Understanding Financial Markets and Changes

It's clearly worrisome. If it's the change I think it is, then what you should have in your portfolio going forward can be very different from what it has been. What I say is we never know where we're going, but we sure as hell ought to know where we are. And if we can be analytical about what's going on in the markets today, that has implications for tomorrow. Remember, in 1980, the Fed funds rate was 20, and I had a loan outstanding from a bank at 22 and a quarter. Forty years later, the Fed funds rate was zero. and I had a loan outstanding from a bank at two and a quarter. So the decline of interest rates by 20 percentage points over that period was a dominant factor in the financial world. I think it was the most important single event in the financial world in the last 50 years. It doesn't get the credit. In the period 2009 through 2013, the Fed took Fed funds rate to zero to fight the global financial crisis, left it there a long time, and didn't have any luck getting it back up into what you might think are normal ranges. So we had a low interest rate environment, which made life very easy for borrowers, asset owners. It was easy to run a business. The economy did well. We had the longest bull market in history, the longest economic recovery in history. We had very low incidence of default and bankruptcy. It was an easy world. If you read articles about, for example, Silicon Valley Bank, they talk about the easy money environment. And the main point of sea change is we're no longer in an easy money environment. It's clearly worrisome. There's never been a bankruptcy of the U.S., a country like it, so we don't know what's going to happen. Right now, the U.S. dollar is what's called the reserve currency of the world, and we get to print them. And we can print, in the short run, we can print as many as we want. And as long as that's the case, we're not going to go under. It's like if you have an unlimited checking account, you can pay your credit card bills without limitation. We just don't know where it's going. That's the problem. And people... This business about using a default as a negotiating tool is very, very dangerous. It's the golden goose. We have this reserve currency status because the dollar is the safest currency in the world and the U.S. economy is the best. There is a part in Sea Change where I talk about the fact that a guy says, oh, we can buy this company and make 10% a year. Then he turns to his capital markets person and says, what will it cost to get the money? We can borrow at eight. Borrow at 8, invest at 10, great, we do it. You buy the company, but in these stimulated environment of low interest rates, the company does better, you make more than 10. Your cost of money declines from 8 to 6 to 5, and it costs you less to borrow the money, and you say, boy, I'm a genius. I think that rates are likely to be between 2 and 4, not between 0 and 2, the Fed funds rate. And between 0 and 2 is an emergency measure. The Fed funds rate was zero probably the majority of the time in the 2009 to 2021 period. And that's inappropriate. It stimulates. You can't live on a shot of adrenaline every morning for 13 years. And it does subsidize borrowers and penalize lenders and savers. And I would like to see a Fed get to a neutral position, which is neither stimulative nor restrictive. And I'd describe that as two to four. If inflation's two, then... The Fed funds rate should be higher than that so that there's a positive real Fed funds rate. If you came into this business since 1980, which is almost everybody, you have only seen declining interest rates or ultra low interest rates. People tend to say, well, that's what it's been for 40 years. That's normal. That's what it's going to be. But no, you have to recognize that's why I call this sea change, because you have to recognize this is an important pivot. Some people come up to me and say, yes, you're right. Interest rates are low. Nobody has said this is a major change as you say it is, but if it's the change I think it is, then what you should have in your portfolio going forward can be very different from what it has been. And so far I have not had resounding support for that position. You know the S&P has returned 10% a year plus, just a little over 10, for a hundred years. That was enough to turn a dollar in 1920 into fifteen thousand dollars. That's a good rate of return. Today, you can get equity-type returns from what we call credit instruments. Loans, corporate loans, loans for buyouts. You can get high single digits on high-yield bonds and leveraged loans, public instruments that are tradable and liquid, or low double digits on private loans for buyouts. The best buyouts, the biggest buyouts, double-digit returns. Isn't that enough? And returns on credit instruments are much safer. Then equity. Equity just gets the residual. After everybody gets paid, they get what's left. Credit gets paid early in the process, and if people don't pay you, you get the company, because they go bankrupt. So it's quite safe and returns that are fully competitive with equities with a good level of safety. This period of 09 through 21, easy period, easy to get money. Most bankruptcies don't occur because you have a business and it loses money, loses money, loses money, goes away. It occurs because a business borrows money. Times get tough and when it goes to refinance that loan, nobody ever repays their debts. They just... refinance it and when they go to the bank to refinance it the bank says you're not as good a credit as you used to be or we don't have as much money to lend as we used to have or our standards are higher so it really comes from most bankruptcies or defaults are associated with a maturity which is unmet and when you go through a period when it's super easy to raise money for any purpose or no purpose and you go into a period when it's difficult to raise money even for a good purpose clearly many more companies are going to founder. The long-term average default rate on high-yield bonds, for example, is close to 4% for the last, I guess I've been in 45 years. We didn't have any years in the last 15 at 4%. It was a very low period. In the coming years, there will be some. The way I sum it up, You found a company to buy, you went to the bank, they said we'll lend you $800 million at 5%. Now the loan is up for renewal, you go in, they say fine, we'll lend you $500 million at 8%. So you have less money and your cost of capital is higher, and you have a $300 million hole that you can't fill. I do think that today's Fed funds rate is a restrictive measure designed to cool off the economy and inflation, and when the inflation abates, as it seems to be in the process, I think that the Fed funds rate will settle out lower than it is today. And do you think the federal government, including the Fed and the White House and Treasury, made a mistake and not recognized that inflation was coming along and it wasn't transitory? Was that a mistake, you think? It has to do with the definition of the word transitory. It is transitory, just not as transitory as they thought. We don't get in and out of the market. We don't defer bargain purchases because we think we know what the future is going to hold in terms of market action. But we do vary our aggressiveness and we've done it. a few times in a big way over the course of my career. Just to give you some examples, late 04, early 05, we were very worried about the market. So we went defensive, sold a lot of assets, shrunk funds, liquidated funds, raised the bar for new investments. September 08, Lehman Brothers goes bankrupt. Everybody thought the world was going to end and the financial system was going to melt down. We turned extremely aggressive and we invested, I think, 650 million a week on average for the next 15 weeks. That's $10 billion. Wow. And obviously that was a good decision. Let's see, 2012, from 2000 to 2012, if you invested in the S&P 500, you made no money. Zero return, as I recall. So I came out with the memo called Deja Vu All Over Again, I think it was called. And I said, you know, back in 79, most of your viewers may not remember, but Businessweek ran an article, The Death of Equities. And basically what it said is equities have done so badly that nobody will ever buy them. Which makes absolutely no sense. If they've done badly, that means they must be cheap and people should buy them. And that was the same condition in 2012 and I wrote deja vu all over again. The point is, we do vary our degree of aggressiveness and defensiveness, we vary our degree of fundraising, how much money we should have under management. Clearly, when the opportunities are better, we should have more money. When the opportunities are less good, we should have less. And I think that's an important thing to distinguish, is that we're willing to have less when it's appropriate. Today, I'm in a fairly normal posture, except increasing my aggressiveness. I think that the conditions for the bargain hunter, for the lender, for the asset buyer today are better than they have been since the global financial crisis, which ended in 2008. We've been tough times for the bargain hunter for the last 14 years. I think we're in a better situation today. So I would increase my level of aggressiveness. In investing, there are two basic approaches. One is called top-down, where you say, well, what's the economy going to do? What are rates going to do? Which sectors of the economy will do best? Which industries will do best? Let's find some companies. That's one way to do it, top-down or strategic. The other way to do it is bottom-up. What's cheapest today? And that's more opportunistic, less strategic. And really, that's the way we operate. So when we go out into the marketplace, we just say, what's cheap today? It's kind of like, you know... You're a shopper and you have a Saturday off. You just say, well, where are the sales? And we like to buy the things that are on markdown. Last 14 years were really quite idyllic in the economy and in the market. We had the longest bull market in history, the longest economic recovery in history. We set a lot of records in many ways. Living was easy. Interest rates were low. Companies can get all the money they wanted. Very few defaults or bankruptcies, easy times. I don't believe in forecasts, especially my own. Oak Tree, as I mentioned, does not invest according to forecasts, but in general, we think that the living will be a little less easy in the months and years to come. So I think, you know, for us, the big question is, is it gonna be easy times like the last 14 years or more back to normal? I'm not calling for a cataclysm, but I'm just calling for a more normal world where interest rates are higher, it costs more money to borrow. It's not so easy to borrow. Bad companies can't borrow. Bad companies can default. Bad companies can go bankrupt. It's a little more of a struggle. This is not unusual. This is the norm. The last 14 years have been the unusual time. The Fed has been highly stimulative for the last 14 years, kept rates low to keep the economy going. I think it's going to be less stimulative in the period ahead. I don't think it can do it forever. What I would say is this. Investing is a fascinating field because... There are so many variables that have to be juggled and so many uncertainties that have to be dealt with. It's stimulating. The solutions are never static. Yesterday's solution will not work tomorrow. It keeps you on your toes. On the other hand, because of the imprecision, you fail a lot. And Warren Buffett always talks about Ted Williams who batted 400. That means 60% of the time he was out at the plate. The great investors are right 60%, 70%, maybe 80% of the time. If you're the kind of person who has to be right all the time, you shouldn't be in investing. So if somebody said to you, what is the most common investment mistake that the average person makes, what would you say? Can I do two? Sure. Number one is that people believe in the ability to predict the future. Either their ability or others that they can identify. And in general, I agree with John Kenneth Galbraith, who said there are two kinds of forecasters, the ones who don't know and the ones who don't know they don't know. So I think that the average person has to learn that they don't know what the future holds and nobody else does either. The other thing is people believe that there's kind of a direct and mechanical linkage. If a company has a good event, the securities do well. If they have a bad event, like earnings, securities do poorly. But that's not the case because. There's a intermediate step, which is people's reaction. So it's not just whether the event was positive, it's how people reacted to the event that determines the impact on the security prices. And that's two different things. So you can't forget this psychological and human factor. Has anybody been a mentor to you or given you investment advice or what's the best investment advice you've ever received? You know, I received snippets from hanging around with smart people. I didn't have a single mentor. I read a lot. And I was fortunate to associate with people who are generous with their knowledge and shared it with me. And that's why I write the memos, to share it with others. Now, do people come up to you at cocktail parties and say, well, you're a famous investor, I've got $100,000, what should I do with it? Or what do you tell people about what they should do with their money when they just ask you for free advice? Well, the main thing I do is I say, that's kind of like going to a doctor and saying, do you have any good medicines? What is the condition you're trying to treat? Do you have more money than you need or less? Do you want to live a long time or a short time? Do you have dependents? What are their needs? Do you have what it takes viscerally to live with ups and downs or not? If it's going to make you miserable, you shouldn't do it. I think that investments have to be appropriate for the individual. But, you know, when the markets are doing well or when we're doing well, then people have that cocktail party conversation. When the markets are doing poorly, I just stand in the corner.

And if we can be analytical about what's going on in the markets today, that has implications for tomorrow. Remember, in 1980, the Fed funds rate was 20, and I had a loan outstanding from a bank at 22 and a quarter. Forty years later, the Fed funds rate was zero. and I had a loan outstanding from a bank at two and a quarter.

So the decline of interest rates by 20 percentage points over that period was a dominant factor in the financial world. I think it was the most important single event in the financial world in the last 50 years. It doesn't get the credit.

In the period 2009 through 2013, the Fed took Fed funds rate to zero to fight the global financial crisis, left it there a long time, and didn't have any luck getting it back up into what you might think are normal ranges. So we had a low interest rate environment, which made life very easy for borrowers, asset owners. It was easy to run a business.

The economy did well. We had the longest bull market in history, the longest economic recovery in history. We had very low incidence of default and bankruptcy.

It was an easy world. If you read articles about, for example, Silicon Valley Bank, they talk about the easy money environment. And the main point of sea change is we're no longer in an easy money environment. It's clearly worrisome.

There's never been a bankruptcy of the U.S., a country like it, so we don't know what's going to happen. Right now, the U.S. dollar is what's called the reserve currency of the world, and we get to print them. And we can print, in the short run, we can print as many as we want.

And as long as that's the case, we're not going to go under. It's like if you have an unlimited checking account, you can pay your credit card bills without limitation. We just don't know where it's going. That's the problem.

And people... This business about using a default as a negotiating tool is very, very dangerous. It's the golden goose.

We have this reserve currency status because the dollar is the safest currency in the world and the U.S. economy is the best. There is a part in Sea Change where I talk about the fact that a guy says, oh, we can buy this company and make 10% a year. Then he turns to his capital markets person and says, what will it cost to get the money?

We can borrow at eight. Borrow at 8, invest at 10, great, we do it. You buy the company, but in these stimulated environment of low interest rates, the company does better, you make more than 10. Your cost of money declines from 8 to 6 to 5, and it costs you less to borrow the money, and you say, boy, I'm a genius.

I think that rates are likely to be between 2 and 4, not between 0 and 2, the Fed funds rate. And between 0 and 2 is an emergency measure. The Fed funds rate was zero probably the majority of the time in the 2009 to 2021 period. And that's inappropriate.

It stimulates. You can't live on a shot of adrenaline every morning for 13 years. And it does subsidize borrowers and penalize lenders and savers. And I would like to see a Fed get to a neutral position, which is neither stimulative nor restrictive.

And I'd describe that as two to four. If inflation's two, then... The Fed funds rate should be higher than that so that there's a positive real Fed funds rate. If you came into this business since 1980, which is almost everybody, you have only seen declining interest rates or ultra low interest rates.

People tend to say, well, that's what it's been for 40 years. That's normal. That's what it's going to be. But no, you have to recognize that's why I call this sea change, because you have to recognize this is an important pivot.

Some people come up to me and say, yes, you're right. Interest rates are low. Nobody has said this is a major change as you say it is, but if it's the change I think it is, then what you should have in your portfolio going forward can be very different from what it has been.

And so far I have not had resounding support for that position. You know the S&P has returned 10% a year plus, just a little over 10, for a hundred years. That was enough to turn a dollar in 1920 into fifteen thousand dollars.

That's a good rate of return. Today, you can get equity-type returns from what we call credit instruments. Loans, corporate loans, loans for buyouts. You can get high single digits on high-yield bonds and leveraged loans, public instruments that are tradable and liquid, or low double digits on private loans for buyouts.

The best buyouts, the biggest buyouts, double-digit returns. Isn't that enough? And returns on credit instruments are much safer. Then equity.

Equity just gets the residual. After everybody gets paid, they get what's left. Credit gets paid early in the process, and if people don't pay you, you get the company, because they go bankrupt. So it's quite safe and returns that are fully competitive with equities with a good level of safety. This period of 09 through 21, easy period, easy to get money.

Most bankruptcies don't occur because you have a business and it loses money, loses money, loses money, goes away. It occurs because a business borrows money. Times get tough and when it goes to refinance that loan, nobody ever repays their debts. They just... refinance it and when they go to the bank to refinance it the bank says you're not as good a credit as you used to be or we don't have as much money to lend as we used to have or our standards are higher so it really comes from most bankruptcies or defaults are associated with a maturity which is unmet and when you go through a period when it's super easy to raise money for any purpose or no purpose and you go into a period when it's difficult to raise money even for a good purpose clearly many more companies are going to founder.

The long-term average default rate on high-yield bonds, for example, is close to 4% for the last, I guess I've been in 45 years. We didn't have any years in the last 15 at 4%. It was a very low period.

In the coming years, there will be some. The way I sum it up, You found a company to buy, you went to the bank, they said we'll lend you $800 million at 5%. Now the loan is up for renewal, you go in, they say fine, we'll lend you $500 million at 8%. So you have less money and your cost of capital is higher, and you have a $300 million hole that you can't fill.

I do think that today's Fed funds rate is a restrictive measure designed to cool off the economy and inflation, and when the inflation abates, as it seems to be in the process, I think that the Fed funds rate will settle out lower than it is today. And do you think the federal government, including the Fed and the White House and Treasury, made a mistake and not recognized that inflation was coming along and it wasn't transitory? Was that a mistake, you think? It has to do with the definition of the word transitory. It is transitory, just not as transitory as they thought.

We don't get in and out of the market. We don't defer bargain purchases because we think we know what the future is going to hold in terms of market action. But we do vary our aggressiveness and we've done it. a few times in a big way over the course of my career.

Just to give you some examples, late 04, early 05, we were very worried about the market. So we went defensive, sold a lot of assets, shrunk funds, liquidated funds, raised the bar for new investments. September 08, Lehman Brothers goes bankrupt.

Everybody thought the world was going to end and the financial system was going to melt down. We turned extremely aggressive and we invested, I think, 650 million a week on average for the next 15 weeks. That's $10 billion. Wow.

And obviously that was a good decision. Let's see, 2012, from 2000 to 2012, if you invested in the S&P 500, you made no money. Zero return, as I recall.

So I came out with the memo called Deja Vu All Over Again, I think it was called. And I said, you know, back in 79, most of your viewers may not remember, but Businessweek ran an article, The Death of Equities. And basically what it said is equities have done so badly that nobody will ever buy them. Which makes absolutely no sense.

If they've done badly, that means they must be cheap and people should buy them. And that was the same condition in 2012 and I wrote deja vu all over again. The point is, we do vary our degree of aggressiveness and defensiveness, we vary our degree of fundraising, how much money we should have under management. Clearly, when the opportunities are better, we should have more money.

When the opportunities are less good, we should have less. And I think that's an important thing to distinguish, is that we're willing to have less when it's appropriate. Today, I'm in a fairly normal posture, except increasing my aggressiveness. I think that the conditions for the bargain hunter, for the lender, for the asset buyer today are better than they have been since the global financial crisis, which ended in 2008. We've been tough times for the bargain hunter for the last 14 years. I think we're in a better situation today.

So I would increase my level of aggressiveness. In investing, there are two basic approaches. One is called top-down, where you say, well, what's the economy going to do? What are rates going to do?

Which sectors of the economy will do best? Which industries will do best? Let's find some companies. That's one way to do it, top-down or strategic. The other way to do it is bottom-up.

What's cheapest today? And that's more opportunistic, less strategic. And really, that's the way we operate.

So when we go out into the marketplace, we just say, what's cheap today? It's kind of like, you know... You're a shopper and you have a Saturday off. You just say, well, where are the sales? And we like to buy the things that are on markdown.

Last 14 years were really quite idyllic in the economy and in the market. We had the longest bull market in history, the longest economic recovery in history. We set a lot of records in many ways. Living was easy. Interest rates were low.

Companies can get all the money they wanted. Very few defaults or bankruptcies, easy times. I don't believe in forecasts, especially my own.

Oak Tree, as I mentioned, does not invest according to forecasts, but in general, we think that the living will be a little less easy in the months and years to come. So I think, you know, for us, the big question is, is it gonna be easy times like the last 14 years or more back to normal? I'm not calling for a cataclysm, but I'm just calling for a more normal world where interest rates are higher, it costs more money to borrow.

It's not so easy to borrow. Bad companies can't borrow. Bad companies can default. Bad companies can go bankrupt.

It's a little more of a struggle. This is not unusual. This is the norm. The last 14 years have been the unusual time.

The Fed has been highly stimulative for the last 14 years, kept rates low to keep the economy going. I think it's going to be less stimulative in the period ahead. I don't think it can do it forever.

What I would say is this. Investing is a fascinating field because... There are so many variables that have to be juggled and so many uncertainties that have to be dealt with. It's stimulating.

The solutions are never static. Yesterday's solution will not work tomorrow. It keeps you on your toes. On the other hand, because of the imprecision, you fail a lot.

And Warren Buffett always talks about Ted Williams who batted 400. That means 60% of the time he was out at the plate. The great investors are right 60%, 70%, maybe 80% of the time. If you're the kind of person who has to be right all the time, you shouldn't be in investing.

So if somebody said to you, what is the most common investment mistake that the average person makes, what would you say? Can I do two? Sure.

Number one is that people believe in the ability to predict the future. Either their ability or others that they can identify. And in general, I agree with John Kenneth Galbraith, who said there are two kinds of forecasters, the ones who don't know and the ones who don't know they don't know.

So I think that the average person has to learn that they don't know what the future holds and nobody else does either. The other thing is people believe that there's kind of a direct and mechanical linkage. If a company has a good event, the securities do well. If they have a bad event, like earnings, securities do poorly.

But that's not the case because. There's a intermediate step, which is people's reaction. So it's not just whether the event was positive, it's how people reacted to the event that determines the impact on the security prices. And that's two different things. So you can't forget this psychological and human factor.

Has anybody been a mentor to you or given you investment advice or what's the best investment advice you've ever received? You know, I received snippets from hanging around with smart people. I didn't have a single mentor.

I read a lot. And I was fortunate to associate with people who are generous with their knowledge and shared it with me. And that's why I write the memos, to share it with others. Now, do people come up to you at cocktail parties and say, well, you're a famous investor, I've got $100,000, what should I do with it?

Or what do you tell people about what they should do with their money when they just ask you for free advice? Well, the main thing I do is I say, that's kind of like going to a doctor and saying, do you have any good medicines? What is the condition you're trying to treat?

Do you have more money than you need or less? Do you want to live a long time or a short time? Do you have dependents? What are their needs? Do you have what it takes viscerally to live with ups and downs or not?

If it's going to make you miserable, you shouldn't do it. I think that investments have to be appropriate for the individual. But, you know, when the markets are doing well or when we're doing well, then people have that cocktail party conversation. When the markets are doing poorly, I just stand in the corner.

Transcript for:Understanding Financial Markets and Changes

Transcript for:
Understanding Financial Markets and Changes