Treading the Market's Middle Ground

 | Aug 07, 2013 | 3:00 PM EDT  | Comments
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I just read the latest missive from Howard Marks of Oaktree Capital Management. Marks has been around the markets since the 1970s, primarily as a distressed investor and has racked up some pretty impressive returns along the way.

His chairman's memos are a must read for serious investors and are filled with common sense observations about markets and risk. His latest, The Role of Confidence, is no exception.

Marks talks about the role of confidence in the markets and emphasizes that overconfidence leads to bear markets as assets become overpriced amidst the high degree of faith in the future. Conversely, a lack of belief in the economic future leads to asset underpricing and sets the stage for a bull market.

He said that the current market does not display a huge degree of confidence on the part of investors. He thinks investors may be holding riskier positions that they might prefer as a result of coercion from the Fed, rather than as a result of a high degree of confidence in the future.

Marks also does a much better job than I can of laying out the case of all the things to worry about that are keeping confidence muted. He discusses the sideways recovery in the United States, the morass of Europe. He questions the ability of the current global leadership to stand up to the task of repairing the global economy; he worries about the climate of regulation, taxes and spiraling healthcare costs that are discouraging business spending in the United States.

He brings up the geopolitical concerns that surround nations like Korea, Iran and the rest of the Middle East. The growth rate in China and the effect of a slow down on commodity prices on nations like Australia and Brazil are concerning many investors. Will Abenomics work and the Japanese economy on a growth track? Investors may have been forced into markets in search of returns in a world of ZIRP but they are more nervous that confident. Does fracking really create US energy independence and what does that mean for global energy markets?

Because of the combination of concerns and money literally forced into the markets, Marks concludes that most assets are neither dangerously expensive nor egregiously underpriced. We are in the middle ground where it is harder to know the best course and investors should resist the urge to become too clever in search of returns. He suggests in the coming months that we avoid being overly aggressive and apply liberal doses on caution and prudence.

This is all in line with my thoughts in recent weeks. As I said last week the market is more concerning to me than any time in my career. As Marks memo points out, there is just a lot that can go wrong in the economy and the world right now.

Main Street and Wall Street have suffered a huge disconnect over the past few years. We have a "step and stumble" economy where every good report is met by a bad one. The politicians seem more interested in "kicking the can" than any real solution to creating a strong and lasting economic recovery. In spite of all this the stock market is soaring to new highs.

The only real solution for investors right now is to seek investments that are egregiously underpriced and avoid those that are dangerously expensive. Nothing can fully protect you from the swings of the stock market in the short run. Finding stocks that are safe and cheap, while holding lots of cash in reserve, can give you an edge -- no matter which way things swing in the short turn.

I have stay focused on the cheapest stocks I can find and prefer those that trade well below book value with high Altman Z scores and Piotroksi F scores. We have found a few net-net stocks like Gencor (GENC) and Stanley Furniture (STLY) and have included those in portfolios. Many materials and resource stocks are priced like the world is going to end and although I am concerned I think we will survive and have picked up stocks like Arcelor Mittal (MT) and Resolute Forest Products (RFP).

I can still find cheap small bank stocks to buy at large discounts from their asset value. I am being more selective than usual, however, and am focusing on only the cheapest stocks with the best fundamental characteristics and a large margin of safety.

There is a lot to worry about, and markets love to climb a wall of worry. Position yourself so that you are prepared for either outcome to the greatest degree possible. I find that owning safe and cheap stocks and holding lots of cash to be a prudent course right now.

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