“It is of the highest importance in the art of detection to be able to recognize, out of a number of facts, which are incidental and which vital.” - Sherlock Holmes Basil Rathbone as The Reigate Puzzle Sherlock Holmes Conventional Wisdom Conventional Wisdom “The most important aspect of my personality, as far as determining my success goes, has been my questioning conventional wisdom, doubting experts and questioning authority.” - Larry Ellison 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 1
Thoughts on Luck Thoughts on Luck “I’m a great believer in luck. The harder I work, the more luck I have.” - Benjamin Franklin "Progress always involves risk; you can't steal second base and keep your foot on first." - Frederick Wilcox 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 2
“The belief that cyclicality has been ended exemplifies a way of thinking based on the dangerous premise that ‘this time it’s different.’ “These four words should strike fear – and perhaps suggest an opportunity for profit – for anyone who understands the past and knows it repeats.” - Howard Marks The Most Important Thing “Of the two ways to perform as an investor – racking up exceptional gains and avoiding losses – I believe the latter is the more dependable.” - Howard Marks The Most Important Thing 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 3
Company Company Neutron Legislation - Late 1980s “It was OK to lend money to build a building, but it wasn’t OK to lend money to any company that would hire a person to work in the building.” 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 4
Examples of Regulation Following Volatility Period Volatility Regulation 1780s Weak state currencies Constitution/Commerce Clause 1830s-1850s Wildcat state banking National currency/Banking acts 1893 Stock market panic Bankruptcy Act 1907 Run on trust companies Federal Reserve Act 1929-1933 Market crash Securities & Exchange Act 1930-1933 Bank failures Glass-Steagall Act, FDIC, New Deal 1970s Commodities speculation CFTC 1970-90s Employment insecurity ERISA, COBRA, HIPAA 1987 S&L Crisis FIRREA 2002 Dot.com/Enron/etc. Sarbanes-Oxley 2008 Great Recession Dodd-Frank Pages in the Code of Federal Regulations 180,000 160,000 140,000 120,000 100,000 80,000 60,000 1975 1983 1991 1999 2007 2015 Source: Georg Washington University Regulatory Studies Center, 2015. 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 5
Regulation Complexity 6 pages More than 2,000 pages… … longer than the Torah, Bible and Quran COMBINED! The Nature of Credit 1. Credit is what counts, not leverage. 2. Most loans to real estate are not investment-grade. 3. Interest rates are volatile and unpredictable. 4. Credit research is more than ratings. 5. Sovereign debt is historically risky. 6. Debt values underpin all capital markets 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 6
Home Prices Don’t Go Up Forever Change in home prices in 128 years Great 70’s 80’s Last 30% Depression Boom Boom Boom WWI WWII 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% 1890 1906 1922 1938 1954 1970 1986 2002 2018 Sources: IHS Global Insight, Corelogic, Milken Institute, 3/1/2018. Central Bank Target Interest Rates Begin to Rise Percent 7 Bank of England 6 5 4 European 3 Central Bank U.S. Federal Reserve 2 1 0 Bank of Japan -1 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Source: Thomson Reuters (8/21/2018). 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 7
Central Bank Assets US$ trillions European Central Bank U.S. Federal Reserve 15 Bank of Japan 12 Bank of England 9 6 3 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Source: Thomson Reuter (6/25/2018). 1974 1974 The most important year in financial history since World War II. 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 8
1974 1974 Interest rates double in one year; highest level in recent recorded U.S. history Regulation restricts lending Energy prices skyrocket U.S. stock market plunges 50% Unemployment almost doubles 1974 1974 RESULT #1: Companies with the highest returns on capital, fastest rates of growth in market share and employment, and greatest innovation were denied access to equity and debt capital. 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 9
1974 1974 RESULT #2: With financial institutions weakened by the recession, public and private markets began displacing banks as the source of most corporate financing. 1974 1974 RESULT #3: The creation of the modern money- management industry (mutual funds and non-trust money managers). 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 10
The $55 Billion Misunderstanding Investing in the Nifty Fifty 12/31/72 – 12/31/81 The average P/E ratio of these 16 companies dropped from 66 to 11. Avon ADP Coca-Cola Disney Dr. Pepper Kodak H-P J&J Eli Lilly Marriott McDonald ’ s Merck Polaroid Rite-Aid Wal-Mart Xerox The $55 Billion Misunderstanding Investing in the Nifty Fifty 12/31/72 – 12/31/81 90% of the “ Nifty Fifty ” showed a negative return over nine years. The average inflation-adjusted rate of return was -46%. 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 11
By 1974, Singer Manufacturing had been paying dividends since 1863. Source: Chicago Tribune Women’s Corner Dow Industrials: 1973-76 Dow Industrials: 1973-76 Index 110 100 90 80 70 60 December, 6 1974 $578 50 Source: Thomson Reuters (10/4/2017). 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 12
Dow Industrials: 1973-76 and 2008-11 Dow Industrials: 1973-76 and 2008-11 Index 110 100 90 80 70 60 December, 6 1974 February, 18 2009 $6,547 $578 50 Source: Thomson Reuters (10/4/2017). High-Yield Bonds vs. Inflation and Treasuries Index, December 1987 = 100 High Yield 1,200 1,000 800 600 Treasuries 400 200 Inflation 0 1987 1992 1997 2002 2007 2012 2018 Note: BofA Merrill Lynch High Yield Master II, BofA Merrill Lynch Treasury Master, CPI. Sources: Thomson Reuters (8/21/2018). 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 13
Commodity Returns 2018 YTD Percent, 2018 YTD Cocoa 20 Gas Oil 12 11 Crude Oil 9 Brent Crude Nickel 6 Cotton 6 Heating Oil 3 Natural Gas 1 Soybeans -8 Gold -8 -9 Aluminum -23 Coffee Zinc -28 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25 Source: Bloomberg (8/21/2018). Note: Metals = LME 3mth, Gas and Oil = NYMEX, Heat Oil and Coffee = ICE, Commodities = CBOT and ICE. Currency Returns YTD 2018 Percent, as appreciation versus U.S. Dollar Mexican Peso 3% Japanese Yen 2% Saudi Riyal 0% Iraqi Dinar -1% Egyptian Pound -1% Swiss Franc -2% Singapore Dollar -2% Canadian Dollar -4% South Korean Won -5% Euro -5% British Pound -6% Australian Dollar -7% New Zealand Dollar -7% Swedish Krona -10% South African Rand -15% Brazilian Real -17% -18% -17% -16% -15% -14% -13% -12% -11% -10% -9% -8% -7% -6% -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% Source: Thomson Reuters (8/21/2018). 2018 Milken Institute Hamptons Dialogues A Conversation with Howard Marks and Mike MIlken 14
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