idle workers on the sidelines, employees gain bargaining
power and can successfully negotiate for higher wages. It was also believed for decades that an
unemployment rate around 5.5% indicated “full employment.” But unemployment fell below 5.5% in
March 2015 (and reached a 50-year low of 3.5% in September 2019), yet there was no significant
increase in inflation (in wages or otherwise) until 2021. So the Phillips curve described an important
relationship that was built into economic models for decades but, seemingly, didn’t apply over much of
the last decade.

Cromwell’s rule is also relevant. Unlike in the physical sciences, in markets and economies there’s very
little that absolutely has to happen or definitely can’t happen. Thus, in my book Mastering the Market
Cycle, I listed seven terms that investors should purge from their vocabularies: “never,” “always,”
“forever,” “can’t,” “won’t,” “will,” and “has to.” But if it’s true that those words have to be discarded,
then so too must the idea that one can build a model that can dependably predict the macro future. In
other words, very little is immutable in our world.

3
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
The unpredictability of behavior is a favorite topic of mine. Noted physicist Richard Feynman once said,
“Imagine how much harder physics would be if electrons had feelings.” The rules of physics are reliable
precisely because electrons always do what they’re supposed to do. They never forget to perform. They
never rebel. They never go on strike. They never innovate. They never behave in a contrary manner.
But none of these things is true of the participants in an economy, and for that reason their
behavior is unpredictable. And if the participants’ behavior is unpredictable, how can the
workings of an economy be modeled?

What we’re talking about here is the future, and there’s simply no way to deal with the future that
doesn’t require the making of assumptions. Small errors in assumptions regarding the economic
environment and small changes in participants’ behavior can make differences that are highly
problematic. As mathematician and meteorologist Edward Lorenz famously suggested, “The flapping of
a butterfly’s wings in Brazil could set off a tornado in Texas.” (Historian Niall Ferguson references this
remark in the article I discuss below.)

Thinking about all the above, can we ever consider a model of an economy to be reliable? Can a model
replicate reality? Can it describe the millions of participants and their interactions? Are the processes it
attempts to model dependable?
able? Can the processes be reduced to mathematics? Can mathematics capture
the qualitative nuances of people and their behavior? Can a model anticipate changes in consumer
preferences, changes in the behavior of businesses, and participants’ reactions to t innovation? In other
words, can we trust its output?

Clearly, economic relationships aren’t hard-wired,

wired, and economies aren
aren’t governed by schematic diagrams
(which models try to simulate). Thus, for me, the bottom line is that the output from a model may
point in the right direction much of the time, when the assumptions aren
aren’t violated. But it can’t
always be accurate, especially at critical moments such as inflection points . . . and that
that’s when
accurate predictions would be most valuable.

The Inputs

No amount of sophistication is going to allay the fact that all of your knowledge is about
the past and all your decisions are about the future.

– Ian H. Wilson (former GE executive)

Having considered the incredible complexity of an economy and the need to make simplifying
assumptions that decrease any economic model
model’s accuracy, let’s now think about the inputs a model
requires – the raw materials from which forecasts are manufactured. Will the estimated inputs prove
valid? Can we know enough about them for the resulting forecast to be meaningful? Or will we simply
be reminded of the ultimate truth about models: “garbage in, garbage out”? Clearly, no forecast can
be better than the inputs on which it’s based.

Here’s what Niall Ferguson wrote in Bloomberg Opinion on July 17:

Consider for a moment what we are implicitly asking when we pose the question: Has
inflation peaked? We are not only asking about the supply of and demand for
94,000 different commodities, manufactures and services. We are also asking about the
future path of interest rates set by the Fed, which – despite the much-vaunted policy of
“forward guidance” – is far from certain. We are asking about how long the strength of
the dollar will be sustained, as it is currently holding down the price of U.S. imports.

4
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 But there’s more. We are at the same time implicitly asking how long the war in Ukraine
will last, as the disruption caused since February by the Russian invasion has
significantly exacerbated energy and food price inflation. We are asking whether oil-
producing countries such as Saudi Arabia will respond to pleas from Western
governments to pump more crude. . . .

We should probably also ask ourselves what the impact on Western labor markets will be
of the latest Covid omicron sub-variant, BA.5. UK data indicate that BA.5 is 35% more
transmissible than its predecessor BA.2, which in turn was over 20% more transmissible
than the original omicron.

Good luck adding all those variables to your model. It is in fact just as impossible to be
sure about the future path of inflation as it is to be sure about the future path of the war in
Ukraine and the future path of the Covid pandemic.

I found Ferguson’s article so relevant to the subject of this memo that I’m m including a link to it here. It
makes a lot of important points, although I beg to differ in one regard. Fer Ferguson
guson says above, “It is in fact
just as impossible to be sure about the future path of inflation as it is to be sure about the future path of
the war in Ukraine and the future path of the Covid pandemic.” I think accurately predicting inflation is
“more impossible” (if there is such a thing) than predicting the outcomes of the other two, since doing so
requires being right about both of those outcomes and a thousand other things. How can anyone possibly
get all these things right?

Here’ss my rough description of the forecasting process from The Value of Predictions:

I imagine that for most money managers, the process goes like this: “I predict the
economy will do A. If A happens, interest rates should do B. With interest rates of B,
the stock market should do C. Under that environment, the best performing sector should
be D, and stock E should rise the most.”
most. The portfolio expected to do best under that
scenario is then assembled.

But how likely is E anyway? Remember that E is conditioned on A, B, C and D. Being

right two-thirds
thirds of the time would be a great accomplishment in the world of forecasting.
But if each of the five predictions has a 67% chance of being right, then there is a 13%
probability that all five will be corre
correct and that the stock will perform as expected.

Predicting event E on the basis of assumptions concerning A, B, C and D is what I call single-
scenario forecasting.. In other words, if what was assumed regarding A, B, C or D turns out to have been
erroneous, the forecasted outcome for E is unlikely to materialize. All of the underlying forecasts have to
be right in order for E to turn out as predicted, and that’s highly improbable. No one can invest
intelligently without considering (a) the other possible outcomes for each element, (b) the likelihood of
these alternative scenarios, (c) what would have to happen for one of them to be the actual outcome, and
(d) what the impact on E would be.

Ferguson’s article raises an interesting question about economic modeling: What’s to be assumed
regarding the general macro environment under which economic participants will operate? Doesn’t this
question indicate an insoluble feedback loop: To predict the overall performance of the economy,
we need to make assumptions about, for example, consumer behavior. But to predict consumer
behavior, don’t we need to make assumptions regarding the overall economic environment?
In Nobody Knows II (March 2020), my first memo of the pandemic, I mentioned that in a discussion of
the coronavirus, Harvard epidemiologist Marc Lipsitch had said there are (a) facts, (b) informed

5
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
extrapolations from analogies to other viruses, and (c) opinion or speculation. This is standard fare when
we deal with uncertain events. In the case of economic or market forecasts, we have a vast trove of
history and lots of analogous past events from which to extrapolate (neither of which was the case with
Covid-19). But even when these things are used as inputs for a well-constructed forecasting machine,
they’re still highly unlikely to be predictive of the future. They may be useful fodder, or they may be
garbage.

To illustrate, people often ask me which of the past cycles I’ve experienced was most like this one. My
answer is that current developments bear a passing resemblance to some past cycles, but there is no
absolute parallel. The differences are profound in every case and outweigh the similarities. And
even if we could find an identical prior period, how much reliance should we put on a sample size of
one? I’d say not much. Investors rely on historical references (and the forecasts they foster)
because they fear that without them they’d be flying blind. But that doesn’t make them reliable.

Unpredictable Influences

Forecasts create the mirage that the future is knowable.

– Peter Bernstein

We can’tt consider the reasonableness of forecasting without first deciding whether we think our
world is one of order or of randomness. Put simply, is it entirely predictable, entirely unpredictable, or
something in between? The bottom line for me is that it’s in between, but unpredictable enough that most
forecasts are unhelpful. And since our world is predictable at some times and unpredictable at others,
what good are forecasts if we can’tt tell which is which?

I learned a new word from reading Ferguson’ss article: “deterministic.” It’s defined by Oxford Languages
as “causally
causally determined by preceding events or natural laws.
laws.” The world is much simpler when we deal
with things that function according to rules . . . like Feynman
Feynman’s electrons. But, clearly, economies and
markets aren’tt governed by natural laws – thanks to the involvement of people – and preceding events
may “set the stage” or “tend
tend to repeat,”
repeat, but events rarely unfold in the same way twice. Thus, I believe
the processes that constitute the operation of economies and markets aren
aren’t deterministic, meaning they
aren’t predictable.

Further, the inputs clearly are undependable. Many are subject to randomness, such as weather,
earthquakes, accidents, and deaths. Others involve political and geopolitical issues – ones we’re aware of
and ones that haven’tt yet surfaced.

In his Bloomberg Opinion article, Ferguson mentioned the English writer G. K. Chesterton. That
reminded me to include a Chesterton quote that I used in Risk Revisited Again (June 2015):

The real trouble with this world of ours is not that it is an unreasonable world, nor even
that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable,
but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little
more mathematical and regular than it is; its exactitude is obvious, but its
inexactitude is hidden; its wildness lies in wait. (Emphasis added)

Going back to the lunch described on page one, the host opened the proceedings roughly as follows: “In
recent years, we’ve experienced the Covid-19 pandemic, the surprising success of the Fed’s rescue
actions, and the invasion of Ukraine. This has been a very challenging environment, since all of these

6
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
developments arrived out of the blue.” I imagine the implication for him was that the attendees should let
themselves off the hook for the inaccuracy of their 2020-22 forecasts and go back to work predicting
future events and betting on their judgments. But my reaction was quite different: “The list of events that
shaped the current environment is quite extensive. Doesn’t the fact that no one was able to predict any
of them convince those present that they should give up on forecasting?”

For another example, let’s think back to the fall of 2016. There were two things that almost everyone was
sure of: (a) Hillary Clinton would be elected president and (b) if for some reason Donald Trump were
elected instead, the markets would tank. Nonetheless, Trump won, and the markets soared. The impact
on the economy and markets over the last six years was profound, and I’m confident no forecast that
took a conventional view of the coming 2016 election got the period since then correct. Again,
shouldn’t that be enough to convince people that (a) we don’t know what’s going to happen and (b) we
don’t know how the markets will react to what happens?

Do Forecasts Add Value?

It ain’t what you don’t know that gets you into trouble. It’ss what you know for sure that
just ain’t so.

– Mark Twain

As I mentioned in my recent memo Thinking About Macro, in the 1970s we used to describe an
economist as “a portfolio manager who never marks to market.”
market. In other words, economists make
forecasts; events prove them either wrong or right; they go on to make new forecasts; but they don’t keep
track of how often they get it right (or they don’tt publish the stats).

Can you imagine hiring a money manager (or being hired, if you are a money manager) without reference
to a track record? And yet, economists and strategists stay in business, presumably because there are
customers for their forecasts, despite there being no published records.

Are you a consumer of forecasts? Are there forecasters and economists on staff where you work? Or do
you subscribe to their publications and invite them in for briefings, as was the case with my previous
employers? If so, do you know how often each has been right? Have you found a way to rigorously
determine which ones to rely on and which to ignore? Is there a way to quantify their contributions to
your investment returns? I ask because I’ve never seen or heard of any research along these lines. The
world seems incredibly short on information regarding the value added by macro forecasts, especially
given the large number of people involved in this pursuit.

Despite the lack of evidence regarding its value, macro forecasting goes on. Many of the forecasters are
part of teams managing equity funds, or they provide advice and forecasts to those teams. What we know
for sure is that actively managed equity funds have been losing market share to index funds and other
passive vehicles for decades due to the poor performance of active management, and as a result, actively
managed funds now account for less than half of the capital in U.S. equity mutual funds. Could the
unhelpful nature of macro forecasts be part of the reason?

The only place I know to look for quantification regarding this issue is the performance of so-called
macro hedge funds. Hedge Fund Research (HFR) publishes broad hedge fund performance indices as
well as a number of sub-indices. Below is the long-term performance of a broad hedge fund index, a
macro fund sub-index, and the Standard & Poor’s 500 Index.

7
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 HFRI Hedge Fund HFRI Macro (Total) S&P 500 Index
Index* Index
5-year annualized return* 5.2% 5.0% 12.8%
10-year annualized return* 5.1 2.8 13.8

* Performance through July 31, 2022. The broad hedge fund index shown is the Fund Weighted
Composite Index.

What the table above shows is that, according to HFR, the average hedge fund woefully underperformed
the S&P 500 in the period under study, and the average macro fund did considerably worse (especially in
the period from 2012 to 2017). Given that investors continue to entrust roughly $4.5 trillion of capital to
hedge funds, they must deliver some benefit other than returns, but it’s not obvious what that could be.
This seems to be especially true for the macro funds.

To support my opinion regarding forecasts, I’ll cite a rare example of self-assessment:

assessment: a seven
seven-page
feature that appeared in the Sunday Opinion section of The New York Times on July 224 titled “I Was
Wrong.” In it, eight Times opinion writers opened up about incorrect predictions they made and flawed
advice they had given. The most relevant here is Paul Krugman, who wrote a confession titled “I Was
Wrong About Inflation.” I’ll string together some excerpts:

In early 2021, there was an intense debate among economists about the likely
consequences of the American Rescue Plan . . . . I was on [the side that was less
concerned about the impact on inflation]. As it turned out, of course
course, that was a very bad
call. . . .

. . . history wouldn’tt have led us to expect this much inflation from overheating. So
something was wrong with my model . . . . One possibility is that history was
misleading . . . . Also, disruptions associated with adjusting to the pandemic and its
aftermath may still be playing a large role. And of course both Russia
Russia’s invasion of
Ukraine and China’ss lockdown of major cities have added a whole new level of
disruption. . . .

In any case, the whole experience has bbeen a lesson in humility. Nobody will believe
this, but in the aftermath of the 2008 crisis, standard economic models performed pretty
well, and I felt comfortable applying these models in 2021. But in retrospect I should
have realized that in the face oof the new world created by Covid-19, that kind of
extrapolation wasn
wasn’t a safe bet. (Emphasis added)

I salute Krugman for this incredible bout of candor (although I have to say I don’t remember a lot of
2009-10 market forecasts that were optimistic enough to capture the reality of the subsequent decade).
Krugman’s explanation for his error is fine as far as it goes, but I don’t see any mention of
abstaining from modeling, extrapolating, or forecasting in the future.

Humility may even be seeping into one of the world’s biggest producers of economic forecasts, the U.S.
Federal Reserve, home of more than 400 Ph.D. economists. Here’s what economist Gary Shilling wrote
in Bloomberg Opinion on August 22:

The Federal Reserve’s forward guidance program has been a disaster, so much so that it
has strained the central bank’s credibility. Chair Jerome Powell seems to agree that

8
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 providing estimates of where the Fed sees interest rates, economic growth and inflation at
different points in the future should be junked. . . .

The basic problem with forward guidance is that it depends on data that the Fed
had a miserable record of forecasting. It was consistently too optimistic about an
economic recovery after the 2007-2009 Great Recession. In September 2014, policy
makers forecast real gross domestic product growth in 2015 of 3.40% but were forced to
constantly crank their expectations down to 2.10% by September 2015.

The federal funds rate is not a market-determined interest rate but is set and
controlled by the Fed, and nobody challenges the central bank. Yet the FOMC
members were infamously terrible at forecasting what they themselves would do . . .
In 2015, their average projection of the 2016 federal funds rate was 0.90% and 3.30% in
2019. The actual numbers were 0.38% and 2.38%. . . .

To be sure, many current events today have caused uncertainty in markets, but the Fed
has been in there hot and heavy with its forward guidance. Recall that early this year th
the
central bank believed that inflation caused by frictions in reopening the economy after the
pandemic and supply-chain
chain disruptions was temporary. Only belatedly did it reverse
gears, raise rates and signal that further substantial hikes are coming. Faulty Fed
forecasts resulted in faulty forward guidance and increased financial market volatility.
(Emphasis added)

Lastly on this subject, where are the people who’veve gotten famous (and rich) by profiting from macro
views? I certainly don’t know everyone in the investment world, but among the people I do know or am
aware of, there are only a few highly successful “macro
macro investors.”
investors. When the number of instances of
something is tiny, it’ss an indication, as my mother used to say, that they’re
they “the exceptions that prove the
rule.” The rule in this case is that macro forecasts rarely lead to exceptional performance. For me,
the exceptionalness of the success stories proves the general truth of that assertion.

Practitioners’ Need to Predict

Forecasts usually tell us more of the forecaster than of the future.

– Warren Buffett

How many people are capable of making macro forecasts that are valuable most of the time? Not many, I
think. And how many investment managers, economists, and forecasters try? Thousands, at a minimum.
That raises an interesting question: why? If macro forecasts don’t add to investment success over time,
why do so many members of the investment management industry espouse belief in forecasts and pursue
them? I think the reasons probably center on these:

It’s part of the job.

Investors have always done it.
Everyone I know does it, especially my competitors.
I’ve always done it – I can’t quit now.
If I don’t do it, I won’t be able to attract clients.

9
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Since investing consists of positioning capital to benefit from future events, how can anyone
expect to do a good job without a view regarding what those events will be? We need forecasts,
even if they’re imperfect.

This summer, at the suggestion of my son Andrew, I read an extremely interesting book: Mistakes Were
Made (but Not by Me): Why We Justify Foolish Beliefs, Bad Decisions, and Hurtful Acts, written by
psychologists Carol Tavris and Elliot Aronson. Its topic is self-justification. The authors explain that
“cognitive dissonance” arises when people are confronted with new evidence that calls into question
their pre-existing positions and that when it does, unconscious mechanisms enable them to justify
and uphold those positions. Here are some selected quotes:

If you hold a set of beliefs that guide your practice and you learn that some of them are
incorrect, you must either admit you were wrong and change your approach or reject the
new evidence.

Most people, when directly confronted by evidence that they are wrong, do not change
their point of view or plan of action but justify it even more tenaciously.

Once we are invested in a belief and have justified its wisdom, changing our minds is
literally hard work. It’ss much easier to slot that new evidence
evidence into an existing framework
and do the mental justification to keep it there than it is to change the framework.

The mechanisms that people generally employ when responding to evidence that throws their beliefs into
doubt include these (paraphrasing the authors’ words):

an unwillingness to heed dissonant information;

selectively remembering parts of their lives, focusing on those parts that support their own points
of view; and
operating under cognitive biases that ensure people see what they want to see and seek
confirmation of what they already believe.

I have little doubt that these are among the factors that cause and enable people to continue making and
consuming forecasts. What specific form might they take in this case?

thinking of macro forecasts as an indispensable part of investing;

pleasantly recalling correct forecasts, especially any that were bold and non
non-consensus;
overestimating how often forecasts were right;
forgetting or minimizing the ones that were wrong;
not keeping records regarding forecasts’ accuracy or failing to calculate a batting average;
focusing on the “pot of gold” that will reward correct forecasts in the future;
saying “everyone does it”; and
perhaps most importantly, blaming unsuccessful forecasts on having been blindsided by random
occurrences or exogenous events. (But, as I said earlier, that’s the point: Why make forecasts if
they’re so easily rendered inaccurate?)

Most people – even honest people with good intentions – take positions or actions that are in their own
interests, sometimes at the expense of others or of objective truth. They don’t know they’re doing it; they
think it’s the right thing; and they have tons of justification. As Charlie Munger often says, quoting
Demosthenes, “Nothing is easier than self-deceit. For what every man wishes, that he also believes to be
true.”

10
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
I don’t think of forecasters as crooks or charlatans. Most are bright, educated people who think they’re
doing something useful. But self-interest causes them to act in a certain way, and self-justification
enables them to stick with it in the face of evidence to the contrary. As Morgan Housel put it in a
recent newsletter:

The inability to forecast the past has no impact on our desire to forecast the future.
Certainty is so valuable that we’ll never give up the quest for it, and most people couldn’t
get out of bed in the morning if they were honest about how uncertain the future is. (“Big
Beliefs,” Collaborative Fund, August 24, 2022)

For my birthday several years ago, my Oaktree co-founder Richard Masson gave me one of his typical
quirky gifts. In this case, it consisted of some bound copies of The New York Times. I’ve been waiting
for an opportunity to write about my favorite sub-headline from the issue dated October 30, 1929, which
followed two days on which the Dow Jones Industrial Average declined by a total of 223%. It read,
“Bankers Optimistic.” (Less than three years later, the Dow was roughly 85% lower.) Most bankers –
and most money managers – seem to be congenitally optimistic about the future. Among other things, it’s
in their best interests, as it helps them do more business. But their optimism certainly shapes their
forecasts and their resulting behavior.

Can They or Can’t They?

I never think about the future – it comes soon enough.

– Albert Einstein

Consider the following aspects of macro forecasting:

the number of assumptions/inputs that are required,

the number of processes/relationships that have to be incorporated,
the inherent undependability and instability of those processes, and
the role of randomness and the likelihood of surprises.

The bottom line for me is that forecasts can

can’t be right often enough to be worthwhile. I’ve described it
many times, but just for the sake of completeness, II’m going to restate my view of the utility (or rather,
futility) of macro forecasts:

Most forecasts consist of extrapolation of past performance.

Because macro developments usually don’t diverge from prior trends, extrapolation is usually
successful.
Thus, most forecasts are correct. But since extrapolation is usually anticipated by security prices,
those who follow expectations based on extrapolation don’t enjoy unusual profits when it holds.
Once in a while, the behavior of the economy does deviate materially from past patterns. Since
this deviation comes as a surprise to most investors, its occurrence moves markets, meaning an
accurate prediction of the deviation would be highly profitable.
However, since the economy doesn’t diverge from past performance very often, correct forecasts
of deviation are rarely made and most forecasts of deviation turn out to be incorrect.

11
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Thus, we have (a) extrapolation forecasts, most of which are correct but unprofitable, and (b)
potentially profitable forecasts of deviation, which are rarely correct and thus are generally
unprofitable.
Q.E.D.: Most forecasts don’t add to returns.

At the lunch described at the beginning of this memo, people were asked what they expected in terms of,
for example, Fed policy, and how that influenced their investment stance. One person replied with
something like, “I think the Fed will remain very worried about inflation and thus will raise rates
significantly, bringing on a recession. So I’m in risk-off mode.” Another said, “I foresee inflation
moderating in the fourth quarter, allowing the Fed to turn dovish in January. That will allow them to
bring interest rates back down and stimulate the economy. I’m very bullish on 2023.”

We hear statements like these all the time. But it must be recognized that these people are applying
one-factor models: The speaker is basing his or her forecast on a single variable.. Talk about simplifying
assumptions: These forecasters are implicitly holding everything constant other than Fed policy. They They’re
playing checkers when they need to be playing 3-D D chess. Leaving aside the impossibility of predicting
Fed behavior,
avior, the reaction of inflation to that behavior, and the reaction of markets to inflation, what
about all the other things that matter? If a thousand things play a part in determining the future direction
of the economy and markets, what about the other 999? What about the impact of wage negotiations, the
mid-term elections, the war in Ukraine, and the price of oil?

The truth is that humans can hold only a few things in their minds at any given time. It’s hard to factor
in a large number of considerations and especially to understand how a large number of things will
interact (correlation is always the real stumper).

Even if you somehow manage to get an economic forecast correct, that that’s only half the battle. You still
need to anticipate how that economic activity will translate into a market outcome. This requires an
entirely different forecast, also involving innumerable variables, many of which pertain to psychology
and thus are practically unknowable. According to his student Warren Buffett, Ben Graham said, “In the
short run, the market is a voting machine, but in the long run, it is a weighing machine.
machine.” How can
investors’ short-run
run choices be predicted? Some economic forecasters correctly concluded that the
actions of the Fed and Treasury announced in March 2020 would rescue the U.S. economy and
trigger an economic recovery. But I’ I not aware of anyone who predicted the torrid bull market
I’m
that lifted off well before the recovery got underway
underway.

As I’ve
ve described before, in 2016 Buffett shar
shared with me his view of macro forecasts. “For a piece of
information to be desirable, it has to satisfy two criteria: It has to be important, and it has to be
knowable.”

Of course, the macro outlook is important. These days it seems as if investors hang on every
forecaster’s word, macro event, and twitch on the part of the Fed. Unlike my early days in this
business, it seems like macro is everything and corporate developments count for relatively little.
But I agree strongly with Buffett that the macro future isn’t knowable, or at least almost no
one can consistently know more about it than the mass of investors, which is what matters in
trying to gain a knowledge advantage and make superior investment decisions.

Clearly, Buffett’s name goes at the top of the list of investors who’ve succeeded by shunning macro
forecasts and instead focusing on learning more than others about “the micro”: companies, industries and
securities.

12
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 * * *

In a 2001 memo called What’s It All About, Alpha?, I introduced the concept of the “I know” school and
the “I don’t know” school, and in 2004, I elaborated on this at length in Us and Them. To close the
current memo, I’m going to insert some of what I wrote in the latter about the two schools:

Most of the investors I’ve met over the years have belonged to the “I know” school. This
was particularly true in 1968-78, when I analyzed equities, and even in 1978-95, when I
had switched to non-mainstream investments but still worked at equity-centric money
management firms.

It’s easy to identify members of the “I know” school:

They think knowledge of the future direction of economies, interest rates,

markets and widely followed mainstream stocks is essential for investment
success.
They’re confident it can be achieved.
They know they can do it.
They’re
re aware that lots of other people are trying to do it too, but they figure
either (a) everyone can be successful at the same time, or (b) only a few can be,
but they’re among them.
They’re
re comfortable investing based on their opinions regarding the future.
They’re
re also glad to share their views with others, even though correct forecasts
should be of such great value that no one would give them away gratis.
They rarely look back to rigorously assess their record as forecasters.

“Confident” is the key word for describing members of this school. For the “I don’t
know” school, on the other hand, the word
wo – especially when dealing with the macro-
future – is “guarded.” Its adherents generally believe you can
can’t know the future; you
don’tt have to know the future; and the proper goal is to do the best possible job of
investing in the absence of that knowled
knowledge.

As a member of the “I “ know”

know school, you get to opine on the future (and maybe have
people take notes). You may be sought out for your opinions and considered a desirable
dinner guest . . . especially when the stock market
market’s going up.

Join the “I don’t know” school and the results are more mixed. You’ll soon tire of saying
“I don’t know” to friends and strangers alike. After a while, even relatives will stop
asking where you think the market’s going. You’ll never get to enjoy that 1-in-1,000
moment when your forecast comes true and The Wall Street Journal runs your picture.
On the other hand, you’ll be spared all those times when forecasts miss the mark, as well
as the losses that can result from investing based on over-rated knowledge of the future.
But how do you think it feels to have prospective clients ask about your investment
outlook and have to say, “I have no idea”?
For me, the bottom line on which school is best comes from the late Stanford behaviorist,
Amos Tversky: “It’s frightening to think that you might not know something, but
more frightening to think that, by and large, the world is run by people who have
faith that they know exactly what’s going on.”

13
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
It’s certainly standard practice in the investment management business to come up with macro forecasts,
share them on request, and bet clients’ money on them. It also seems conventional for money managers
to trust in forecasts, especially their own. Not doing so would introduce enormous dissonance, as
described above. But is their belief justified by the facts? I’m eager to hear what you think.

* * *

A few years ago, a highly respected sell-side economist with whom I became friendly during my early
Citibank days called me with an important message: “You’ve changed my life,” he said. “I’ve stopped
making forecasts. Instead, I just tell people what’s going on today and what I see as the possible
implications for the future. Life is so much better.” Can I help you reach the same state of bliss?

September 8, 2022

14
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitationn to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital
ital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oak
Oaktree.

15
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: I Beg to Differ

_______________________________________________________________________________

I’ve written many times about having joined the investment industry in 1969, when the “Nifty Fifty”
stocks were in full flower. My first employer, First National City Bank, as well as many of the other
“money-center banks” (the leading investment managers of the day), were enthralled with these
companies, with their powerful business models and flawless prospects. Sentiment surrounding their
stocks was uniformly positive, and portfolio managers found great safety in numbers. For example, a
common refrain at the time was “you can’t be fired for buying IBM,” the era’s quintessential growth
company.

I’ve also written extensively about the fate of these stocks. In 1973-74,
74, the OPEC oil embargo and the
resultant recession took the S&P 500 Index down a totall of 47%. And many of the Nifty Fifty, for which
it had been thought that “no price was too high,” did far worse, falling from peak p/e ratios of 60
60-90 to
trough multiples in the single digits. Thus, their devotees lost almost all of their money in the sstocks of
companies that “everyone knew” were great. This was my first chance to see what can happen to assets
that are on what I call “the pedestal of popularity.”

In 1978, I was asked to move to the bank’ss bond department to start funds in convertible
convertibl bonds and,
shortly thereafter, high yield bonds. Now I was investing in securities most fiduciaries considered
“uninvestable” and which practically no one knew about, cared about, or deemed desirable . . . and I was
making money steadily and safely. I quickly recognized that my strong performance resulted in
large part from precisely that fact: I was investing in securities that practically no one knew about,
cared about, or deemed desirable. This brought home the key money-making
money lesson of the Efficient
Market Hypothesis, which I had been introduced to at the University of Chicago Business School: IIf you
seek superior investment results, you have to invest in things that others haven’t flocked to and caused to
be fully valued. In other words, you
you have to do something different.

The Essential Difference

ifference
ifference

Inn 2006, I wrote a memo called Dare to Be Great. It was mostly about having high aspirations, and it
included a rant against conformity and investment bureaucracy, as well as an assertion that the route to
superior returns by necessity runs through unconventionality. The element of that memo that people still
talk to me about is a simple two-by-two matrix:

Conventional Unconventional
Behavior Behavior
Favorable Outcomes Average good results Above average results

Unfavorable Outcomes Average bad results Below average results

© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Here’s how I explained the situation:

Of course, it’s not easy and clear-cut, but I think it’s the general situation. If your
behavior and that of your managers is conventional, you’re likely to get conventional
results – either good or bad. Only if the behavior is unconventional is your performance
likely to be unconventional . . . and only if the judgments are superior is your
performance likely to be above average.

The consensus opinion of market participants is baked into market prices. Thus, if
investors lack insight that is superior to the average of the people who make up the
consensus, they should expect average risk-adjusted performance.

Many years have passed since I wrote that memo, and the investing world has gotten a lot more
sophisticated, but the message conveyed by the matrix and the accompanying explanation remains
unchanged. Talk about simple – in the memo, I reduced the issue to a single sentence: “This just in:
You can’tt take the same actions as everyone else and expect to outperform.”

The best way to understand this idea is by thinking through a highly logical and almost mathematical
process (greatly simplified, as usual, for illustrative purposes):

A certain (but unascertainable) number of dollars will be made over any given period by all
investors collectively in an individual stock, a given market, or all markets taken together. That
amount will be a function of (a) how companies or assets fare in fundamental terms (e.g., how
their profits grow or decline) and (b) how people feel ab about those fundamentals and treat asset
prices.
On average, all investors will do average.
If you’rere happy doing average, you can simply invest in a broad swath of the assets in question,
buying some of each in proportion to its representation in the releva
relevant universe or index. By
engaging in average behavior in this way, you you’re guaranteed average performance. (Obviously,
this is the idea behind index funds.)
If you want to be above average, you have to depart from consensus behavior. You have to
overweight ht some securities, asset classes, or markets and underweight others. In other words,
you have to do something different.
The challenge lies in the fact that (a) market prices are the result of everyone
everyone’s collective thinking
and (b) it’ss hard for any in
individual to consistently figure out when the consensus is wrong and an
asset is priced too high or too low.
Nevertheless, “active investors”
investors place active bets in an effort to be above average.
o Investor A decides stocks as a whole are too cheap, and he sells bonds in order to
overweight stocks. Investor B thinks stocks are too expensive, so she moves to an
underweighting by selling some of her stocks to Investor A and putting the proceeds into
bonds.
o Investor X decides a certain stock is too cheap and overweights it, buying from investor
Y, who thinks it’s too expensive and therefore wants to underweight it.
It’s essential to note that in each of the above cases, one investor is right and the other is
wrong. Now go back to the first bullet point above: Since the total dollars earned by all investors
collectively are fixed in amount, all active bets, taken together, constitute a zero-sum game (or
negative-sum after commissions and other costs). The investor who’s right earns an above
average return, and by definition the one who’s wrong earns a below average return.
Thus, every active bet placed in the pursuit of above average returns carries with it the risk
of below average returns. There’s no way to make an active bet such that you’ll win if it works

2
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 but not lose if it doesn’t. Financial innovations are often described as offering some version of
this impossible bargain, but they invariably fail to live up to the hype.
The bottom line of the above is simple: You can’t hope to earn above average returns if you
don’t place active bets, but if your active bets are wrong, your return will be below average.

Investing strikes me as being very much like golf, where playing conditions and the performance of
competitors can change from day to day, as can the placement of the holes. On some days, one approach
to the course is appropriate, but on other days, different tactics are called for. To win, you have to either
do a better job than others of selecting your approach or executing on it, or both.

The same is true for investors. It’s simple: If you hope to distinguish yourself in terms of
performance, you have to depart from the pack. But, having departed, the difference will only be
positive if your choice of strategies and tactics is correct and/or you’re able to execute better.

Second-Level Thinking

In 2009, when Columbia Business School Publishing was considering whether to publish my book The
Most Important Thing,, they asked to see a sample chapter. As has often been my experience, I sat down
and described a concept I hadn’tt previously written about or named. That description became the book book’s
first chapter, addressing one of its most important topics: second-level
second level thinking. It
It’s certainly the concept
from the book that people ask me about most often.

The idea of second-level thinking builds on what I wrote in Dare to Be Great. First, I repeated my view
that success in investing means doing better than others. All active investors (and certainly money
managers hoping to earn a living) are driven by the pursuit of superior returns.

But that universality also makes beating the market a difficult task. Millions of people
are competing for each dollar of investment gain. Who Who’ll get it? The person who’s a step
ahead. In some pursuits, getting up to the front of the pack means more schooling, more
time in the gym or the library, better nutrition, more perspiration, greater stamina or
better equipment. But in investing, where these things count for less, it call
calls for more
perceptive thinking . . . at what I call the second level.

The basic idea behind second-

second-level
second -level thinking is easily summarized: In order to outperform, your
thinking has to be different and better
better.

Remember, your goal in investing isn

isn’t to earn average returns; you want to do better
than average. Thus, your thinking has to be better than that of others – both more
powerful and at a higher level. Since other investors may be smart, well informed and
highly computerized, you must find an edge they don’t have. You must think of
something they haven’t thought of, see things they miss, or bring insight they don’t
possess. You have to react differently and behave differently. In short, being right may
be a necessary condition for investment success, but it won’t be sufficient. You have
to be more right than others . . . which by definition means your thinking has to be
different.

3
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
Having made the case, I went on to distinguish second-level thinkers from those who operate at the first
level:

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad
sign for anything involving an attempt at superiority). All the first-level thinker needs is
an opinion about the future, as in “The outlook for the company is favorable, meaning the
stock will go up.”

Second-level thinking is deep, complex, and convoluted. The second-level thinker takes
a great many things into account:

What is the range of likely future outcomes?

What outcome do I think will occur?
What’s the probability I’m right?
What does the consensus think?
How does my expectation differ from the consensus?
How does the current price for the asset comport with the consensus view of the
future, and with mine?
Is the consensus psychology that’ss incorporated in the price too bullish or bearish?
What will happen to the asset’ss price if the consensus turns out to be right, and
what if I’m right?

The difference in workload between first-level

level and second-level
second thinking is clearly
massive, and the number of people capable of the latter is tiny compared to the number
capable of the former.

First-level
level thinkers look for simple formulas and easy answers. Second-level
Second
thinkers know that success in investing is the antithesis of simple.

Speaking about difficulty reminds me of an important idea that arose in my discussions with my son
Andrew during the pandemic (described in the memo Something of Value, published in January 2021). In
the memo’s extensive discussion of how efficient most markets have become in recent decades, Andrew
makes a terrific point: “Readily
eadily available quantitative information with regard to the present cannot
be the source of superior performa
performance.” After all, everyone has access to this type of information –
with regard to public U.S. securities, that
that’s the whole point of the SEC’s Reg FD (for fair disclosure) –
and nowadays all investors should know how to manipulate data and run screens.

So, then, how can investors who are intent on outperforming hope to reach their goal? As Andrew and I
said on a podcast where we discussed Something of Value, they have to go beyond readily available
quantitative information with regard to the present. Instead, their superiority has to come from an ability
to:

better understand the significance of the published numbers,

better assess the qualitative aspects of the company, and/or
better divine the future.

Obviously, none of these things can be determined with certainty, measured empirically, or processed
using surefire formulas. Unlike present-day quantitative information, there’s no source you can turn to
for easy answers. They all come down to judgment or insight. Second-level thinkers who have better

4
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
judgment are likely to achieve superior returns, and those who are less insightful are likely to generate
inferior performance.

This all leads me back to something Charlie Munger told me around the time The Most Important Thing
was published: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” Anyone who thinks
there’s a formula for investing that guarantees success (and that they can possess it) clearly doesn’t
understand the complex, dynamic, and competitive nature of the investing process. The prize for
superior investing can amount to a lot of money. In the highly competitive investment arena, it simply
can’t be easy to be the one who pockets the extra dollars.

Contrarianism

There’s a concept in the investing world that’ss closely related to being different: contrarianism. “The
investment herd” refers to the masses of people (or institutions) that drive security prices one way or the
other. It’s their actions that take asset prices to bull market highs and sometimes bubbles and, in the other
direction, to bear market territory and occasional crashes. At these extremes, which are invariably
overdone, it’s essential to act in a contrary fashion.

Joining in the swings described

ed above causes people to own or buy assets at high prices and to sell or fail
to buy at low prices. For this reason, it can be important to part company with the herd and behave in a
way that’s contrary to the actions of most others.

Contrarianism received its own chapter in The Most Important Thing

Thing. Here’s how I set forth the logic:

Markets swing dramatically, from bullish to bearish, and from overpriced to

underpriced.
Their movements are driven by the actions of “the crowd,” “the herd,” and “most
people.” Bull markets occur because more people want to buy than sell, or the
buyers are more highly motivated than the sellers. The market rises as people switch
from being sellers to being buyers, and as buyers become even more motivated and
the sellers less so. (If buyers didn
didn’t predominate, the market wouldn’t be rising.)
Market extremes represent inflection points. These occur when bullishness or
bearishness reaches a maximum. Figuratively speaking, a top occurs when the last
person who will become a buyer does so. Since every buyer has joined the bullish
herd by the time the top is reached, bullishness can go no further, and the market is
as high as it can go. Buying or holding is dangerous.
Since there’s’ no one left to turn bullish, the market stops going up. And if the next
day one person switches from buyer to seller, it will start to go down.
So at the extremes, which are created by what “most people” believe, most
people are wrong.
Therefore, the key to investment success has to lie in doing the opposite: in
diverging from the crowd. Those who recognize the errors that others make can
profit enormously from contrarianism.

To sum up, if the extreme highs and lows are excessive and the result of the concerted, mistaken actions
of most investors, then it’s essential to leave the crowd and be a contrarian.

In his 2000 book, Pioneering Portfolio Management, David Swensen, the former chief investment officer
of Yale University, explained why investing institutions are vulnerable to conformity with current

5
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
consensus belief and why they should instead embrace contrarianism. (For more on Swensen’s approach
to investing, see “A Case in Point” below.) He also stressed the importance of building infrastructure that
enables contrarianism to be employed successfully:

Unless institutions maintain contrarian positions through difficult times, the resulting
damage imposes severe financial and reputational costs on the institution.

Casually researched, consensus-oriented investment positions provide little prospect for

producing superior results in the intensely competitive investment management world.

Unfortunately, overcoming the tendency to follow the crowd, while necessary, proves
insufficient to guarantee investment success . . . While courage to take a different path
enhances chances for success, investors face likely failure unless a thoughtful set of
investment principles undergirds the courage.

Before I leave the subject of contrarianism, I want to make something else very clear. First
First-level thinkers
– to the extent they’re interested in the concept of contrarianism – might believe contrarianism means
doing the opposite of what most people are doing, so selling when the market rises and buying
buy when it
falls. But this overly simplistic definition of contrarianism is unlikely to be of much help to investors.
Instead, the understanding of contrarianism itself has to take place at a second level.

In The Most Important Thing Illuminated,, an annotated edition of my book, four professional inv
investors
and academics provided commentary on what I had written. My good friend Joel Greenblatt, an
exceptional equity investor, provided a very apt observation regarding knee
knee-jerk contrarianism: “. . . just
because no one else will jump in front of a Mack truck barreling down the highway doesn
doesn’t mean that you
should.” In other words, the mass of investors aren’tt wrong all the time, or wrong so dependably that it’s
it
always right to do the opposite of what they do. Rather, to be an effective contrarian, you have to figure
out:

what the herd is doing;

why it’s doing it;
what’ss wrong, if anything, with what it
it’s doing; and
what you should do about it.

Like the second-level

level thought process laid out in bullet points on page four, intelligent contrarianism is
deep and complex. It amounts to much more than simply doing the opposite of the crowd. Nevertheless,
good investment decisions made at the best oppopportunities – at the most overdone market extremes –
invariably include an element of contrarian thinking.

The Decision to Risk Being Wrong

There are only so many topics I find worth writing about, and since I know I’ll never know all there is to
know about them, I return to some from time to time and add to what I’ve written previously. Thus, in
2014, I followed up on 2006’s Dare to Be Great with a memo creatively titled Dare to Be Great II. To
begin, I repeated my insistence on the importance of being different:

If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but
you can’t do different. And being different is absolutely essential if you want a chance at
being superior. . . .

6
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
I followed that with a discussion of the challenges associated with being different:

Most great investments begin in discomfort. The things most people feel good about –
investments where the underlying premise is widely accepted, the recent performance has
been positive, and the outlook is rosy – are unlikely to be available at bargain prices.
Rather, bargains are usually found among things that are controversial, that people are
pessimistic about, and that have been performing badly of late.

But then, perhaps most importantly, I took the idea a step further, moving from daring to be
different to its natural corollary: daring to be wrong. Most investment books are about how to be
right, not the possibility of being wrong. And yet, the would-be active investor must understand that
every attempt at success by necessity carries with it the chance for failure. The two are absolutely
inseparable, as I described at the top of page three.

In a market that is even moderately efficient, everything you do to depart from the consensus in
pursuit of above average returns has the potential to result in below average returns if your
departure turns out to be a mistake. Overweighting something versus ersus underweighting it; concentrating
versus diversifying; holding versus selling; hedging versus not hedging – these are all double
double-edged
swords. You gain when you make the right choice and lose when you’re wrong.

One of my favorite sayings came from a pit boss at a Las Vegas casino: “The more you bet, the more you
win when you win.” Absolutely inarguable. But the pit boss conveniently omitted the converse: “The
more you bet, the more you lose when you lose.” Clearly, those two ideas go together.

In a presentation I occasionally make to institutional clients, I employ PowerPoint animation to

graphically portray the essence of this situation:

A bubble drops down, containing the words “Try to be right.right.” That’s what active investing is all
about. But then a few more words show up in the bubble: “Run the risk of being wrong.” The
bottom line is that you simply can’t
can’ do the former without also doing the latter. They’re
can They
inextricably intertwined.
Then another bubble drops down, with the label “Can’t lose.” There are can’t-lose strategies in
investing. If you buy T-bills,
T bills, you can’t
can have a negative return. If you invest in an index fund,
you can’tt underperform the index. But then two more words appear in the second bubble: “Can’t
win.” Peoplee who use cancan’t-lose strategies by necessity surrender the possibility of winning. T-
bill investors can’t
can earn more than the lowest of yields. Index fund investors cancan’t outperform.
And that brings me to the assignment I imagine receiving from unenlighte
unenlightened clients: “Just apply
the first set of words from each bubble: Try to outperform while employing can can’t-lose strategies.”
But that combination happens to be unavailable.

The above shows that active investing carries a cost that goes beyond commissions and management fees:
heightened risk of inferior performance. Thus, every investor has to make a conscious decision about
which course to follow. Pursue superior returns at the risk of coming in behind the pack, or hug
the consensus position and ensure average performance. It should be clear that you can’t hope to earn
superior returns if you’re unwilling to bear the risk of sub-par results.

And that brings me to my favorite fortune cookie, which I received with dessert 40-50 years ago. The
message inside was simple: The cautious seldom err or write great poetry. In my college classes in
Japanese studies, I learned about the koan, which Oxford Languages defines as “a paradoxical anecdote
or riddle, used in Zen Buddhism to demonstrate the inadequacy of logical reasoning and to provoke

7
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
enlightenment.” I think of my fortune that way because it raises a question I find paradoxical and capable
of leading to enlightenment.

But what does the fortune mean? That you should be cautious, because cautious people seldom make
mistakes? Or that you shouldn’t be cautious, because cautious people rarely accomplish great things?

The fortune can be read both ways, and both conclusions seem reasonable. Thus the key question is,
“Which meaning is right for you?” As an investor, do you like the idea of avoiding error, or would you
rather try for superiority? Which path is more likely to lead to success as you define it, and which is more
feasible for you? You can follow either path, but clearly not both simultaneously.

Thus, investors have to answer what should be a very basic question: Will you (a) strive to be above
average, which costs money, is far from sure to work, and can result in your being below average, or (b)
accept average performance – which helps you reduce those costs but also means youyou’ll have to look on
with envy as winners report mouth-watering successes. Here’s how I put it in Dare to Be Great II II:

How much emphasis should be put on diversifying, avoiding risk, and ensuring against
below-pack performance,
nce, and how much on sacrificing these things in the hope of doing
better?

And here’s how I described some of the considerations:

Unconventional behavior is the only road to superior investment results, but it isn’t
for everyone. In addition to superior skill,, successful investing requires the ability
to look wrong for a while and survive some mistakes
mistakes. Thus each person has to assess
whether he’ss temperamentally equipped to do these things and whether his circumstances
– in terms of employers, clients and the impact of other people’s
people opinions – will allow it
. . . when the chips are down and the early going makes him look wrong, as it invariably
will.

You can’tt have it both ways. And as in so many aspects of investing, there
there’s no right or wrong, only
right or wrong for you.

A Case in Point

The aforementioned David Swensen ran Yale University

University’s endowment from 1985 until his passing in
2021, an unusual 36-year
year tenure. He was a true pioneer, developing what has come to be called “the Yale
Model” or “the Endowment Model.” He radically reduced Yale’s holdings of public stocks and bonds,
and invested heavily in innovative, illiquid strategies such as hedge funds, venture capital, and private
equity at a time when almost no other institutions were doing so. He identified managers in those fields
who went on to generate superior results, several of whom earned investment fame. Yale’s resulting
performance beat almost all other endowments by miles. In addition, Swensen sent out into the
endowment community a number of disciples who produced enviable performance for other institutions.
Many endowments emulated Yale’s approach, especially beginning around 2003-04, after these
institutions had been punished by the bursting of the tech/Internet bubble. But few if any duplicated
Yale’s success. They did the same things, but not nearly as early or as well.

To sum up all the above, I’d say Swensen dared to be different. He did things others didn’t do. He did
these things long before most others picked up the thread. He did them to a degree that others didn’t
approach. And he did them with exceptional skill. What a great formula for outperformance.

8
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
In Pioneering Portfolio Management, Swensen provided a description of the challenge at the core of
investing – especially institutional investing. It’s one of the best paragraphs I’ve ever read and includes a
two-word phrase (which I’ve bolded for emphasis) that for me reads like sheer investment poetry. I’ve
borrowed it countless times:

. . . Active management strategies demand uninstitutional behavior from institutions,

creating a paradox that few can unravel. Establishing and maintaining an unconventional
investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which
frequently appear downright imprudent in the eyes of conventional wisdom.

As with many great quotes, this one from Swensen says a great deal in just a few words. Let’s parse its
meaning:

Idiosyncratic – When all investors love something, it’ss likely their buying will render it highly priced.
When they hate it, their selling will probably cause it to become cheap. Thus, it’s preferable to buy things
most people hate and sell things most people love. Such behavior is by definition highly idiosyncratic
(i.e., “eccentric,” “quirky,” or “peculiar”).

Uncomfortable – The mass of investors take the positions they take for reasons they find convincing.
convincing
We witness the same developments they do and are impacted ed by the same news. Yet, we realize that if
we want to be above average, our reaction to those inputs – and thus our behavior – should in many
instances be different from that of others. Regardless of the reasons, if millions of investors are doing A,
it may be quite uncomfortable to do B.

And if we do bring ourselves to do B, our action is unlikely to prove correct right away. After we’ve sold
a market darling because we think it’ss overvalued, its price probably won’t
won start to drop the next day.
Most of the time, the hot asset you’vee sold will keep rising for a while, and sometimes a good while. As
John Maynard Keynes said, “Markets
Markets can remain irrational longer than you can remain solvent.
solvent.” And as
the old adage goes, “Being
Being too far ahead of your time
time is indistinguishable from being wrong.
wrong.” These two
ideas are closely related to another great Keynes quote: “Worldly wisdom teaches that it is better for
reputation to fail conventionally than to succeed unconventionally.
unconventionally.” Departing from the mainstream can
be embarrassing and painful.

Uninstitutional behavior from institutions – We all know what Swensen meant by the word
“institutions”: bureaucratic,
bureaucratic hidebound,
hidebound conservative, conventional, risk-averse, and ruled by consensus;
in short, unlikely maverick
mavericks
mavericks.s. In such setting
settings, the cost of being different and wrong can be viewed as
highly unacceptable relative to the potential benefit from being different and right. For the people
involved, passing up profitable investment
investments (errors of omission) poses far less risk than making
investments that produce losses (errors of commission). Thus, investing entities that behave
“institutionally” are, by their nature, highly unlikely to engage in idiosyncratic behavior.

Early in his time at Yale, Swensen chose to:

minimize holdings of public stocks;

vastly overweight strategies falling under the heading “alternative investments” (although he
started to do so well before that label was created);
in so doing, commit a substantial portion of Yale’s endowment to illiquid investments for which
there was no market; and
hire managers without lengthy track records on the basis of what he perceived to be their
investment acumen.

9
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
To use his words, these actions probably appeared “downright imprudent in the eyes of conventional
wisdom.” Swensen’s behavior was certainly idiosyncratic and uninstitutional, but he understood that the
only way to outperform was to risk being wrong, and he accepted that risk with great results.

One Way to Diverge from the Pack

To conclude, I want to describe a recent occurrence. In mid-June, we held the London edition of
Oaktree’s biannual conference, which followed on the heels of the Los Angeles version. My assigned
topic at both conferences was the market environment. I faced a dilemma while preparing for the London
conference, because so much had changed between the two events: On May 19, the S&P 500 was at
roughly 3,900, but by June 21 it was at approximately 3,750, down almost 4% in roughly a month. Here
was my issue: Should I update my slides, which had become somewhat dated, or reuse the LA slides to
deliver a consistent message to both audiences?

I decided to use the LA slides as the jumping-off point

int for a discussion of how much things had changed
in that short period. The key segment of my London presentation consisted of a stream-of-consciousness
discussion of the concerns of the day. I told the attendees that I pay close attention to the quest
questions
people ask most often at any given point in time, as the questions tell me what
what’s on people’s minds. And
the questions I’m asked these days overwhelmingly surround:

the outlook for inflation,

the extent to which the Federal Reserve will raise intere
interest rates to bring it under control, and
whether doing so will produce a soft landing or a recession (and if the latter, how bad).

Afterwards, I wasn’tt completely happy with my remarks, so I rethought them over lunch. And when it
was time to resume the program,
ogram, I went up on stage for another two minutes. Here’s
Here what I said:

All the discussion surrounding inflation, rates,

rates, and recession falls under the same heading: the short term.
And yet:

We can’tt know much about the short-term

short future (or, I should say, we can’t dependably know
more than the consensus).
If we have an opinion about the short term, we can
can’t (or shouldn’t) have much confidence in it.
If we reach a conclusion, there
there’s not much we can do about it – most investors can’t and won’t
meaningfully
meaningfull y revamp their portfolios based on such opinions.
We really shouldn
shouldn’t care about the short term – after all, we’re investors, not traders.

I think it’s the last point that matters most. The question is whether you agree or not.

For example, when asked whether we’re heading toward a recession, my usual answer is that whenever
we’re not in a recession, we’re heading toward one. The question is when. I believe we’ll always have
cycles, which means recessions and recoveries will always lie ahead. Does the fact that there’s a
recession ahead mean we should reduce our investments or alter our portfolio allocation? I don’t
think so. Since 1920, there have been 17 recessions as well as one Great Depression, a World War and
several smaller wars, multiple periods of worry about global cataclysm, and now a pandemic. And yet, as
I mentioned in my January memo, Selling Out, the S&P 500 has returned about 10½% a year on average
over that century-plus. Would investors have improved their performance by getting in and out of the
market to avoid those problem spots . . . or would doing so have diminished it? Ever since I quoted Bill
Miller in that memo, I’ve been impressed by his formulation that “it’s time, not timing” that leads to real

10
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
wealth accumulation. Thus, most investors would be better off ignoring short-term considerations if they
want to enjoy the benefits of long-term compounding.

Two of the six tenets of Oaktree’s investment philosophy say (a) we don’t base our investment decisions
on macro forecasts and (b) we’re not market timers. I told the London audience our main goal is to
buy debt or make loans that will be repaid and to buy interests in companies that will do well and
make money. None of that has anything to do with the short term.

From time to time, when we consider it warranted, we do vary our balance between aggressiveness and
defensiveness, primarily by altering the size of our closed-end funds, the pace at which we invest, and the
level of risk we’ll accept. But we do these things on the basis of current market conditions, not
expectations regarding future events.

Everyone at Oaktree has opinions on the short-run phenomena mentioned above. We just don don’t bet
heavily that they’re
re right. During our recent meetings with clients in London, Bruce Karsh and I spent a
lot of time discussing the significance of the short-term concerns. Here’ss how he followed up in a note to
me:

. . . Will things be as bad or worse or better than expected? Unknowable . . . and equally
unknowable how much is priced in, i.e. what the market is truly expecting. One would
think a recession is priced in, but many analysts say that’s not the case. This stuff is
hard…!!!

Bruce’ss comment highlights another weakness of having a short-term

short focus. Even if we think we know
what’ss in store in terms of things like inflation, recessions
recessions, and interest rates, there’s absolutely no way to
know how market pricess comport with those expectations. This is more significant than most people
realize. If you’ve
ve developed opinions regarding the issues of the day, or have access to those of pundits
you respect, take a look at any asset and ask yourself whether it it’s priced rich, cheap, or fair in light of
those views. That’ss what matters when you you’rere pursuing investments that are reasonably priced
priced.

The possibility – or even the fact – that a negative event lies ahead isn
isn’t in itself a reason to reduce
risk; investors should
hould only do so if the event lies ahead and it isn’t appropriately reflected in asset
prices. But, as Bruce says, there’
there’s
’ss usually no way to know.

Att the beginning of my career, we thought in terms of investing in a stock for five or six years; something
held for less than a year was considered a short
short-term trade. One of the biggest changes I’ve witnessed
since then is the incredible shortening of time horizons. Money managers know their returns in real time,
and many clients are fixated on how their mamanagers did in the most recent quarter.

No strategy – and no level of brilliance – will make every quarter or every year a successful one.
Strategies become more or less effective as the environment changes and their popularity waxes and
wanes. In fact, highly disciplined managers who hold most rigorously to a given approach will tend to
report the worst performance when that approach goes out of favor. Regardless of the appropriateness of
a strategy and the quality of investment decisions, every portfolio and every manager will experience
good and bad quarters and years that have no lasting impact and say nothing about the manager’s ability.
Often this poor performance will be due to unforeseen and unforeseeable developments.

Thus, what does it mean that someone or something has performed poorly for a while? No one should
fire managers or change strategies based on short-term results. Rather than taking capital away from
underperformers, clients should consider increasing their allocations in the spirit of contrarianism (but

11
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
few do). I find it incredibly simple: If you wait at a bus stop long enough, you’re guaranteed to
catch a bus, but if you run from bus stop to bus stop, you may never catch a bus.

I believe most investors have their eye on the wrong ball. One quarter’s or one year’s performance is
meaningless at best and a harmful distraction at worst. But most investment committees still spend the
first hour of every meeting discussing returns in the most recent quarter and the year to date. If everyone
else is focusing on something that doesn’t matter and ignoring the thing that does, investors can
profitably diverge from the pack by blocking out short-term concerns and maintaining a laser focus
on long-term capital deployment.

A final quote from Pioneering Portfolio Management does a great job of summing up how institutions
can pursue the superior performance most want. (Its concepts are also relevant to individuals):

Appropriate investment procedures contribute significantly to investment success,

allowing investors to pursue profitable long-term
term contrarian investment positions. By
reducing pressures to produce in the short run, liberated managers gain the freedom to
create portfolios positioned to take advantagee of opportunities created by short-term
short
players. By encouraging managers to make potentially embarrassing out out-of-favor
investments, fiduciaries increase the likelihood of investment success.

Oaktree is probably in the extreme minority in its relative indifference to macro projections, especially
regarding the short term. Most investors fuss over expectations regarding short
short-term phenomena, but I
wonder whether they actually do much about their concerns, and whether it helps.

Many investors – and especially

cially institutions such as pension funds, endowments, insurance
companies, and sovereign wealth funds, all of which are relatively insulated from the risk of sudden
withdrawals – have the luxury of being able to focus exclusively on the long term . . . if they will
take advantage of it. Thus, my suggestion to you is to depart from the investment crowd, with its
unhelpful preoccupation with the short term, and to instead join us in focusing on the things that really
matter.

July 26, 2022

12
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) ree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

13
© 2022 Oaktree Capital Management, L.P. All Rights Reserved
Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Conversation at Panmure House

I recently was asked by Patrick Schotanus of Edinburgh Business School to participate in their
inaugural symposium on the subject of cognitive economics. The symposium took place at Panmure
House, the final residence of the great economist Adam Smith, and the theme was the Market Mind
Hypothesis (MMH), which Patrick developed. I spent an hour recording a video interview with him,
which on May 24 was shown at the symposium and followed by a live question-and-answer session.
We then used software to create a transcript of the taped interview. I’ve
ve edited it only to make my
remarks more intelligible and less painful to read (without changing their message); any serious
additions are shown in brackets.

While little of my content is totally new (in fact, you might recognize some thoughts that I went on to
incorporate in Bull Market Rhymes), it seems only right to share it with Oaktree’s
Oaktree clients because it’s
never all been presented in one place before. I hope you’llll find something worthwhile in the
conversation.

* * *

Patrick Schotanus: Hello, Howard. Thank you first of all for participating in our symposium by way
of this fireside interview, in which we’ll
we’ll discuss some of your memos as well as other reflections that
you’ve
’ve shared with investors over the years. For the benefit of our multidisciplinary audience, I’ll
I’
introduce some of these questions with some explanatory background, especially from a cognitive
angle. So I’d like to start with a few questions by MMH team members. The first one is from James
Clunie:

You
ou often write about the concept of the pendulum. More recently, in a podcast, you applied it to
international affairs. While th
the pendulum appears at first glance to be a mechanical model,
importantly, you have also applied it to human psychology, especially mood swings. These fit much
more with a spontaneous “market mind,” which you have also referred to, for example, in your
memo You Can’t Predict. You Can Prepare. Consequently, the question is, in what way and to what
extent is the pendulum mechanical? For example, would it be correct to say that while the pendulum
implies mean reversion, the latter is not a mechanical process and is thus difficult to predict?

HM: Thanks for that question, Patrick. I’m very pleased to be discussing these topics with you.
As you know, they’re something I’m fixated on, and it’s great to have someone to talk with
about them. I think the pendulum is a good example of many of the things we’re going to
discuss today. It’s an idea. It’s a concept. The idea is that it’s something that swings back and
forth. Something that oscillates, something that fluctuates around a midpoint. That’s the whole
concept.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 It’s certainly not mechanical. In physics, I think the pendulum has certain qualities, and as a
result, its behavior can be predicted. But in the things I’m talking about, no. As you know, my
last book, in 2018, was called Mastering the Market Cycle, and I talked a lot in there about the
pendulum. I got a note from Nick Train of Lindsell Train in London, saying something like, “I
disagree with you, Howard: this isn’t a pendulum. Its movement is not regular, it’s not
predictable, the speed of the fluctuations varies, and their extent varies.” And I said, “Nick, let’s
have lunch.” So, when I next got to London, we sat down and I explained to him that there are
multiple definitions of a pendulum. One definition says it’s mechanical and thus predictable,
and governed by the laws of physics. And another definition says that it’s a swing.”

In your question to me, Patrick, you used the term “mood swing,” and I think understanding it as
a mood swing is much more useful for our purposes. As this discussion progresses this
morning, I think the main thrust is going to be that these things are not scientific and thus not
consistent and repeatable.

PS: Russellll Napier, another member, has a related question also covering the mechanical angle.
Mainstream economics, also known as mechanical economics, which partners the unlikely
bedfellows of Neoclassical and Neo-Keynesian economics, views and treats the market as some
automaton, in a way, that can be centrally engineered, planned,
ned,, and steer
ned steered. If instead we view the
market as embodying our collective extended mind, acknowledging its warts and all, which obviously
is our thesis, which two episodes in your career would be best suited to study the market mind?

HM: Russell’ss question about the two episodes, contained in your last sentence, would limit me
too much. So, if you don’t mind, I’m m going to go way beyond that, because I think my answer
to this question is central to our whole discussion today.

Your first few words, when you discussed what Russell said, refer to the economy as
mechanical, and I think that isn’t ’tt helpful. Applying the word “mechanical” (again, as with the
first question) suggests that it
it’s
’ss governed by the rules of physics, the laws of nature, that it’s
it a
science, that it performs the same each time, that it it’s repeatable, studiable and extrapolable.
And I think these are all wrong.

And in fact, I aggressively remind people that II’m not an economist, but also that economics is
called the “dismal
dismal science.”
science. And I’m not sure it’s a science at all, but if it is, it’s certainly
dismal, in the sense that it
it’s not like physics, where if you do A, you always get B. Sometimes
you get C or sometimes nothing at all. Richard Feynman, the great physicist, once said,
“Physics would be much harder if electrons had feelings.” You walk into a room, you throw the
light switch, and the light goes on. It always goes on, because every time you throw the switch,
the electrons flow from the switch to the light. They never forget to flow; they never decide to
flow in a different direction; they never flow from the light to the switch. They never go on
strike or complain that they’re underpaid.

So, the point is that economics is not a science, in my opinion. You know, science is all about
causality and predictability, and if A happens, then B is sure to happen. Well, that’s certainly
not true in economics. If A happens, B might tend to happen most of the time. That doesn’t
make it a science.

Now let’s talk about using these concepts to refer to investing, not economics. I have a
presentation that I give, called The Human Side of Investing, or the Difference between Theory
2
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 and Practice. It was inspired by a quote from a great philosopher. You may know him (or
maybe not, since you’re mostly not Americans): Yogi Berra. Yogi was a great catcher for the
New York Yankees baseball team in the 1950s – a highly skilled baseball player, but more
famous today for the things he said, or maybe he didn’t say them. (One of the things Yogi said
is, “I never said half the things I said.”)

But anyway, he once said, supposedly, that “In theory there’s no difference between theory and
practice, but in practice there is.” And to me, that’s the essence of this answer to you. It’s the
essence of my work, and in my opinion, it should be the essence of your work and that of your
colleagues at this conference.

What we learn in school, in my opinion, and what we should learn in school, is how things are
supposed to work. That goes for the economy, and that goes for the markets. However, the
teachers might also help by adding, “. . . but it doesn’tt always work that way. That’s
That a
framework; that’s a thought model. It certainly doesn’tt govern all the time.
time.” And that’s the key.
Using the term “mechanical” to refer to the economy – or to the markets – is describing the way
things are supposed to work. The “psychological” or “behavioral”
behavioral” is all about the way things do
work. And there’s a big difference between the two.

I’ve
ve spent a lot of my career trying to reconcile the two: the things I learned as a student at the
University of Chicago’s Graduate School of Business
siness 55 years ago and the things I’ve
experienced in the markets since then.

I was introduced to the concept of the efficient market hypothesis and so forth back at Chicago.
I was very fortunate: those things were developed there mostly, I think, betwe
between ’62 and ’64. I
got there in ’67, so by definition I was in one of the first classes taught these things, and it was
very helpful to me. Not in the sense that the Chicago School of thought should govern your
actions, but it should inform them. And, as I say, II’ve worked hard to reconcile this education
with what I saw later.

As an undergraduate, I went to Wharton, which was entirely qualitative and pragmatic. Then I
went to Chicago, which was entirely quantitative and theoretical. At Chicago, most oof the
professors dismissed anything that was qualitative and pragmatic or “real world.” But I took a
course in investing from JJames Lorie, who co-headed the Center for Research in Security Prices.
His course was derided as “Lorie’s Stories,” because he would bring in actual practitioners every
couple of weeks to talk about what they did, and that was considered heresy at Chicago. The
final examination consisted of one question: “You’ve learned the theory at Chicago, how do you
square that with real world considerations?” I think that’s the key.

In the late ’90s, I wrote a memo called What's It All About, Alpha? You may recall that there
was a movie called Alfie; I think it starred Michael Caine (it was a long time ago, maybe 40-50
years ago). It had a theme song, “What’s It All About, Alfie?”, sung by Dionne Warwick.
Wonderful song. I borrowed the title and changed it to “Alpha” for a memo talking about
reconciling the Chicago theory, and in particular the efficient market hypothesis, with the real
world. In there, I stated my view that the hypothesis says that because of the concerted actions
of so many investors, security prices are “right,” meaning investors price securities so that you
can expect a fair risk-adjusted return, no more, no less. Again, that’s how it’s supposed to work,
but certainly not how it does work.

3
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 I think I said in the conclusion of that memo that if you ignore the efficient market hypothesis,
you’re going to be very disappointed, because you’re going to find out that very few of your
active investment decisions work. But if you swallow it whole, you won’t be an investor, and
you’ll give up on active success. So the truth, if there is one, has to lie somewhere in between,
and that’s what I believe.

PS: In fairness to Russell, it was in my introduction to Russell’s question [i.e., not in Russell’s
question itself] that I said the economy is mechanical and that’s the definition of mainstream
economics. Russell and I do not necessarily agree on that. But to continue on mechanical
economics as a theory: In your memo On the Couch, you talk about your own early exposure to the
efficient-market-type classes. For the audience, EMH is based on the rational expectations
hypothesis; EMH states that markets are rational because any pockets of irrationality are averaged
away [i.e., the errors made by the group become smaller than those made by individuals]. In
contrast, you also highlight the reality of irrationality that can be observed in markets, something
that both Alan Greenspan and Robert Shiller called “irrational exuberance.” Later, the GFC, or the
Global Financial Crisis, painfully hit home that what seems rational for an individual can be
dangerously irrational if done collectively. So my first question is, can we square this circle? For
example, is irrationality just about semantics, or is it something real that not only exists, but because
of the collective dynamic,, can actually threaten the economic system and may thus not necessarily be
averaged away?

HM: To me, Patrick, the answer lies in my view of the efficient market hypothesis. Again, the
efficient market hypothesis says that due to the concerted actions of so many investors, who are
intelligent and numerate and computerized and informed and highly motivated and rational and
objective and willing to substitute A for B, prices for securities are right, such that they presage
a fair risk-adjusted
-adjusted return. I believe that’ss the definition.

But you get into a problem, because when I listed off the qu
qualities that are necessary for a
market to be efficient, I snuck in there the economist
economist’s notion of the perfect market and its
requirement that the participants be rational and objective. And in investing, they’re not. That’s
really the point.

“Economic man”” is supposed to make all these decisions in a way that optimizes wealth. But
she often doesn’t,
doesn’t, because she’s
she not always objective and rational. She has moods. And those
moods interfere with this arriving at the right price. So my definition of ththe efficient market
hypothesis is that because of the concerted efforts of all the participants, the price at a given
point in time is as close to right as those people can get. And because it’s as close to right as
most of them can get, it’s very hard to outperform the market by finding errors – what theory
calls “inefficiencies” and I just think of as “mistakes.”

Sometimes prices are too high. Sometimes prices are too low. But because the price reflects the
collective wisdom of all investors on that subject, very few of the individuals can identify those
mistakes and profit from them. And that’s why active investing doesn’t consistently work, in
my opinion. I think my version of the efficient market hypothesis makes it roughly just as hard
for active managers to beat the market as does the strong form of the hypothesis, that
everything’s always priced right. But I think mine is more reflective of reality. I wrote in one of
my memos – maybe it was What’s It All About, Alpha? – about a stock that was $400 in 2000
and $2 in 2001. Now it’s possible – but to me it’s unlikely – that both of those observations
were “right.” Rather, I think they merely reflected the consensus of opinion at the time.
4
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 This business – I shouldn’t say “this business”; that sounds derogatory – the idea that
inefficiencies will be arbitraged away by the operations of the market ignores one of the key
elements that I think describes reality, and that is mass hysteria. And I think the markets –
economies too, but more importantly the markets – are subject to mass hysteria.

I think it was in On the Couch that I said, “in the real world, things fluctuate between pretty
good and not so hot. But in the markets, they go from flawless to hopeless.” Just think about
that one sentence. If it’s true – and I believe it’s true – that shows you the error, because nothing
is flawless and nothing is hopeless. But markets, I believe, treat things as flawless and hopeless,
and there’s the error.

The book I mentioned, Mastering the Market Cycle (I’m going to keep repeating the title in the
hope that everybody will buy a copy) . . . You know, I’mm a devotee of cycles. I’m
I a student of
cycles. I’ve lived through a half a dozen important cycles in my
y career. I’ve
I’ thought about
them. I think they dominate what I do. And I got about two-thirds of the way through writing
that book and something dawned on me, a question: Why do we have cycles?

The S&P 500 – I mentioned Jim Lorie – the Center for Research in Security Prices told us
almost 60 years ago, that from 1928 to ’62, the S&P 500 had returned an average of 9.2% a year.
Things have been better since then, and I think if you go back and look at the whole last 90
years, it’s 10½% a year, the return
urn on the S&P 500.

Here’s a question: Why doesn’tt it just return 10½% every year? Why sometimes up 20% and
sometimes down 20%, and so forth? In fact – and I included this factoid in one of my memos –
it’ss almost never up between 8% and 12%. So if the average return is 10½%, why isnisn’t the
return clustered around 10½%? Why is it clustered outside the central range
range? I think the answer
is mass hysteria.

And by the way, the same is true of the economy and mainstream economics, which of course
you described as mechanical, and I think that many people would describe as mechanical. But,
certainly, economics is driven by decisions made by people, who are not always rational and
objective. Maybe in theory they
they’re closer than investors to being rational and objective, but still
they’re
re not always.

But anyway, my explanation for the occurrence of cycles is “excesses and corrections.” You
have a secular trend or a “normal” statistic. Let’s say it’s the secular trend of the S&P 500.
Sometimes, people get too excited. They buy the stocks too enthusiastically. The prices rise.
They rise at more than a 10½% annual rate until they get to a price that is unsustainable. And
then everybody says, “No, I think they’re too high.” So then they correct back toward the
trendline. But, of course, given the nature of psychology, they correct through the trendline to
an excess on the downside. And then people say, “No, that’s too low,” so then they bring it back
toward the trendline and through it to an excess on the high side.

So excesses and corrections: that’s what cycles are about, in my opinion. Where do the excesses
come from? Psychology. People get too optimistic, then they get too pessimistic. They get too
greedy, then they get too fearful. They become too credulous, then they become too skeptical,
and so forth. Oh, and the big one: they become too risk-tolerant, and then they become too risk-
averse.
5
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
PS: If I can just follow up on that – particularly for our cognitively inclined audience – implied in
this you suggest that there might be mental causality, and my next questions are basically also to
motivate future research as part of economics revision. But during your September podcast, in
which you revisit the On the Couch memo, you talk about causality and how complex it can be. And
we agree and highlight this in our work.

For example, when Alan Greenspan, in that famous ’96 “irrational exuberance” speech, mentions
the complexity of the interactions of asset markets and the economy, and I’m quoting him now: “It
chiefly concerns, at least in our view, this dualism of the psychological of the former and the physical
of the latter.” Now, saying this, mental causality is highly controversial and complex in cognitive
science, but cognitive science is the area that really studies this. So, you also specifically refer to
Soros’s reflexivity in that context, and as you already indicated just now, but also in your memo, you
equate prices almost to psychology. And finally, we’ve all experienced this dangerous – to the point
of existential – tail-wagging-the-dog
-wagging-the-dog dynamic surrounding Lehman’s collapse. So my first question
is,, if we agree that we will not gain much by identifying yet another behavioral bias, nor by running
yet another regression, what would you like to see investigated by cognitive scientists that could
potentially lead to more important insights, especially regarding our understanding of the interaction
between these two domains of the real and financial economies?

HM: Well, the people at this symposium know much more than I do about how to get to the
bottom of these things. But clearly there’ss so much grist for this mill. Now, exactly how you
quantify mood, and so-called animal spirits and irrational exuberance, is beyond me. I always
say, Patrick, and I think I said it in Mastering the Market Cycle
Cycle, that if I could know just one
thing about every security I was thinking about buying, it would be how much optimism is in the
price.

When you watch TV and you hear the newsreaders talking about what happened in the stock
market
arket today, you get the impression that prices are the result of fundamentals and changes
chang in
prices are the result of changes in fundamentals. And that is vastly inadequate. (By the way,
they always say, “The The market went up today because of X X” or “The market went down today
because of Y.” I always say, “Where do they go to find that out, because I haven’t found it
yet?” I haven’tt found where you go to get an explanation of the market’s
market behavior, even after
the fact.) But it’s
it’ss not true that it
it’s all about fundamentals. The price of an asset is based on
fundamentals and how people view those fundamentals. And a change in an asset price is based
on the change in fundamentals and the change in how people view those fundamentals. So, facts
and attitudes. Any research that could capture changes in attitudes, I think is important.

Now, what about quantifying these animal spirits? In one of the more jocular portions of my
first book, The Most Important Thing, I include something I called “the poor man’s guide to
market assessment.” I have a list of things in one column, and I have a list of things in the other
column, and whichever list is more descriptive of current conditions tells you whether it’s
optimism or pessimism that’s governing the market. There are things like, do deals get sold out
or do they languish? Are hedge fund managers being welcomed on TV or not? Who does the
crowd form around at cocktail parties? What is the media saying: “We’re going to the moon” or
“We’re cratering forever”? I don’t know how to quantify these things. But these are among the
very important things that I listen to in order to figure out where we stand in the cycle. And I
believe where we are in the cycle plays a very strong role in figuring out where we’ll go next.
(In fact, take the title of my second book, Mastering the Market Cycle. When I was thinking
6
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 about writing it, it was called Listening to the Cycle. “Listening” in the sense of taking our
signals from where we are in the cycle. “Listening” also in the sense of obeying. The publisher
thought we’d sell more books if the title implied the book would help you master the market
cycle.) But I, as a practical investor, try to figure out what’s going on around me.

Now let’s go back. I didn’t do what I should have, because I didn’t answer Russell Napier’s real
question: can I name two episodes that showed this kind of thing in action? I was glad to have
the questions in advance, because it allowed me to think about the two episodes I want to
propose.

In the spring of 2007, I wrote a memo called The Race to the Bottom. This was when the
subprime mortgage mania was at its apex, I think, and when the logs had been stacked in the
fireplace for the conflagration that became the Global Financial Crisis. It happens that I was
driving around England in the fall of ’06 – maybe November or December ’06 – and I was
reading the FT (I mean I wasn’tt driving and reading; I was being driven so I could read), and
there was an article in the FT that said that, historically, the English banks had been willing to
lend people three-and-a-half
-a-half times their salary in a mortgage. But now, XYZ Bank announced
that it was willing to lend four times your salary, and then ABC Bank said, “No, we’ll lend
five.” And that bidding contest – to make loans by lowering credit standards – seemed to me to
be a race to the bottom. And I wrote that markets are an auction place where the opportunity to
make a loan, or the opportunity to buy a stock or a bond, goes to the person who who’s willing to pay
the most for it. That is to say, get the least for his money, just like in an auction of a painting.
And so, in this case, the bank that was willing to have the lowest credit standards and the
weakest loans was likely to win the auction and make the loans: race to the bottom. And I said
this is what happens when there’ss too much money in the hands of providers of capital
c and
they’re
re too eager to put it to work. Mood! And, of course, we all know the Global F Financial
Crisis ensued.

Now
ow fast forward from February ’07 to October ’08: Lehman Brothers goes bankrupt on
September 15, 2008, and now, rather than being carefree, the pendulum has swung, and people
are terrified. Rather than seeing risk as their friend
friend, as in, “The more risk you take, the more
money you make, because riskier assets have higher returns,
returns,” now people say “Risk bearing is
just another way to lose money. Get me out at any price.
price.”

So the pendulum swung, and of course people

people’s optimism collapsed, the S&P 500 collapsed, and
the prices of debt collapsed. So I wrote a memo right around October the 10th of ’08 – maybe
that day was the all-time low for credit, I don’t know exactly – that was called The Limits to
Negativism, based on an experience I had. I needed to raise some money to delever a levered
fund that we had that was in danger of melting down due to margin calls, and I went out to my
clients. I got more money. We reduced the fund’s debt from four times its equity to two times.
Now we’re again approaching the point where we can get a margin call. Now I need to delever
it from two times to one time. I met with a client who said, “No, I don’t want to do it anymore.”
And I said, “You gotta do it. These are senior loans, and the default rate on senior loans has
been infinitesimal over time. There’s potential for a levered return of 26% a year from what I
consider incredibly safe instruments.”

This client – excuse me if I belabor this, but I think it’s interesting – this client said to me,
“What if there are defaults?” And I said, “Well, our historical default rate on high yield bonds –
which are junior to these instruments – is 1% a year. So if you start with 26% and you take off
7
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 1% for defaults, you still get 25%.” So she said, “What if it’s worse than that?” I said, “The
high yield bond universe default rate has been 4% a year, so you’re still getting 22% net.” She
says, “What if it’s worse than that?” And I said, “The worst five years in our default experience
is 7½%, and if that happens, you’re still getting 19%.” She says, “What if it’s worse than that?”,
and I said, “The worst year in history is 13%. If that recurs every year for the next eight years,
you’ll still make 13% a year.” She says, “What if it’s worse than that?” And I said, “Do you
have any equities?” She said, “Yes, we have a lot of equities.” I said, “If we get a default rate
on high yield bonds of more than 13% a year every year into the future, what happens to your
equities in that environment?”

I describe myself as having run back to my office after that meeting to write that memo, The
Limits to Negativism. What I wrote there was that it’s very important when you’re an investor to
be a skeptic and not believe everything you hear. And most people think being a skeptic
consists of dealing with excessive optimism by saying, “That’ss too good to be true.”
true. But when
it’s pessimism that’s excessive, being a skeptic means saying, “That’ss too bad to be true.” That
particular investor couldn’t imagine any scenario that couldn’tt be exceeded on the downside.
So, in other words, for that person, there was no limit to negativism.

And
nd when I conclude that the other people in the market, the people setting the market prices,
are excessively negative and excessively risk averse, then I – an inherently conservative person
– and my partner, Bruce Karsh, who runs our distressed debt funds – also an inherently
conservative person – we go crazy spending money when we conclude there there’s excessive
pessimism, fear,, and risk aversion incorporated in asset prices [meaning they’re lower than they
should be]. So it’ss not just the mechanical aspects that determine market prices – it’s
psychology. It’ss mass hysteria, which comes in waves from time to time, that leads to market
cycles that prove excessive.

PS: Before I go to my next question, I’d like to come back to your point where you say it’s hard to
quantify mood. But perhaps that’s exactly the pproblem: that we’re trying to capture it with analytical
tools like Excel and MATHLAB.
MATHLAB. Or Or it
it is when, for example, you talk about, we need to measure the
temperature of the market, and when we’ we’re perceptive, we can gauge it. And it seems to me almost
like when you’re trying to assess a mood in a restaurant, it’s a qualitative aspect. And some people
perhaps have this innate ability, whereas others would perhaps be helped with different
methodologies and different tools, and we can try to grasp mood better in that way, because,
nowadays, people talk about market sentiment and try to capture it by looking at the VIX or put/call
ratioss or things like that, which I think you would disqualify as market mood. That’s not market
mood.

HM: Those things are indicators or symptomatic, but they don’t all move in the same direction
at the same time. Sometimes A and B will go up, and C won’t. Sometimes A and C will go up,
but B won’t. So, clearly, they’re not reliable indicators, and they also can’t be dealt with in a
mechanical sense. But I wrote in one of my memos – I think it was Risk Revisited Again in 2015
– I said superior investors have a better sense for the shape of the probability distribution that
will govern future stock price movements, and thus a better sense for whether the expected
return justifies taking on the potential negative events that lurk in the left-hand tail. I think
that’s it, and there’s nothing in there about measuring, Patrick, or anything mechanical.

You know, I was locked up with my son for several months during the pandemic. He and his
family moved in with us, so we had a lot of time for talking. He’s an optimist. (He would say
8
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 he’s not an optimist – that he’s a realist – but of course all optimists think they’re realists, and all
pessimists think they’re realists.) Anyway, he has an optimistic bent. He’s a tech investor, a
venture capitalist; he runs a VC fund; he does a fabulous job at it, and we talked about these
things at great length. He made a point, which I incorporated in a memo called Something of
Value in January of ’21 about our conversations – and that’s the memo that has gotten the most
positive reaction of all of them over 30-plus years. He made the point that, as he puts it, because
information and understanding are so widespread, so ubiquitous, “readily available quantitative
information with regard to the present” cannot be depended on to produce superior returns.

This is the epitome of the efficient market hypothesis. If everybody has all the same “readily
available quantitative information with regard to the present,” then being a superior investor has
to be a matter of going beyond that. You have to have something else. And if he’s right in that
description, then what are the things that can be the source of superior investing? It seems to me
there are two:

Number one: A better comprehension, if that’ss the right word, of the future. Some people
see the future better than others, and that could do the trick, because, remember, what he
says doesn’tt suffice is readily available quantitative information about the present. By
definition, there’ss no information about the future, but maybe some people can see the
future better than others.

Orr the other thing that could be a source of superior results is a superior ability to process
qualitative information. Remember, what he described as not helpful is readily available
quantitative information about the present. What about qualitative information?
inf
Qualitative information includes mood, and we we’ve been talking about the market mood.
And maybe some people have a better feeling than others for the collective psyche and for
whether it’ss too depressed and therefore presenting great opportunities to buy or too
enthusiastic and thus offering great opportunities to sell or short. [In addition to mood,
qualitative information also includes things like the quality of management, the
effectiveness of the company’s
company product development capability, and the strength of its
company’
accounting.]

The point is that a superior investor has to do at least one of those two things better, and maybe
both. I think that that’s
that s where the superiority comes in.

And, by the way, to take it one step further, we can ask, “How many people have a superior
view of the future? And how many people have a superior understanding of the market mood
[and other qualitative factors]?” And if the answer to both is “not so many,” then that explains
why active investing has been a flop for most people who’ve tried it.

PS: My next question goes in a somewhat different direction. Investing offers many dilemmas and
conundrums. And specifically, to assume that things will remain roughly the same, also known as
“history rhymes,” may be just as dangerous as expecting change, also known as “it’s different this
time.” Which side of the debate are you generally on and why?

HM: There’s a quote widely attributed to Mark Twain: “History does not repeat, but it does
rhyme.” I’m a believer in that. When Twain says history doesn’t repeat, what he’s saying is

9
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 that the causes of events vary, the consequences of events vary, the form they take varies. But
there are things that do recur. For example:

Number one: Generally speaking in the markets, when things have been going well for a
few years, people become less risk-averse. When they become less risk-averse, they do
riskier things. When the economy eventually turns down, those things produce outsized
losses.

Number two: When people are feeling good and things have been going well for a while,
people use more leverage. And, eventually, they reach a level of leverage such that they
can’t survive in tough times, and they melt down when tough times arrive.

Number three: Because borrowing for the short term is cheaper than borrowing long, people
tend to borrow short for long-term
term projects in order to maximize the delta. But if a bad day
comes when you have to refinance your short-term
term debts because they
they’re due and the
market is closed, you can’t, and you’re out of business.

These are themes that we see recur over time. Not exactly the same every time, and with
different reasons from time to time. But I do think that themes – mostly relating to psychology
– tend to rhyme, you know. The particulars of market mechanics, the use of different forms of
fundraising, and different forms of securities – these
se change all the time: ETFs, algorithmic
funds, index funds, senior loans, and high yield bonds. These things are innovative
innovative; they’re the
reflection of people’ss minds as applied to financial problems. But the tendencies of the human
mind itself tend to rhyme over the years.

By the way, the first time I ever came across the saying you mentioned – “It’s different this
time” – was October the 11th of 1987. There was an article in The New York Times entitled
“Why This Market Cycle Isn’tt Different.”
Different. It talked about the fact that people often say it’s
different this time and that this saying is generally employed to explain why historical norms
don’tt apply anymore: norms of valuation and the rhymes that I was just talking about. Anise
Wallace wrote that article – it made a big impression on me – and she said, “You know what?
This time it’ss no different; these things will eventually lead to the same outcomes as they always
have.” [The assertion that things were different was being used at the time to justify the very
high stock market valuations. As it happens, the article ran just eight days before “Black
Monday,” on which the Dow Jones Industrial Average declined by 22.6% in a single day.]

Wallace mentioned that Sir John Templeton said, “About 20% of the time, things actually do
change.” I wrote another memo within the last two years in which I said that, given the ubiquity
of technology and the high rate of innovation, I think things actually do change more than 20%
of the time. So you shouldn’t bet your life on the fact that the world doesn’t change. But you
also shouldn’t bet your life on your ability to predict the change, and especially the timing.

PS: It was John Templeton who also said, “The most dangerous words in investment are ‘it’s
different this time.’”

HM: Exactly, so I think you have to balance the two. Things like the psychological or
behavioral themes I’ve mentioned – and by the way, this goes for the various biases, including
confirmation bias – I think these things do repeat from year to year, decade to decade, cycle to

10
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 cycle, however you want to define it. But there’s also change, and a lot of that takes place in the
mechanical world: changes in information processing, changes in technological products, and so
forth.

PS: I’d like to talk more about the memo Investing Without People. You basically express your
worry about mechanical investing, specifically passive investing. I’ll quote as follows: “When
everyone decides to refrain from performing the functions of analysis, price discovery and asset
allocation, the appropriateness of market prices can go out the window as a result of passive
investing, just as it does from a mindless boom or bust.” Do you think mechanical investing could
have a negative impact on informational efficiency because it only uses market internals like market
cap, bid/ask, momentum, and, in a way, therefore distorts or ignores the transmission of information
coming from the real economy? And, as a consequence, if we look at a chain of discovery through
the economic system – starting with a scientist having an insight, and then an inventor having an
invention, and an entrepreneur making an innovation, eventually ending up in financial markets
valuing this stuff – when things become more and more mechanical through the growth of these
strategies – which include high frequency trading, trend-following, smart beta, which you mentioned,
and of course passive investing – we run the risk that the separation between Mr. Market and the
real economy just increases … that, in other words, this chain becomes more vulnerable and can
break?

HM:
M: You know, Patrick, I think the flaw in passive investing lies in the fact that you have to
view passive investing – things like indexation, especially – as kind of a hitchhiker, a free-rider
on the market. In other words, there are 1,000 people out here doing active investing and
distilling all the information and thinking about the future of the company and thinking about the
fairness of the price, and the result is a market price. And, as I said before, that price is the best
everybody collectively can do in trying to value the company and its future. And then there are
ten people over there who run index funds, and they just buy at the market prices because they
think those prices are probably fair, or the best you can do, so why go to all the trouble and
expense of doing fundamental analysis? [The managers of passive funds feel no need to
independently think about company fundamentals or the fairness of price. They take the active
investors’ word for it.] So, that’s
that why I say, “free-rider.” The ten free-ride on the efforts of the
1,000.

But what happens if the number of people doing fundamenta

fundamental analysis – active investing –
declines from 1,000 to 500 to 100 to 50 to 10? Now you have 1,000 people free-riding on the
efforts of the ten. The potential for divergence between price and fair price increases, and free
free-
riding is not as easy to do or as risk-free. I think the irony, as I said in that memo, Investing
Without People, is that active investing is no good; passive investing works better, but only if
people keep doing active investing.

You mentioned conundrums. This is a conundrum: the less people invest actively, the greater
scope there is for price to diverge from value. In theory, it becomes easier to find bargains and
overpriced securities, and the return from active effort rises. So that’s the irony.

And, the other thing is, we have to bear in mind that, let’s say everybody at this conference
stipulated that over the next ten years, every dollar that went into the stock market would go into
the S&P 500, perhaps through index funds or ETFs. Clearly, the prices of the S&P 500 stocks
would rise, maybe more than they should, and everything else would languish. Given the
fundamental realities, eventually the things outside the index would be so demonstrably cheap
11
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 relative to the things inside the index that they have to begin to do better, at which point active
investing outperforms and maybe a few people at the margin give up on passive. So it’s kind of
reflexive. I take reflexivity to mean that the actions of the participants change the formula for
success, and that’s what we could be talking about here.

PS: But if we come back to the chain of discovery, if this growing mechanization has an impact on
the transmission and allocation of capital at the core of where people innovate, then that clearly is
detrimental for society. To put it controversially, but acknowledging this risk, should passive
investing be charged for its free-riding and subsidize the extra costs of active investing?

HM: The only way to do that, of course, would be to keep the prices of assets secret and charge
people for admission to that room, but I don’t think that’s ever going to happen. In the memo
Investing Without People, there are three sections. The first is passive and index, which is here
now in a big way. The second is algorithmic and systematic, which is here in a small way. And
the third is AI and machine learning, which is really – for investing – not here yet. We know
what’s happened with passive investing, because it has outperformed active [and now is
employed to manage a substantial portion of equity investments].
investments]. There are systematic and
algorithmic funds like Renaissance that have done a fabulous job and produced very, very high
returns, based primarily on finding exceptions to historical
al patterns, I think. But then what
happens when we get into artificial intelligence and machine learning? The questions I posed in
the memo included “Can a computer read five business plans and figure out which of them will
be the next Amazon?” and “CanCan a computer sit down with five CEOs and figure out which
whic will
be the next Steve Jobs?” Things like that.

I believe not. I believe computers can’t. t. First of all, I don

don’t think the essence of the business
plans or the CEOs can completely be converted into data and input into the computers. And II’m
not an expert, but I wouldn’tt think computers can make those qualitative subjective judgments
better than the best people. Now clearly, not every person can do those things either. Most
people can’tt sit down with business plans and find Amazon, for example. A few can. They
invested in it. Maybe it was Kleiner Perkins, maybe it was Sequoia, or maybe it was
Benchmark. So not all the people can do it, but a few have been able to – we can argue about
whether that was luck or skill. But I dondon’t think computers will be able to do it, either. To me,
the key conclusion of that memo was that computers can outperform most people, but not the
best people. If so, there will still be room in active investing for the best. As my mother used to
say, it’s the exception that proves the rule.

PS: Howard, once again, thank you very much for sharing your insights with us, and we hope to
welcome you in person one day in Panmure House. There are many questions on my list that we
haven’t touched on. I’d like to ask them perhaps one day, another time, but thank you.

HM: Very good Patrick. Thank you for your good questions and for conducting this discussion,
and I hope it’s what you wanted for yourself and your colleagues.

June 23, 2022

12
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.
The conversation on pp. 7-8 of this memo is for illustrative purposes only. It isn’t representative and
doesn’t represent an estimate or projection of the actual return of any Oaktree product that is or will be
available. All investments contain risk.
This memorandum is being made availableilable for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securiti
securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assu assumptions on which
such information is based.
This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

13
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Bull Market Rhymes

While I employ a great many adages and quotes in my writings, my main go-to list consists of a relatively
small number. One of my favorites is widely attributed to Mark Twain: “History doesn’t repeat itself, but
it does rhyme.” It’s well documented that Twain used the first four words in 1874, but there’s no clear
evidence that he ever said the rest. Many others have said something similar over the years, and in 1965
psychoanalyst Theodor Reik said essentially the same thing in an essay titled “The Unreachables.” It
took him a few more words, but I think his formulation is the best:

There are recurring cycles, ups and downs, but the course of events is essentially the
same, with small variations. It has been said that history repeats itself. This is perhaps
not quite correct; it merely rhymes.

The events of investment history don’tt repeat, but familiar themes do recur, especially behavioral themes.
It’s these that I study.

In the last two years, we’ve

ve seen dramatic examples of the ups and downs Reik wrote about. And I’ve
I
been struck by the reappearance of some classic themes in investor behavior. They
They’ll be the topic of this
memo.

I want
nt to mention up front that this memo has nothing to do with assessing the markets’
markets likely
direction from here. Bullish behavior came out of the pandemic-related
pandemic bottom of March 2020; since
then, significant problems have developed inside the economy (inf
(inflation) and outside (Ukraine); and
there’ss been a significant correction. No one, including me, knows what the sum of those things
implies for the future.

I’m
m writing only to place recent events in the context of history and point out a few implied lessons.
les This
is important, because we have to go back 22 years – to before the bursting of the tech-media-telecom
bubble in 2000 – to see what I consider a real bull market and the ending of the resultant bear
market,, and I imagine many of my readers entere
entered the investment world too late to have experienced that
event. You may ask, “What
“What about the market gains that preceded the Global Financial Crisis of 2008-09
2008
and the pandemic-related
related collapse of 2020?” In my view, in both cases, the preceding appreciation was
gradual, not parabolic; it wasn’t driven by overheated psychology; and it didn’t take stock prices to crazy
heights. Moreover, high stock prices weren’t the cause of either crisis. The excesses in the former lay in
the housing market and the creation of securities backed by sub-prime mortgages, and the latter collapse
was a consequence of the arrival of Covid-19 and the government’s decision to shut down the economy to
limit the spread of the disease.

When I refer above to “a real bull market,” I’m not talking about standard definitions such as these from
Investopedia:

A period of time in financial markets when the price of an asset or security rises
continuously
A situation in which stock prices rise by 20%, usually after a drop of 20%

© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
The first of these is too bland, failing to capture a bull market’s emotional essence, and the second
attempts false precision. A bull market shouldn’t be defined as a percentage price movement. For me,
it’s best described by what it feels like, the psychology behind it, and the behavior that psychology
leads to.

(I started investing before the development of numerical criteria for bull and bear markets, and I consider
such yardsticks meaningless. Take a look, for example, at a couple of recent newspaper articles. On May
20, the S&P 500 Index’s decline from the top passed the “magic” 20% threshold; thus on May 21 the
Financial Times wrote, “Wall Street stocks slumped into a bear market yesterday . . .” But because a late
rally reduced the final decline to just under 20%, the headline of the same day’s New York Times read,
“S&P 500 Drops . . . but Evades Bear Market.” Does it really matter whether the S&P 500 is down
19.9% or 20.1%? I prefer the old-school definition of a bear market: nerve-racking.)

Excesses and Corrections

My second book is Mastering the Market Cycle: Getting the Odds on Your Side Side. It’s well known that I’m
a student of cycles and a believer in cycles. I’ve
ve lived through (and been schooled by) several significant
cycles during my years as an investor. I believe understanding where we stand in the market cycle can
give us a hint regarding what’ss coming next. And yet, when I was about two-thirds
two of the way through
writing that book, a question dawned on me that I hadn’tt considered before: Why do we have cycles?

For example, if the S&P 500 has returned just over 10% a year on average
avera over the 65 years since it
assumed its present form in 1957, why doesn’tt it just return 10% every year? And updating a question I
asked in my memo The Happy Medium (July July 2004), why has its annual return been between 8% and 12%
just six times during this period? Why is it so far from the mean 90% of the time?

After
fter pondering this question for a while, I landed on what I consider ththe explanation: excesses and
corrections. If the stock market was a machine, it might be reasonable to expect it to perform
consistently over time. Instead, I think the substantial influence of psychology on investors’
investors
decision-making
making largely explains the market
market’s gyrations.

When investors turn highly bullish, they tend to conclude that (a) everything
everything’s going to go up forever and
(b) regardless of what they pay for an asset, someone else will come along to buy it from them for more
(the “greater-fool
fool theory”).
ry”).
”). Because of the high level of optimism:

Stock prices rise faster than company profits, soaring well above fair value ((excess to the
upside).
Eventually, conditions in the investment environment disappoint, and/or the folly of the elevated
prices becomes clear, and they fall back toward fair value (correction) and then through it.
The price declines generate further pessimism, and this process eventually causes prices to far
understate the value of stocks (excess to the downside).
Resultant buying on the part of bargain-hunters causes the depressed prices to recover toward fair
value (correction).

The excess to the upside makes for a period of above average returns, and the swing toward excess on the
downside makes for a period of below average returns. There can be many other factors at work, of
course, but in my view, “excesses and corrections” covers most of the ground. We saw a number of
excesses to the upside in 2020-21, and now we’re seeing corrections thereof.

2
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Bull Market Psychology

In a bull market, favorable developments lead to price rises and lift investor psychology. Positive
psychology induces aggressive behavior. Aggressive behavior leads to higher prices. Rising prices
encourage rosier psychology and further risk-taking. This upward spiral is the essence of a bull market.
When it’s underway, it feels unstoppable.

We saw a classic collapse of asset prices in the early days of the pandemic. For example, the S&P 500
reached a then-all-time high of 3,386 on February 19, 2020 before falling by one-third in just 34 days to a
low of 2,237 on March 23. After that, a number of forces combined to produce massive price gains:

The Federal Reserve cut the fed funds rate to roughly zero, and the Fed was joined by the
Treasury in announcing massive stimulative measures.
These actions convinced investors that these institutions would do whatever it took to stabilize the
economy.
The interest rate cut significantly reduced the prospective returns required to make investments
look attractive in relative terms.
The combination of these factors forced investors to bear risks they had been running from just a
short time earlier.
Asset prices rose: byy late August, the S&P 500 had retraced its decline and surpassed its February
high.
The FAAMGs (Facebook, Amazon, Apple, Microsoft and Google), software stocks stocks, and other
tech stocks rose dramatically, pushing the market higher.
Eventually, investors concluded – as they often do when things are going well – that they
could expect more of the same.

The most important thing about bull market psychology is that, as cited in the final bullet point
above, most people take rising stock prices as a positive sign of things to come. Many are converted
to optimism. Relatively few suspect that the gains
gains to date might have been excessive and borrowed from
future returns and that they presage reversal, not continuation.

That reminds me of another of my favorite adages – one of the first ones I learned, roughly 50 years ago –
“the three stages of a bulll market”:
market

the first, when a few forward

forward-looking people begin to believe things will get better,
the second, when most investors realize improvement is actually underway, and
the third, when everyone concludes that things will get better forever.

It’s interesting to note that even though the market moved from despondent in March 2020 to booming in
May, largely thanks to the Fed, the most frequent attitude I encountered during that period was
dubiousness. And the question I was asked most frequently was “If the environment is so bad – with the
pandemic raging and the economy shuttered – isn’t it wrong for the market to rise?” It was hard to find
any optimists. Many of the buyers were what my late father-in-law used to call “handcuff volunteers”:
they didn’t buy because they wanted to; they bought because they had to, since the return on cash was so
low. And once markets started to rise, people were afraid of being left behind, so they chased prices
higher. Thus, the market gains seemed to be the result of the Fed’s manipulation of the capital markets,
rather than positive corporate developments or optimistic psychology. It was only around the end of 2020
– when the S&P 500 was up by 16.3% for the year and 67.9% from the March bottom – that investor
psychology caught up with the booming stock prices.

3
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
The bull market of 2020 was unprecedented in my experience, in that there was essentially no first stage
and very little of the second. Many investors went straight from hopeless in late March to highly
optimistic later in the year. This is a great reminder that, while some themes do recur, it’s a big
mistake to expect history to repeat exactly.

Optimistic Rationales, Super Stocks, and the New, New Thing

Raging bull markets are examples of mass hysteria. At the extreme, thinking and thus behavior become
unmoored from reality. In order for this to occur, however, there has to be some factor that activates
investors’ imagination and discourages prudence. Thus, special attention should be paid to an element
that almost always characterizes bull markets: a new development, invention or justification for the rising
stock prices.

Bull
ull markets are, by definition, characterized by exuberance, confidence, credulousness, and a
willingness to pay high prices for assets – all at levels that are shown in retrospect to have been
excessive. History has generally shown the importance of keeping these things in moderation. For
that reason, the intellectual or emotional rationale for a bull market is often based on something
new that history can’t be used to discount.

Those last six words are very important. History amply demonstrates that when (a) markets exhibit
bullish behavior, (b) valuations become excessive, and (c) the latest thing is accepted without hesitation,
the consequences are often very painful. Everyone knows – or should know – that parabolic stock market
advances are generally followed by declines of 20-50%.
50%. Yet those advances occur and recur, abetted by
what I learned in high school English class to call “the willing suspension of disbelief.
disbelief.” Here’s another of
my very favorite quotes:

Contributing to . . . euphoria are two further factors little noted in our time or in past
times. The first is the extreme brevity of the financial memory. In consequence,
financial disaster is quickly forgotten. In further consequence, when the same or closely
similar circumstances occur
occur again, sometimes in only a few years, they are hailed by a
new, often youthful, and always supremely selfself-confident generation as a brilliantly
innovative discovery in the financial and larger economic world. There can be few fields
of human endeavor in which history counts for so little as in the world of finance. Past
experience, to the extent that it is part of memory at all, is dismissed as the primitive
refuge of those who do not have the insight to appreciate the incredible wonders of
the present. (John Kenneth Galbraith, A Short History of Financial Euphoria, 1990 –
emphasis added)

I’ve shared that quote with readers many times over the last 30 years – since I think it so beautifully sums
up a number of important points – but I haven’t previously shared my explanation for the behavior it
describes. I don’t think investors are actually forgetful. Rather, knowledge of history and the
appropriateness of prudence sit on one side of the balance, and the dream of getting rich sits on the
other. The latter always wins. Memory, prudence, realism, and risk aversion would only get in the
way of that dream. For this reason, reasonable concerns are regularly dismissed when bull markets
get going.

What appears in their place is often intellectual justifications for valuations that exceed historical norms.
On October 11, 1987, Anise Wallace described this phenomenon in an article in The New York Times
titled “Why This Market Cycle Isn’t Different.” Optimistic thinking was being embraced at the time to
justify unusually high stock prices, but Wallace said it wouldn’t hold:

4
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 The four most dangerous words in investing are “this time it’s different,” according to
John Templeton, the 74-year-old mutual fund manager. At stock market tops and
bottoms, investors invariably use this rationale to justify their emotion-driven decisions.

Over the next year, many investors are likely to repeat those four words as they defend
higher stock prices. But they should treat them with the same consideration they give
“the check’s in the mail.” No matter what brokers or money managers say, bull markets
do not last forever.

It didn’t take a year. Just eight days later, the world experienced “Black Monday,” when the Dow Jones
Industrial Average dropped by 22.6% in a single day.

Another justification for bull markets is often found in the belief that certain businesses are guaranteed to
enjoy a terrific future. This applies to the Nifty-Fifty
Fifty growth companies in the late 1960s; disc drive
manufacturers in the ’80s; and telecom, Internet and e-commerce
commerce companies in the late ’90s. Each of
these developments was believed to be capable of changing the world, such that the past realities of
business need not constrain investors’ imaginations and willingness to pay up. And they did change
the world. Nevertheless, the highly elevated asset valuations they were thought to justify didn
didn’t hold.

In many bull markets, one or more groups are anointed as what I call “super stocks.” Their rapid rise
makes investors increasingly
gly optimistic. In the circular process that often characterizes the
markets, this rising optimism takes the stocks to still-higher
higher prices. And some of this positivity and
appreciation reflects favorably on other groups of securities – or all securities – through relative-
value comparisons and/or because of the general improvement in investors
investors’ mood.

Topping the list of companies that fed investors’ excitement in 2020

2020-21 were the FAAMGs, whose level
of market dominance and ability to scale had never beebeen seen before. The dramatic performance of the
FAAMGs in 2020 attracted the attention of investors and supported a widespread swing toward
bullishness. By September 2020 (that is, within six months), these stocks had nearly doubled from their
March lows and were up 61% from the beginning of the year. Notably, these five stocks are heavily
weighted in the S&P 500, so their performance resulted in a good overall gain for the index, but this
distracted attention from the far-less
far-less-impressive
far less--impressive performance of the other 495 stocks. The performance of
less
the super stocks inflamed investors’
investors ardor, enabling them to disregard worries regarding the persistence of
the pandemic or other risks.

Source: Goldman Sachs

5
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
The raging success of the FAAMGs created a luster that reflected positively on tech stocks in general.
Demand soared for stocks in the sector and, as is usual in the investment world, strong demand
encouraged and enabled supply. One notable barometer in this case is the attitude toward IPOs from
unprofitable companies. Prior to the tech bubble of the late 1990s, IPOs from companies that didn’t make
money were relatively rare. They became the norm during the bubble, but their number sunk again
thereafter. In the 2020-21 bull market, IPOs from unprofitable companies experienced a big resurgence,
as investors easily made allowance for tech companies’ desire to scale and biotech companies’ need to
spend on drug trials.

If companies with bright futures provide fuel for bull markets, things that are new to the markets can
supercharge market excesses. SPACs are a great recent example. Investors gave these newly formed
vehicles blank checks for acquisitions on the proviso that investors could get their mone
money back with
interest (a) if no acquisition was consummated within two years or (b) if investors didn
didn’t like the
acquisition that was proposed. This seemed like a “no-lose proposition” (three of the most dangerous
words in the world), and the number of SPACs Cs organized soared from just 10 in 2013 and 59 in 2019 to
248 in 2020 and 613 in 2021. Some produced big profits, and in other cases investors took back their
money with interest. But the lack of skepticism surrounding this relatively untested innovatio
innovation – fueled
by bull market psychology – allowed too many SPACs to be created, by competent and incompetent
organizers alike who would be highly paid for pulling off an acquisition . . . any acquisition.

Today, the average SPAC that de-SPAC-ed since 2020 by completing an acquisition (in each case, with
the approval of its investors) is selling at $5.25, versus its issue price of $10.00. This is a good example
of a new thing that turned out to be less dependable than investors – who fell once again for a can’t-lose
silver bullet – had thought. SPACs’ defenders argue that these vehicles are just an alternative way to take
companies public, but their potential usefulness isn’t
isn my concern. II’m focused on how readily investors
embraced an untested innovation in hot times.

Another dynamic involving novel factors deserves mention, since it exemplifies the way “the new thing”
can contribute to bull markets:

Robinhood Markets began offering commission

commission-free trading in stocks, ETFs and cryptocurrencies
in the years before the pandemic. Once the Covid-19
Covid crisis hit, this encouraged people to “play
the stock market,”
market, as casinos and sports events were closed for betting.
Generous stimulus checks were sent to millions who hadnhadn’t lost their jobs, meaning many people
saw their disposable income rise during the pandemic.
Bulletin boards like Reddit turned investing into a social activity for people shut in at home.
As a result, large numbers of novice retail investors were recruited online, many of whom lacked
the experience needed to know what constitutes investment merit.
Newcomers were stirred by a popular cult figure who said, “stocks only go up.”
As a result, many tech and “meme stocks” soared.

The final element worth discussing is cryptocurrency. Proponents of Bitcoin, for example, cite its variety
of uses, as well as the limited supply relative to the potential demand. Skeptics, on the other hand, point
to Bitcoin’s lack of cash flow and intrinsic value and thus the impossibility of assigning a fair price.
Regardless of which side will turn out to be right, Bitcoin satisfies some characteristics of a bull market
beneficiary:

6
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 It’s relatively new (although it has been around for 14 years, it’s been in most people’s
consciousness for only five).
It enjoyed a dramatic price spike, rising from $5,000 in 2020 to a high of $68,000 in 2021.
And it’s certainly something that, per Galbraith, prior generations “do not have the insight to
appreciate.”
In all these regards, it perfectly satisfies Galbraith’s description of something “hailed by a new,
often youthful, and always supremely self-confident generation as a brilliantly innovative
discovery in the financial . . . world.”

Bitcoin is off a little more than half from its 2021 high, but others among the thousands of
cryptocurrencies that have been created have declined much more.

The striking performance of the FAAMGs, tech stocks generally, SPACs, meme stocks and
cryptocurrencies in 2020 reinforced the craze for them and added to investors’ general optimism. It’s
hard to imagine a full-throated bull market arising in the absence of something that’sthat never been
seen or heard before. The “new, new thing” and belief that “this time it’ss different
different” are shining
examples of recurring bull market themes.

The Race to the Bottom

Another bull market theme that rhymes from cycle to cycle is the deleterious impact of bull market
trends on the quality of investors’ decision-making. In short, when burning optimism takes over from
levelheadedness:

asset prices rise,

greed grows relative to fear,
fear of missing out replaces fear of losing money, and
risk aversion and caution evaporate.

It’ss essential to bear in mind that it’s

it’’ss risk aversion and the fear of loss that keep markets safe and
it
sane. The developments listed above typically combine to lift markets, drive out cautious investigation
and deliberation, and make the markets a dangerous place.

In my 2007 memo The Race to the Bottom

Bottom, I explained that when there’s too much money in the hands of
investors and providers of capital and they
they’re too eager to put it to work, they bid too aggressively for
securities and the chance to lend. Their spirited bidding drives down prospective returns, drives up risk,
weakens security structures, and reduces the margin for error.

The cautious investor, sticking to her guns, says, “I insist on 8% interest and strong covenants.”
Her competitor responds, “I’ll accept 7% interest and demand fewer covenants.”
The least disciplined, not wanting to miss the opportunity, says, “I’ll settle for 6% interest and no
covenants.”

This is the race to the bottom. This is why it’s often said that “the worst of loans are made in the
best of times.” This is something that can’t happen when people are smarting from recent losses
and afraid of experiencing more. It’s not a coincidence that the record-long 10-plus-year economic
recovery and stock market rise that followed the Fed’s massive response to the Global Financial Crisis
were accompanied by:

7
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 a wave of IPOs from money-losing companies;
record issuance of sub-investment grade securities, including risky CCC-rated debt;
debt issuance from companies in volatile industries such as tech and software that lenders are
likely to shun in more cautious times;
rising valuation multiples on acquisitions and buyouts; and
shrinking risk premiums.

Favorable developments also encourage the increased use of leverage. Leverage magnifies gains and
losses, but in bull markets, investors feel sure of gains and disregard the possibility of loss. Under such
conditions, few can see a reason not to incur debt – with its piddling interest cost – to increase the payoff
from their successes. But putting more debt on investments made at high prices late in the up-cycle is no
formula for success. When times turn bad, leverage turns disadvantageous. And when investment banks
issue late-cycle debt that they can’t place with buyers, they’re stuck with it. Debt “hung” on banks’
balance sheets is often a “canary in the coal mine” with regard to what’s in store.

Since I’m relying on time-worn investment adages, it’ss appropriate at this point to invoke
inv the one I
consider the greatest regarding investor behavior over cycles: “WhatWhat the wise man does in the
beginning, the fool does in the end.” People who buy in stage one of a bull market, when prices are low
because of prevailing pessimism (such as during
ring the Global Financial Crisis of 2008
2008-09 and in the early
days of the Covid-19
19 pandemic in 2020), have the potential to earn high prospective returns with little
risk: the main prerequisites are money to spend and the nerve to spend it. But when bull markets heat
up and good returns encourage investors’ optimism, the traits that are rewarded are eagerness,
credulousness, and risk-taking.
taking. In stage three of a bull market, new entrants buy aggressively,
keeping it aloft for a while. Caution,
n, selectivity, and discipline go out the window just when they
they’re
needed most.

Particularly noteworthy is the fact that investors who are in a good mood and being rewarded for risk
tolerance typically cease to practice discernment regarding investment opportunities. Not only do
investors consider it a certainty that some examples of “the new thing” will succeed, but eventually they
conclude that everything in that sector will do well, so differentiating is unnecessary.

Because of all the above, the term

term “bull market psychology” isn’t a positive. It connotes carefree
behavior and a high level of risk tolerance, and investors should find it worrisome, not encouraging.
As Warren Buffett puts it, “The
The less prudence with which others conduct their affairs,
affairs the greater the
prudence with which we should conduct our own affairs.
affairs.” Investors have to know when bull market
psychology is in ascendance and apply the required caution.

The Pendulum Swings

Bull markets don’t arise out of thin air. The winners in each bull market are winners for the
simple reason that a grain of truth underlies their gains. However, the bullishness I’ve described
above tends to exaggerate the merits and pushes security prices to levels that are excessive and thus
vulnerable. And the upward swing doesn’t last forever.

In On the Couch (January 2016), I wrote, “in the real world, things generally fluctuate between ‘pretty
good’ and ‘not so hot.’ But in the world of investing, perception often swings from ‘flawless’ to
‘hopeless.’” The way things are seriously overdone in the markets is one of the key characteristics of
investor behavior. During bull markets, investors conclude that difficult, unlikely, and unprecedented
things are sure to work. But in less ebullient times, favorable economic news and “earnings beats” fail to

8
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
inspire buying, and rising prices no longer make life painful for people who are underinvested. Thus, we
stop seeing the willing suspension of disbelief, and psychology flips to negativism.

The key lies in the fact that investors are capable of interpreting virtually any piece of news either
positively or negatively, depending on how it’s reported and on their mood. (The cartoon below, one
of my all-time favorites, was published many decades ago – check out those rabbit ears and the depth of
the TV set – but clearly the caption is relevant to this very moment.)

Reflecting the “flawless-to-hopeless”

hopeless progression I mentioned earlier, prevailing narratives are subject to
hopeless”
reversal. While the argument supporting the bull market may have been reasonably likely to hold,
investors treated it as ironclad when all was going well. When ssome of the argument’s flaws come to
light, however, it’ss dismissed as all wrong.

In the happy season (all of a year ago), the tech bulls said, “You have to buy growth stocks for
their decades of potential earnings increases.” But now, after a significant decline, we instead
hear, “Investing based on future potential is too risky. You have to stick to value stocks for their
ascertainable present value and reasonable prices.”
Likewise, in the heady times, participants in IPOs of money-losing companies said, “There’s
nothing wrong with companies that report losses. They’re justified in spending to scale up.” But
in the present correction, many say, “Who would invest in unprofitable companies? They’re just
cash incinerators.”

People who haven’t spent much time watching markets may believe that asset prices are all about
fundamentals, but that’s certainly not so. The price of an asset is based on fundamentals and how people
view those fundamentals. So the change in an asset price is based on a change in fundamentals and/or a
change in how people view those fundamentals. Company fundamentals are theoretically subject to

9
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
something called “analysis” and possibly even prediction. On the other hand, attitudes regarding
fundamentals are psychological/emotional, not subject to analysis or prediction, and capable of
changing much faster and more dramatically. There are adages that capture this dimension, too:

The air goes out of the balloon much faster than it goes in.
It takes longer for things to happen than you thought it would, but then they happen much faster
than you thought they could.

As for the latter, in my experience, we often see positive or negative fundamental developments pile up
for a good while, with no reaction on the part of security prices. But then a tipping point is reached –
either fundamental or psychological – and the whole pile suddenly gets reflected in prices, sometimes to
excess.

Then What Happens?

Bull markets don’tt treat all sectors the same. In bull markets, as I discussed earlier,
earlier, optimism coalesces
most powerfully around certain groups of securities, such as “the
the new thing” or “super stocks.” These
rise the most, become emblematic of the bull in this period, and attract further buying. The media pay
these sectors the most attention, extending the process. In 2020-21,
21, the FAAMGs and other tech stocks
were the best examples of this phenomenon.

It goes without saying – but I’ll say it anyway – that investors holding large amounts of the things that
lead in each bull market do very well. And fund managers who are smart enough or lucky enough to be
dedicated exclusively to those things report the highest returns while optimism prevails and show up on
the front page of newspapers and on cable TV shows
shows.. In the past, II’ve said our business is full of
people who got famous for being right once in a row. That can go double for fund managers who
are smart or lucky enough to be overweight the sectors that lead a bull market.

However, the stocks that rise the most in the up years ooften experience the greatest declines in the down
years. The applicable adages here are from the real world, but that doesn
doesn’t reduce their relevance: “live
by the sword, die by the sword;” “what
what goes up must come down;
down;” and “the bigger they are, the harder
they fall”:

One tech fund rose by 157% in 2020, moving from obscurity to fame. But it lost 23% in 2021
and is down another 57% so far in 2022. $100 invested at year
year-end 2019 was worth $257 a year
later, but that’s
that s down to $85 today.
Another tech fund
fund, somewhat less volatile, was up by 48% in 2020 but is down by 48% since.
Unfortunately, up 48% and down 48% don’t combine to produce zero change, but rather a net
decline of $22 per $100 invested.
A third tech fund was up a startling 291% in year one, but it fell by 21%, 60%, and 61% in the
three years that followed. $100 invested at the beginning of this four-year period was worth $43
at the end, a decline of 89% from the end of that incredible first year. But wait a minute: there
haven’t been four years in the current boom/bust. No, the results I cite are from 1999-2002, when
the last tech bubble inflated and collapsed. I include them only as a reminder that the current
performance pattern is a recurrence.

Earlier I mentioned Robinhood, the originator of commission-free trading. It epitomized the role of the
digital in the 2020-21 bull market. Robinhood went public in July 2021 at $38, and over the next week,
the stock price shot up to $85. Today it’s at $10, an 88% drop from the high in less than a year.

10
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
But the equity averages aren’t doing that badly, right? The tech-heavy Nasdaq Composite is “only” down
27.4% in 2022. One of the characteristics of this bull market is that the biggest companies’ stocks –
which are the most heavily weighted – have done the best, buoying the indices. Consider what that
implies for the rest; 22% of Nasdaq stocks are down at least 50%. (Data here and below are as of May
20.)

Here are the declines from the top of some well-known tech/digital/innovation stocks that I picked at
random. Maybe there are a few here that, when they were at their peak, you kicked yourself for not
having bought:

PayPal -57%
Beyond Meat -63
Coinbase -74
Salesforce -37
Carvana -86
DocuSign -50
Moderna -46
Netflix -69
Shopify -74
Spotify -54
Uber -44
Zoom -51

Average -59%
59%

Let’ss say you still believe market prices are set by a consensus of intelligent investors on the basis of
fundamentals. If that’ss the case, then why are all these stocks down by such large percentages? And do
you really believe the value of these busines
businesses
ses has more than halved on average in the last few months?
This line of inquiry leads to something else I think about often. On days when the stock market makes its
biggest moves, Bitcoin often moves in the same direction. Is there any fundamental reas reason why the two
should be correlated? The same goes for international links: when Japan starts off the day with a big
decline, Europe and the U.S. often follow suit. And sometimes it seems U.S. stocks lead and it it’s Japan
that falls in line. Are these cou
countries’
ntries fundamentals connected enough to justify co-movement?
ntries’

My answer to all these questions is generally “no.” The common thread isn’t fundamentals: it’s
psychology, and when the latter changes significantly, all of these things are similarly affect
affected.

The Lessons

As always for students of investing, what matters most isn’t what events transpired in a given period of
time, but what we can learn from these events. And there’s a lot to be learned from the trends in 2020-21
that rhymed with those in previous cycles. In bull markets:

Optimism builds around the things that are doing spectacularly well.
The impact is strongest when the upswing arises from a particularly depressed base in terms of
psychology and prices.
Bull market psychology is accompanied by a lack of worry and a high level of risk tolerance, and
thus highly aggressive behavior. Risk-bearing is rewarded, and the need for thorough diligence is
ignored.
11
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 High returns reinforce belief in the new, the unlikely, and the optimistic. When the crowd
becomes convinced of those things’ merit, they tend to conclude “there’s no price too high.”
These influences cool eventually, after they (and prices) have reached unsustainable levels.
Elevated markets are vulnerable to exogenous events, like Russia’s invasion of Ukraine.
The assets that rose the most – and the investors who over-weighted them – often experience
painful reversals.

These are themes I’ve seen play out numerous times during my career. None of them relates exclusively
to fundamental developments. Rather, their causes are largely psychological, and the way psychology
works is unlikely to change. That’s why I’m sure that as long as humans are involved in the
investment process, we’ll see them recur time and time again.

And, as a reminder, since the major ups and downs of the markets are primarily driven by psychology, it’s
clear that market movements can only be predicted, if ever, when prices are at absurd highs or lows.

May 26, 2022

12
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written co
consent of Oaktree.

13
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: The Pendulum in International Affairs

As regular readers of my memos and books know, I’m strongly interested in – you might say obsessed
with – the concept of the pendulum. The following is only a partial list of my writings on the subject:

My second memo, written in April 1991, was creatively titled First Quarter Performance. It
talked about the oscillation in securities markets between euphoria and depression; between
celebrating positive developments and obsessing over negatives; and thus between overpriced and
underpriced assets.
On Regulation, written in March 2011, discussed the outlook for rulemaking stemming from the
Global Financial Crisis. I said future developments were likely to be driven by the long-term
pendulum-like swing inn attitudes on that subject. Over time, those attitudes tend to fluctuate
between “the markets best serve the country when they’re re unfettered by rules
rules” to “we need the
government to protect us from participants’ misbehavior.””
In The Role of Confidence, from August 2013, I discussed the way shifts in fundamentals are
translated into market volatility by often-excessive
excessive swings in iinvestor confidence.
And in my 2018 book, Mastering the Market Cycle,
Cycle, I interrupted my discussion of the various
cycles – in the economy, corporate profits, credit availability, etc. – to use the metaphor of a
pendulum, not a cycle, to describe the swings of investor psychology.

Because psychology swings so often toward one extreme or the other – and spends relatively little time at
the “happy medium” – I believe the pendulum is the best metaphor for understanding trends in anything
affected by psychology . . . not just investing.

People frequently ask what caused me to start writing memos in 1990. My very first memo, The Route to
Performance, resulted from two events I witnessed in short order, the juxtaposition of which led to what I
thought was an important observation. Over the years, many memos have been prompted by connections
I sensed between ostensibly unconnected events.

Att a recent meeting of the Brookfield Asset Management board, a discussion of Ukraine triggered an
association with another aspect of international affairs – offshoring – which I first discussed in the memo
Economic Reality (May 2016). Thus the inspirat
inspiration for this memo.

Background

The first item on the agenda for Brookfield’s board meeting was, naturally, the tragic situation in Ukraine.
We talked about the many facets of the problem, ranging from human to economic to military to
geopolitical. In my view, energy is one of the aspects worth pondering. The desire to punish Russia for
its unconscionable behavior is complicated enormously by Europe’s heavy dependence on Russia to meet
its energy needs; Russia supplies roughly one-third of Europe’s oil, 45% of its imported gas, and nearly
half its coal.

Since it can be hard to arrange for alternative sources of energy on short notice, sanctioning Russia by
prohibiting energy exports would cause a significant dislocation in Europe’s energy supply. Curtailing

© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
this supply would be difficult at any time, but particularly so at this time of year, when people need to
heat their homes. That means Russia’s biggest export – and largest source of hard currency ($20 billion a
month is the figure I see) – is the hardest one to sanction, as doing so would cause serious hardship for
our allies. Thus, the sanctions on Russia include an exception for sales of energy commodities. This
greatly complicates the process of bringing economic and social pressure to bear on Vladimir Putin. In
effect, we’re determined to influence Russia through sanctions . . . just not the potentially most effective
one, because it would require substantial sacrifice in Europe. More on this later.

The other subject I focused on, offshoring, is quite different from Europe’s energy dependence. One of
the major trends impacting the U.S. economy over the last year or so – and a factor receiving much of the
blame for today’s inflation – relates to our global supply chains, the weaknesses of which have recently
been on display. Thus, many companies are seeking to shorten their supply lines and make them more
dependable, primarily by bringing production back on shore.

Over recent decades, as we all know, many industries moved a significant percentage of their production
offshore – primarily to Asia – bringing down costs by utilizing cheaper labor. This process boosted
economic growth in the emerging nations where the work was done, increased savings and
competitiveness for manufacturers and importers, and provided low-priced
priced goods to consumers. But the
supply-chain disruption that resulted from the Covid-19
19 pandemic, combined with the shutdown of much
of the world’ss productive capacity, has shown the downside of that trend, as supply has been
b unable to
keep pace with elevated demand in our highly stimulated economy.

At first glance, these two items – Europe’ss energy dependence and supply-chain
supply disruption – may seem to
have little in common other than the fact that they both involve interna
international considerations. But I think
juxtaposing them is informative . . . and worthy of a memo.

Russian Energy

In 2019, Russia’ss top four exports were crude petroleum, refined petroleum, petroleum gas, and coal
briquettes. These
hese totaled $223 billion, or 55% of Russia
Russia’s total exports of $407 billion, according to the
Observatory of Economic Complexity.

As shown in the following table, Russia is exceptionally well positioned to wield influence over Europe
through exports of energy commodities.

Europe Russia
Produces Consumes Net Produces Consumes Net
Oil (bbl/day) 3.6 mm 15.0 mm (11.4 mm) 11.0 mm 3.4 mm 7.6 mm
Gas (cu met/year) 230 bn 560 bn (330 bn) 700 bn 400 bn 300 bn
Coal (tons/year) 475 mm 950 mm (475 mm) 800 mm 300 mm 500 mm

Source: “The West’s Green Delusions Empowered Putin,” Michael Shellenberger, Common
Sense with Bari Weiss, March 1, 2022. Some data is approximate or rounded. (Common Sense
is probably as tendentious as other media outlets, but I have no reason to believe the data is
inaccurate.)

The implications are clear. Europe uses far more energy than it produces and makes up the difference
through imports. Russia, on the other hand, uses far less than it produces, leaving the remainder to
generate economic and strategic gains.

2
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
How did things get this way? According to Shellenberger (see source above):

While Putin expanded Russia’s oil production, expanded natural gas production, and then
doubled nuclear energy production to allow more exports of its precious gas, Europe, led
by Germany, shut down its nuclear power plants, closed gas fields, and refused to
develop more through advanced methods like fracking.

The numbers tell the story best. In 2016, 30 percent of the natural gas consumed by the
European Union came from Russia. In 2018, that figure jumped to 40 percent. By 2020,
it was nearly 44 percent, and by early 2021, it was nearly 47 percent.

The following chart makes the situation clear. In 1980, imports from Russia represented less than one-
third of Europe’s oil and gas production. European production peaked about 20 years ago and has almost
halved since then, ending up near where it was in 1980. In the same roughly 40-year
year period, imports from
Russia have tripled, meaning they’re now roughly equal to Europe’ss production.

Source: BP, Gazprom, Eurostat, Perovic et al., Russia Federal Customs Service. Journal of
Policy Analysis and Management calculations, 2021.

Shellenberger asserts – and it seems credible – that Europe allowed its dependence on imports of energy
commodities, especially from Russia, to increase so dramatically because it wanted to be more
ecologically responsible at home. In addition to limiting their production of oil and gas, some nations
(especially Germany) reduced their use of nuclear power generation – which could arguably offer the best
energy option by providing large-scale power production without emitting greenhouse gases – in a
concession to those who consider nuclear power unsafe or environmentally unfriendly. As Shellenberger
puts it:

3
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 At the turn of the millennium, Germany’s electricity was around 30 percent nuclear-
powered. But Germany has been sacking its reliable, inexpensive nuclear plants. . . . By
2020, Germany had reduced its nuclear share from 30 percent to 11 percent. Then, on the
last day of 2021, Germany shut down half of its remaining six nuclear reactors. The
other three are slated for shutdown at the end of this year.

During a briefing earlier this month, a U.S. senator told the nonpartisan political organization No Labels,
“The energy issue regarding ‘Putin’s war’ has four components: energy, climate, security, and economics
(both national and at the household level).” Security doesn’t seem to have received much
consideration in the deliberations that led to Germany’s energy dependency on Russia. Just one of
the four factors – climate – appears to have motivated the decision. Choosing to count on a hostile
neighbor for essential goods is like building a bank vault and contracting with the mob to supply it with
guards. But that’s what happened.

Foreign Sourcing

The downside of Europe’ss dependence on Russian oil and gas has made its way into the consciousness of
many people only recently, as a result of the invasion of Ukraine. But the shift to sourcing and
manufacturing overseas is something that’s been on people’ss minds for decades.

If you think back a few hundred years, limitations on transportation required that production take place
near the point of consumption. But after the advent of the railroad, it became possible to separate the
locations of production
n and consumption by hundreds – or even thousands – of miles. This must have
been an important element in the creation of national champions that eventually supplied whole countries
with goods such as food and building materials that previously had to be manufactured near the local
customers. This enabled goods to be produced in places where labor was most readily available or where
benefits from specialization could be maximized. It was inevitable that these forces would affect
countries around the world and – with the emergence of airfreight and containerization – result in rapidly
growing cross-border trade.

Shortly after World War II, cheap labor and skill in assembling products permitted Japan to rapidly
become a major exporter of electronic goods and automobiles. The products were highly cost cost-
competitive and initially of low quality, but Japan soon developed some of the world
world’s most desired
brands. In the late 1950s, Japanese auto companies exported just a few hundred cars a year to the U.S.,
the main selling point of which was low price. But quality rose even as prices remained attractive, and by
the early 1980s, the Reagan administration, in an attempt to protect the U.S. auto industry, asked Japanese
manufacturers to “voluntarily”
voluntarily limit exports to the U.S. to 1.68 million cars per year.

The lure of low manufacturing costs caused producers to shift operations from Japan to other parts of
Asia over time. A large-scale shift to China began in earnest around 1995. Subsequently, the production
of low-value-added goods such as T-shirts and jeans shifted to Vietnam, Bangladesh and Pakistan. As
each country benefited from the growth of manufacturing, the supply of labor got tighter, and workers
became able to demand higher wages. Per-capita incomes and standards of living rose, expanding the
middle class and strengthening domestic consumption. Higher wages in one country caused the mantle of
lowest-cost manufacturer to pass to others. Wages may have risen locally, but as a consequence, the
search for low-margin, low-skill work moved on to new low-cost venues.

Asia’s ability to produce goods inexpensively soon led U.S. companies to capitalize on Asia’s advantages
by (a) building factories abroad and (b) hiring Asian contractors to do manufacturing for them. The
reasons are clear: vastly lower wages and fewer protections for workers, which permitted long days and

4
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
poor labor conditions that wouldn’t be tolerated in the U.S. The result was more jobs for non-U.S.
workers, economic growth for the countries where the manufacturing was done, increased
competitiveness for U.S. importers, and bargain-priced goods for American consumers.

In addition, offshoring undoubtedly contributed substantially to the low level of inflation

experienced in the U.S. over the last 40 years. One popular gauge of inflation, the Personal
Consumption Expenditures (PCE) deflator, rose by only 1.8% per year from 1995 (importantly, the blast-
off point for Chinese exports to the U.S.) through 2020. Inflation was considered tame at that level, and,
in fact, many in business and government wished it were a bit higher. But a look inside the numbers is
instructive:

Personal Consumption Expenditures Annual Inflation Share of PCE

All 1.8%
Non-Durables 1.6 25
25-30%
Durables (2.0) 10-15
10
Services 2.6 55-60

Source: Federal Reserve Bank of St. Louis FRED database; AmosWEB

It’ss startling to note that the prices of durables fell by almost 40% over the 25 years in question.
The availability of ever-cheaper
cheaper goods like cars, appliances and furniture produced abroad was a major
contributor to the benign U.S. inflation picture in this quarter-century.
quarter century. Likewise, although prices of non-
durables didn’tt actually come down, cheap imports of items like clothing helped keep the lid on prices
overall.. This was an important benefit of globalization for the net
net-importing nations.

On the other hand, offshoring also led to the elimination of millions of U.S. jobs, the hollowing out
of the manufacturing regions and middle class of our country, and most likely the weakening of
private-sector labor unions.

Ford, for example, reported in 1992 that 53 percent of its employees worked in the U.S.
and Canada. By 2009, its North American workforce (by then Ford had expanded to
Mexico) made up only 37 percent of total payroll. (The Week, January 11, 2015)

Capitalism is based on the

the desire to maximize income. Globalization allows production to be
performed where the costs are lowest. The combination of these two powerful forces has had a
profound influence on the world over the last half
half-century.

Semiconductors present an outstanding example of this trend. Many of the most important early
developments in electronics – transistors, integrated circuits, and semiconductors – took place at U.S.
companies such as Bell Labs and Fairchild Semiconductor. In 1990, the U.S. and Europe were
responsible for over 80% of global semiconductor production. By 2020, their share was estimated to be
only around 20% (data from Boston Consulting Group and the Semiconductor Industry Association).
Taiwan (led by Taiwan Semiconductor Manufacturing Company (TSMC)) and South Korea (essentially
Samsung) have taken the place of the U.S. and Europe as the largest producers of semiconductors.
Today, “TSMC and Samsung are the only companies capable of producing today’s most advanced 5-
nanometer chips that go into iPhones.” (Visual Capitalist) The upshot is well known:

While pandemic-induced shutdowns have hampered supply, the demand for chips has
continued surging with reopening economies. The resulting chip shortage has rattled

5
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 several industries with lead times – the gap between when a semiconductor is ordered and
when it is delivered is at a record high of 22 weeks.

The chip shortage is a boon to semiconductor companies, but downstream firms are
struggling. Global automakers are set to make 7.7 million fewer cars in 2021, which
translates into a $210 billion hit to their revenues. Consumer electronics have taken a
blow as well, with popular products like the PlayStation 5 console in short supply.
(Visual Capitalist)

The Common Thread

So, what’s the connection? U.S. companies’ foreign sourcing, in particular with regard to
semiconductors, differs from Europe’s energy emergency in many ways. But both are marked by
inadequate supply of an essential good demanded by countries or companies that permitted
themselves to become reliant on others. And considering
sidering how critical electronics are to U.S.
national security – what today in terms of surveillance, communications, analysis and
transportation isn’t reliant on electronics? – this vulnerability could, at some point, come back to
bite the U.S. in the same way that dependence on Russian energy resources has the European
Union.

How did the world get into this position? How did Europe become so dependent on Russian exports of
energy commodities, and how did such a high percentage of semiconductors and oth other goods destined for
the U.S. come to be manufactured abroad? Just ust as Europe allowed its energy dependence to increase due
to its desire to be more green, U.S. businesses came to rely increasingly on materials, components, and
finished goods from abroad to remain price-competitive
competitive and deliver greater profits.

Key geopolitical developments in recent decades included (a) the perception that the world was shrinking,
due to improvements in transportation and communications, and (b) the relative peace of the world,
stemming from:

the dismantling of the Berlin Wall;

the fall of the USSR;
the low perceived threat from nuclear arms (thanks to the realization that their use would assure
mutual destruction);
the absence of conflicts that could escalate into a multi-national war; and
the shortness of memory, which permits people to believe benign conditions will remain so.

Together, these developments gave rise to a huge swing of the pendulum toward globalization and
thus countries’ interdependence. Companies and countries found that massive benefits could be
tapped by looking abroad for solutions, and it was easy to overlook or minimize potential pitfalls.

As a result, in recent decades, countries and companies have been able to opt for what seemed to be the
cheapest and easiest solutions, and perhaps the greenest. Thus, the choices made included reliance on
distant sources of supply and just-in-time ordering.

(As an aside, I acknowledge that in countries with less-well-developed economies, environmental

protection, high safety and labor standards, and green behavior may sometimes be considered
unaffordable luxuries. Thus offshoring may allow companies to engage in practices that wouldn’t be
acceptable at home – low-cost manufacturing based on burning coal is a good example. In this way,

6
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
offshoring may help a company’s or even a country’s domestic profile while being bad for the world as a
whole.)

As I’ve written in the past, economics is the science of choice (the same seems true of geopolitics,
although there’s even less science regarding that realm.) Few options in these fields offer only
positives and no negatives. Most entail tradeoffs. However, the negatives often become apparent
“only when the tide goes out,” as they have recently. The invasion of Ukraine has shown that Europe’s
importation of oil and gas from Russia has left it vulnerable to a hostile, unprincipled nation (worse in this
case – to such an individual) at the same time that winding down nuclear power generation has increased
the region’s need for imported oil and gas. The practice of offshore procurement similarly makes
countries and companies dependent on their positive relations with foreign nations and the efficacy of our
transportation system.

The recognition of these negative aspects of globalization has now caused the pendulum to swing
back toward local sourcing. Rather than the cheapest, easiest and greenest sources, there’ll
there probably be
more of a premium put on the safest and surest. For example, both U.S. and non- non-U.S.
non -U.S. companies have
announced that they intend to build new foundries to produce semiconductors in the U.S. And I imagine
many U.S. importers of materials,
terials, components and finished goods are looking for sources closer to home.
Similarly, it’s now less likely that Germany will follow through on its plan to turn off its three remaining
nuclear reactors on December 31 and more likely that it will reactivate
reactivate the three it retired at the end of
2021 (and perhaps, with the rest of Europe, recalibrate the balance between energy imports and domestic
energy production).

If the pendulum continues to move for a while in the direction I foresee, there will be ram
ramifications for
investors. Globalization has been a boon for worldwide GDP, the nations whose economies it has lifted,
and the companies that reduced costs by buying abroad. The swing away will be less favorable in those
regards, but it may (a) improve importers’ security, (b) increase the competitiveness of onshore producers
and the number of domestic manufacturing jobs, and (c) create investment opportunities in the transition.

For how long will the pendulum swing away from globalization and toward onshoring? The answer
depends in part on how the current situations are resolved and in part on which force wins: the need for
dependability and security or the desire for cheap sourcing.

* * *

In complex fields like economics and geopolitics, there are few easy decisions – just choices, many of
them very difficult. There are too many moving parts, too many unknowns, and too many pros and cons
whose merits can’t be weighed quantitatively. What sits on either side of the scale doesn’t necessarily
change much, but the pendulum swings radically in terms of how those things are viewed and weighted in
the decision.

Here’s what I wrote in On Regulation concerning the swing of the pendulum toward and away from
regulation of the financial markets:

It’s my belief that because both free markets and regulation are imperfect – and because
of the strength of people’s political and philosophical biases – we will never settle
permanently on either a completely free market or a thoroughly regulated system. Any
position will prove merely temporary, and the pendulum will continue to swing toward
one end of the spectrum and then back toward the other.

7
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
If you substitute the words “offshoring” and “domestic sourcing” for “free markets” and “regulation,”
then this passage just as accurately describes the choice between the cheapest sourcing and the most
secure sourcing. This absence of perfect, permanent solutions is characteristic of pendulums – it’s
why they swing. And after many decades of globalization and cost minimization, I think we’re about to
find investment opportunities in the swing toward reliable supply.

March 23, 2022

8
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
 Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to
change without notice. Oaktree has no duty or obligation to update the information contained herein.
Further, Oaktree makes no representation, and it should not be assumed, that past investment
performance is an indication of future results. Moreover, wherever there is the potential for profit there
is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any
other purpose. The information contained herein does not constitute and should not be construed as an
offering of advisory services or an offer to sell or solicitation to buy any securities or related financial
instruments in any jurisdiction. Certain information contained herein concerning economic trends and
performance is based on or derived from information provided by independent third-party sources.
Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources from which such information
has been obtained are reliable; however,
wever, it cannot guarantee the accuracy of such information and has
not independently verified the accuracy or completeness of such information or the assumptions on which
such information is based.

This memorandum, including the information contained herein,

erein, may not be copied, reproduced,
republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.

9
© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
Memo to: Oaktree Clients

From: Howard Marks

Re: Selling Out

As I’m now in my fourth decade of memo writing, I’m sometimes tempted to conclude I should quit,
because I’ve covered all the relevant topics. Then a new idea for a memo pops up, delivering a pleasant
surprise. My January 2021 memo Something of Value, which chronicled the time I spent in 2020 living
and discussing investing with my son Andrew, recounted a semi-real conversation in which we briefly
discussed whether and when to sell appreciated assets. It occurred to me that even though selling is an
inescapable part of the investment process, I’ve never devoted an entire memo to it.
it

The Basic Idea

Everyone is familiar with the old saw that’s supposed to capture investing’s
investing basic proposition: “buy
low, sell high.” It’s a hackneyed caricature of the way most people view investing
investing. But few things that
are important can be distilled into just four words; thus, “buy
buy low, sell high”
high is nothing but a starting point
for discussion of a very complex process.

Will Rogers, an American film star and humorist of the 1920s

19 and ’30s, provided what he may have
thought was a more comprehensive roadmap for success in the pursuit of wealth:

Don’tt gamble; take all your savings and buy some good stock and hold it till it goes up,
then sell it. If it don’t go up, don’tt buy it.

The illogicality of his advice makes clear how simplistic this adage – like many others – really is.
However, regardless
egardless of the details, people may unquestioningly accept that they should sell appreciated
investments. But how helpful is that basic concept?

Origins

Much of what I’llll write here got its start in a 2015

201 memo called Liquidity. The hot topic in the investment
world at that moment was the concern about a perceived decline in the liquidity provided by the market
(when I say “the market,” I’m talking specifically about the U.S. stock market, but the statement has
broad applicability). This was commonly attributed to a combination of (a) the licking investment banks
had taken in the Global Financial Crisis of 2008-09 and (b) the Volcker Rule, which prohibited risky
activities such as proprietary trading on the part of systemically important financial institutions. The
latter constrained banks’ ability to “position” securities, or buy them, when clients wanted to sell.

Maybe liquidity in 2015 was less than it had previously been, and maybe it wasn’t. However, looking
beyond the events of the day, I closed that memo by stating my conviction that (a) most investors trade
too much, to their own detriment, and (b) the best solution for illiquidity is to build portfolios for the long
term that don’t rely on liquidity for success. Long-term investors have an advantage over those with short
timeframes (and I think the latter describes the majority of market participants these days). Patient

© 2022 Oaktree Capital Management, L.P. All Rights Reserved

Follow us:
investors are able to ignore short-term performance, hold for the long run, and avoid excessive trading
costs, while everyone else worries about what’s going to happen in the next month or quarter and
therefore trades excessively. In addition, long-term investors can take advantage if illiquid assets become
available for purchase at bargain prices.

Like so many things in investing, however, just holding is easier said than done. Too many people equate
activity with adding value. Here’s how I summed up this idea in Liquidity, inspired by something
Andrew had said:

When you find an investment with the potential to compound over a long period, one of
the hardest things is to be patient and maintain your position as long as doing so is
warranted based on the prospective return and risk. Investors can easily be moved to sell
by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of
a new, seemingly more promising idea. When you look at the chart for something
that’ss gone up and to the right for 20 years, think about all the times a holder
holde would
have had to convince himself not to sell.

Everyone wishes they’d bought Amazon at $5 on the first day of 1998,, since it’s now up 660x at $3,304.

But who would have continued to hold when the stock hit $85 in 1999 – up 17x in less than two
years?
Who among those who held on would have been able to avoid panicking in 2001, as the price fell
93%, to $6?
And who wouldn’t have sold by late 2015 when it hit $600
$ – up 100x from the 2001 low? Yet
anyone who sold at $600 captured only the first 18%
1 of the overall rise from that low.

This reminds me of the time I once visited Malibu with a friend and mentioned that the Rindge family is
said to have bought the entire area – all 13,330 acres – in 1892 for $300,000, or $22.50 per acre. (It’s
clearly worth many billions today.) My friend said, “I’d like to have bought all of Malibu for $300,000.”
My response was simple: “you
you would have sold it when it got to $600,000.”

The more I’ve thought about it since writing Liquidity, the more convinced I’ve become that there
are two main reasons why people sell investments
investments: because they’re up and because they’re down.
You may say that sounds nutty, but what
what’s really nutty is many investors’ behavior.

Selling Because It’ss Up

“Profit-taking” is the intelligent-sounding term in our business for selling things that have appreciated.
To understand why people engage in it, you need insight into human behavior, because a lot of investors’
selling is motivated by psychology.

In short, a good deal of selling takes place because people like the fact that their assets show gains,
and they’re afraid the profits will go away. Most people invest a lot of time and effort trying to avoid
unpleasant feelings like regret and embarrassment. What could cause an investor more self-recrimination
than watching a big gain evaporate? And what about the professional investor who reports a big winner
to clients one quarter and then has to explain why the holding is at or below cost the next? It’s only
human to want to realize profits to avoid these outcomes.

© 2022 Oaktree Capital Management, L.P. 2 All Rights Reserved

Follow us:
If you sell an appreciated asset, that puts the gain “in the books,” and it can never be reversed. Thus,
some people consider selling winners extremely desirable – they love realized gains. In fact, at a meeting
of a non-profit’s investment committee, a member suggested that they should be leery of increasing
endowment spending in response to gains because those gains were unrealized. I was quick to point out
that it’s usually a mistake to view realized gains as less transient than unrealized ones (assuming there’s
no reason to doubt the veracity of the unrealized carrying values). Yes, the former have been made
concrete. However, sales proceeds are generally reinvested, meaning the profits – and the principal – are
put back at risk. One might argue that appreciated securities are more vulnerable to declines than new
investments in assets currently deemed to be attractively priced, but that’s far from a certainty.

I’m not saying investors shouldn’t sell appreciated assets and realize profits. But it certainly doesn’t
make sense to sell things just because they’re up.

Selling Because It’s Down

As wrong as it is to sell appreciated assets solely to crystalize gains, it’s

’s even worse to sell them just
because they’re down. Nevertheless, I’m sure many people do it.

While the rule is “buy low, sell high,” clearly many people become more motivated to sell assets the more
they decline. In fact, just as continued buying of appreciated assets can eventually turn a bull
market into a bubble, widespread selling of things that are down has the potential to turn market
declines into crashes. Bubbles and crashes do occur, proving that investors contribute to excesses
in both directions.

In a movie that plays in my head, the typical investor buys something at $100. If it goes to $120, he says,
“I think I’m onto something – I should add,” and if it reaches $150, he says, “Now I’m highly confident –
I’m going to double up.” On the other hand, if it falls to $90, he says, “I’m going to think about
increasing my position to reduce my average costcost,”” but at $75, he concludes he should reconfirm his
thesis before averaging down further. At $50, he says, “I’d better wait for the dust to settle before buying
more.” And at $20 he says, “Itt feels like it’s going to zero; get me out!”

Just like those who are afraid of surrendering gains, many investors worry about letting losses
compound. They might fear their clients will say (or they’ll say to themselves), “What kind of a lame-
brain continues to hold a security after it
it’s gone from $100 to $50? Everyone knows a decline like that
can foreshadow further decline
declines. And look – it happened.”

Do investors really make behavioral errors such as those I’ve described? There’s plenty of anecdotal
evidence. For example, studies have shown that the average mutual fund investor performs worse than
the average mutual fund. How can that be? If she merely held her positions, or if her errors were
unsystematic, the average fund investor would, by definition, fare the same as the average fund. For the
studies’ findings to occur, investors have to on balance reduce the amount of capital they have in funds
that subsequently do better and increase their allocation to funds that go on to do worse. Let me put that
another way: on average, mutual fund investors tend to sell the funds with the worst recent performance
(missing out on their potential recoveries) in order to chase the funds that have done the best (and thus
likely participate in their return to earth).

We know that “retail investors” tend to be trend-followers, as described above, and their long-term
performance often suffers as a result. What about the pros? Here the evidence is even clearer: the

© 2022 Oaktree Capital Management, L.P. 3 All Rights Reserved

Follow us:
powerful shift in recent decades toward indexing and other forms of passive investing has taken place for
the simple reason that active investment decisions are so often wrong. Of course, many forms of error
contribute to this reality. Whatever the reason, however, we have to conclude that, on average, active
professional investors held more of the things that did less well and less of the things that outperformed,
and/or that they bought too much at elevated prices and sold too much at depressed prices. Passive
investing hasn’t grown to cover the majority of U.S. equity mutual fund capital because passive results
have been so good; I think it’s because active management has been so bad.

Back when I worked at First National City Bank 50 years ago, prospective clients used to ask, “What kind
of return do you think you can make in an equity portfolio?” The standard answer was 12%. Why?
“Well,” we said (so simplistically), “the stock market returns about 10% a year. A little effort should
enable us to improve on that by at least 20%.” Of course, as time has shown, there’s no truth in that. “A
little effort” didn’t add anything. In fact, in most cases, active investing detracted: most equity funds
failed to keep up with the indices, especially after fees.

What about the ultimate proof? The essential ingredient in Oaktree’ss investments in distressed debt –
bargain purchases – has emanated from the great opportunities sellers gave us. Negativity reaches a
crescendo during economic and market crises, causing many investors to become depressed or fearful and
sell in panic. Results like those we target in distressed debt can only be achieved when holders sell to us
at irrationally low prices.

Superior investing consists largely of taking advantage of mistakes made by others. Clearly, selling
things because they’re down is a mistake that can give the buyers great opportunities.
opportunitie

When Should Investors Sell?

If you shouldn’t sell things because they’rere up,

up and you shouldn’t
shouldn sell because they’re down, is it ever
right to sell? As I previously mentioned,
mentioned I describ
described
ed the discussions that took place while Andrew and his
family lived with Nancy and me in 2020 in Something of ValueValue. That experience truly was of great value
– an unexpected silver lining to the pandemic
pandemic. That memo evoked the strongest reaction from readers of
any of my memos to date. This is response
response was probably attributable to (a) the content, which mostly
related to value investing; (b) the personal insights provided, and especially my confession regarding my
need to grow with the times;
times; or (c) the recreated conversation that I included as an appendix. The last of
these went like this, in part
part:

Howard: Hey, I see XYZ is up xx% this year and selling at a p/e ratio of xx. Are you
tempted to take some profits?

Andrew: Dad, I’ve told you I’m not a seller. Why would I sell?

H: Well, you might sell some here because (a) you’re up so much; (b) you want to put
some of the gain “in the books” to make sure you don’t give it all back; and (c) at that
valuation, it might be overvalued and precarious. And, of course, (d) no one ever went
broke taking a profit.

A: Yeah, but on the other hand, (a) I’m a long-term investor, and I don’t think of shares
as pieces of paper to trade, but as part ownership in a business; (b) the company still has
enormous potential; and (c) I can live with a short-term downward fluctuation, the threat

© 2022 Oaktree Capital Management, L.P. 4 All Rights Reserved

Follow us:
 of which is part of what creates opportunities in stocks to begin with. Ultimately, it’s
only the long term that matters. (There’s a lot of “a-b-c” in our house. I wonder where
Andrew got that.)

H: But if it’s potentially overvalued in the short term, shouldn’t you trim your holding
and pocket some of the gain? Then if it goes down, (a) you’ve limited your regret and (b)
you can buy in lower.

A: If I owned a stake in a private company with enormous potential, strong momentum

and great management, I would never sell part of it just because someone offered me a
full price. Great compounders are extremely hard to find, so it’s usually a mistake to let
them go. Also, I think it’s much more straightforward to predict the long-term outcome
for a company than short-term price movements, and it doesn’t make sense to trade off a
decision in an area of high conviction for one about which you’re
re limited to low
conviction. . . .

H: Isn’t there any point where you’d begin to sell?

A: In theory there is, but it largely depends on (a) whether the fundamentals are playing
out as I hope and (b) how this opportunity compares to the others that are available,
taking into account my high level of comfort with this one.

Aphorisms like “no one ever went broke taking a profit”” may be relevant to people who invest part-time
part
for themselves, but they should have no place in professional investing. There certainly are good
reasons for selling, but they have nothing to do with the fear of making mistakes, experiencing
regret and looking bad. Rather, these reasons should be based on the outlook for the investment – not
the psyche of the investor – and they have to be identified through hardheaded financial analysis, rigor
and discipline.

Stanford University professor Sidney

ney Cottle was the editor of the later versions of Benjamin Graham and
David L. Dodd’s Security Analysis,
Analysis, “the
the bible of value investing,”
investing, including the edition I read at Wharton
56 years ago. For that reason, I knew the book as “Graham, Dodd and Cottle.” Sid was a consultant to
the investment department at First National City Bank in the 1970s, and I’ve never forgotten his
description of investing: “the
the discipline of relative selection.”
selection. In other words, most of the portfolio
decisions investors make are relative choices.

It’ss patently clear that relative considerations should play an enormous pa

part in any decision to sell existing
holdings.

If your investment thesis seems less valid than it did previously and/or the probability that it will
prove accurate has declined, selling some or all of the holding is probably appropriate.
Likewise, if another investment comes along that appears to have more promise – to offer a
superior risk-adjusted prospective return – it’s reasonable to reduce or eliminate existing holdings
to make room for it.

Selling an asset is a decision that must not be considered in isolation. Cottle’s concept of “relative
selection” highlights the fact that every sale results in proceeds. What will you do with them? Do you
have something in mind that you think might produce a superior return? What might you miss by
switching to the new investment? And what will you give up if you continue to hold the asset in your

© 2022 Oaktree Capital Management, L.P. 5 All Rights Reserved

Follow us:
portfolio rather than making the change? Or perhaps you don’t plan to reinvest the proceeds. In that
case, what’s the likelihood that holding the proceeds in cash will make you better off than you would
have been if you had held onto the thing you sold? Questions like these relate to the concept of
“opportunity cost,” one of the most important ideas in financial decision-making.

Switching gears, what about the idea of selling because you think a temporary dip lies ahead that will
affect one of your holdings or the whole market? There are real problems with this approach:

Why sell something you think has a positive long-term future to prepare for a dip you expect to
be temporary?
Doing so introduces one more way to be wrong (of which there are so many), since the decline
might not occur.
Charlie Munger, vice chairman of Berkshire Hathaway, points out that selling for market-timing
purposes actually gives an investor two ways to be wrong: the decline may or may not occur, and
if it does, you’ll have to figure out when the time is right to go back in.
Or maybe it’s three ways, because once you sell, you also have to decide what to do with the
proceeds while you wait until the dip occurs and the time comes to get back in.
People who avoid declines by selling too often may revel in their brilliance and fail to reinstate
their positions at the resulting lows. Thus, even sellers who were right can fail to accomplish
anything of lasting value.
Lastly, what if you’re wrong and there is no dip? In that case,
case you’ll miss out on the ensuing
gains and either never get back in or do so at higher prices.

So it’s generally not a good idea to sell for purposes of market timing.
timing There are very few occasions to
do so profitably and very few people who possess the skill needed to take advantage of these
opportunities.

Before I close on this subject, it’ss important to note that decisions to sell aren’t
aren always within an
investment manager’s control. Clients can withdraw capital from accounts and fund funds, necessitating sales,
and the limited lifespan of closed-endend funds can require managers to liquidate holdings even though
they’re not ripe for selling. The choice of what to sell under these conditions can still be based on a
manager’s expectations regarding future returns, but deciding
deci not to sell isn’t among the manager’s
choices.

How Much Iss Too Much to Hold

Hold?

Certainly there are times when it’s right to sell one asset in favor of another based on the idea of relative
selection. But we mustn’t do this in a mechanical manner. If we did, at the logical extreme, we would
put all of our capital into the one investment we consider the best.

Virtually all investors – even the best – diversify their portfolios. We may have a sense for which holding
is the absolute best, but I’ve never heard of an investor with a one-asset portfolio. They may
overweight favorites to take advantage of what they think they know, but they still diversify to
protect against what they don’t know. That means they sub-optimize, potentially trading off some of
their chance at a maximal return to increase the likelihood of a merely excellent one.

© 2022 Oaktree Capital Management, L.P. 6 All Rights Reserved

Follow us:
Here’s a related question from my reconstructed conversation with Andrew:

H: You run a concentrated portfolio. XYZ was a big position when you invested, and it’s
even bigger today, given the appreciation. Intelligent investors concentrate portfolios and
hold on to take advantage of what they know, but they diversify holdings and sell as
things rise to limit the potential damage from what they don’t know. Hasn’t the growth
in this position put our portfolio out of whack in that regard?

A: Perhaps that’s true, depending on your goals. But trimming would mean selling
something I feel immense comfort with based on my bottom-up assessment and moving
into something I feel less good about or know less well (or cash). To me, it’s far better to
own a small number of things about which I feel strongly. I’ll only have a few good
insights over my lifetime, so I have to maximize the few I have.

All professional investors want good investment performance for their clients, but they alalso want
financial success for themselves.. And amateurs have to invest within the limits of their risk tolerance.
For these reasons, most investors – and certainly most investment managers’ clients – aren’t immune to
apprehension regarding portfolio concentration and thus susceptibility to untoward
un developments. These
considerations introduce valid reasons for limiting the size of individual asset purchases and trimming
positions as they appreciate.

Investors sometimes delegate the decision on how to weight assets in portfolios to a process called
portfolio optimization. Inputs regarding asset classes’ return potential, risk and correlation are fed into a
computer model, and out comes the portfolio with the optimal expected risk-adjusted return. If an asset
appreciates relative to the others, the model can be rerun
rerun, and it will tell you what to buy and sell. The
main problem with these models lies in the fact that all the data we have regarding those three parameters
relates to the past, but to arrive at the ideal portfolio, the model needs data that accurately describes the
future. Further, the models need a numericalerical input for risk, and I absolutely insist that no single number
can fully describe an asset’ss risk. Thus,, optimization
optimization models can’t successfully dictate portfolio actions.

The bottom line:

we should base our invest

investment
ment decisions on our estimates of each asset’s potential,
we shouldn’tt sell just because the price has risen and the position has swelled,
swelled
there can be legitimate reasons to limit the size of the positions we hold,
but there’ss no way to scientifically calculate what those limits should be.

In other words, the decision to trim positions or to sell out entirely comes down to judgment . . . like
everything else that matters in investing.

The Final Word on Selling

Most investors try to add value by over- and underweighting specific assets and/or through well-timed
buying and selling. While few have demonstrated the ability to consistently do these things correctly (see
my comments on active management on page 4), everyone’s free to have a go at it. There is, however, a
big “but.”

© 2022 Oaktree Capital Management, L.P. 7 All Rights Reserved

Follow us:
What’s clear to me is that simply being invested is by far “the most important thing.” (Someone
should write a book with that title!) Most actively managed portfolios won’t outperform the market as a
result of manipulation of portfolio weightings or buying and selling for purposes of market timing. You
can try to add to returns by engaging in such machinations, but these actions are unlikely to work
at best and can get in the way at worst.

Most economies and corporations benefit from positive underlying secular trends, and thus most
securities markets rise in most years and certainly over long periods. One of the longest-running U.S.
equity indices, the S&P 500, has produced an estimated compound average return over the last 90 years
of 10.5% per year. That’s startling performance. It means $1 invested in the S&P 500 90 years ago
would have grown to roughly $8,000 today.

Many people have remarked on the wonders of compounding. For example, Albert Einstein reportedly
called compound interest “the eighth wonder of the world.” If $1 could be invested today at the historic
compound return of 10.5% per year, it would grow to $147 in 50 years. One might argue that economic
growth will be slower in the years ahead than it was in the past, or that bargain stocks
stock were easier to find
in previous periods than they are today. Nevertheless, even if it compounds at just 7%, $1 invested today
will grow to over $29 in 50 years. Thus, someone entering adulthood today is practically guaranteed
to be well fixed by the time they retire if they merely start investing
invest promptly and avoid tampering
with the process by trading.

I like the way Bill Miller, one of the great investors of our time, put it in his 3Q 2021 Market Letter:

In the post-war
war period the US stock market has gone up in around 70% of the years . . .
Odds much less favorable than that have made casino owners very rich, yet most
investors
nvestors try to guess the 30% of the time stocks decline, or even worse spend time trying
to surf, to no avail, the quarterly up and down waves in the market. Most of the returns in
stocks are concentrated in sharp bursts beginning in periods of great pes
pessimism or fear, as
we saw most recently in the 2020 pandemic decline. We believe time, not timing, is the
key to building wealth in the stock market. (October 18, 2021. Emphasis added)

What are the “sharp bursts” Miller talks about? On April 11, 2019, The Motley Fool cited data from JP
Morgan Asset Management’ss 2019 Retirement Guide showing that in the 20-year period between 1999
and 2018, the annual return on the S&P 500 was 5.6%, but your return would only have been 2.0% if you
had sat out the 10 best days (or roughly 0.4% of the trading days), and you wouldn’t have made any
money at all if you had missed the 20 best days. In the past, returns have often been similarly
concentrated in a small number of days. Nevertheless, overactive investors continue to jump in and out of
the market, incurring transactions costs and capital gains taxes and running the risk of missing those
“sharp bursts.”

As mentioned earlier, investors often engage in selling because they believe a decline is imminent and
they have the ability to avoid it. The truth, however, is that buying or holding – even at elevated prices –
and experiencing a decline is in itself far from fatal. Usually, every market high is followed by a higher
one and, after all, only the long-term return matters. Reducing market exposure through ill-conceived
selling – and thus failing to participate fully in the markets’ positive long-term trend – is a cardinal
sin in investing. That’s even more true of selling without reason things that have fallen, turning
negative fluctuations into permanent losses and missing out on the miracle of long-term
compounding.

© 2022 Oaktree Capital Management, L.P. 8 All Rights Reserved

Follow us:
 * * *

When I meet people for the first time and they find out I’m in the investment business, they often ask
(especially in Europe) “what do you trade?” That question makes me bristle. To me, “trading” means
jumping in and out of individual assets and whole markets on the basis of guesswork as to what prices
will do in the next hour, day, month or quarter. We don’t engage in such activity at Oaktree, and few
people have demonstrated the ability to do it well.

Rather than traders, we consider ourselves investors. In my view, investing means committing capital
to assets based on well-reasoned estimates of their potential and benefitting from the results over
the long term. Oaktree does employ people called traders, but their job consists of implementing long-
term investment decisions made by portfolio managers based on assets’ fundamentals. No one at Oaktree
believes they can make money or advance their career by selling now and buying back after an
intervening decline, as opposed to holding for years and letting value lift prices if fundamental
expectations prove out.

When Oaktree was formed in 1995, the five founders – who at that point had worked together for nine
years on average – established an investment philosophy based on what wewe’d successfully done in that
time. One of the six tenets expressed our view on trying to time markets when buying and selling:

Because we do not believe in the predictive ability required to correctly time markets, we
keep portfolios fully invested whenever attractively priced assets can be bought. Concern
about the market climate may cause us to tilt toward more defensive investments
investments,
increase selectivityty or act more deliberately, but we never move to raise cash. Clients
hire uss to invest in specific market niches, and we must never fail to do our job. Holding
investments that decline in price is unpleasant, but missing out on returns because we
failed to buy what we were hired to buy is inexcusable.

We’ve
ve never changed any of the six tenets of our investment philosophy – including this one – and we
have no plans to do so.

January 13, 2022

© 2022 Oaktree Capital Management, L.P. 9 All Rights Reserved

Follow us: