Larry Fink of BlackRock is CNBC’s newest member of their “Masters of the Markets” club. “That and a dime will get you a phone call” was an expression used during the pay phone era to demonstrate that the recognition was worthless; its replacement would be something like “that and an iPhone with an unlimited calling plan will get you a phone call.”
Today, Fink made two claims about the sustainability of current market trends that I thought were remarkable. First, he said that the so-called “risk on” trade is sustainable because many investors (presumably pension funds) have long dated liabilities and need 7% to 8% returns to meet those liabilities.
My answer to that first statement is similar to what I would tell a small child who says he needs something that he cannot have: it will not materialize just because you think you need it.
Yet, at bottom, I think Fink is correct. Pension funds will reach for 7% to 8% returns. They will put on risk because the alternative returns look worse. And, many are likely to end up in a bigger hole than the one they were in before. Which, ironically, brings to mind Buffett’s old line: “When you find yourself in a hole, stop digging.” I say ironically because Fink uses Buffett as a crutch in these videos.
If a large number of investors did not behave this way, investors like Seth Klarman and I would be out of business. Klarman has made it clear that he would never chase a return hurdle because investors have no control over returns. They do, however, control the amount of risk that they assume. Investors can manage risk most effectively when they only invest when they have a margin of safety (MOS). Those who manage risk and avoid losses will often underperform the market in the short run but outperform it in the long run. Those who chase returns will underperform the market.
Fink’s second rationale for the sustainability of market trends is forward looking P/E ratios are as low as they have been since 1980. He reasoned that despite better looking alternatives (high bond rates) at the time, the US had a strong stock rally beginning around 1980.
My take on the latter is: first, rates have nowhere to go but up from here and if they do the value of stocks will drop. The long-run fundamental value of stocks is simply the present value of future free cash flows. If rates rise, that present value drops. Conversely, after 1980, rates were much more likely to drop than rise as Volcker and Reagan were attacking inflationary forces. Second, in 1980 the Cyclically Adjusted P/E (CAPE) ratio was near an all-time low at about 7, which further validates the CAPE, a remarkable measure first proposed by Benjamin Graham. When the CAPE is low, buy stocks. But today, the CAPE is near all-time highs (excluding the dot com bubble) at 21.
Fink closes his appearance with the statement that “when it feels the worst” then that is the best time to invest. I agree, but do any investors really feel as if this is as bad as it gets? I certainly felt that way in March of 2009 and I found tons of opportunities with huge MOS back then. And, I feel pretty good about what transpired since March of 2009. But we have gradually reduced our market exposure since then to almost nothing today, not because it feels bad, but because there are few MOS opportunities.
One should not compare 1980 with 2011. I am sure that Fink is a smart man, which is why I suspect he is merely talking his book here. Large ships such as BlackRock cannot turn quickly even if they wanted to, and they cannot risk lagging their benchmarks by sailing into port. They are paid fees based on the size of their portfolios, not on their performance, so they just need to keep pace with their benchmarks to maintain or grow their market share. So, even when their benchmarks plummet because markets were previously inflated relative to fundamental values, BlackRock can preserve its revenue share if its portfolios only plummet as much as a benchmark, but no more. BlackRock’s investors may lose, but BlackRock does not.
I do agree with some of the other statements that Fink made during his appearance (with my qualifications in parentheses):
1. Europe is worse off than the US (but that does not mean the US is in good shape);
2. Investors should take a long-term view (which should make them less likely to take immediate action given high market prices and elevated risks);
3. Cash is a terrible long-term investment (but not when prices and risks are elevated).