Howard Marks on Bubbles & Crashes

© 2026 Oaktree Capital Management, L.P All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: AI Hurtles Ahead When I was preparing to write my December memo about artificial intelligence, Is It a Bubble?, I gained a great deal from speaking with some interesting techies in their thirties and forties. It’s stimulating to explore fresh territory and an absolute requirement for staying current as an investor. It’s one of the most enjoyable parts of my job. I recently returned to those people to follow up on the December memo. As part of that process, someone suggested I ask Claude, Anthropic’s AI model, to create a tutorial explaining artificial intelligence and the changes that have taken place in the last three months. I did so, and it gave me a great deal to work with. This resulting memo is intended as an addendum to December’s. Much of it will recap Claude’s 10,000- word essay, to which I’ll add a few observations of my own. In the process, I’ll highlight some terms that were new to me and might be new to you. I could have saved myself a lot of time by asking Claude to write this memo, but I decided not to, because I consider putting words on paper a big part of the fun. I will, however, quote liberally from Claude’s work product. That’ll be the source of all quotations that aren’t otherwise identified. Before I start in, I want to try to communicate the level of awe with which I viewed Claude’s output.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: amounts, growing to today’s market of roughly $1.5 trillion in the U.S. The significant increase in the ability to issue this type of financing helped fuel the growth of private equity. After the tech bubble of the late 1990s imploded in 2000, leading to the first three-year decline in the S&P stock index since the Great Depression, investors became uninterested in the stock market and stayed that way for a decade. And when central banks reduced interest rates to fight the resulting economic and market malaise, investors sought returns above those available on bonds. With stocks and bonds out of favor, investors looked for a new solution. They turned to hedge funds and private equity, which had held up relatively well, and the label “alternative investments” was born. Hedge funds couldn’t find enough bargain-priced opportunities to accommodate large amounts of institutional capital, so many investors gravitated toward private equity as the solution du jour. The first $10 billion private equity funds were organized. Around the same time, corporate debt began to be securitized in “structured credit” vehicles such as collateralized loan obligations, or CLOs. The banks that packaged these vehicles, with internal leverage from “tranching,” found eager buyers for both the high-yielding junior classes and the overcollateralized senior classes.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In “generative AI,” the word generative means “able to create new things, not just analyze or label existing ones.” It refers to AI systems that learn patterns in data and then generate new content that resembles that data. Is this thinking? Or something else? Or am I belaboring “a distinction without a difference?” We’ll get some indication of this on page six. Recent Developments in AI My main reason for writing this addendum is to address significant changes that have taken place in AI over the three months since Is It a Bubble? was published on December 9. First, there’s the pace at which developments in AI are occurring. That speed is unlike anything we’ve seen before now, and this has implications that have never existed. AI is growing at speeds that greatly outpace the technological innovations of the past. Compare its development with that of the computer. • The building of the first computer, ENIAC, was completed in 1945. IBM’s Thomas J. Watson, Sr. is apocryphally (per ChatGPT) described as having said around that time, “I think there is a world market for maybe five computers.” Even if it wasn’t his, this observation reflects the state of opinion in the mid-1940s. • Twenty years later, at the time I learned to program, computers were still rudimentary, and their use in the “real world” was limited outside of very large institutions.

Now the analysis errs in the opposite direction, with excessive pessimism and skepticism replacing eagerness and gullibility, and with sheer terror replacing the blind faith that enabled investment when everything was going well. The implications of AI for the software industry, limitations on liquidity in private assets, and uncertainty regarding the accuracy of direct lending funds’ pricing have been there for years. But, simply put, people may not have asked enough questions or paid enough attention in the good times . . . as usual. This has led to the current discomfort of investors in direct lending vehicles. Individual investors in a new phenomenon like direct lending are unlikely to fully grasp its potential complications, especially if it has never been seen in action during tough times. The inclusion of leverage in the vehicles may have been touted as profit-enhancing, and now investors are seeing it at work in the opposite direction. And the investment vehicles’ limitations on liquidity – which may have been glossed over with a representation that “most of the time, you’ll probably be okay” – has come into play with surprising effect. True believers make the most money in manias, and skeptics lose the least when they crash. But the key to the investment success we aim for lies in always maintaining a healthy balance between belief and doubt.

As Charlie Munger used to say, quoting the ancient philosopher Demosthenes, “For that which a man wishes, that he will believe.” Most people dream of getting rich and are willing to trust when promised a way to do so without risk. But the new thing rarely pays off as expected, especially if invested in unskeptically while it’s raging. It’s safest to stick to tried and true investments and leave the more innovative developments to experts who are able to understand and cope with the implications. But few can resist the siren song of easy profits that accompanies most untested fads. It will ever be so. The Lessons of 1929 The best investing book I’ve read in years, one that pulled me along from chapter to chapter, is 1929: Inside the Greatest Crash in Wall Street History – and How It Shattered a Nation, by Andrew Ross Sorkin. It describes the leadup to the Great Crash of October 29, 1929, and its aftermath, and it does so not by dryly recounting the events, but through profiles of the protagonists of the day.lessons

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: to be learned from 1929, along the lines of my favorite books about market excesses: A Short History of Financial Euphoria by John Kenneth Galbraith (1994) and Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor (2000). My take from 1929 was that three things in particular were primarily responsible for the bubble that ended in the Great Crash: • the sale of stock to the public without regard for suitability, • the provision of heavy leverage to the buyers, and • the mismatch between the illiquidity of the assets bought and the short-term nature of the loans that financed the purchases. Individual investors were lured into the stock market following an ascent that had gone on for years; the major stock market averages had already risen by roughly 400% between 1921 and 1928. Brokerage firms, hungry for commissions and markups on larger transactions, provided margin loans for up to 90% of the purchase price. And those loans could be called – and the positions sold out – if a decline wiped out the investor’s 10% equity and additional cash couldn’t be posted. The story sounds familiar (and has been repeated several times since): • A lack of financial sophistication on the part of individual investors leaves them susceptible to promotions and too-good-to-be-true promises.

• Leverage is described as capable of magnifying the fruits of success, but the corresponding downside risk is often omitted from the sales pitch. • The perhaps-unmentioned terms of margin debt – and the difficulty of imagining the full depth of a potential market decline – expose investors to the risk of ruin. It’s not easy to lose everything in the stock market, but the combination of these three elements can do the trick in a bad-enough boom/bust cycle. The things described above took place in 1929 against the background of a near-total absence of laws governing the investment business, including requirements for honesty in prospectuses, and were compounded by the self-serving delusion, lack of principles, and downright venality of some Wall Street leaders. The result was a market and economic catastrophe that scarred several generations. Sorkin mostly limits himself to chronicling his characters’ behavior, leaving the drawing of conclusions and morals until the very end. But he finishes with a punch: The devastation wrought by the stock market’s decline – not just during the crash itself but for most of the ensuing decade – caused millions of Americans insufferable pain. It caused them to not just turn away from the market but to revile those who made their living buying and selling stocks. Yet the forces that drove the market to such stratospheric levels – optimism, ambition, and the belief that the future could be endlessly brighter – did not disappear forever.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: will dress up hope as certainty. And in that collective fever, humanity will again and again lose its head. The enduring lesson is not that booms can be prevented, or that busts can be fully averted. It is that we need to remember how easily we forget. The antidote to irrational exuberance is not regulation by itself, nor skepticism, but humility – the humility to know that no system is foolproof, no market fully rational, and no generation exempt. The greater the heights of our certainty, the longer and harder we fall. Sorkin’s concluding observations capture the lessons that can be learned from the mistakes that rhyme from cycle to cycle. What’s a Manager to Do? In my opinion, perhaps the conscientious manager’s biggest problem arises when too much capital is being pushed into their market and investors are too eager to put it to work. I talked about this at length in my February 2007 memo, The Race to the Bottom, on the doorstep of the Global Financial Crisis (I can’t believe it’s almost 20 years old). That’s roughly when Citibank’s CEO, Chuck Prince, was moved to say, “As long as the music is playing, you’ve got to get up and dance.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: we have to rely on “opinion or speculation.” Given the limitations discussed above on AI’s ability to tackle brand new situations, will its speculation about new things – as opposed to extrapolating historic patterns – be consistently superior to that of all humans? I believe there will continue to be human investors who are superior to AI, since I don’t think AI will be able to do an unbeatable job of these things. Because a lot of the investing process comes down to speculation, and because of AI’s less-than-total reliability, I think it’s unlikely that AI will be infallible as an investor. It will propose well-reasoned hypotheses, but they – like humans’ decisions – won’t always be right. Before investors take action on the basis of AI’s hypotheses, then, I think they’ll have to be checked for reasonableness. No one can do this infallibly, and most people probably can’t make these assessments better than AI can. Again, however, I believe there will be an ability for superior investors to add value in this way. So, Bottom-Line Me: Is It a Bubble? This question is still a dominant one, and it’s one I should be able to shed some light on. But the question itself is multi-faceted and complex: there are a lot of possible bubbles to think about: • Is the technology a fad or an illusion?

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: But Claude’s main argument on this subject – that since the current demand for AI exceeds the supply, the infrastructure building isn’t excessive – doesn’t necessarily take into account all the infrastructure building that’s in the pipeline. And, purely as a matter of logic, Claude’s answer doesn’t necessarily preclude the possibility that demand growth could slow or infrastructure building could run ahead of it. While I mentioned it in my December memo, I want to point out again that some AI revenue is currently “circular” in nature, derived from AI companies buying from each other. The chain of revenue has to ultimately rest on end users paying for real economic value, and while that’s increasingly the case, the question of how much revenue is circular remains an open one. Finally, I want to point out here that when Claude’s tutorial ventured into the subject of a possible bubble, most of what it said was in regard to the first few questions above: that (a) the technology is genuine and (b) the very real and rapidly growing demand for its service means AI isn’t a bubble. Even Claude acknowledges that it didn’t say a word about the appropriateness of the prices of AI assets. The bottom line for me is that AI is very real, capable of doing a lot of work that heretofore has been done by knowledge workers, and growing extremely rapidly in terms of applications. What we see today is only the beginning.

As I mentioned above, if I had to guess, I’d say its potential is more likely underestimated today rather than overestimated. However, that’s not the same as saying AI investments are on the bargain counter or even fairly priced. Thus, I’ll end by carrying forward my advice from Is It a Bubble?: Since no one can say definitively whether this is a bubble, I’d advise that no one should go all-in without acknowledging that they face the risk of ruin if things go badly. But by the same token, no one should stay all-out and risk missing out on one of the great technological steps forward. A moderate position, applied with selectivity and prudence, seems like the best approach. February 26, 2026 P.s.: In my December memo, after I concluded my discussion of whether AI was the subject of a financial bubble, I added a post-script regarding its implications for society in terms of joblessness and purposelessness, about which I’m terribly concerned. I haven’t changed my tune, but now I can share what I’ve heard from others, including Claude. Many readers have echoed my concerns. Like me, they can’t foresee where enough jobs will come from to replace all the “thinking” jobs that AI will take over, as well as the “doing” jobs that will be performed by machines controlled by AI. • A friend of my daughter-in-law heads the department that writes advertising copy for an e- commerce company. She told me AI could replace 80% of her staff.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: The Calculus of Value On July 28, I flew to South America on a plane without Wi-Fi, leaving me without email or entertainment. What was I to do but start in on a memo? Interestingly, the things I wrote during that flight turned out to be the answers to many of the questions I received from clients after I landed, so writing what follows served me well. I hope it’ll do the same for you. * * * January 2 of this year was the 25 th anniversary of my memo bubble.com, the one that put my writing on the map, and I marked the occasion by publishing another memo, called On Bubble Watch. While the title may have raised concern for readers, my main conclusion was that the elevated U.S. stock market valuations at the time didn’t necessarily signal the existence of a bubble, mainly because I didn’t detect the extreme investor psychology I associate with bubbles. Security prices were “lofty but not nutty” is how I put it. Because a lot has taken place in the seven months since then, it’s time for an update on asset values. Before I start, please note that I’m talking about investing in general. My specific reference will be to public U.S. corporate securities – stocks and bonds – since they mark to market regularly and are the assets that most enter my consciousness.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: On Bubble Watch Exactly 25 years ago today, I published the first memo that brought a response from readers (after having written for almost ten years without receiving any). The memo was called bubble.com, and the subject was the irrational behavior I thought was taking place with respect to tech, internet, and e-commerce stocks. The memo had two things going for it: it was right, and it was right fast. One of the first great investment adages I learned in the early 1970s is that “being too far ahead of your time is indistinguishable from being wrong.” In this case, however, I wasn’t too far ahead. This milestone anniversary gives me an occasion to write again about bubbles, a subject that’s very much of interest today. Some of what I write here will be familiar to anyone who read my December memo about the macro picture. But that memo only went to Oaktree clients, so I’m going to recycle here the part of its content that relates to the subject of bubbles. Since I’m a credit investor, having stopped analyzing stocks nearly five decades ago, and since I’ve never ventured far into the world of technology, I’m certainly not going to say much about today’s hot companies and their stocks. All of my observations will be generalities, but I’m hopeful they’ll be relevant nonetheless.

© 2025 Oaktree Capital Management, L.P All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Is It a Bubble? Ours is a remarkable moment in world history. A transformative technology is ascending, and its supporters claim it will forever change the world. To build it requires companies to invest a sum of money unlike anything in living memory. News reports are filled with widespread fears that America’s biggest corporations are propping up a bubble that will soon pop. During my visits to clients in Asia and the Middle East last month, I was often asked about the possibility of a bubble surrounding artificial intelligence, and my discussions gave rise to this memo. I want to start off with my usual caveats: I’m not active in the stock market; I merely watch it as the best barometer of investor psychology. I’m also no techie, and I don’t know any more about AI than most generalist investors. But I’ll do my best. One of the most interesting aspects of bubbles is their regularity, not in terms of timing, but rather the progression they follow. Something new and seemingly revolutionary appears and worms its way into people’s minds. It captures their imagination, and the excitement is overwhelming. The early participants enjoy huge gains. Those who merely look on feel incredible envy and regret and – motivated by the fear of continuing to miss out – pile in.

They do this without knowledge of what the future will bring or concern about whether the price they’re paying can possibly be expected to produce a reasonable return with a tolerable amount of risk. The end result for investors is inevitably painful in the short to medium term, although it’s possible to end up ahead after enough years have passed. I’ve lived through several bubbles and read about others, and they’ve all hewed to this description. One might think the losses experienced when past bubbles popped would discourage the next one from forming. But that hasn’t happened yet, and I’m sure it never will. Memories are short, and prudence and natural risk aversion are no match for the dream of getting rich on the back of a revolutionary technology that “everyone knows” will change the world. I took the quote that opens this memo from Derek Thompson’s November 4 newsletter entitled “AI Could Be the Railroad of the 21 st Century. Brace Yourself,” about parallels between what’s going on today in AI and the railroad boom of the 1860s. Its word-for-word applicability to both shows clearly what’s meant by the phrase widely attributed to Mark Twain: “history rhymes.” Understanding Bubbles Before diving into the subject at hand – and having read a great deal about it in preparation – I want to start with a point of clarification. Everyone asks, “Is there a bubble in AI?” I think there’s ambiguity even in the question.

* * * In this century’s first decade, investors had the opportunity to participate in – and lose money due to – two spectacular bubbles. The first was the tech-media-telecom (“TMT”) bubble of the late ’90s, which began to burst in mid-2000, and the second was the housing bubble of the mid-aughts, which gave rise to (a) extending mortgages to sub-prime borrowers who couldn’t or wouldn’t document income or assets, (b) the structuring of those loans into levered, tranched mortgage-backed securities, and consequently (c) massive losses for investors in those securities, especially the financial institutions that had created them and retained some. As a result of those experiences, many people these days are on heightened alert for bubbles, and I’m often asked whether there’s a bubble surrounding the Standard & Poor’s 500 and the handful of stocks that have been leading it. The seven top stocks in the S&P 500 – the so-called “Magnificent Seven” – are Apple, Microsoft, Alphabet (Google’s parent), Amazon.com, Nvidia, Meta (owner of Facebook, WhatsApp, and Instagram), and Tesla. I’m sure I don’t have to go into detail regarding the performance of these stocks; everyone’s aware of the phenomenon. Suffice it to say that a small number of stocks have dominated the S&P 500 in recent years and have been responsible for a highly disproportionate share of its gains. A chart from Michael Cembalest, chief strategist at J.P.

I’ve concluded there are two different but interrelated bubble possibilities to think about: one in the behavior of companies within the industry, and the other in how investors are behaving with regard to the industry. I have absolutely no ability to judge whether the AI companies’ aggressive behavior is justified, so I’ll try to stick primarily to the question of whether there’s a bubble around AI in the financial world.

Morgan Asset Management, shows that: • the market capitalization of the seven largest components of the S&P 500 represented 32-33% of the index’s total capitalization at the end of October; • that percentage is roughly double the leaders’ share five years ago; and • prior to the emergence of the “Magnificent Seven,” the highest share for the top seven stocks in the last 28 years was roughly 22% in 2000, at the height of the TMT bubble.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The main job of an investment analyst – especially in the so-called “value” school to which I subscribe – is to (a) study companies and other assets and assess the level of and outlook for their intrinsic value and (b) make investment decisions on the basis of that value. Most of the change the analyst encounters in the short to medium term surrounds the asset’s price and its relationship to underlying value. That relationship, in turn, is essentially the result of investor psychology. Market bubbles aren’t caused directly by technological or financial developments. Rather, they result from the application of excessive optimism to those developments. As I wrote in my January memo On Bubble Watch, bubbles are temporary manias in which developments in those areas become the subject of what former U.S. Federal Reserve Chairman Alan Greenspan called “irrational exuberance.’’ Bubbles usually coalesce around new financial developments (e.g., the South Sea Company of the early 1700s or sub-prime residential mortgage-backed securities in 2005-06) or technological progress (optical fiber in the late 1990s and the internet in 1998-2000). Newness plays a huge part in this. Because there’s no history to restrain the imagination, the future can appear limitless for the new thing.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: It’s also important to note that at the end of November, U.S. stocks represented over 70% of the MSCI World Index, the highest percentage since 1970 according to another Cembalest chart. Thus, it’s clear that (a) U.S. companies are worth a lot compared to the companies in other regions and (b) the top seven U.S. stocks are worth a heightened amount relative to the rest of U.S. stocks. But is it a bubble? What Is a Bubble? Investment lingo comes and goes. My young Oaktree colleagues use a lot of terms these days for which I have to request translation. But “bubble” and “crash” have been in the financial lexicon for as long as I’ve been in the investment business, and I imagine they’ll remain there for generations to come. Today, the mainstream media uses them broadly, and people seem to consider them to be subject to objective definition. But for me, a bubble or crash is more a state of mind than a quantitative calculation.

” It’s also called a “risk premium,” which is what it is: the incremental return you’re offered to accept incremental default risk. Thus, it’s the equivalent of an insurance premium: what policyholders pay to get auto insurers to shoulder the risk that they’ll crash their cars. Yield spreads primarily fluctuate with trends in, and investor psychology regarding, defaults. When more companies are defaulting and investors expect elevated defaults in the future, they’ll demand more protection in the form of wider spreads. They’ll do so to a lesser degree when they’re optimistic about creditworthiness. Thus, the spread is a good barometer of investor psychology, or a “fear gauge.” It’s worth noting the obvious: the spread doesn’t tell you what the actual default rate will be, as some mistakenly say. It tells you what investors think the default rate will be. The thoughtful investor has to evaluate that expression of opinion against what the reality is likely to be and assess whether investors are being too optimistic or too pessimistic. Are Today’s Yield Spreads Adequate? This is the question of the day. Let’s say high yield bonds yield 8% and a Treasury note of the same maturity offers 5%, for a yield spread of 3%, or 300 basis points. Which is the better deal? It all depends on the likelihood of default.

In my view, a bubble not only reflects a rapid rise in stock prices, but it is a temporary mania characterized by – or, perhaps better, resulting from – the following: • highly irrational exuberance (to borrow a term from former Federal Reserve Chair Alan Greenspan), • outright adoration of the subject companies or assets, and a belief that they can’t miss, • massive fear of being left behind if one fails to participate (‘‘FOMO’’), and • resulting conviction that, for these stocks, “there’s no price too high.” “No price too high” stands out to me in particular. When you can’t imagine any flaws in the argument and are terrified that your officemate/golf partner/brother-in-law/competitor will own the asset in question and you won’t, it’s hard to conclude there’s a price at which you shouldn’t buy. (As Charles Kindleberger and Robert Aliber observed in the fifth edition of Manias, Panics, and Crashes: A History of Financial Crises, “there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.”) So, to discern a bubble, you can look at valuation parameters, but I’ve long believed a psychological diagnosis is more effective. Whenever I hear “there’s no price too high” or one of its variants – a more disciplined investor might say, “of course there’s a price that’s too high, but we’re not there yet” – I consider it a sure sign that a bubble is brewing. Roughly fifty years ago, an elder gave me the gift of one of my favorite maxims.

And futures that are perceived to be limitless can justify valuations that go well beyond past norms – leading to asset prices that aren’t justified on the basis of predictable earning power. The role of newness is well described in my favorite passage from a book that greatly influenced me, A Short History of Financial Euphoria by John Kenneth Galbraith. Galbraith wrote about what he called “the extreme brevity of the financial memory” and pointed out that in the financial markets, “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.” In other words, history can impose limits on awe regarding the present and imagination regarding the future. In the absence of history, on the other hand, all things seem possible. The key thing to note here is that the new thing understandably inspires great enthusiasm, but bubbles are what happen when the enthusiasm reaches irrational proportions. Who can identify the boundary of rationality? Who can say when an optimistic market has become a bubble? It’s just a matter of judgment. Something that occurred to me this past month is that two of my best “calls” came in 2000, when I cautioned about what was going on in the market for tech and internet stocks, and in 2005-07, when I cited the dearth of risk aversion and the resulting ease of doing crazy deals in the pre-Global Financial Crisis world.

I’ve written about it several times in my memos, but in my opinion, I can’t do so often enough. It’s “the three stages of the bull market”: The first stage usually comes on the heels of a market decline or crash that has left most investors licking their wounds and highly dispirited. At this point, only a few unusually insightful people are capable of imagining that there could be improvement ahead. In the second stage, the economy, companies, and markets are doing well, and most people accept that improvement is actually taking place. In the third stage, after a period in which the economic news has been great, companies have reported soaring earnings, and stocks have appreciated wildly, everyone concludes that things can only get better forever.

• First, in neither case did I possess any expertise regarding the things that turned out to be the subjects of the bubbles: the internet and sub-prime mortgage-backed securities. All I did was render observations regarding the behavior taking place around me. • And second, the value in my calls consisted mostly of describing the folly in that behavior, not in insisting that it had brought on a bubble. Struggling with whether to apply the “bubble” label can bog you down and interfere with proper judgment; we can accomplish a great deal by merely assessing what’s going on around us and drawing inferences with regard to proper behavior.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: What’s Good About Bubbles? Before going on to discuss AI and whether it’s presently in a bubble, I want to spend a little time on a subject that may seem somewhat academic from the standpoint of investors: the upside of bubbles. You may find the attention I devote to this topic excessive, but I do so because I find it fascinating. The November 5 Stratechery newsletter was entitled “The Benefits of Bubbles.” In it, Ben Thompson (no relation to Derek) cites a book titled Boom: Bubbles and the End of Stagnation. It was written by Byrne Hobart and Tobias Huber, who propose that there are two kinds of bubbles: . . . “Inflection Bubbles” – the good kind of bubbles, as opposed to the much more damaging “Mean-reversion Bubbles” like the 2000’s subprime mortgage bubble. I find this a useful dichotomy. • The financial fads I’ve read about or witnessed – the South Sea Company, portfolio insurance, and sub-prime mortgage-backed securities – stirred the imagination based on the promise of returns without risk, but there was no expectation that they would represent overall progress for mankind. There was, for example, no thought that housing would be revolutionized by the sub-prime mortgage movement, merely a feeling that there was money to be made from backing new buyers.

The recurring roller coaster of psychology and the resulting behavior is the most important of them. The key observation is that good times lead to complacency, risk tolerance, and carelessness, as people bid aggressively for assets and compete to make loans. And then, bad times expose the results of that carelessness, as investments that were entered into without an adequate investigation and margin for error fail to hold up in a hostile environment. This is nothing new. As financial historian Edward Chancellor wrote in his 2022 book The Price of Time: The Manchester banker John Mills commented perceptively [in 1865] that “as a rule, panics do not destroy capital; they merely revealed the extent to which it has previously been destroyed by its betrayal into hopelessly unproductive works.” In other words, many flawed decisions, which the economist Friedrich Hayek aptly described as “malinvestment,” are made in booms and exposed in busts. It will ever be so. This is summed up most concisely in a great banking adage: “The worst of loans are made in the best of times.” A Good Bezzle Charlie Munger and I used to enjoy talking about the economist John Kenneth Galbraith. Galbraith was the source of many of my favorite expressions with regard to the financial markets. One I haven’t mentioned since my memo The Long View in 2009 is the “bezzle,” a concept Galbraith introduced in his book The Great Crash 1929. What’s a bezzle?

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The important inferences aren’t with regard to economic or corporate events. They involve investor psychology. It’s not a matter of what’s happening in the macro world; it’s how people view the developments. When few people think there can be improvement, security prices by definition don’t incorporate much optimism. But when everyone believes things can only get better forever, it can be hard to find anything that’s reasonably priced. Bubbles are marked by bubble thinking. Perhaps for working purposes we should say that bubbles and crashes are times when extreme events cause people to lose their objectivity and view the world through highly skewed psychology – either too positive or too negative. Here’s how Kindleberger put it in the first edition of Manias, Panics, and Crashes: . . . As firms or households see others making profits from speculative purchases and resales, they tend to follow. When the number of firms and households indulging in these practices grows larger, bringing in segments of the population that are normally aloof from such ventures, speculation for profit leads away from normal, rational behavior to what have been described as “manias” or “bubbles.” The word “mania” emphasizes the irrationality; “bubble” foreshadows the bursting. (Emphasis added) For me, it’s psychological extremeness that marks a bubble.

Often, as Kindleberger indicates, it can be inferred from widespread participation in the investment fad of the moment, especially among non- financial types. Legend has it that J.P. Morgan knew there was a problem when the person shining his shoes started giving him stock tips. My partner John Frank says he saw it in 2000, when he heard the dads at his son’s soccer game bragging about the tech stocks they owned, and again in 2006, when a Las Vegas cab driver told him about the three condos he’d purchased. When Mark Twain purportedly said, “history doesn’t repeat itself, but it often rhymes,” it’s this kind of thing he was talking about. The New, New Thing If bubble thinking is irrational, what is it that permits investors to get away from rational thinking, like the thrust of a rocket ship that breaks free of the limits imposed by gravity and attains escape velocity? There’s a simple answer: newness. This phenomenon relies on another time-honored investment phrase, “this time is different.” Bubbles are invariably associated with new developments. There were bubbles in the Nifty Fifty stocks in the 1960s (more on them just below), disc drive companies in the 1980s, TMT/internet stocks in the late 1990s, and sub-prime mortgage-backed securities in 2004-06.

Hobart and Huber call these “mean-reverting bubbles,” presumably because there’s no expectation that the underlying developments would move the world forward. Fads merely rise and fall. • On the other hand, Hobart and Huber call bubbles based on technological progress – as in the case of the railroads and the internet – “inflection bubbles.” After an inflection-driven bubble, the world will not revert to its prior state. In such a bubble, “investors decide that the future will be meaningfully different from the past and trade accordingly.” As Thompson tells us: The definitive book on bubbles has long been Carlota Perez’s Technological Revolutions and Financial Capital. Bubbles were – are – thought to be something negative and to be avoided, particularly at the time Perez published her book. The year was 2002 and much of the world was in a recession coming off the puncturing of the dot-com bubble. Perez didn’t deny the pain: in fact, she noted that similar crashes marked previous revolutions, including the Industrial Revolution, railways, electricity, and the automobile. In each case the bubbles were not regrettable, but necessary: the speculative mania enabled what Perez called the “Installation Phase,” where necessary but not necessarily financially wise investments laid the groundwork for the “Deployment Period.” What marked the shift to the deployment period was the popping of the bubble; what enabled the deployment period were the money-losing investments.

These relatively recent manias followed in the tradition of ones like (a) the 1630s craze in Holland over recently introduced tulips and (b) the South Sea Bubble in 1720 England concerning the riches that were sure to ensue from a trading monopoly that the Crown had awarded to the South Sea Company. In normal circumstances, if an industry’s or a country’s securities are attracting unusually high valuations, investment historians are able to point out that, in the past, those stocks had never sold at more than an x% premium over the average, or some similar metric. In this way, attention to history can serve as a tether, keeping a favored group grounded on terra firma. But if something’s new, meaning there is no history, then there’s nothing to temper enthusiasm. After all, it’s owned by the brightest people – the ones who are showing up in the headlines and on TV – and they’ve made a fortune. Who’s willing to throw a wet blanket over that party or sit out that dance?

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Hobart and Huber go on to describe in greater depth the process through which bubbles finance the building of the infrastructure required by the new technology and thus accelerate its adoption: Most novel technology doesn’t just appear ex nihilo [i.e., from nothing], entering the world fully formed and all at once. Rather, it builds on previous false starts, failures, iterations, and historical path dependencies. Bubbles create opportunities to deploy the capital necessary to fund and speed up such large-scale experimentation – which includes lots of trial and error done in parallel – thereby accelerating the rate of potentially disruptive technologies and breakthroughs. By generating positive feedback cycles of enthusiasm and investment, bubbles can be net beneficial. Optimism can be a self-fulfilling prophecy. Speculation provides the massive financing needed to fund highly risky and exploratory projects; what appears in the short term to be excessive enthusiasm or just bad investing turns out to be essential for bootstrapping social and technological innovations . . . A bubble can be a collective delusion, but it can also be an expression of collective vision. That vision becomes a site of coordination for people and capital and for the parallelization of innovation. Instead of happening over time, bursts of progress happen simultaneously across different domains. And with mounting enthusiasm . . .

For example: • An AI stock can be a risky holding for the manager of a mutual fund that’s priced daily and subject to daily withdrawals – or for an investor who’s likely to panic during a market crash and sell at the bottom – but much less so for a sovereign wealth fund where the money is unlikely to be withdrawn and there’s no requirement to publish financials and satisfy public opinion. • An investor whose compensation is based on metrics that penalize volatility may consider a publicly traded bond riskier than a private loan from the same issuer that doesn’t mark to market, even though the risk of default is the same for both. If it’s true that an asset’s volatility can bring risk for some investors but not others, then clearly the risk doesn’t lie in the investment, but in something in the investor’s environment. While I think the risk of permanent loss is the most important investment risk, I recognize that volatility can be a material real-world risk for some investors. My experience with the pension fund session reminded me that rapidly fluctuating portfolio values can require fluctuating contributions from pension plan sponsors.legitimate

comes increased risk tolerance and strong network effects. The fear of missing out, or FOMO, attracts even more participants, entrepreneurs, and speculators, further reinforcing this positive feedback loop. Like bubbles, FOMO tends to have a bad reputation, but it’s sometimes a healthy instinct. After all, none of us wants to miss out on a once-in-a-lifetime chance to build the future. In other words, bubbles based on technological progress are good because they excite investors into pouring in money – a good bit of which is thrown away – to carpet-bomb a new area of opportunity and thus jump-start its exploitation. The key realization seems to be that if people remained patient, prudent, analytical, and value- insistent, novel technologies would take many years and perhaps decades to be built out. Instead, the hysteria of the bubble causes the process to be compressed into a very short period – with some of the money going into life-changing investment in the winners but a lot of it being incinerated. A bubble has aspects that are both technological and financial, but the above citations are from the standpoint of people who crave technological progress and are perfectly happy to see investors lose money in its interest. “We,” on the other hand, would like to see technological progress but have no desire to throw away money to help bring it about.

literally. Three factors contributed to investors’ fascination with these stocks. First, the U.S. economy grew strongly in the post-World War II period. Second, these companies benefitted from their involvement with areas of innovation such as computers, drugs, and consumer products. And third, they represented the first wave of “growth stocks,” a new investment style that separately became a fad in itself. The Nifty Fifty were the object of the first big bubble in roughly 40 years, and since there hadn’t been one for so long, investors had forgotten what a bubble looks like. As a result of the popularity that was conferred on them, if you bought these stocks on the day I started work and held them tenaciously for five years, you lost well over 90% of your money . . . in the best companies in America. What happened? The Nifty Fifty had been put on a pedestal, and investors get hurt when something falls from it. The stock market as a whole declined by about half in 1973-74. And it turned out these stocks had been selling at prices that actually were too high; in many cases, their price/earnings ratios fell from the range of 60 to 90 to the range of 6 to 9 (that’s the easy way to lose 90%). Further, bad things actually did happen to several of the companies in fundamental terms. My early brush with a genuine bubble caused me to formulate some guiding principles that carried me through the next 50-odd years: It’s not what you buy, it’s what you pay that counts.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: this new field often fail to grasp that even a bright newcomer can be supplanted. The disrupters can be disrupted, whether by skillful competitors or even newer technologies. In my early decades in business, technology seemed to evolve gradually. Computers, drugs, and other innovative products improved a little at a time. But in the 1990s, innovation came in a big rush. When Oaktree was founded in 1995, I insisted that I could get by with just WordPerfect for word processing and Lotus 1-2-3 for spreadsheets. But when we moved to our current office in 1998, I threw in the towel and let our IT team install e-mail and the internet (and, of course, WordPerfect gave way to Word, and Lotus 1- 2-3 to Excel). At the time, investors were sure “the internet will change the world.” It certainly looked that way, and that assumption prompted tremendous demand for everything internet-related. E-commerce stocks went public at seemingly high prices and then tripled the first day. There was a real goldrush. There’s usually a grain of truth that underlies every mania and bubble. It just gets taken too far. It’s clear that the internet absolutely did change the world – in fact, we can’t imagine a world without it. But the vast majority of internet and e-commerce companies that soared in the late ’90s bubble ended up worthless.

When a bubble burst in my early investing days, The Wall Street Journal would run a box on the front page listing stocks that were down by 90%. In the aftermath of the TMT Bubble, they’d lost 99%. When something is on the pedestal of popularity, the risk of a decline is high. When people assume – and price in – an expectation that things can only get better, the damage done by negative surprises is profound. When something is new, the competitors and disruptive technologies have yet to arrive. The merit may be there, but if it’s overestimated it can be overpriced, only to evaporate when reality sets in. In the real world, trees don’t grow to the sky. The foregoing discussion centered on the risk of overestimating fundamental strength. But optimism surrounding the power and potential of the new thing often causes the error to be compounded through the assignment of too high a stock price. • As mentioned above, for something new, there by definition is no historical indicator of what an appropriate valuation might be. • Further, the companies’ potential hasn’t yet been turned into steady-state profits, meaning the thing that’s being valued is conjectural. In the TMT Bubble, the companies didn’t have earnings, so p/e ratios were out. And as startups, they often didn’t have revenues to value.

As a result, new metrics were invented, and trusting investors ended up paying a multiple of “clicks” or “eyeballs,” regardless of whether these measurables could be turned into revenues and profits. • Since bubble participants can’t imagine there being any downside, they tend to award valuations that assume success. • In fact, it’s not infrequent for investors to treat all contenders in a new field as likely to succeed, whereas in reality only a few may thrive, or perhaps even survive. • Ultimately, with a really hot new thing, investors can adopt what I call “a lottery ticket mentality.” If a successful startup in a hot field can return 200x, it’s mathematically worth investing in even if it’s only 1% likely to succeed. And what doesn’t have a 1% likelihood of success? When investors think this way, there are few limits on what they’ll support or the prices they’ll pay. Obviously, investors can get caught up in the race to buy the new, new thing. That’s where the bubble comes in.

Morgan published a graph showing that if you bought the S&P 500 index at 23 times the coming year’s earnings per share in the period 1987-2014 (the only period for which there’s data on forward-looking p/e ratios and resulting ten-year returns), your average annual return over the subsequent ten years was between plus 2% and minus 2% every time. To the extent this p/e ratio history is relevant, it bodes pretty poorly for the S&P 500. • I concluded in my January memo that this was troublesome but not threatening, again mostly because the temporary mania or “irrational exuberance” that I believe accompanies – or gives rise to – most bubbles wasn’t present. That was then. What has happened since? The U.S. stock markets saw declines of up to 10% in the first quarter of this year, with the tech-heavy Nasdaq Composite falling the most. This was primarily the result of unspectacular economic and corporate performance, moderate but still higher-than-desired inflation, and possibly worries about valuation levels and whether the U.S. would retain its position as the world’s investment destination of choice. Then, on April 2, President Trump announced tariffs on imported goods that were much higher and much more sweeping than had been anticipated. Investors promptly concluded the tariffs were likely to cause inflation to accelerate, economic growth to slow, and the U.S. to be viewed less favorably by nations and investors around the world.

In other words, is it possible AI will increase the efficiency of businesses without increasing their profitability? Should we worry about so-called “circular deals”? In the telecom boom of the late 1990s, in which optical fiber became overbuilt, fiber-owning companies engaged in transactions with each other that permitted them to report profits. If two companies own fiber, they just have an asset on their books. But if each buys capacity from the other, they can both report profits . . . so they did. In other cases, manufacturers loaned network operators money to buy equipment from them, before the operators had customers to justify the buildout. All this resulted in profits that were illusory. Nowadays, deals are being announced in which money appears to be round-tripped between AI players. People who believe there’s an AI bubble find it easy to view these transactions with suspicion. Is the purpose to achieve legitimate business goals or to exaggerate progress? Adding to worries, critics say, some of the deals that OpenAI has made with chipmakers, cloud computing companies and others are oddly circular. OpenAI is set to receive billions from tech companies but also sends billions back to the same companies to pay for computing power and other services. . . .

My belief is that the risk in private credit isn’t systemic, since (a) private loan portfolios and their owners aren’t levered nearly as much as banks were in 2007-08 and (b) there isn’t the same level of interconnectedness, or “counterparty risk,” since the holders haven’t sold each other default protection and other forms of hedging, like banks did before the GFC. There are those who believe some holders of private credit have multiple layers of leverage, which could increase the risk in a downside scenario, but I have no way of knowing. The bottom line for me is that the return premium on private credit relative to public credit seems roughly fair given the merits. Extra return is a good thing, but the downside related to the lack of liquidity and resulting difficulty in actively managing holdings is a real consideration. All else equal, I would suggest employing a combination of the two. Credit Versus Equities I’ve written about equity valuations – primarily referencing the Standard & Poor’s 500 – as recently as this January in my memo On Bubble Watch.year,

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Exxon Mobil Johnson & Johnson Intel Qualcomm Citigroup Bristol-Myers Squibb IBM Pfizer Oracle AT&T Home Depot Verizon At the beginning of 2024, however, only six of them were still in the top twenty: Microsoft Johnson & Johnson Walmart Procter & Gamble Exxon Mobil Home Depot Importantly, of today’s Magnificent Seven, only Microsoft was in the top twenty 24 years ago. In bubbles, investors treat the leading companies – and pay for their stocks – as though the firms are sure to remain leaders for decades. Some do and some don’t, but change seems to be more the rule than persistence. Whole Markets The greatest bubbles usually originate in connection with innovations, mostly technological or financial, and they initially affect a small group of stocks. But sometimes they extend to whole markets, as the fervor for a bubble group spreads to everything. In the 1990s, the S&P 500 was borne aloft by (a) the continuing decline of interest rates from their inflation-fighting peak in the early 1980s and (b) the return of investor enthusiasm for stocks that had been lost in the traumatic ’70s. Technological innovation and the rapid earnings growth of the high-tech companies added to the excitement. And an upswing in the popularity of stocks was reinforced by new academic research showing there had never been a long period in which the S&P 500 failed to outperform bonds, cash, and inflation.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: and some investment banks have expressed expectations that are similarly in the low to mid-single digits. Obviously, today’s expected returns on credit are considerably higher. On January 27, an article on the front page of The Wall Street Journal said the following: “Stocks haven’t looked this unattractive, by at least one measure, since the aftermath of the dot-com era.” This wasn’t a reference to the elevated p/e ratio, but to the fact that the yield on the 10-year U.S. Treasury note is higher than the “earnings yield” on the S&P 500 stock index. (The earnings yield is the ratio of earnings to price, the inverse of the p/e ratio.) This doesn’t prove that bonds are going to beat stocks in the years ahead, but it’s one more argument. And if Treasurys are poised to out-yield the S&P 500, high yield bonds will do so to an even greater extent (assuming credit losses don’t exceed the historical experience). As I’ve written in other memos recently, the current level of offered yields implies higher returns from credit than the S&P 500, with returns that are contractual and thus subject to much less variability and uncertainty. This is true despite the return contraction that has been brought on by the swing from pessimism to optimism over the last two years, and even given today’s narrow spreads.

The combination of these positive factors caused the annual return on the index to average more than 20% for the decade. I’ve never seen another period like it. I always say the riskiest thing in the world is the belief that there’s no risk. In a similar vein, heated buying spurred by the observation that stocks had never performed poorly for a long period caused stock prices to rise to a point from which they were destined to do just that. In my view, that’s George Soros’s investment “reflexivity” at work. Stocks were tarred in the bursting of the TMT Bubble, and the S&P 500 declined in 2000, 2001, and 2002 for the first three-year decline since 1939, during the Great Depression. As a consequence of this poor performance, investors deserted stocks en masse, causing the S&P 500 to have a cumulative return of zero for the more than eleven years from the bubble peak in mid-2000 until December 2011. Lately, I’ve been repeating a quote I attribute to Warren Buffett: “When investors forget that corporate profits grow about 7% per year they tend to get into trouble.” What this means is that if corporate profits grow at 7% a year and stocks (which represent a share in corporate profits) appreciate at 20% a year for a while, eventually stocks will be so highly priced relative to their earnings that they’ll be risky. (I recently asked Warren for a source on the quote, and he told me he never said it. But I think it’s great, so I keep using it.)

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The point is that when stocks rise too fast – out of proportion to the growth in the underlying companies’ earnings – they’re unlikely to keep on appreciating. Michael Cembalest has another chart that makes this point. It shows that prior to two years ago, there were only four times in the history of the S&P 500 when it returned 20% or more for two years in a row. In three of those four instances (a small sample, mind you), the index declined in the subsequent two-year period. (The exception was 1995-98, when the powerful TMT bubble caused the decline to be delayed until 2000. But then the index lost almost 40% in three years.) In the last two years, it’s happened for the fifth time. The S&P 500 was up 26% in 2023 and 25% in 2024, for the best two-year stretch since 1997-98. That brings us to 2025. What lies ahead?

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: we can’t answer any questions.’ ” (“This Is How the AI Bubble Will Pop,” Derek Thompson Substack, October 2) But that’s ancient history. . . already two months old. Here’s an update: Thinking Machines Lab, the artificial intelligence startup founded by former Open AI executive Mira Murati, is in early talks to raise a new funding round at a roughly $50 billion valuation, Bloomberg News reported on Thursday. The startup was last valued at $12 billion in July, after it raised about $2 billion. (Reuters, November 13) And Thinking Machines Lab isn’t alone: In one of the boldest bets yet in the AI arms race, Safe Superintelligence (SSI), the stealth startup founded by former OpenAI chief scientist Ilya Sutskever, has raised $2 billion in a round that values the company at $32 billion – despite having no publicly released product or service. (CTech by Calcalist, April 13) What’s the end state? Part of the issue with AI includes the unusual nature of this newest thing. This isn’t like a business that designs and sells a product, making money if the selling price exceeds the cost of the inputs. Rather, it’s companies building an airplane while it’s in flight, and once it’s built, they’ll know what it can do and whether anyone will pay for its services.

You might say, “making plus-or-minus-2% wouldn’t be the worst thing in the world,” and that’s certainly true if stocks were to sit still for the next ten years as the companies’ earnings rose, bringing the multiples back to earth. But another possibility is that the multiple correction is compressed into a year or two, implying a big decline in stock prices such as we saw in 1973-74 and 2000-02. The result in that case wouldn’t be benign. The above are the things to worry about. Here are the counterarguments: • the p/e ratio on the S&P 500 is high but not insane, • the Magnificent Seven are incredible companies, so their high p/e ratios could be warranted, • I don’t hear people saying, “there’s no price too high;” and • the markets, while high-priced and perhaps frothy, don’t seem nutty to me. * * * As I said at the start of this memo, I’m not an equity investor, and I’m certainly no expert on technology. Thus, I can’t speak authoritatively about whether we’re in a bubble. I just want to lay out the facts as I see them and suggest how you might think about them . . . just as I did 25 years ago. I hope you’ll keep reading for the next 25!2025

Compared to the past, today’s S&P 500 is increasingly made up of companies that (a) grow faster, (b) are less cyclical, (c) require less incremental capital to grow, enabling them to generate more free cash flow, and (d) have much stronger competitive positions or “moats.” Thus, they deserve above average p/e ratios. This explanation makes complete sense. It cites factors that really might be different. And per Sir John Templeton, the first person that I know talked about the trap of “it’s different this time,” 20 percent of the time things really are; today I’d bet it’s more than 20 percent. So, on one hand, “it’s different this time” is a recurring bull-market cliche that always bears scrutiny, and on the other hand, failing to recognize when things actually are different is something that stands between the average investor and superiority. I just have no idea which of those two concerns is more valid today. But investors should bear three things in mind: • the enormous likelihood that AI and related developments will change the world, • the possibility that it is “different” for some companies – those that truly embody the factors listed above and will demonstrate the “persistence” I described in On Bubble Watch, but also • the fact that in most “new, new things,” investors tend to treat far too many companies – and often the wrong ones – as likely to succeed.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Here are some important paragraphs from Azeem Azhar’s Exponential View of October 18: When does an AI boom tip into a bubble? [Investor and engineer] Paul Kedrosky points to the Minsky moment – the inflection point when credit expansion exhausts its good projects and starts chasing bad ones, funding marginal deals with vendor financing and questionable coverage ratios. For AI infrastructure, that shift may already be underway; the telltale signs include hyperscalers’ capex outpacing revenue momentum and lenders sweetening terms to keep the party alive. Paul makes a compelling case. We’ve entered speculative finance territory – arguably past the tentative stage – and recent deals will set dangerous precedents. As Paul warns, this financing will “create templates for future such transactions,” spurring rapid expansion in junk issuance and SPV proliferation among hyperscalers chasing dominance at any cost. . . . For AI infrastructure, the warning signs are flashing: vendor financing proliferates, coverage ratios thin, and hyperscalers leverage balance sheets to maintain capex velocity even as revenue momentum lags. We see both sides – genuine infrastructure expansion alongside financing gymnastics that recall the 2000 telecom bust. The boom may yet prove productive, but only if revenue catches up before credit tightens. When does healthy strain become systemic risk?

That’s the question we must answer before the market does. (Emphasis added) Azhar references the use of off-balance sheet financing via special-purpose vehicles, or SPVs, which were among the biggest contributors to Enron’s precariousness and eventual collapse. A company and its partners set up an SPV for some specific purpose(s) and supply the equity capital. The parent company may have operating control, but because it doesn’t have majority ownership, it doesn’t consolidate the SPV on its financial statements. The SPV takes on debt, but that debt doesn’t appear on the parent’s books. The parent may be an investment grade borrower, but likewise, the debt isn’t an obligation of the parent or guaranteed by it. Today’s debt may be backed by promised rent from a data center tenant – sometimes an equity partner – but the debt isn’t a direct obligation of the equity partner either. Essentially, an SPV is a way to make it look like a company isn’t doing the things the SPV is doing and doesn’t have the debt the SPV does. (Private equity funds and private credit funds are highly likely to be found among the partners and lenders in these entities.) As I quoted earlier, according to Perez (who wrote on the heels of the dot-com bubble), “what enabled the deployment period were the money-losing investments.” Early investment is lost in the “Minsky moment,” in which unwise commitments made in an extended up-cycle encounters value destruction in a correction.

” As a result, radio turned into one of the biggest bubbles in history – peaking in 1929, before losing 97 percent of its value in the crash. This wasn’t an incidental sector; RCA was, along with Ford Motor Company, the most high-traded stock on the market. It was, as The New Yorker recently wrote, “the Nvidia of its day.” . . . In 1927, Charles Lindbergh flew the first solo nonstop transatlantic flight from New York to Paris. . . .enormous,

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: ChatGPT-launch-level coordinating event – a signal to investors to pour money into the industry. “Expert investors appreciated correctly the importance of airplanes and air travel,” Goldfarb and Kirsch write, but “the narrative of inevitability largely drowned out their caution. Technological uncertainty was framed as opportunity, not risk. The market overestimated how quickly the industry would achieve technological viability and profitability.’’ As a result, the bubble burst in 1929 – from its peak in May, aviation stocks dropped 96 percent by May 1932. . . . It’s worth reiterating that two of the closest analogs AI seems to have in tech bubble history are aviation and broadcast radio. Both were wrapped in high degrees of uncertainty and both were hyped with incredibly powerful coordinating narratives. Both were seized on by pure play companies seeking to capitalize on the new game-changing tech, and both were accessible to the retail investors of the day. Both helped inflate a bubble so big that when it burst, in 1929, it left us with the Great Depression. (“AI Is the Bubble to Burst Them All,” Brian Merchant, Wired, October 27 – emphasis added. N.b., the Depression had many causes beyond the bursting of the radio/aviation bubble.)

Derek Thompson, who supplied the quote with which I opened this memo, ended his newsletter with some terrific historical perspective: The railroads were a bubble and they transformed America. Electricity was a bubble, and it transformed America. The broadband build-out of the late-1990s was a bubble that transformed America. I am not rooting for a bubble, and quite the contrary, I hope that the US economy doesn’t experience another recession for many years. But given the amount of debt now flowing into AI data center construction, I think it’s unlikely that AI will be the first transformative technology that isn’t overbuilt and doesn’t incur a brief painful correction. (“AI Could Be the Railroad of the 21 st Century. Brace Yourself.participants

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: I’ll elaborate regarding the first of the proposed non-comparable factors. Unlike in the internet bubble, AI products already exist at scale, the demand for them is exploding, and they’re producing revenues in rapidly increasing amounts. For example, Anthropic, one of the two leaders in producing models for AI coding as described on page 12, is said to have “10x-ed” its revenues in each of the last two years (for those who didn’t study higher math, that’s 100x in two years). Revenues from Claude Code, a program for coding that Anthropic introduced earlier this year, already are said to be running at an annual rate of $1 billion. Revenues for the other leader, Cursor, were $1 million in 2023 and $100 million in 2024, and they, too, are expected to reach $1 billion this year. As to the final bullet point, see the table below, which comes from Goldman Sachs via Derek Thompson. You’ll notice that during the internet bubble of 1998-2000, the p/e ratios were much higher for Microsoft, Cisco, and Oracle than they are today for the biggest AI players – Nvidia, Microsoft, Alphabet, Amazon, and Meta (OpenAI doesn’t have earnings). In fact, Microsoft’s on a half-off sale relative to its p/e 26 years ago! In the first bubble I witnessed – surrounding the Nifty-Fifty in 1969-72 – the p/e ratios for the leading companies were even higher than those of 1998-2000.

In Conclusion For my final citation, I’ll look to Sam Altman of OpenAI. His comments seem to me to capture the essence of what’s going on: “When bubbles happen, smart people get overexcited about a kernel of truth,” Mr. Altman told reporters this year. “Are we in a phase where investors as a whole are overexcited about A.I.? My opinion is yes. Is A.I. the most important thing to happen in a very long time? My opinion is also yes.” (The New York Times, November 20) But do I have a bottom line? Yes, I do. Alan Greenspan’s phrase, mentioned earlier, serves as an excellent way to sum up a stock market bubble: “irrational exuberance.” There is no doubt that investors are applying exuberance with regard to AI. The question is whether it’s irrational. Given the vast potential of AI but also the large number of enormous unknowns, I think virtually no one can say for sure. We can theorize about whether the current enthusiasm is excessive, but we won’t know until years from now whether it was. Bubbles are best identified in retrospect.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: While the parallels to past bubbles are inescapable, believers in the technology will argue that “this time it’s different.” Those four words are heard in virtually every bubble, explaining why the present situation isn’t a bubble, unlike the analogous prior ones. On the other hand, Sir John Templeton, who in 1987 drew my attention to those four words, was quick to point out that 20% of the time things really are different. But on the third hand, it must be borne in mind that behavior based on the belief that it’s different is what causes it to not be different! Today’s situation calls to mind a comment attributed to American economist Stuart Chase about faith. I believe it’s also applicable to AI (as well as to gold and cryptocurrencies): For those who believe, no proof is necessary. For those who don't believe, no proof is possible. Here’s my actual bottom line: • There’s a consistent history of transformational technologies generating excessive enthusiasm and investment, resulting in more infrastructure than is needed and asset prices that prove to have been too high. The excesses accelerate the adoption of the technology in a way that wouldn’t occur in their absence. The common word for these excesses is “bubbles.” • AI has the potential to be one of the greatest transformational technologies of all time. • As I wrote just above, AI is currently the subject of great enthusiasm.

If that enthusiasm doesn’t produce a bubble conforming to the historical pattern, that will be a first. • Bubbles created in this process usually end in losses for those who fuel them. • The losses stem largely from the fact that the technology’s newness renders the extent and timing of its impact unpredictable. This in turn makes it easy to judge companies too positively amid all the enthusiasm and difficult to know which will emerge as winners when the dust settles. • There can be no way to participate fully in the potential benefits from the new technology without being exposed to the losses that will arise if the enthusiasm and thus investors’ behavior prove to have been excessive. • The use of debt in this process – which the high level of uncertainty usually precluded in past technological revolutions – has the potential to magnify all of the above this time. Since no one can say definitively whether this is a bubble, I’d advise that no one should go all-in without acknowledging that they face the risk of ruin if things go badly. But by the same token, no one should stay all-out and risk missing out on one of the great technological steps forward. A moderate position, applied with selectivity and prudence, seems like the best approach. Finally, it’s essential to bear in mind that there are no magic words in investing.

These days, people promoting real estate funds say, “Office buildings are so yesterday, but we’re investing in the future through data centers,” whereupon everyone nods in agreement. But data centers can be in shortage or in oversupply, and rental rates can surprise to the upside or the downside. As a result, they can be profitable . . . or not. Intelligent investment in data centers, and thus in AI – like everything else – requires sober, insightful judgment and skillful implementation. December 9, 2025 P.S.: The following has nothing to do with the financial markets or the question of whether AI is the subject of a bubble. My topic is the impact of AI on society through joblessness and purposelessness.

© 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, a memo that primarily discussed the 13-year period from the end of 2008, when the U.S.

© 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 environment causes riskier investments to be aggressively pursued as described above; • in addition to moving lower, the capital market line also can 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 investors embrace illiquid investments. In all these ways, the return increments associated with longer-term, riskier, or less-liquid assets can become inadequate to fully compensate for the increase in risk.

© 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?

(I’m not going to go into detail, since the contemporaneous memos I cite in each section will supply more than enough for those 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 why I’ve long stressed the role of causality in market cycles. January 2000 In the fall of 1999, against the backdrop of the massive gains being achieved in tech, media, and telecom stocks, I read Edward 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.RESERVED

• 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 investment strategies that have served you best since 2009 will do so in the years ahead. Having supplied this summary, I’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?” Some suggest the Global Financial Crisis and bankruptcy of Lehman Brothers, some the bursting of the tech bubble, and some the Fed/government response to the pandemic-related woes. No one cites my candidate: the 2,000-basis-point 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 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 it in cool water and turn on the stove, it’ll just sit there, oblivious, until it boils to death.

© 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 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-aughts that felt to me like a slow- developing trainwreck, with an emphasis on “slow-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 bursting. Thus, in my memo Risk and Return Today from late 2004, I observed that (a) prospective returns on most asset classes were unusually low and (b) risk-seeking on the part of investors looking to improve on those low returns had led them to embrace higher-risk and “alternative” investments. I identified some 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. 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 investments, guided by time-honored platitudes such as “it’s different this time,” “higher risk means higher returns,” or “if it stops working, I’ll just get 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.

© 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, the S&P 500 dropped in 2000, 2001, and 2002, the first three- year stretch of negative returns since 1939. These declines caused many investors to lose interest in equities.

© 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 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’t be permitted to engage in risky activities, as this creates a situation where “heads, the shareholders and management win; tails, the taxpayers lose.” That proposition seems reasonable on its face and was implemented via the Dodd-Frank Act and its Volcker Rule. In general, bank regulation was significantly tightened. As time passed, the normal pushback against regulation emerged. The aspect that’s 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 billion (thanks in part to the lobbying of SVB’s 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 of days. Nevertheless, thanks to the post-GFC rules, the major U.S.

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-term average and enough to turn $1 in 1979 into $32 in 1999!! Once more from Déjà Vu All Over 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. And it will always be so. . . . The great irony here is that the extrapolator actually thinks he’s being respectful of history: he’s assuming continuation of a trend that has been underway. But the history that deserves his attention 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.

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. © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Bullish behavior came out of the pandemic-related bottom of March 2020; since then, significant problems have developed inside the economy (inflation) and outside (Ukraine); and there’s been a significant correction. No one, including me, knows what the sum of those things implies for the future. I’m writing only to place recent events in the context of history and point out a few implied lessons. 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 entered the investment world too late to have experienced that event. You may ask, “What about the market gains that preceded the Global Financial Crisis of 2008-09 and the pandemic-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.

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 cost,” 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, “It 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’s gone from $100 to $50? Everyone knows a decline like that can foreshadow further 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.

© 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.

© 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 money back with interest (a) if no acquisition was consummated within two years or (b) if investors 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 organized soared from just 10 in 2013 and 59 in 2019 to 248 in 2020 and 613 in 2021.

© 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 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’s 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, 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 today, you get the impression that prices are the result of fundamentals and changes in prices are the result of changes in fundamentals. And that is vastly inadequate. (By the way, they always say, “The market went up today because of 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’t found where you go to get an explanation of the market’s behavior, even after the fact.) But it’s not true that it’s all about fundamentals.

Reducing volatility for its own sake is a suboptimizing strategy: It should be presumed that favoring lower- volatility assets and approaches will – all things being equal – lead to lower 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 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 began to pile into hedge funds following the three-year decline of stocks brought on by the bursting of the tech bubble in 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 they knew it was what the institutions were after.

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.” 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 do the former without also doing the latter. They’re 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, you can’t have a negative return. If you invest in an index fund, you can’t underperform the index. But then two more words appear in the second bubble: “Can’t win.” People who use can’t-lose strategies by necessity surrender the possibility of winning. T- bill investors can’t earn more than the lowest of yields. Index fund investors can’t outperform. • And that brings me to the assignment I imagine receiving from unenlightened clients: “Just apply the first set of words from each bubble: Try to outperform while employing can’t-lose strategies.” But that combination happens to be unavailable.

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. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

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. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Since the Tech Bubble burst in 2000, however, the market has appeared to think mostly about the economy, the Federal Reserve and Treasury, and world events. That’s been even more true since the Global Financial Crisis in 2008. That’s why I’m devoting a memo to a subject I largely disavow. I’ll try below to enumerate the macro issues that matter, discuss the outlook for them, and end with some advice regarding what to do about them. That reminds me to put forth my conviction that we all have views about the future, but as we say at Oaktree, “It’s one thing to have an opinion, but something very different to assume it’s right and bet heavily on it.” That’s what Oaktree doesn’t do. Inflation As of this writing, macro considerations are certainly in the ascendency, centering on the subject of inflation. Over the last 16 months, the Fed, Treasury and Congress have used a firehose of money to support, subsidize and stimulate workers, businesses, state and local governments, the overall economy and the financial markets. This has resulted in (a) confidence in the prospects for a strong economic recovery, (b) skyrocketing asset prices, and (c) fear of rising inflation.

The growth investing camp, on the other hand, came into existence during the “go-go” early years of the 1960s, the decade in which I started my career in the equity research department at First National City Bank. Investor interest in rapid growth led to anointment of the so-called Nifty Fifty stocks, which became the investment focus of many of the money-center banks (including my employer), which were the leading institutional investors of the day. This group comprised the fifty companies believed to be the best and fastest-growing in America: companies that were considered so good that “nothing bad could happen to them” and “there was no price too high” for their shares. Like the objects of most manias, the Nifty Fifty stocks showed phenomenal performance for years as the companies’ earnings grew and their valuations rose to nosebleed levels, before declining precipitously between 1972 and 1974. Thanks to that crash, they showed negative holding-period returns for many years. Their dismal performance cost me my job as director of equity research (and led to my being assigned to start funds for investment in high yield and convertible bonds – my lucky break). It’s worth noting, however, that the truly durable growth companies among the Nifty Fifty – about half of them – compiled respectable returns for 25 years, even when measured from their pre-crash highs, suggesting that very high valuations can be fundamentally justified in the long term for the rare breed of company.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: I began to form my investment philosophy in the 1960s. Investment thought was much less developed at that time, and what did exist was heavily dominated by the philosophy espoused by Ben Graham. Buffett was still searching for his last puff of “cigar butts” and had yet to coin the term “moat” in reference to the lasting competitive advantages that sustain high-quality businesses. My philosophy was informed by the fact that I started working in 1969, during the “Nifty Fifty” bubble, which I watched crash around me. It was further shaped by my transition in 1978 from equities to fixed income investments in the form of convertible and high yield bonds. Importantly, Graham and his less famous co-author, David Dodd, characterized bond management as a “negative art.” What did they mean? In general, bond investors’ return is capped at a yield that stems from the promised interest payments and payoff at par upon maturity; that’s why it’s called “fixed income.” The upshot is that all bonds bought at a 6% yield will return 6% when held to maturity if they pay. Bonds that don’t pay, on the other hand, will produce losses of varying magnitudes. Thus, oversimplifying, you improve your performance in bonds not through which paying bonds you buy (since all 6% bonds that pay will have the same return), but through what you exclude (that is, whether you’re able to avoid the ones that don’t pay).

It’s important to note, that when markets are at extreme levels of optimism, as we saw in both the Nifty Fifty and Dot Com bubbles, (a) every company in the affected field is treated as a long-term winner, (b) if bought in times of significant optimism and extreme valuations for growth, the stocks of even the greatest companies are likely to produce outcomes that are mediocre at best, and (c) in the crashes that follow most bubbles, enormous interim markdowns can befall good companies as well as bad, requiring sharp analysis to differentiate between them, and high conviction and an iron stomach to hold on. I want to make very clear that I do not intend this to imply an opinion about growth stocks’ valuations today. I’ve heard a variety of views, and while I have my own, I don’t want to make it the subject of this memo. In the spirit of seeking to understand this new world, market commentators (including me) would be well served to understand the fundamentals underpinning the small number of companies that currently drive a huge percentage of the market, instead of basing top-down conclusions on purely historical valuation comparisons. And it seems imprudent to opine on the level of the overall market without being fully informed regarding the tech companies that now account for so much of equity indices like the S&P 500.

What happens to parts of the country that are left out of the new economy? Finally, much of the worry about whether we’re in a bubble relates to valuations. For the S&P 500, for example, the current ratio of price to projected 2021 earnings is roughly 22 (depending on which earnings estimates you use). This seems expensive compared to the historic average in the range of 15- 16. But knee-jerk judgments based on the relationship between current valuations and historic averages are too simplistic to be dispositive. Before making a judgment about today’s valuation of the S&P 500, one must consider (a) the context in terms of interest rates, (b) the shift in its composition in favor of rapidly growing technology companies, with their higher valuations, (c) the valuations of the index’s individual components, including those tech companies, and (d) the outlook for the economy. With these factors in mind, I don’t think most of today’s asset valuations are crazy. Of course, a big correction in speculative stocks could have a negative impact on today’s bullish investor psychology. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In particular, as to item (a) above, we can look at the relationship between today’s 4.5% earnings yield* on the S&P 500 and the yield on the 10-year Treasury note of 1.4%. The implied “equity risk premium” of 310 basis points is very much in line with the average of 300 bp over the last 20 years. Valuations can also be viewed relative to short-term interest rates. The current p/e ratio on the S&P 500 of 22 is slightly below the reading of 24 in March 2000 (the height of the tech bubble), and the fed funds rate is around zero today versus 6.5% back then. Thus, in 2000, the earning yield on the S&P 500 was 4.2%, or 230 basis points below the fed funds rate, while today it’s 450 bp above. In other words, the S&P 500 is much cheaper today relative to short-term rates than it was 21 years ago. The story is similar in the credit market. For example, the yield spread on high yield bonds versus Treasurys is below the historic range, although probably still more than adequate to offset likely credit losses. Thus, as with most other assets today, the price of high yield bonds is high in the absolute, fair-ish in relative terms, and highly reliant on interest rates staying low. So where does that leave us?

In many ways, we’re back to the investment environment we faced in the years immediately prior to 2020: an uncertain world, offering the lowest prospective returns we’ve ever seen, with asset prices that are at least full to high, and with people engaging in pro-risk behavior in search of better returns. This suggests we should return to Oaktree’s pre-Covid-19 mantra: move forward, but with caution. But a year or two ago, we were in an economic recovery that was a decade old – the longest in history. Instead, it now appears we’re at the beginning of an economic up-cycle that’s likely to run for years. Over the course of my career, there have been a handful of times when I felt the logic for calling a top (or bottom) was compelling and the probability of success was high. This isn’t one of them. There’s increasing mention of a possible bubble based on concerns about valuations, federal government spending, inflation and interest rates, but I see too many positives for the answer to be black-or-white. In the interest of moving toward a conclusion, I’m going to briefly recap the pros, cons and counter- arguments: • The economic outlook is positive, although Chairman Powell warns that the recovery remains “uneven and far from complete,” with inadequate job creation. • Thus he says the Fed will keep interest rates low for years. But with fiscal and monetary policy extremely accommodative, rates are already on the move up and vulnerable to increased inflation.

The old me likely would have latched onto today’s high valuations and instances of risky behavior to warn of a bubble and the subsequent correction. But looking through a new lens, I’ve concluded that while those things are there, it makes little sense to significantly reduce market exposure: • on the basis of inflation predictions that may or may not come true, • in the face of some very positive counterarguments, and • when the most important rule in investing is that we should commit for the long run, remaining fully invested unless the evidence to the contrary is absolutely compelling. Finally, I want to briefly touch on the level of today’s markets. Over the four or five years leading up to 2020, I was often asked whether we were in a high yield bond bubble. “No,” I answered, “we’re in a bond bubble.” High yield bonds were priced fairly relative to other bonds, but all bonds were priced high because interest rates were low. Today, we hear people say everything’s in a bubble. Again, I consider the prices of most assets to be fair relative to each other. But given the powerful role of interest rates in determining those prices, and the fact that interest rates are the lowest we’ve ever seen, isn’t it reasonable that many asset prices are the highest we’ve ever seen? For example, with the p/e ratio of the S&P 500 in the low 20s, the “earnings yield” (the inverse of the p/e ratio) is between 4% and 5%. To me, that seems fair relative to the yield of roughly 1.

We’ve never had such a catalyst for technology adoption as we’ve had in the coronavirus pandemic. We’ve had a boom of new public companies coming to market, both through IPOs and SPACs, reversing the long trend of a shrinkage in the number of public companies. We’ve never had interest rates as low as they are and as likely to stay low for as long as has been telegraphed. The Internet has permeated the world and changed it, and business models have evolved in a way that makes today’s situation incomparable to the Nifty Fifty or the Dot Com Bubble of the late ’90s (for example, in 1998 there were 150 million Internet users globally; today there are more than that in Indonesia alone). I believe most types of investment are likely to go through periods of both outperformance and underperformance. There are reasons to believe (with ample counterarguments) that as the tide turns on monetary policy (if it ever does), rising interest rates will disproportionately hurt growth stocks, just as they’ve been disproportionately helped during this period of easy money. More importantly, it has long been true that when something works, people follow the herd, chase the gains, and bid it up to the point where prospective returns are paltry, thus positioning investments that have been out of favor to become the new outperformers. But, as I said earlier, broad observations about historic valuations are not a sufficient foundation for market opinions today.

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 limited to low conviction. H: Well for one thing, the p/e ratio is awfully high. A: The p/e ratio is just a very quick heuristic that doesn’t necessarily tell you much about the company. You can’t say a stock is overvalued just because its p/e ratio is high relative to historic average p/e’s for the market. All that matters is thinking about how much cash flow the company can produce over a long period of time, discounting that at a reasonable discount rate, and comparing the resultant present value against the current price. There are lots of things – about both the company’s present condition and its future potential – that don’t get picked up in a p/e ratio, so a high multiple alone shouldn’t scare you off. H: Aha! That’s just what they said during the Nifty Fifty bubble around the time I started working. “No price too high,” was a widespread mantra.

Coca-Cola reached 46x earnings at the height of the bubble in mid-1972 – 2.4x the p/e on the S&P 500. From there it fell 65% over the next year and a half. A: First, saying a high p/e alone shouldn’t stop you from owning something doesn’t mean there’s no price too high. It simply means that no single metric can hold the key to investment decisions, and the price of something should be weighed against its fundamental potential. Coke may have been overvalued in 1972 at its p/e of 46. In particular, since it dealt in a physical product and required incremental capital to grow, © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: it didn’t have potential for exponential growth. But note that Coke holders did earn a compound return of 16% percent a year for 26 years even if they bought at the 1972 pre-crash high. So, even without the growth prospects of today’s best businesses, companies that can compound earnings at high rates can merit very high p/e ratios. H: Aren’t you concerned that if the leading stocks of today go out of style, you could see XYZ down a third or more? A: Stocks can go in and out of style, causing their prices to fluctuate wildly. And when a group is in vogue, it may be more likely to experience a reversal. But, at the end of the day, all I care about is this specific company and its long-term potential which, even when using conservative assumptions, I find to be immense relative to its current price. Seeing it fall wouldn’t be fun, but I think selling here and missing out on part of that future would be far worse. Some years XYZ may do well, and some years it may do poorly (even perhaps very poorly). But if I’m right, I think it has a great long-term future ahead of it. The only way to be sure we participate in that future is to hold on throughout. And, by the way, if you don’t sell, you get to compound without paying capital gains taxes until the end. H: You run a concentrated portfolio. XYZ was a big position when you invested, and it’s even bigger today, given the appreciation.

Around the early-June high and in the time since, the most frequent ones have been, “How can stocks be doing so well during a severe pandemic and recession?” “Have the securities markets decoupled from reality?” and “Is this irrational exuberance?” The process of answering these questions gives me an opportunity to dissect the breathtaking market rise. The world is combatting the greatest pandemic in a century and the worst economic contraction of the last 80+ years. And yet the stock market – supposedly a gauge of current conditions and a barometer regarding the future – was able to compile a record advance and nearly recapture an all-time high that had been achieved at a time when the economy was humming, the outlook was rosy, and the risk of a pandemic hadn’t registered. How could that be? The possible reasons for the markets’ recovery are many and, as I write this memo, the list is growing as people find more things to take positively. (As usual, the higher the market goes, the easier it becomes for investors to find rationalizations for a further rise.) I’ll survey the apparent reasons below: © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The U.S.’s effective private sector will supplement the public health efforts of government, producing massive amounts of supplies and equipment, and developing testing, treatments and vaccines. • The price declines of securities will draw in buyers, and ample capital is available in the form of dry powder in funds. When I read the more positive views regarding the current episode, I can’t help but think back to my favorite newspaper headline, which included the phrase “Bankers Optimistic.” Usually the case, perhaps, but it’s worth noting that the story in question was published on October 30, 1929, reporting on the prior day’s stock market crash. On that day of optimism, the Great Depression still had eleven years to run. The Negative Case I always say we have to be aware of and open about our biases. I admit to mine: I’m more of a worrier than a dreamer. Maybe that’s what made me a better credit analyst than equity analyst. On average I may have been more defensive than was necessary (although somehow I was able to shift to aggressive action when crisis lows were reached during my career). Thus it shouldn’t come as a surprise today that my list of cons is longer than my pros (and I will elaborate on them at greater length). • I’m very worried about the outlook for the disease, especially in the U.S. For a long time, the response consisted of suggestions or advice, not orders and rules.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Self-Fulfilling Expectations Pose Real Economic Risks: Consumers increasingly expect the economy to get worse. Morning Consult’s Index of Consumer Expectations (ICE) fell 2.5 points since Feb. 24 and currently stands at 112.9. The fear for policymakers is that the slide in consumers’ future expectations becomes a self-fulfilling prophecy: As more consumers expect the economy to contract in the coming months, they become more likely to delay discretionary purchases, which in turn drives down aggregate U.S. demand. (Morning Consult, March 1) Investor Reaction The markets’ decline in the seven trading days February 20-28 certainly represents a very strong negative reaction. The S&P 500, for example, declined by 432 points, or 12.8%. Here are a couple of indications of its magnitude: The market crash in the past two weeks has been truly historic: its probability of occurrence is ~0.1% since 1896; the velocity of the plunge and of the VIX surge is the fastest on record; and the 10-year [Treasury yield] is at all-time low.

(Hao Hong, BOCOM International, a subsidiary of Bank of Communications, March 1) While we are merely days into it, this stress episode is already among the most substantial of the last 25 years, joining an elite group that includes Asian Contagion (1997), LTCM (1998), the WTC attack (2001), the Accounting Scandals (2002), the Big One (2008-2009), the Flash Crash (2010), the Eurozone Crisis (2011), the China “re-peg” (2015) and the VIX event (2018). (Dean Curnutt, Macro Risk Advisors, March 1) There’s no doubt about the fact that the coronavirus represents a major problem, or that the reaction so far has been severe. What really matters is whether the price change is proportional to the worsening of fundamentals. For most people, the easy thing is to say that (a) the disease is dangerous, (b) it will have a negative impact on business, (c) it has kicked off a major reaction to date, and (d) we have no way of knowing how far the decline will go, so (e) we should sell to avoid further carnage. But none of the above means selling is necessarily the right thing to do. All these statements reflect a measure of pessimism. However, there’s no way to tell whether that pessimism is appropriate, inadequate or excessive. I wrote in On the Couch, (January 2016) that “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.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: companies have grown and become more highly valued, and as indices like the S&P 500 have changed their composition to remain relevant. While I’m no expert, I’m going to cite a few of the arguments regarding the significance and implications of this trend. (Thus I pass on these appealing arguments; I don’t endorse them). First, the attributes and returns on the two groups of stocks have become more differentiated. • The gap between the growth outlook for FAAMG (Facebook, Apple, Amazon, Microsoft and Google) and similar companies and that for the rest (in the slow-growing 21st century) is huge and expanding. • The adoption of technology has been pulled forward by the pandemic. Thus virtual meetings, ecommerce and cloud computing are now commonplace, not the exception. • Current profits severely understate the tech leaders’ potential. They currently choose to spend aggressively on new product development to expand share and head off competition, voluntarily suppressing profit margins. Thus enormous potential exists for the tech companies to increase profit margins in the future when they become willing to moderate their growth rates. • Their addressable markets are larger than ever and growing, giving them greater “runway.” For example, at the end of 1999, during the tech bubble, there were 248 million Internet users in the world. Now there are more than that in the U.S. alone and almost 5 billion worldwide.

What It All Means for the Markets For years leading up to 2020, I described the investment environment as follows: • An unusually high level of uncertainty (mostly exogenous and geopolitical) • The lowest prospective returns ever • Asset prices that were full to excessive • Pro-risk behavior being engaged in by investors trying for high returns Taken together, these things told me we were living in a low-return world in which the promised returns didn’t fully compensate for the risks. It wasn’t a bubble, characterized by absurdly high prices. And there was no way to say for sure when the good times would end or why. It was merely the absence of justification for taking full risk. Thus Oaktree operated under the mantra “Move forward, but with caution.” We invested, and we tried to be fully invested. But we endeavored to do so “with caution.” And since we always take a cautious approach to our risk-asset strategies, it really meant “more caution than usual.” Being fully invested in a cautious portfolio caused us to lag the benchmarks a bit in some of the asset classes where we have them, as it turned out that caution generally wasn’t needed – until this year. Our cautious stance was rewarded in the difficult first quarter of 2020. The conditions I described above made the markets vulnerable to exogenous shock, and we got a doozy.

They will be hearing overwhelmingly compelling reasons why stock prices should go higher, why the bull market should last considerably longer than any other in history, why this boom will not be followed by a 1929-like crash and why “this time it’s different.” Many of these arguments will be tempting because they will have some element of truth to them. Even Mr. Templeton concedes that when people say things are different, 20 percent of the time they are right. But the danger lies in thinking that the different factor – like the recent investment in United States stocks by the Japanese – will be uninterrupted. Wallace’s essential message is that investors must take heed when the four words are in widespread use. Why? Look back at the paragraph introducing the above quote: when you first read it, did you happen to notice the date of publication? It was just eight days before Black Monday (October 19, 1987), the worst day in stock market history. We know how bad it feels when the market falls 20% in a year. Try 22% in a day!! Wallace’s warning was particularly important at the time the article was published, but for me it’s always important. * * * © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: capital investment in the information age, so less demand for long-term debt capital. One more thing that may be bringing down long-term yields is an increase in general worry among investors, and thus a flight to the safety of Treasurys. When demand for bonds rises, sellers are able to require buyers to pay higher prices, which translate into lower yields. I don’t fully understand why an inverted yield curve should be a negative, but its fans swear that it is. I merely can’t prove that it’s not. One possible ramification is the threat to bank profitability: an inverted yield curve takes away banks’ ability to make money simply by borrowing short to lend long. Profitless success – Historically, companies have been considered valuable primarily because they produce profits – if not immediately, then at least they were expected to do so in the foreseeable future. Then the view arose in the tech-media-telecom bubble of the late 1990s that companies could be great (and valuable) even in the absence of profits for years to come. Today, profitless companies are back in vogue and sometimes valued in the tens of billions of dollars. Tech and venture investors have made a lot of money over the last ten years.

Thus there’s great interest in tech companies (including ones like Uber and Lyft that are applying technology to enable new business models) and willingness to pay high prices today for the possibility of profits far down the road. There’s nothing wrong with this, as long as the possibility is real, not over-rated and not over-priced. The issue for me is that in a period when profitless-ness isn’t an impediment to investor affection – when projected tech-company profitability commencing years from now is valued as highly as, or higher than, the current profits of more mundane firms – investing in these companies can be a big mistake. Today there are a lot of investors who weren’t around to see the 2000 bursting of the TMT bubble, in which large numbers of Internet and e-commerce companies were given the benefit of the doubt, only to end up worthless. Venture capital funds showed triple-digit annual returns in the late 1990s, but the ones started around 2000 performed very poorly (and people began to ask me if venture capital was a legitimate asset class). Today, some tech and venture investments have again produced great results, and the doubts seem to be gone. In investing, however, the truth usually lies somewhere between the extremes of infinite value and worthlessness. Investor sentiment seems to be closer to the positive end of the pendulum’s arc these days, but it’s unlikely to stay there in perpetuity.

”  The potential catalysts for decline that we have to worry about most may be the unknown ones. And although I read recently that bull markets don’t die of old age or collapse of their own weight, I think sometimes they do (a dollar for anyone who can identify the catalyst for the collapse of the bull market and tech bubble in 2000 – it’s not easy). The bottom line of the above is that some people are excited about the fundamentals, and others are wary of asset prices. Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily. As I wrote in September, most people (and certainly the media) want definite answers: in or out? buy or sell? risk-on or risk-off? But it’s rare for answers that simple to be correct. There’s a wide range of possible stances that investors might adopt. At one end of the spectrum there’s maximum aggressiveness (100% invested in high-beta, high-risk assets, or maybe more than 100% through the use of leverage), and at the other there’s maximum defensiveness (100% cash, or perhaps being net short). Most investors are never either of those. And I certainly wouldn’t be either of them today; I’d be someplace in between. That’s easy to say. But where? Closer to the bullish end of the spectrum or the bearish end? Or balancing the two equally? My answer today, as readers know, is that I would favor the defensive or cautious part of the spectrum.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The market seems extremely comfortable with the proposition that as long as the macro- environment remains benign, stocks prices can continue to appreciate at rates that far outstrip the growth of their issuers’ profits, and thus the growth of their intrinsic value. Few market participants seem concerned about appropriate valuation levels – the relationship between assets and their prices – and this is a condition that we think must eventually have negative consequences. . . . Today’s combination of a stable economy, low interest rates, enormous cash flows and strong investor optimism has created a climate in which capital is available for both good investments and bad, and in which risk is rarely seen as something to be shunned. I wrote that in 1997, in a clients-only memo entitled “Are You an Investor or a Speculator?” I was cautionary then, like I am now. And it took almost three years for that to turn out to be correct. That doesn’t mean it wasn’t correct when it was written . . . just early. Today there’s beginning to be talk of a possible late-bull-market melt-up, making investors more money but perhaps fulfilling the requirements for a full-fledged bubble. (This may be part of the usual pattern of capitulation that occurs when those who haven’t fully participated lose the will to keep abstaining after years of market gains.)

The basic themes supporting the “melt-up” theory include (a) the existence of the fundamental positives listed above and (b) the arrival of euphoric psychology, which has been absent to date. For me the key points regarding the general market outlook are as follows:  The absence of widespread euphoria certainly is an important flaw in any near-term bearish view.  Thus there’s no reason for confidence in the existence of a soon-to-burst bubble.  Investor psychology continues to grow more confident, however.  Asset prices are already unusually high.  Future events remain unpredictable, but today’s high prices mean the odds are against a significant long-term upward move from here.  No one can say what’s going to happen in the short term. Asset prices and valuation metrics are certainly worrisome, but psychology and its implications – as well as timing – are unpredictable. I think that’s about all we can know. Thus Oaktree will continue to invest on the basis of value and its relationship to price, and to refrain from trying to time markets based on predictions regarding economies, markets or psychology. The “melt-up” school says securities that already are highly priced may become more so. We’d never bet on whether they will or won’t. Our post-2011 mantra remains in force: we’re investing when we find reasonable propositions, albeit with caution.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: This time around, it’s mainly public and private debt that’s the subject of highly increased popularity, the hunt by investors for return without commensurate risk, and the aggressive behavior described above. Thus it appears to be debt instruments that will be found at ground zero when things next go wrong. As often, Grant’s Interest Rate Observer puts it well: Naturally, the lowest interest rates in 3,000 years have made their mark on the way people lend and borrow. Corporate credit, as [Wells Fargo Securities analyst David] Preston observes, is “lower-rated and higher-levered. This is true of investment- grade corporate debt. This is true in the loan market. This is true in private credit.” So corporate debt is a soft spot, perhaps the soft spot of the cycle. It is vulnerable not in spite of, but because of, resurgent prosperity. The greater the prosperity (and the lower the interest rates), the weaker the vigilance. It’s the vigilance deficit that crystalizes the errors that lead to a crisis of confidence. Conditions overall aren’t nearly as bad as they were in 2007, when banks were levered 32-to-1; highly levered investment products were being invented (and swallowed) daily; and financial institutions were investing heavily in investment vehicles built out of sub-prime mortgages totally lacking in substance. Thus I’m not describing a credit bubble or predicting a resulting crash.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: There They Go Again . . . Again Some of the memos I’m happiest about having written came at times when bullish trends went too far, risk aversion disappeared and bubbles inflated. The first and best example is probably “bubble.com,” which raised questions about Internet and e-commerce stocks on the first business day of 2000. As I tell it, after ten years without a single response, that one made my memo writing an overnight success. Another was “The Race to the Bottom” (February 2007), which talked about the mindless shouldering of risk that takes place when investors are eager to put money to work. Both of those memos raised doubts about investment trends that soon turned out to have been big mistakes. Those are only two of the many cautionary memos I’ve written over the years. In the last cycle, they started coming two years before “The Race to the Bottom” and included “There They Go Again” (the inspiration for this memo’s title), “Hindsight First, Please,” “Everyone Knows” and “It’s All Good.” When I wrote them, they appeared to be wrong for a while. It took time before they were shown to have been right, and just too early.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so. Do you see any differences between then and now? Is there any need to redo this description? Not for me; I think “ditto” will suffice. I’ll simply go on to borrow the conclusion from “The Race to the Bottom” (February 2007): Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. The Seeds for a Boom My son Andrew worked extensively with me in preparing this memo. We particularly enjoyed making a list of the elements that typically form the foundation for a bull market, boom or bubble. We concluded that some or all of the following are necessary conditions. A few will give us a bull market.

All of them together will deliver a boom or bubble:  A benign environment – good results lull investors into complacency, as they get used to having their positive expectations rewarded. Gains in the recent past encourage the heated pursuit of further gains in the future (rather than suggest that past gains might have borrowed from future gains).  A grain of truth – the story supporting a boom isn’t created out of whole cloth; it generally coalesces around something real. The seed usually isn’t imaginary, just eventually overblown.  Early success – the gains enjoyed by the “wise man in the beginning” – the first to seize upon the grain of truth – tends to attract “the fool in the end” who jumps in too late.  More money than ideas – when capital is in oversupply, it is inevitable that risk aversion dries up, gullibility expands, and investment standards are relaxed.  Willing suspension of disbelief – the quest for gain overcomes prudence and deference to history. Everyone concludes “this time it’s different.” No story is too good to be true.  Rejection of valuation norms – all we hear is, “the asset is so great: there’s no price too high.” Buying into a fad regardless of price is the absolute hallmark of a bubble.  The pursuit of the new – old timers fare worst in a boom, with the gains going disproportionately to those who are untrammeled by knowledge of the past and thus able to buy into an entirely new future.

The idea that you would do something different with a March expectation rather than a December expectation ignores the likelihood that the expectation of a March rate rise would begin to be reflected in asset prices well before March. That means the likely date of a rate rise is not a very useful piece of information. What could go wrong? – For years it has felt to most people that we’ve been in a Goldilocks environment: neither too hot nor too cold. The economy hasn’t grown slowly enough to cause recession or deflation, or fast enough to bring on hyperinflation and the need for restrictive action. The markets have been strong enough to bode well, but not so strong as to suggest a bubble. Ditto for investor psychology. Most people don’t want to tempt fate by saying things will go well forever, and in fact they know they won’t. It’s just that they can’t decide what it is that will go wrong. The truth is that while I can enumerate them, the obvious candidates (changes in oil prices, interest rates, exchange rates, etc.) are likely to already be anticipated and largely priced in. It’s the surprises no one can anticipate that would move markets most if they were to happen. But (a) most people can’t imagine them and (b) most of the time they don’t happen. That’s why they’re called surprises.

The “pro” side of the argument foresees limitless appreciation, but that doesn’t make sense. Think of any other currency: isn’t there a price at which you wouldn’t accept it? Would you sell your house for euros that are said to be worth two or three times as much as the dollar? Marc Andreessen wrote an excellent article in The New York Times’ Dealbook, titled “Why Bitcoin Matters” (January 21, 2014). The article outlined Bitcoin’s potential as a payment system and described many of the advantages listed above. But it didn’t include one word about why these advantages give Bitcoin appreciation potential. So what’s my real bottom line?  Advocates say if Bitcoin is accepted as described above, you’ll make more than 50 times your money. Thus success doesn’t have to be highly probable for buying Bitcoin to have a huge expected return. This is called “lottery-ticket thinking,” under which it seems smart to bet on an improbable outcome that offers a huge potential payoff. We saw it in full flower in the dot-com boom in 1999-2000, and I think we’re seeing it in action again today with regard to Bitcoin. Nothing is as seductive as the possibility of vast wealth.  Several of the “seeds for a boom” that I listed in “There They Go Again . . .

Again” are at work in the Bitcoin surge: (a) there is a grain of underlying truth as set out above; (b) there’s the prospect of a virtuous circle: widespread demand will lead to wider acceptance as legal tender, which will lead to widespread demand; and (c) thus this tree may grow to the sky, as there is no obvious limit to this logic. None of these things necessarily make Bitcoin a mistake. They merely say elements that contributed to past bubbles can be detected today with regard to Bitcoin.  Finally, Bitcoin isn’t alone. There are hundreds of digital currencies already – including eleven with market capitalizations over a billion dollars – and no limits on the creation of new ones. So even if digital currencies are here to stay, who knows which one will turn out to be the winner? Hundreds of e-commerce start-ups appreciated rapidly in the tech bubble based on the premise that “the Internet will change the world.” It did, but most of the companies ended up worthless. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

In the tech bubble of the late 1990’s, for example, investors concluded that:  stocks were doing so well that they would continue to attract capital,  since tech companies and tech stocks were the best performers, they were sure to continue attracting a disproportionate share of the new buying,  the superior performance of the tech stocks would cause more of them to be added to the stock indices,  this would require index funds and closet indexers to direct a rising share of their buying to tech stocks, © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Thanks to the people who took the time to educate me, I’m a little less of a dinosaur regarding Bitcoin than I was when I wrote my last memo. I think I understand what a digital currency is, how Bitcoin works, and some of the arguments for it. But I still don’t feel like putting my money into it, because I consider it a speculative bubble. I’m willing to be proved wrong. Passive Investing Passive investing can be thought of as a low-risk, low-cost and non-opinionated way to participate in “the market,” and that view is making it more and more popular. But I continue to think about the impact of passive investing on the market. One of the most important things to always bear in mind is George Soros’s “theory of reflexivity,” which I paraphrase as saying that the efforts of investors to master the market affect the market they’re trying to master. In other words, how would golf be if the course played back: if the efforts of golfers to put their shot in the right place caused the right place to become the wrong place? That’s certainly the case with investing. It’s tempting to think of the investment environment as an unchanging backdrop, that is, an independent variable. Then all you have to do is figure out the right course of action and take it. But what if the environment is a dependent variable? Does the behavior of investors alter the environment in which they work? Of course it does.

” In short, as I wrote in the memo, I believe the market is “not a nonsensical bubble – just high and therefore risky.” I wouldn’t use the word “bubble” to describe today’s general investment environment. It happens that our last two experiences were bubble-crash (1998-2002) and bubble-crash (2005-09). But that doesn’t mean every advance will become a bubble, or that by definition it will be followed by a crash.  Current psychology cannot be described as “euphoric” or “over-the-moon.” Most people seem to be aware of the uncertainties that are present and of the fact that the good times won’t roll on forever.  Since there hasn’t been an economic boom in this recovery, there doesn’t have to be a major bust.  Leverage at the banks is a fraction of the levels reached in 2007, and it was those levels that gave rise to the meltdowns we witnessed.  Importantly, sub-prime mortgages and sub-prime-based mortgage backed securities were the key ingredient whose failure directly caused the Global Financial Crisis, and I see no analog to them today, either in magnitude or degree of dubiousness. It’s time for caution, as I wrote in the memo, not a full-scale exodus. There is absolutely no reason to expect a crash.

Start-ups that have followed this path have generally collected Ether from investors and exchanged them for units of their own specialized virtual currency, leaving the entrepreneurs with the Ether to convert into dollars and spend on operational expenses. These coin offerings, which have proliferated in recent months, have created a surge of demand for the Ether currency. Just last week, investors sent $150 million worth of Ether to a start-up, Bancor, that wants to make it easier to launch virtual currencies. Bottom line: you can use the imaginary currency Ether to buy other new imaginary currencies, or to invest in new companies that will create other new currencies. In “bubble.com,” I highlighted some illogical aspects of e-commerce by including some of my father’s old jokes regarding how to make money. Here’s another that seems 100% appropriate for the digital currency movement: Two guys meet in the street. Joe tells Bob about the hamster he has for sale: pedigreed and highly intelligent. Bob says he’d like to buy a hamster for his kid: “How much is it?” Joe answers, “half a million,” and Bob tells him he’s crazy. They meet again the next day. “How’d you do with that hamster?” Bob asks. “Sold it,” says Joe. “Did you get $500,000?” Bob asks. “Sure,” says Joe. “Cash?” “No,” Joe answers, “I took two $250,000 canaries.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Maybe I’m just a dinosaur, too technologically backward to appreciate the greatness of digital currency. But it is my firm view that the ability of these things to gain acceptance is just one more proof of the prevalence today of financial naiveté, willing risk-taking and wishful thinking. In my view, digital currencies are nothing but an unfounded fad (or perhaps even a pyramid scheme), based on a willingness to ascribe value to something that has little or none beyond what people will pay for it. But this isn’t the first time. The same description can be applied to the Tulip mania that peaked in 1637, the South Sea Bubble (1720) and the Internet Bubble (1999-2000). Serious investing consists of buying things because the price is attractive relative to intrinsic value. Speculation, on the other hand, occurs when people buy something without any consideration of its underlying value or the appropriateness of its price, solely because they think others will pay more for it in the future. It isn’t unreasonable for someone to use Bitcoin to pay for something – or for a seller to accept Bitcoin in payment – based on an agreement between the parties: barter takes place all the time. But does that make it “currency”? The price of Bitcoin has more than doubled since the start of the year.

Can something that does that seriously be considered a “medium of exchange” or “store of value,” rather than the subject of a speculative mania? Maybe not, but Bitcoin looks staid in comparison to Ether, which has appreciated 4,500% so far this year. The outstanding Ether is now worth 82% as much as all the Bitcoin in the world, up from 5% at the beginning of the year. The New York Times notes that together, the outstanding Bitcoin and Ether are worth more than Paypal and almost as much as Goldman Sachs. Would you rather own all of the two digital currencies or one of those companies? In other words, are these currencies’ values real? They’re likely to keep working as long as optimism is present, but their performance in bad times is far from dependable. What will happen to Bitcoin’s price and liquidity in a crisis if people decide they’d rather hold dollars (or gold)? We Agree, But . . . Andrew told me about a conversation he had recently with some fund managers, in which he went over a lot of what I’m discussing here. Given today’s conditions, their response started predictably: “We agree, but . . .” We hear a lot of that these days:  We agree, but the things we’re doing offer higher returns than the rest.  We agree, but cash isn’t an option when it returns nearly nothing.  We agree, but we can’t take the risk of being out of the market.  We agree, but there’s no alternative. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: All I’m saying is that for all the things listed above to simultaneously be gaining in popularity and attracting so much capital, credulousness has to be high and risk aversion has to be low. It’s not that these things are doomed, just that their returns may not fully justify their risk. And, more importantly, that they show the temperature of today’s market to be elevated. Not a nonsensical bubble – just high and therefore risky. Try to think of the things that could knock today’s market off kilter, like a surprising spike in inflation, a significant slowdown in growth, central banks losing control, or the big tech stocks running into trouble. The good news is that they all seem unlikely. The bad news is that their unlikelihood causes all these concerns to be dismissed, leaving the markets susceptible should any of them actually occur. That means this is a market in which riskiness is being tolerated and perhaps ignored, and one in which most investors are happy to bear risk. Thus it’s not one in which we should do so. What else:  My observations are always indicative, not predictive. The usual consequences of the conditions I describe – like an eventual increase in risk aversion – should happen, but they don’t have to happen.  And they certainly don’t have to happen soon. No one knows anything about timing.

” The duration, pace, amplitude and details of each investment cycle are different from those of its predecessors, but the basic themes and essential ingredients are usually vaguely familiar. What Twain calls rhyming history I describe as “common threads.” The themes or threads that repeatedly characterize too-bullish markets are the ones listed on page 4. While they don’t all have to be present for a top, bull market or boom to form, (a) usually many are present when one does and (b) it’s hard for a full-throated bubble to come into existence without them. They truly are the raw materials for market excesses on the upside. On the other hand, the keys to avoiding the classic mistakes also recur, and I listed them in “There They Go Again”:  awareness of history,  belief in cycles rather than unabated, unidirectional trends,  skepticism regarding the free lunch, and  insistence on low purchase prices that provide lots of room for error. Adherence to these things – all parts of the canon of defensive investing – invariably will cause you to miss the most exciting part of bull markets, when trends reach irrational extremes and prices go from fair to excessive. But they’ll also make you a long-term survivor. I can’t help thinking that’s a prerequisite for investment success. The checklist for market sanity and safety is simple, and the answers will tell you what to do: © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

We want to buy things whose price underestimates the value of the underlying assets or earnings (value investing) or the future potential (growth investing). In either case, we’re looking for instances when the market is wrong. If we thought the market was always right – the efficient market hypothesis – we wouldn’t spend our lives as active investors. Since we do, we’d better believe we know more than the consensus. So by definition we must not think the market – that is, the sum of all other investors – knows everything, or knows more than we do, or is always right. That’s point number two. And that leads logically to point number three: why take instruction from a group of people who know less than you do? In “On the Couch,” I wrote that it all seems obvious: investors rarely maintain objective, rational, neutral and stable positions. Do you agree with that or not? Is the market a clinical and rational fundamental analyst, or a barometer of investor sentiment? Does the market’s behavior these days look like something a mature adult should emulate? It seems clear to me: the market does not have above average insight, but it often is above average in emotionality. Thus we shouldn’t follow its dictates. In fact, contrarianism is built on the premise that we generally should do the opposite of what the crowd is doing, especially at the extremes, and I prefer it. A Case in Point – The Crash of 2008 The year 2008 culminated in the greatest panic I’ve ever seen.

Like the lesson of the Schlesinger story, the rest of economics is also pretty straightforward, and its laws are quite reliable. If you buy for $50 and sell for $40, you won’t make money . . . period (or stay in business long). That reminds me of a joke I used in “bubble.com” in January 2000, one my father told me roughly 60 years ago: “I lose money on everything I sell.” “Then how do you stay in business?” “I make it up on volume.” © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

I want to highlight Krugman’s reference to “psychological contagion.” It’s interesting in this regard that, last week, the world’s stock markets saw the following declines: S&P 500 – 6.0%, FTSE 100 – 5.3%, DAX – 8.3% and Nikkei – 7.0%. I consider it highly unlikely that such uniform declines were the result of independent, objective analysis of the impact of events on each economy and company. Rather, I think they show the extent to which markets are linked by their investors’ shared psychology. So what about the likelihood of another 2008-style crash? The bottom line for me is that a rerun of the Global Financial Crisis isn’t in the cards:  We haven’t had a boom (either in the economy or in the stock market), so I don’t think we’re fated to have a bust. Because most businesses have been particularly loath to expand their facilities, I don’t think they’ll be slammed if revenues flatten or turn down.  The leverage in the private sector has been reduced. This is particularly true of the banks, where leverage has gone from the region of 30+ times equity before the crisis to very low double digits today. And, of course, banks are now barred from investing adventurously for their own account.  Finally, the main villain in the crisis was sub-prime mortgage backed securities. The raw material – the underlying mortgages – was unsound and often fraudulent. The structured mortgage vehicles were highly levered and absurdly highly rated.

© Oaktree Capital Management, L.P. All Rights Reserved sitting frozen on the sideline, refusing to buy, cash can be king. Often when a crash follows a bubble-driven run-up, most people are short of cash (and/or the willingness to spend it). But it may not be a good idea to always sit with a large amount of cash so as to be able to provide liquidity and scoop up bargains in a once-a-decade crash. This may equate to sub-optimizing. It would have paid off in 1990-91, 2001-02 and 2008-09, but what about the other 19 years in the last 25?  A high degree of concern over illiquidity can push investors to avoid it to excess. For example, institutions whose realities could permit a long-term investment approach sometimes decide to invest only in things they can get out of quickly. Is this prudence, or merely sub- optimizing? Is it done in response to a threat that has a reasonable likelihood of materializing, or to a crisis while it is fresh in memory (“fighting the last war”)? Is it realistic, or the result of an irrational desire to be able to turn the whole portfolio into cash in short order? Or is it done in order to always be able to comply with a sell order from the boss or the investment committee? Liquidity is a good thing (everything else being equal). But is it smart to require that a portfolio be able to provide more liquidity than is ever likely to be called on? Let’s remember that liquidity isn’t free. There’s usually a cost, and it comes in the form of return forgone.

© Oaktree Capital Management, L.P. All Rights Reserved Alan Greenspan warned of “irrational exuberance” in December 1996, but the stock market continued upward for more than three years. A brilliant manager I know who turned bearish around the same time had to wait until 2000 to be proved correct . . . during which time his investors withdrew much of their capital. He wasn’t “wrong,” just early. But that didn’t make his experience any less painful. Likewise, John Paulson made the most profitable trade in history by shorting mortgage securities in 2006. Many others entered into the same transactions, but too early. When the bets failed to work at first, the appearance of being on the wrong track ate into the investors’ ability to stick with their decision, and they were forced to close out positions that would have been extremely profitable. In order to be a superior investor, you need the strength to diverge from the herd, stand by your convictions, and maintain positions until events prove them right. Investors operating under harsh scrutiny and unstable working conditions can have a harder time doing this than others. That brings me to the second quote I promised from Yale’s David Swensen: . . . active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel. Charlie Munger was right about it not being easy.

The two main ones are fundamental risk (relating to how a company or asset performs in the real world) and valuation risk (relating to how the market prices that performance). For years investors, fiduciaries and rule-makers acted on the belief that it’s safe to buy high-quality assets and risky to buy low-quality assets. But between 1968 and 1973, many investors in the “Nifty Fifty” (the stocks of the fifty fastest-growing and best companies in America) lost 80-90% of their money. Attitudes have evolved since then, and today there’s less of an assumption that high quality prevents fundamental risk, and much less preoccupation with quality for its own sake. On the other hand, investors are more sensitive to the pivotal role played by price. At bottom, the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that’s irrationally low (ditto). A low price provides a “margin of safety,” and that’s what risk-controlled investing is all about. Valuation risk should be easily combatted, since it’s largely within the investor’s control. All you have to do is refuse to buy if the price is too high given the fundamentals. “Who wouldn’t do that?” you might ask. Just think about the people who bought into the tech bubble. Fundamental risk and valuation risk bear on the risk of losing money in an individual security or asset, but that’s far from the whole story.

Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last three years Oaktree’s mantra has been “move forward, but with caution.” At this time, in reiterating that mantra, I would increase the emphasis on those last three words: “but with caution.” Economic and company fundamentals in the U.S. are fine today, and asset prices – while full – don’t seem to be at bubble levels. But when undemanding capital markets and a low level of risk aversion combine to encourage investors to engage in risky practices, something usually goes wrong eventually. Although I have no idea what could make the day of reckoning come sooner rather than later, I don’t think it’s too early to take today’s carefree market conditions into consideration. What I do know is that those conditions are creating a degree of risk for which there is no commensurate risk premium. We have to behave accordingly. September 3, 2014 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Valuation risk should be easily combatted, since it’s largely within the investor’s control. All you have to do is refuse to buy if the price is too high given the fundamentals. “Who wouldn’t do that?” you might ask. Just think about the people who bought into the tech bubble. Fundamental risk and valuation risk bear on the risk of losing money in an individual security or asset, but that’s far from the whole story. Correlation is the essential additional piece of the puzzle. Correlation is the degree to which an asset’s price will move in sympathy with the movements of others. The higher the correlation among its components, all other things being equal, the less effective diversification a portfolio has, and the more exposed it is to untoward developments. An asset doesn’t have “a correlation.” Rather, it has a different correlation with every other asset. A bond has a certain correlation with a stock. One stock has a certain correlation with another stock (and a different correlation with a third). Stocks of one type (such as emerging market, high-tech or large-cap) are likely to be highly correlated with others within their category, but they may be either high or low in correlation with those in other categories. Bottom line: it’s hard to estimate the riskiness of a given asset, but many times harder to estimate its correlation with all the other assets in a portfolio, and thus the impact on performance of adding it to the portfolio. This is a real art.

© Oaktree Capital Management, L.P. All Rights Reserved from Chuck Prince, Citigroup’s CEO from 2003 to 2007, anyone who’s totally unwilling to dance to today’s fast-paced music can find it challenging to put money to work. It’s the job of investors to strike a proper balance between offense and defense, and between worrying about losing money and worrying about missing opportunity. Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last four years Oaktree’s mantra has been “move forward, but with caution.” At this time, in reiterating that mantra, I would increase the emphasis on those last three words: “but with caution.” Economic and company fundamentals in the U.S. are fine today, and asset prices – while full – don’t seem to be at bubble levels. But when undemanding capital markets and a low level of risk aversion combine to encourage investors to engage in risky practices, something usually goes wrong eventually. Although I have no idea what could make the day of reckoning come sooner rather than later, I don’t think it’s too early to take today’s carefree market conditions into consideration. What I do know is that those conditions are creating a degree of risk for which there is no commensurate risk premium. We have to behave accordingly. June 8, 2015 (updating Risk Revisited published September 3, 2014) © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. Memo to: Oaktree High Yield Bond Clients From: Howard Marks and Sheldon Stone Re: High Yield Bonds Today Clients often ask for our views on the high yield bond market: “Do we think prices are too high?” “Are yields too low?” “What returns can we expect next year?” We caution them that it’s nearly impossible to accurately predict these things, and anyone who makes such forecasts is unlikely to be right. These days the question is primarily whether high yield bonds are in a bubble and poised to collapse, given last year’s strong performance and today’s historically low yields. We don’t think high yield bonds are any more vulnerable to rising rates than other fixed income instruments. We don’t downplay the risk in the market nowadays and the fact that bond prices are quite high. However, the situation isn’t unique to high yield bonds; rather, it is true of virtually all bonds and reflects the concerted effort on the part of central banks around the world to hold down interest rates. Yields are at historic lows and prices are unusually high all across the fixed income spectrum.

It’s highly informative to assess how the other characteristics of 2007 enumerated above compare with conditions today:  global glut of liquidity – check  minimal interest in traditional investments – check (relatively little is expected today from Treasurys, high grade bonds or equities, encouraging investors to shift toward alternatives)  little apparent concern about risk – check  skimpy prospective returns everywhere – check Risk tolerance and leverage haven’t returned to their pre-crisis highs in quantitative terms, but there’s no doubt in my mind that risk bearing is back in vogue. Examples from the Media My preparation for writing these memos often includes amassing media citations around a central theme. Here are some from the last few weeks:  Now, eight years since the PIK-toggle entered the market, companies are again using the esoteric structures, along with a host of riskier borrowing practices associated with the buyout boom that helped inflate the 2006-07 credit bubble. (Financial Times, October 22)  At the same time, more than $200bn of “cov-lite” loans have been sold so far this year, eclipsing the $100bn issued in 2007. That means 56 per cent of new leveraged loans now come with fewer protections for lenders than normal loans. (Ibid.)  Bankers say much of that issuance has been a result of the return of another pre-crisis market vehicle – the collateralised [sic] loan obligation. . . . Like the rest of the leveraged © OAKTREE CAPITAL MANAGEMENT, L.P.

© Oaktree Capital Management, L.P. All Rights Reserved. But was it desirable? It was not, in my view, because hindsight shows perception to have been very much out of proportion with reality, and thus dangerous:  Consumer confidence, and thus spending, was too high relative to incomes.  Excessive spending – all around the world, at all economic levels – led to excessive use of credit, making the world highly overleveraged.  Buying fueled by confidence and leverage caused asset prices to rise out of proportion to value. I often say the riskiest thing in the world is widespread belief that there’s no risk. And certainly that was the prevailing condition in the pre-crisis years of 2005-07, as well as during the tech bubble of the late 1990s. In both instances the “era of well-being” was followed by a significant economic slowdown and market decline. A feel-good environment characterized by strong confidence creates pleasant current conditions but encourages dangerous behavior and an ascent (in the economy and the markets) from which a correction becomes inevitable. In that way, the less confident attitudes of 2013 create a lackluster, less enjoyable environment, but also a preferable and more prudent base for the future.

Appreciation accelerates, possibly leading to a mania or bubble. Everyone concludes that things can only get better forever. They forget about the risk of losing money and fixate on not missing opportunities. Leveraged buyers become convinced that the things they buy with borrowed money are certain to appreciate at a rate above their borrowing cost.  Eventually things get as good as they can get, the last skeptic capitulates, and the last potential buyer buys. That’s the way the cycle of attitudes toward risk ascends. The skeptic in times of moderation becomes a true believer at the top. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. As we’ve seen endless times, investors reach the overconfident state when things have been going well for a while, meaning prices have already soared. And, alternatively, the latter hopeless state is inevitably reached after a bubble has been punctured, the news has turned unremittingly negative, and prices have collapsed. This is the pattern that makes the herd wrong at the extremes and creates the rewards for contrarianism. And it’s behind my favorite Warren Buffett quote: “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” When most investors are driven to drop their prudence by an excess of confidence, we should be terrified. In the same way, when most investors become devoid of confidence and flee the market, we should turn aggressive. All Good or All Bad? One of the things worth noting about the swing in confidence is not merely that it rises and falls, but that it is often marked by “all-good” or “all-bad” thinking. In short, when investors are optimistic regarding the future:  They tend to see the positives, by which they’re incredibly impressed, and overlook the negatives.  If they consider negatives at all, they fall for rationalizations that refute them. Foremost here is the old standby: “It’s different this time.”  Isolated positive developments, often random or fortuitous, are generalized into an irresistible virtuous circle.

 How will governments reconcile the opposing goals of stimulating growth (lower taxes, increased spending) and reining in deficits (increased taxes, less spending)?  Will prosperous regions (e.g., Germany) continue to be willing to subsidize profligate and poorer ones (e.g., Spain and Portugal)? As to investments:  When the Fed stops buying bonds, will interest rates rise a little or a lot? Does that mean bonds are unattractive?  Are U.S. stocks still attractive after having risen strongly over the last 18 months?  Ditto for real estate following its post-crash recovery?  Can private equity funds buy companies at attractive prices in an environment where few owners are motivated to sell? As I’ve said before, most people are aware of these uncertainties. Unlike the smugness, complacency and obliviousness of the pre-crisis years, today few people are as confident as they used to be about their ability to predict the future, or as certain that it will be rosy. Nevertheless, many investors are accepting (or maybe pursuing) increased risk. The reason, of course, is that they feel they have to. The actions of the central banks to lower interest rates to stimulate economies have made this a low-return world. This has caused investors to move out on the risk curve in pursuit of the returns they want or need. Investors who used to get 6% from Treasurys have turned to high yield bonds for such a return, and so forth.

© Oaktree Capital Management, L.P. All Rights Reserved. what to do. But all-good or all-bad attitudes are rarely right, since there are invariably valid points on both sides and they mustn’t be ignored. Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Most of the time, limits on confidence are more desirable than cocksureness. Over-confidence in one’s judgment is very dangerous. The Bull/Bear Cycle In March 2008, in “The Tide Goes Out,” I repeated one of the most helpful of all the adages to which I hold – the description of the three stages of a bull market:  the first stage, when a few 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’s sure things will get better forever. What does it really mean? The essential raw material for a bull market is cheapness, and that cheapness exists in stage one precisely because there are so few believers and so little confidence that favorable developments and good times lie ahead. Thus stage one provides the launching pad for a bull market. Equally, in the third stage the bull market is primed to end – with the bubble popping and a down-cycle setting in – for the simple reason that there are too many believers (and too few skeptics). In short, there’s too much confidence and too little cheapness. It’s this imbalance that creates market tops.

Second, prices and valuations aren’t highly extended (the p/e ratio on the S&P 500 is around 16, the post- war average, while in 2000 it was in the low 30s: now that’s extended). A rise in risk tolerance is something that should get your attention and focus your concentration. But for it to be highly worrisome, it has to be accompanied by extended valuations. I don’t think we’re there yet. I think most asset classes are priced fully – in many cases on the high side of fair – but not at bubble-type highs. Of course the exception is bonds in general, which the central banks are © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. But as Twain also said, there are themes that rhyme. It‟s what I would call “tendencies” or “behavioral patterns” that present the important lessons. The tendency of investors to overlook or forget the past is noteworthy. So is their habit of succumbing to emotion and swallowing tall (but potentially lucrative) tales. In particular, people tend to forget the cyclical nature of things, extrapolate past trends to excess, and ignore the likelihood of regression to the mean. The tech bubble may not recur anytime soon. No online grocer may ever again sell at 200 times revenues. There may never be another CDO-squared or SIV. Those aren‟t the things that matter. But there’s sure to be another cycle, another bubble and another crisis. There’ll be another time when people overpay for exciting investment ideas because their future appears limitless, and then a time of disillusionment and price collapse. There’ll be another period when leverage is embraced to excess, and then, consequently, a period when it gets people killed. And there’ll certainly be another time when people can only imagine the possibility of gain, and then one when – after huge sums have been lost – they can think only of further declines. These are the kinds of things that rhyme. If we stay alert, we can anticipate and recognize them and thus avoid the losses and opportunity costs they bring so reliably.

But in 1978, most investors wouldn’t buy B-rated bonds – at any price – because doing so was considered speculative and imprudent. In 1999, most investors refused to buy value stocks – also at any price – because they were deemed to lack the world-changing potential of technology stocks. Prejudices like these prevent valuation disparities from being closed.  Capital rigidity – In theory, investors will move capital out of high-priced assets and into cheap ones. But sometimes, investors are condemned to buy in a market even though there are no bargains or to sell even at giveaway prices. In 2000, in venture capital, there was “too much money chasing too few deals.” In 2008, CLOs receiving margin calls had no choice but to sell loans at bankruptcy prices. Rigidities like these create mispricings.  Psychological excesses – In theory, investors will sell assets when they get too rich in a bubble or buy assets when they get cheap enough in a crash. But in practice, investors aren’t all that cold-blooded. They can fail to sell, for example, because of an unwarranted excess of optimism over skepticism, or an excess of greed over fear. Psychological forces like greed, fear, envy and hubris permit mispricings to go uncorrected . . . or become more so.  Herd behavior – In theory, market participants are willing to buy or sell an asset if its price gets out of line. But sometimes there are more buyers for something than sellers (or vice versa), regardless of price.

This one reminds me of my absolute favorite Yogi-ism: “Nobody goes [to that restaurant] anymore. It‟s too crowded.” Wait a minute: how can a restaurant be crowded if nobody goes there? Likewise, in this case, according to the writer, it will take a bull market to attract investor interest and confidence. That sounds reasonable. But isn‟t investor interest and confidence a prerequisite for a bull market? Without it, how can a bull market get started? The answer is that when prices are low enough, stocks can begin to rise without help from a full- fledged bull market, just as when they‟re high enough, stock prices can collapse under their own weight. The bottom line here is simple, and I‟m thoroughly convinced of it: Common sense isn’t common. The crowd is invariably wrong at the extremes. In the investing world, everything that’s intuitively obvious is questionable and everything that’s important is counter-intuitive. And investors prove repeatedly that they can be less logical than Yogi. The Penalty of Youth Let‟s think back to Galbraith‟s statement that “Past experience . . . is dismissed as the primitive refuge of those who do not have insight to appreciate the incredible wonders of the present.” In other words, when a hot new investment fad gets rolling and an idea is elevated to bubble status, © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

executive: “Have you been to an American stockholders‟ meeting lately? They‟re all old fogeys. The stock market is just not where the action‟s at.” And what consistently provides the foundation for this insistence that the game has permanently changed? Four of the most dangerous words in the investment world: it’s different this time. When investors choose to believe that historic valuation standards have become irrelevant; that one industry or product can maintain superior growth and profitability in perpetuity; or that one asset or market can outperform all the others forever regardless of how high its price goes in the process – that is, that trees can grow to the sky – the bubble is invariably undergirded by a steadfast belief that it‟s different this time. Here‟s the support BusinessWeek advanced: Says Alan Coleman, dean of Southern Methodist University‟s business school, “We have entered a new financial age. The old rules no longer apply.” When you see or hear words like these, you should go on high alert. Sometimes the world changes and the past becomes irrelevant, but most of the time I‟ll take the other side of that bet. Getting to the Truth In some ways, understanding the market is like mathematics. You don‟t have to be knowledgeable regarding the specifics of the underlying subject matter to know whether a conclusion makes sense. You just have to be able to apply principles, tell logic from illogic, and exclude the deleterious effects of emotion and psychology.

He sees outflows of capital that, rather than being a negative, have lowered prices and can give rise to a strong price rebound when and if they reverse. Most of all, he sees an asset class to which no optimism is being applied. If I were asked to name just one way to figure out whether something’s a bargain or not, it would be through assessing how much optimism is incorporated in its price. No matter how good the fundamental outlook is for something, when investors apply too much optimism in pricing it, it won‟t be a bargain. That was the story of the Internet bubble; the Internet was expected to change the world, and it did, but when the optimism surrounding it proved to have been excessive, stock prices were decimated. Conversely, no matter how bad the outlook is for an asset, when little or no optimism is incorporated in its price, it can easily be a bargain capable of providing outsized returns with limited risk. Even with a bad “story,” the price of an asset is unlikely to decline (other than perhaps in the very short term) unless the story deteriorates further or the optimism abates. And if there‟s no optimism built into its price, certainly the latter can‟t happen. It was primarily this line of reasoning that allowed me to feel positive in the teeth of the financial crisis in late 2008. The outlook was as bad as it could get – total meltdown – and prices clearly incorporated zero optimism. How, then, could buying be a mistake (providing the world didn‟t end)?

This combination drove large-scale investment into either properties or savings products known as “trusts,” the proceeds of which flowed into fixed asset development. Thus the process went out of control. Good intentions around urbanization and infrastructure development fell victim to massive speculative capital flows. The consequence was excessive fixed investment. (One great way for authorities or central bankers to stimulate an economy is by providing capital for residential construction. This results in increased employment and spending on materials and components. When the economy heats up in response, however, a housing bubble often ensues. Home prices rise and speculative buying follows. The only thing missing is end-buyers for the unneeded or unaffordable homes. It’s particularly interesting to note that excess residential investment contributed in a major way to the recent problems in China, Ireland, Spain and the U.S. In all four countries “Potemkin villages” of new homes grew up, suggesting economic vigor . . . but standing empty.) In China’s case, capital wasn’t withdrawn by external lenders. Rather, the central planners decided it was time to reduce stimulus. In this way leverage would be reduced, the rate of fixed asset investment would ease, and the economy would be kept from overheating and inflating. However, as has been seen throughout history, planned economies tend to defy the planners, and cycles are hard to modulate.

© Oaktree Capital Management, L.P. All Rights Reserved. entailed. Although there’s far less historic data, the same seems true of senior loans and mezzanine debt.  Real estate prices have corrected from the peak of 5-6 years ago and are largely back to the pre-bubble levels of a decade ago. Residential real estate prices are well down from the peak, and the same is true for commercial real estate in all but a half dozen first-tier cities. And why is this true? Because of the third factor: investor psychology that is much curtailed from pre-crisis levels. This is very healthy from a buyer’s point of view. The Psychological Environment These are uncertain times – there’s no doubt about it. The macro outlook is quite unclear, and the level of investor confidence is commensurately low. This reminds me of something that happened – in the larger, non-investment world – eleven years ago this week. I was in New York on 9/11, and I experienced the uncertainty, fear and confusion firsthand. When I finally got to California several days later, I sat down with my son Andrew, then fourteen years old, to make sure he was okay given what had transpired. He asked me, with his usual perceptiveness, “Dad, is the world less safe than it used to be?” The right answer came to me: “Maybe it’s less safe than it used to be . . . and maybe it was never as safe as people thought it was.

Because the probability of those scenarios occurring is materially above zero, we can’t dispense entirely with caution. The presence of arguments on both sides renders strategy setting difficult today. But when all the arguments are on the same side, making the choice clear, that clarity can lead the investing herd to create a bubble or a crash. Thus our criterion for moving ahead can’t be that the way forward has to be obvious. I’m going to repeat what Charlie Munger told me about investing a couple of years ago, even though I used it in my last memo, too: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” The outlook certainly isn’t so propitious (and assets aren’t so cheap) as to call for investing aggressively. But at the same time, market conditions tell me this isn’t a time for hiding under the bed. “Move forward, but with caution” -- that’s my mantra today. The environment is uncertain, but we shouldn’t find that paralyzing. September 11, 2012© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

A great source on the subject is Wall Street Under Oath, a 1939 book on the causes of the Great Crash of 1929 written by Ferdinand Pecora, who was counsel to the Senate committee investigating the crash and later a New York State judge. I first read it about twenty years ago, and I brought it out of storage in 2007. It is a typical polemic, assigning blame and touting regulation pursuant to what I assume were the author’s philosophical/political biases (see page 4). Pecora describes a Wall Street that, up to and including the 1920s, was like the Wild West. Bankers and brokers were out to make money for themselves; their behavior was largely unregulated; and conflicts between their interests and those of their clients were widespread and disregarded. In particular, according to Pecora, disclosure standards were non-existent. © Oaktree Capital Management, L.P.Reserved

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. These facts combined with other causes to produce a market crash of epic proportions; widespread losses; a drying up of capital; deflation; and a massive depression with a resulting increase in unemployment to 25%. Unsurprisingly, fingers were pointed at the prior administration and political power shifted to believers in an activist role for government. The most lasting result was the enactment of laws that governed the financial system for decades and in many cases still do: the Securities Act, the Securities and Exchange Act, and the Glass- Steagall Act. Thus the 1930s saw a massive swing of the pendulum in favor of regulation. The next several decades on Wall Street were – perhaps thanks to the impact of those laws – a relatively placid period. This led to a view that, with rare exceptions, market participants are well-behaved by nature. Further, steady growth with only moderate dips caused a perception of an inherently benign and productive economy that could achieve even more if only the regulatory shackles were loosened. After President Carter deregulated the transportation industry in the late 1970s, the door was open for much of the regulatory apparatus built in the early part of the century to be relaxed. Ronald Reagan, whose famously free-market views coincided with a period of peace and prosperity, led the deregulatory charge.

But when markets get cooking, the lessons of the past are readily dismissed. These are nothing short of eternal verities, and their collective message is indispensible. Why Does Investment Memory Fail? Think back to the emotions you felt so strongly during the recent financial crisis, and the terrifying events that brought them on. You swore at the time that you’d never forget, and yet their memory has receded and nowadays has relatively little influence on your decisions. Why does the collective memory of investment experiences – and especially the unpleasant ones – fade so thoroughly? There are a number of reasons.  First, there’s investor demographics. When the stock market declined for three straight years in 2000-02, for example, it had been almost seventy years since that had last happened in the Great Depression. Clearly, very few investors who were old enough to experience the first such episode were around for the second. For another example, I believe a prime contributor to the powerful equity bull market of the 1990s and its culmination in the tech bubble of 1999 was the fact that in the quarter century from 1975 through 1999, the S&P 500 saw only three minor annual © Oaktree Capital Management, L.P.Reserved

But the difficulty of quantifying prospective returns in public and private equity doesn’t mean the offerings there are any less paltry. And, as Alan Greenspan said, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.” Market Conditions Today In May 2005, I wrote a memo entitled “There They Go Again,” complaining that investors were taking excessive comfort from mindless platitude of the type that accompany and abet the creation of every bubble. These are accepted as a substitute for putting rational intrinsic valuations on the assets that are the subject of the bubble, and despite repeated evidence that trees can’t grow to the sky. I touched on the mania for real estate, as well as the growing popularity of hedge funds and private equity. I went on to assert that this behavior – and the supportive underlying capital market trends – had turned the markets into a “low-return world.” I recite all of this because I have no doubt that investors are making substantial movement back in the same direction. To illustrate, here’s an account of capital market conditions in 2011 (Bridgewater Daily Observations, February 15): Consistent with the pickup in credit creation that we have seen elsewhere, LBO activity and the credit pipes that are supporting it have recently improved. Since the first quarter of 2010 we have seen a steady rise in LBO activity, starting from a very © Oaktree Capital Management, L.P.Reserved

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved low base. The rate of activity is now roughly similar to the average level of activity since 1985, excluding the boom and bust period of 2006 to 2009. . . . today’s deals are similar in size but the number of deals has risen by more than the dollar value of deals. We also see that the leverage in the deals is increasing. For example, so far this year the average deal was financed with 30% equity, down from last year’s 38%, though still up from the most leveraged period of 2005 to 2009 when deals were financed with an average of 25% equity. The leveraged loan market has also picked up and an increasing percentage of leveraged loans are going toward LBOs. A few new CLOs and mutual funds have been created that are concentrated on the leveraged loan market, indicative of renewed demand. Investor demand has pushed prices back up to par and allowed a decline in the average credit quality of the loans, with increasing indications of “covenant light” loans getting done. In other words, in most regards the capital markets – and investors’ tolerance of risk – are retracing their steps back in the direction of the bubble-ish pre-crisis years. Low yields, declining yield spreads, rising leverage ratios, payment-in-kind bonds, covenant-lite debt, increasing levels of LBO activity and the beginnings of the return of levered, structured vehicles . . . all of these are available for the eye to see.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved It’s easy to gauge bond investors’ attitudes. Here are the yield to maturity and yield spread versus Treasurys on the average high yield bond at a few points in the recent past and today: Yield to Spread vs. Maturity Treasurys “Normal” – December 31, 2003 8.2% 443 b.p. Bubble peak – June 30, 2007 7.6 242 Panic trough – December 31, 2008 19.6 1,773 Recovered – March 31, 2010 9.0 666 Shrinking again – April 30, 2011 7.5 492 The yield spread on the average high yield bond is still on the generous side relative to the 30-year norm of 350-550 basis points, a range of spreads that has given rise to excellent relative returns over that period. On the other hand, (a) spreads have fallen back to the normal range from the crisis-induced stratosphere and (b) the lowness of today’s interest rates means that reasonable spreads translate into promised returns that are low in the absolute. The story’s the same for many asset classes. I don’t mean to pick on high yield bonds. I use them here as my prime example only because of my familiarity with them and because their fixed-income status facilitates quantification of attitudes toward risk. In fact, high yield bonds still deliver above average risk compensation, and they remain the highest returning contractual instruments and excellent diversifiers versus high grade bonds.

If you refer back to a memo called “Risk and Return Today” (November 2004), you’ll see that today’s expected returns and risk premiums – especially on the left-hand side of the risk/return spectrum – are eerily similar to those prevailing in late 2004: money market at 1%; 5-year Treasurys at 3%; high grade bonds at 5%; high yield bonds at 7%; stocks expected to return 6-7%. I said at the time that low base interest rates and moderate demanded risk premiums had combined to render the risk/return curve “low and flat.” In other words, absolute prospective returns were at modest levels, as were the return increments that could be expected for taking on incremental risk. I described that environment as “a low-return world.” I think we’re largely back there. (Please note that late 2004 was nowhere near the cyclical peak. Security prices continued to rise and prospective returns to fall for two and a half years thereafter. In particular, in the 30 months following the publication of that memo, high yield bonds went on to return a total of 19.7%. So similarities to 2004 don’t constitute a sign of impending doom, but perhaps a foreshadowing of a potential move into bubble territory.) I want to state very clearly that I do not believe security prices have returned to the 2006-07 peaks. It doesn’t feel like the silly season is back in full. Investors aren’t euphoric. Rather they seem like what my late father-in-law used to call “handcuff © Oaktree Capital Management, L.P.Reserved

The other day, the investment committee of a non-profit on which I sit decided to take the first steps toward marshaling resources and managers so as to be ready to buy into beaten-down assets after the next round of bubble and bust. And it wasn’t even my idea! We can never be sure what will happen – and certainly not when – but it’s important to be prepared for what’s likely to lie ahead. And understanding the inevitable pendulum swing in the way investments are viewed – from weeds to flowers and back – is an essential ingredient in being able to do so. May 25, 2011 P.s.: I hope you’ll consider rereading “Risk and Return Today” (November 2004) and “There They Go Again” (May 2005) (see http://www.oaktreecapital.com). Hopefully they’ll strengthen the case for reflecting on past patterns and help you think through the current conditions. You might also take a look at “The Cat, the Tree, the Carrot and the Stick” in “What’s Going On” (May 2003) for a metaphorical look at the process of risk acceptance. Today’s echoes of those past times are worth noting. © Oaktree Capital Management, L.P.Reserved

 Its popularity rises, attracting more and more adherents, even as undervaluation moves to fully valued.  It turns into a mania or “bubble,” and price becomes immaterial.  Eventually, the last potential buyer becomes convinced and comes on board.  With no one else left to convert to the trend, the bubble of overvaluation is ripe for bursting.  When followers experience the first price declines, disillusionment sets in.  One-time devotees flee en masse, and the bubble turns into a crash. This cycle of discovery, mania and crash is best summed up by the most useful of all investment adages: “What the wise man does in the beginning, the fool does in the end.” This memo will be about recurring patterns, the history of stocks and bonds as I know it, and the adage’s applicability to that history. A Brief History of Stocks A significant milestone occurred in October 2008, attracting a lot of attention. For the first time in almost fifty years, it was reported, the dividend yield on the Standard and Poor’s 500 stock index was equal to the yield to maturity on the U.S. 10-year Treasury Note. People knew this meant stocks had cheapened, but it took an understanding of history to grasp the real significance. The truth is that stocks, like other investment media, tend to go in and out of style, and this was just one more example of the latter. © Oaktree Capital Management, L.P.Reserved

Prior to the 1950s, common stocks were viewed as a speculative, inferior (i.e., junior) asset class. For that reason, stocks had to pay higher yields than bonds in order to attract buyers; of course a riskier asset should yield more. In fact, most states had laws restricting holdings of stocks in fiduciary portfolios. This attitude toward stocks largely traced from the speculative stock bubble in the 1920s – featuring high-margin buying, bucket shops and shoe shine boys sharing stock tips – which collapsed in the Crash of ’29. Poor economic and market performance stretching from 1929 to the end of World War II further contributed to the skepticism toward stocks. It was only after WW II that economic performance began to support optimism. Brokerage firms led by Merrill, Lynch, Pierce, Fenner and Smith trumpeted the merits of stocks. Equity investing became widespread, and “customers’ men” in local brokerage offices delivered stock investing to a great many households: I remember my mother buying 10 shares of Columbia Gas and 15 shares of Chock Full of Nuts around 1959. I also remember a brochure on “growth stock investing” that Merrill put out in the mid-1960s, touting the desirability of rapid earnings growth and the strength of companies like IBM, Xerox, Avon, Coke, Texas Instruments and Johnson & Johnson. This idea grew into “nifty-fifty” investing, a true mania adopted by many of the large banks, among others.

performance led to steady increases in the capital allocated to equities, and eventually to the tech stock bubble. It culminated in books such as the fact-based Stocks for the Long Run and the more fanciful Dow 36,000. If you asked institutional investors what return they expected from stocks going forward, I think just about all would have said 11%. An aside: investors consistently seize upon above average returns as an encouraging sign and extrapolate them, and the 17.6% compound return on the S&P 500 from 1979 through 1999 was certainly a case in point. But rarely do they ask what gave rise to those good returns, or what it implies for the future. In essence, stock ownership conveys the benefits of owning a corporation, and stock appreciation should be powered by increases in profits. Thus long-run returns should reflect corporate growth. But as Warren Buffett has pointed out, “. . . people get into trouble when they forget that in the long run, stocks won't appreciate faster than the growth in corporate profits.” Although that growth is the underlying source of equity profits, it is often overshadowed and obscured in the short run by trends in valuation. People took that 17.6% gain as an encouraging sign, overlooking the fact that it stemmed primarily from the rise of p/e ratios described above and thus was unlikely to continue unabated.

Lyondell Chemical is paying [Libor plus 400 basis points] on its recent $500 million covenant-lite deal. And the energy refiner will emerge from bankruptcy with a much slimmer debt load than before it filed for Chapter 11. Lyondell’s terms are better than 2007’s crop of covenant-lite loans, to be sure, but lenders still are essentially relinquishing their right to force companies into paying them more money, or exiting the loan entirely, should their creditworthiness tumble. So why are lenders doing it again? Lyondell Chemical’s answer: investor demand for higher yielding assets. This is a familiar mantra while official interest rates remain low. But lenders should be mindful of loosening standards or risk finding themselves once again on the short end of the stick. (“Don’t call it a comeback,” breakingviews, April 5) On payment-in-kind loans and flexibility – Clint Eastwood’s Dirty Harry character famously held a gun to a suspect and asked: “Do you feel lucky?” Investors in credit markets seem to be saying yes, if Cerberus’ refinancing of Freedom Group, maker of Remington firearms, is any indication. A deflating gun bubble backfired on the private equity firm’s plans last year for an initial public offering of Freedom. Now trigger-happy credit investors are taking off their safeties and letting Cerberus unload some of its stake. The $225 million of notes are useful ammo for Cerberus.

June 30 to June 30 2007-08 2008-09 2009-10 three years 10-year Treasury bond 12.6% 7.3% 8.3% 30.8% Barclay’s Govt/Credit 7.2 5.3 9.7 23.8 Citi High Yield Index -0.5 -4.2 24.7 18.8 S&P 500 -13.1 -26.2 14.4 -26.6 MS EAFE Index -22.5 -26.1 7.1 -38.7 MS Emerging Markets 2.6 -30.0 20.6 -13.4 Clearly, the recent performance edge of bonds over stocks has been dramatic. What’s Going On Today? Now, suddenly, investors seem to have awakened to bonds’ attractions. This after failing to do so in time for the crisis, when holding bonds would have been of great value. Is this just another case of investors driving while looking in the rearview mirror? And are they shifting from stocks to bonds at just the wrong time? The headlines are dramatic and the facts are clear. In just the last few weeks, we’ve seen newspaper stories like these: “Investors Fleeing Stocks with Cash Flow Lure JP Morgan” (Bloomberg, August 16), “Treasury Bears Cave as Bond Yields Keep Tumbling” (The Wall Street Journal, August 16), and “Growing Concern over Bond Bubble” (Financial Times, August 21). Bloomberg reported as follows: About $33 billion flowed out of funds owning U.S. shares this year . . . About $185 billion was sent to bond funds through July 31, the most on record, according to the Investment Company Institute. These statistics relate to mutual funds and their retail investors. While not necessarily the same for institutions, they are indicative of trends in investor psychology.

© Oaktree Capital Management, L.P. All Rights Reserved  Quant investing arrived, too, achieving its first real fame with the success of Long- Term Capital Management. This Nobel Prize-laden firm used computer models to identify fixed income arbitrage opportunities. Like most other investment miracles, it worked until it didn’t. Thanks to its use of enormous leverage, LTCM melted down spectacularly in 1998.  Investors’ real interest in the last half of the ’90s was in common stocks, with the frenzy accelerating but narrowing to tech-media-telecom stocks around 1997 and narrowing further to Internet stocks in 1999. The “limitless potential” of these instruments was debunked in 2000, and the equity market went into its first three-year decline since the Great Crash of ’29.  Venture capital funds, blessed with triple-digit returns thanks to the fevered appetite for tech stocks, soared in the late 1990s and crashed soon thereafter.  After their three-year slump, the loss of faith in common stocks caused investors to shift their hopes to hedge funds – “absolute return” vehicles expected to make money regardless of what went on in the world.  With the bifurcation of strategies and managers into “beta-based” (market-driven) and “alpha-based” (skill-driven), investors concluded they could identify managers capable of alpha investing, emphasize it, perhaps synthesize it, and “port” or carry it to their portfolios in additive combinations.

Bubble thinking is irrational, given that it’s built on a belief that there’s no price too high. This goes on to manifest itself in a variety of ways. In the 1970s, when hyper-inflation was rampant and interest rates were astronomical, people concluded that no matter the interest rate paid, borrowing to buy “inflation protected” assets like real estate would be profitable. That’s bubble thinking. In my forty-year career, I’ve seen bubbles in growth stocks, small stocks, oil stocks, emerging market stocks and tech stocks, as well as such surefire winners as silver, homes and buyouts. In each instance, there was a logical underlying rationale for the desirability of the subject assets, but people overlooked the possibility that bubble thinking had raised prices to dangerous levels. Alan Greenspan greatly influenced economic and market developments during his term as Fed Chairman from 1987 to 2006, and his record on the subject of bubbles was poor. He set the world on its ear in 1996 by railing against “irrational exuberance” as the Dow Jones Index soared past the 6,000 level, but he was quiet thereafter, rationalizing appreciation well beyond 10,000 based on gains in productivity. Here’s his position on bubbles: . . . bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong.

© Oaktree Capital Management, L.P. All Rights Reserved activity – the very outcome we would be seeking to avoid. Prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy . . . we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact. . . . the idea that the collapse of a bubble can be softened by pricking it in advance is almost surely an illusion. (August 30, 2002) Thus it was his view that (a) bubbles can only be detected in retrospect, not as they occur, (b) even if detected, bubbles are hard to deflate benignly, (c) rather than deflate them, bubbles can be managed, and (d) deflating bubbles isn’t the job of the Fed. This relaxed position on bubbles can easily be seen as having abetted their growth. For example: . . . testimony before Congress last week refutes, once and for all, the existence of an alleged housing market “bubble,” said chief economists of the National Association of Home Builders. . . . “The time has come to put this issue to rest,” said NAHB Chief Economist David Seiders. “The nation’s home builders have said it, the Realtors have said it, and now Alan Greenspan has said it once again, in no uncertain terms: there is no such thing as a current or impending house price bubble.

” Asked about the issue during his testimony, Greenspan said, “We’ve looked at the bubble question and we’ve concluded that it is most unlikely.” He attributed recent “sizeable gains” in home prices to “the effects on demand of low mortgage rates, immigration and shortages of buildable land.” (Business Wire, July 22, 2002, emphasis added) Ignoring bubbles is a special case of ignoring risk in general. The philosopher George Santayana is famous for having said, “Those who cannot remember the past are condemned to repeat it.” Likewise, those who fail to learn from past bubbles are bound to suffer in the bursting of new ones. The More You Bet, the More You Win When You Win In the years just prior to the crash, obliviousness to risk encouraged numerous forms of risky behavior. One of the greatest was the use of leverage to increase returns, a phenomenon that became widespread. People make investments on the basis of positive expected returns. When the cost of borrowing is below the expected return, using leverage appears certain to magnify the gain. Thus the Las Vegas maxim that heads this section comes into play, and it's that kind of thinking that gives leverage its seductive power. But there’s so much more to leverage than that, and unfortunately the rest is learned only when things go badly. Leverage doesn’t make an investment better; it merely magnifies the gains and losses.

” One way to prevent this, as Richard suggests, is to make sure government support and high-octane risk taking don’t take place in the same firms. I’ve been told it isn’t his, but a saying widely attributed to Mark Twain seems to be on the mark: “History doesn’t repeat itself, but it does rhyme.” There’s no need to invent the mechanism through which to accomplish the above; we can look to history and gain inspiration from the Glass-Steagall Act. After the Great Crash, congressional committees investigated its causes, some of which remind one of today’s. The result was this 1933 law, which mandated that banking be separated from investment banking and investment services. It’s far from irrelevant to the current situation that Glass-Steagall’s powers ended in 1999, when key parts were repealed by the Gramm-Leach-Bliley Act. This new law had the goal of encouraging competition in banking, investment services and insurance, by permitting common ownership by financial conglomerates. Protecting society against risky investment activities on the part of government- insured institutions is a good thing. And competition in providing financial services is a good thing. But the two goals can be in conflict and have to be balanced, and the consensus as to which should prevail will oscillate from time to time.to

© Oaktree Capital Management, L.P. All Rights Reserved pundits – believe that there’s a single future, it is knowable in advance, and they’re among the people who know it. They’re eager to tell you what the future holds, and equally willing to overlook the inaccuracy of their past predictions. What they repeatedly ignore is the fact that (a) the future possibilities cover a broad range, (b) some of them – the “black swans” – can’t even be imagined in advance, and (c) even if it’s possible to know which one outcome is the most likely, the others have a substantial combined probability of occurring instead. Thus one key question each investor has to answer is whether he views the future as knowable or unknowable. An investor who feels he knows what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, someone who feels he doesn’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes. The first group of investors did much better in the years leading up to the crash.

But the second group was better prepared when the crash unfolded, and they had more capital available (and more-intact psyches) with which to profit from purchases made at its nadir. Never Forget the 6'-Tall Man Who Drowned Crossing the Stream That Was 5' Deep on Average The range of possibilities – the environments with which we must deal – invariably will include some bad ones. We must prepare for them, and the unavoidable prerequisite for doing so is being aware of them. Following from the section above, the key is to view the future as a range of possibilities, not a reliable point estimate. How does the successful investor prepare for the uncertain future? By building in what Warren Buffett calls “margin for error” or “margin of safety.” It’s having this margin that enables us to do okay even when things don’t go our way. If an investor prepares for a single future and attempts to maximize under the assumption that his view will prove right, he’ll be in big trouble if it doesn’t. The investor who backs off from the maximizing position is likely to do better when negative surprises occur. Thus it’s essential to realize a few things:  It’s not sufficient to think about surviving “on average” – investment survival has to be achieved every day, under all circumstances.  The ability to survive under adverse conditions comes from a portfolio’s margin for error.  Ensuring sufficient margin for error and attempting to maximize returns are incompatible.

© Oaktree Capital Management, L.P. All Rights Reserved technical reasons. Loan investors who were able to hold on recovered, but many who had bought with leverage couldn’t do so. They drowned in the deep part of the stream. Chuck Prince on Dancing A quotation from the former CEO of Citigroup contains just 30 words, but it could serve as a case study regarding the events leading up to the crash: 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. We’re still dancing. (Charles Prince, July 9, 2007) I suspected in mid-2007 that this quotation would end up being emblematic of the cycle. It’s been replayed many times, but usually without the first dozen words. Prince seems to have been more aware of what was going on than people give him credit for. He may have sensed the bank was on thin ice in lending and levering, like the rest. The problem wasn’t that he overlooked the danger; the problem was that he felt he had to participate anyway. One of the dilemmas faced by businesses is that they can conclude that they have no choice but to take part in dangerous behavior. Usually this is because they’re unwilling to cede market share. On October 5, Leo Strine, Vice Chancellor of the Delaware Court of Chancery, wrote as follows in The New York Times Dealbook: . . .

Few investors recognized that increasing past returns bode poorly – not well – for subsequent returns, or that common stock returns couldn’t forever outpace the rate of growth in corporate profits. In 1999, James Glassman chimed in with his book Dow 36,000, asserting that because stocks were such solid investments, equity risk premiums were higher than they should have been, meaning their prices were too low. That pretty much marked the long-cycle top. When the “tech-media-telecom” bubble burst in 2000, stocks went into their first three- year decline in almost 70 years. The broad indices stabilized after 2002 and returned to their 1999 highs in 2007 but, wanting more than equities’ unlevered return, investors shifted their focus to private equity and to equity hedge funds. All of this occurred just in time for the onset of the credit crisis. Last year’s 38.5% decline in the S&P 500 was the biggest since 1931, zeroing out more than a decade of gains. I wonder whether and to what extent equities will be returned to the pedestal of popularity. The Wall Street Journal put it aptly on December 22: One of the hallmarks of the long market downturns in the 1930s and the 1970s has returned: Rank-and-file investors are losing faith in stocks. In the grinding bear markets of the past, huge stock losses left individual investors feeling burned. Failures of once-trusted firms and institutions further sapped their confidence.

© Oaktree Capital Management, L.P. All Rights Reserved confidence in him, but they couldn’t get money they needed from other funds that had put up gates, or they didn’t want to sell other investments that, unlike Bernie’s, were showing big losses. So Madoff received requests for $7 billion of withdrawals, an amount he simply couldn’t raise from new suckers, and his nakedness became apparent. The Madoff story exemplifies the ability of ill-founded investments to prosper in bull markets, and the role of bear markets in exposing them. Now that the tide has gone out, many pre- crisis miracles have been exposed as non-value based, overly dependent on prosperity and easy money, pro-cyclical, over-hyped or just plain flawed. Hopefully next time, investors will give more thought to how their bull-market dalliances will fare when the tide goes out. The Opposite of a Bubble On the heels of the lessons regarding the run-up to the crash, the latter part of 2008 provided several lessons about behavior in times of crisis. With the fundamental outlook terrible, psychology depressed and technical conditions featuring a great deal of forced selling, that period represented one of the greatest buying opportunities I’ve ever seen. I expressed my view that, having been too optimistic before the crash, people were now taking things too far on the downside. It’s not easy to resist emotional excesses at highs and lows, but it’s by doing so that the best investment decisions can be made: . . .

© Oaktree Capital Management, L.P. All Rights Reserved In the years just before the crash, no view was considered too optimistic. There were few skeptics around to point out that a notion might be too good to be true. And then, as Pigou says, the opposite became true post-Lehman Brothers. There was no scenario of which someone wouldn’t suggest, “But what if it’s worse than that?” Now no idea was considered too negative to be true. The error is clear. The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom. Pigou makes an excellent additional point. Bubbles usually build gradually over time, the result of a steady accretion of logical basis, favorable developments, high returns being achieved, platitudes taken to extremes, willing suspension of disbelief, rising optimism and the recruitment of new buyers. But when the bubble’s faulty underpinnings are exposed, it tends to collapse in a rush. The excess of pessimism does arrive quickly, “born a giant.” Or as my partner Sheldon Stone puts it, “the air goes out of the balloon a lot faster than it went in.

They’re not magic, just securities that can perform well when they’re priced right for the coming profits. If sluggish growth lies ahead for the economy in the next few years, it’s no given that common stocks will outperform corporate bonds. Go Around, Come Around Mark Twain is alleged to have said “History doesn’t repeat itself, but it does rhyme.” Mistakes follow long-standing patterns, but applied in new ways. Thus it’s worth noting a few of the many ways in which events of the pre-crisis years are reminiscent of the Roaring Twenties that preceded the Great Crash.  In the 1920s, stock manipulators banded together to force down the price of stocks through non-stop short selling. The damage caused by these “bear raids” led to implementation of the “uptick rule,” under which shares could be shorted only at prices higher than the last. This rule made it hard for short sellers to drive down prices, and it remained in effect right up until July 2007. Its elimination enabled bears to once again drive down the stocks of weakened financial institutions, an emblematic event in 2008.  The combination of banking and investment banking under the same roof received a good part of the blame for the Great Crash (see one of my favorite books, Wall Street Under Oath by Ferdinand Pecora, 1939). This led to passage of the Glass-Steagall Act mandating separation of the two.were

Eventually the pendulum will reach an apex so high that it’ll be incapable of staying there. Then it will swing back, whether under its own weight or because of exogenous forces, or both. In the course of moving from merely heated to torrid, however, I believe it can be counted on to bring out behavior which is manic and dangerous. The current long-term cycle may have begun in the post-World War II recovery. It benefited from the positive factors discussed on pages 2 and 3 and resulted in great capital creation for consumers, homebuyers, businesses, non-profits and investors. But it continued on from “healthy” to “excessive,” resulting in the events of the last eighteen months, many of which can be summed up under the heading of capital destruction. The greatest single example may be the case of Bernard Madoff, in which a trusted, high- performing investment manager allegedly fabricated his record, deceived friends and strangers alike, and lost or stole $50 billion. An increase in fraud can be viewed as a normal component – in fact, perhaps emblematic – of frothy, cycle-driven markets. Who hears of embezzlement during bearish times? A few lines from the Financial Times of December 20 indicate the cyclical aspects of the Madoff affair: The size of the alleged Bernard Madoff scam . . . is astounding, yet unsurprising. History tells us that bubbles spawn swindles. After the biggest credit bubble of all time, we now may have the biggest swindle of all time. . . .“swindling

© Oaktree Capital Management, L.P. All Rights Reserved is demand-determined, following Keynes’s law that demand determines its own supply. . . .” Mr. Madoff’s story was dull . . . but compelling in a credit bubble where yields were everywhere falling. . . . When a wave of redemptions hit the Madoff funds, the Ponzi scheme . . . became unworkable. . . . Reputations inflated in the bubble [of the 1920s] promptly evaporated in the 1929 crash, which exposed a plethora of swindles. Redemptions of the hedge funds business are having the same effect today. Having appreciated in the up cycle, mainstream securities offered only meager returns going forward, causing investors to turn elsewhere. Madoff’s steady 10-11% returns wouldn’t have blown off anyone’s socks in the 1990s, but they were enticing in the 2000s. Add in the optimism, credulity and loosey-goosey attitudes that always accompany the top of a cycle, and the atmosphere was right for what John Kenneth Galbraith called a good “bezzle.” But when things retreated from the lofty level that couldn’t be maintained, investors put in for redemption and the falsehoods came to light. The Madoff scam was cut from the same up-cycle-gone-wild cloth as the elimination of the uptick rule. Scams; unsupportable mortgages on overpriced homes; over- leveraged hedge funds, debt pools and buyouts; insurers with inadequate capital; managers incapable of doing what they said they could . . .

as Warren Buffett says, they’re all exposed when the tide goes out. What are the results to date? The outing of the biggest fraud in history; $1 trillion of write-offs by the banks thus far; $7.8 trillion committed to “recovery activities” by the U.S. alone; the biggest decline in the Dow Jones Industrials in 77 years; more than a decade of equity appreciation lost; the disappearance of every major U.S. non-bank investment bank; and a cry for more and better regulation. Now that the bursting of the credit bubble has affected the general economy, we’re seeing declining consumer incomes, confidence and spending; plummeting home sales, home prices and housing starts; and the highest unemployment rate in many years. All of this is part and parcel of the long-term cycle. Trends Just Ahead Unlike the “era of increasing willingness,” many things will face increased difficulty in the months and years just ahead. It’ll be tougher times for anything dependent on:  bullishness, willingness and expansiveness,  increasing economic activity and consumer spending,  the ability to incur, service, repay or refinance debt,  asset sales and the ability to delever, and  strong asset values and investment returns.

As little as two years ago, investors rushed headlong into things, fearing that if they didn’t, they’d miss out on big gains. Now they’re keeping their money in their wallets, saying “I don’t care if I ever make a penny in the market again, I just don’t want to lose any more.” This change in attitudes – throughout the financial system – is responsible for a lot of today’s deep freeze. Over the last several decades, our economy and markets benefited from positive underlying trends and investors were well rewarded for bearing risk. As a result, there was rising bullishness, willingness and expansiveness. When these trends reached unsustainable excesses, they were corrected with a vengeance. I’m now of the opinion that not only will short-term economic cycles of boom and bust repeat regularly, but also that favorable long-term trends are bound to see a recurrence of this sort of occasional massive pullback . . . at that moment when the passage of time has erased all memory of past corrections and taken investor behavior (and thus asset prices) to unsustainable highs. Buoyant, decades-long up-trends and their explosive endings are the inevitable results of the tendency of human nature to go to extremes. Hopefully the current bursting of the long-term bubble will end within the next few years, and hopefully the next iteration is another 30, 50 or 70 years away. This one’s providing enough excitement for a lifetime.2009

© Oaktree Capital Management, L.P. All Rights Reserved UHow Things Got This Way Much of the current problem can be attributed to a decades-long bubble in the financial sector that made it the employer of obvious choice; attracted employees who were “the best and the brightest” (although often untrammeled by experience); contributed to greed and risk taking; drove out fear and skepticism; and carried institutions, behavior, expectations and asset prices to unsustainable levels. What are the factors that got us in the current mess?  Excess liquidity, which had to find a home.  Interest rates that had been reduced to stimulate the economy.  Dissatisfaction with the resulting prospective returns on low-risk investments.  Inadequate risk aversion, and thus a willingness to step out on the risk curve in search of higher returns.  A broad-scale willingness to try new things, such as structured products and derivatives, and to employ massive leverage.  A desire on the part of financial institutions to supplement operating income with profits from proprietary risk taking – that is, to be “more like Goldman.”  A system of disintermediation, selling onward, and slicing and dicing that caused many participants to overlook risk in the belief that it had been engineered away.  Excessive reliance on rating agencies which were far from competent to cope with the new instruments, and on black-box financial models that extrapolated recent history.

” In English, however, a “canard” is “a Tfalse or unfounded report or story T.” That English meaning comes from the French phrase “vendre des canards à moitié”: to cheat, literally, to half-sell ducks. A canard gained broad acceptance over the last decade or two, as faith in the ability of the free market to optimally allocate assets morphed into an irrational expectation that the free market would produce a continually rising tide, lifting all boats and bringing a better life for everyone. Here’s my version of the saga. One of the longest cycles I’ve witnessed has taken place in the area of government involvement in the financial industry. Prior to 1929 (I wasn’t around for this part), there was little regulation. When much of the subsequent market collapse was attributed to improper conduct in investment banking and in investments generally, this led to significant new regulation. For an interesting look at behavior in the 1920s, I’d recommend Wall Street Under Oath, written in 1939 by Ferdinand Pecora, who led the Senate investigation into the causes of the Great Crash and then became a New York State judge. It’s a scathing indictment: imagine Wall Street operating in the 1920s unhampered by today’s securities laws. Among other things, the Street’s conduct led to the enactment of the Glass-Steagall Act of 1933 that mandated the divorce of commercial banks from investment banks, the Securities Act of 1933 and the Securities Exchange Act of 1934.the

© Oaktree Capital Management, L.P. All Rights Reserved So now we find financial institutions that endangered themselves by using extensive short-term borrowings or deposits to make investments that turned out to be enormously risky when an unlikely disaster – a nationwide decline in home prices – occurred. In many ways, changes in the environment contributed as well. They crept up one by one, unnoticed, but their combined effect is significant. For example,  The Glass-Steagall Act was repealed, permitting banks and investment banks to combine. (It had been enacted in 1933 to outlaw such combinations because they were felt to have contributed to the Crash of ‘29. It’s ironic – and certainly not irrelevant – that it was repealed in 1999, in time to contribute to the current credit crunch.)  The rule limiting short sales to up-ticks was revoked in July 2007, enabling short selling to force stock prices down unabated.  Derivatives were created whose prices were determined by the price of their “real” underlying securities; now we see that in an Alice-in-Wonderland way, they’re able to influence the price of real securities (see below).  And mark-to-market accounting exposed precariously leveraged institutions to the risk that technically-driven declines in asset values might leave them too weak to make it through to a better day. It was during my working lifetime that the phrase “too big to fail” was coined.

In every corner, the cry was “let the market decide.” Clearly, however, the events of recent years attest to excesses prompted by the profit motive. More was better: more leverage, more innovation, higher ratings for a given security and more activity in areas like residential real estate. Equally clearly, not all of the free- market decisions were salutary; the proof can be found in the fact that laissez-faire has landed us in a financial crisis that some observers consider the potentially most serious since the Depression. How can we reconcile theory and practice: the way free-market decisions are supposed to work and the way they do work? The answer lies, I think, in the difference between short term and long, and in the coexistence of beneficial general trends and harmful exceptions. Free markets allocate resources efficiently in the long run. But they can’t make the tide rise continually, and while some boats rise, others will crash. Properly functioning free markets will give rise to times that set the stage for ruin, and then to times of ruin itself. They must create losers as well as winners, and capital destruction as well as capital creation. In pursuit of profit in a free market, people can engage in any behavior that’s not illegal. (Well, actually, they can do illegal things too, but hopefully not for long.) Ethical considerations constrain some but not all, and ethicality seems to wax and wane. There’s no doubt that profit pursuers sometimes push the envelope.

He may start an investment bank unburdened with a legacy of losing positions. Or a bond insurer like Warren Buffett did when MBIA and Ambac became impaired. The cause of the recovery can’t be predicted. There may not even be a visible one. Maybe things will just get so cheap that they can’t stay down. (In ancient history – November 2001 – I wrote “You Can’t Predict; You Can Prepare,” with a thorough description of how cycles happen, based on energy all their own. It might be worth digging up.) I like to point out that, even in retrospect, no one can say what started the collapse of the tech stock bubble in 2000. But it did start . . . just, I think, because stock prices rose far too high. That works in reverse, too. In March, in “The Tide Goes Out,” I mentioned the three stages of a bull market, a notion I’ve been carrying around in my head for about 35 years:  the first, when a few 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’s sure things will get better forever.

© Oaktree Capital Management, L.P. All Rights Reserved One of the great investment books of the 1960s was The Money Game by the pseudonymous Adam Smith. Smith talked about a veteran investor, the Great Winfield, who knew he was falling behind the times but had the answer: “Our trouble is that we are too old for this market. . . . My solution to the current market: kids.” In the last decade or two, everyone hired quantitative whiz kids, and the results were disastrous. Hopefully, the events of the last few years will produce a sea change, in which investors come to rely more on seasoned judgment and less on financial engineers. UGreenspan and the Fed Alan Greenspan deserves a lot of credit for presiding over one of the greatest periods of prosperity and market gains in our history, and for saying, presciently, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.” With apologies to my indirect personal connection to the ex-Fed Chairman, I must express my view that his stewardship wasn’t perfect. (Of course, I doubt he’d say it was perfect.)  Because he rarely used his bully pulpit to warn about excesses, advances were permitted to run unchecked. For example, his warning against “irrational exuberance” attracted a lot of attention, but I’ve always wondered why, if he considered it justified in 1996 with the Dow at 6,400, we heard nothing from him on the subject in 2000, when it topped out at 11,700.

But any misdeeds are likely to be symptomatic of a lax environment, not causes of the problem, and punishing them is unlikely to be an effective part of the solution. UEliminating the Fear of Loss A couple of weeks ago, I had a great talk with Tom Petruno, an insightful business reporter for the Los Angeles Times. Calling on our shared experience as Californians, he presented what I consider a very apt analogy. It went like this: We’ve all heard about the connection between the Fed’s actions and moral hazard. There’ve been many incidents and scares over the last couple of decades: Black Monday, the meltdown of Long-Term Capital Management, Y2K, the bursting of the tech bubble, 9/11, and a recession here and there. Each time, the Fed rushed in with interest rate cuts and increases in liquidity designed to prevent or offset their depressing effects. A few times, it was said, these actions averted a collapse of the world financial system. But the cost was moral hazard: a growing expectation that the Fed would bail out imprudent risk takers. By behaving in ways that cause people to think they’ll always come to the rescue, authorities encourage risky behavior. And we all share the cost of rescuing the risk takers, whether we participated or not. In this way, the risk taking encouraged by the Fed’s policy of protecting participants caused the risks to grow ever- higher.

The result is a housing bubble and full-scale credit crunch that together have cost millions of people money and perhaps their homes, pushed financial institutions to the brink, and caused the government to expend a lot of its problem-solving resources. Tom asked if I didn’t see a parallel between the management of our financial system and the policy toward forest fires.for

First, let’s consider financial institutions and the housing market. In recent years, as everyone knows, the former combined with the latter to create a bubble based on the combination of leverage, innovative structuring and heedless buying. Institutions and housing have been gravely hurt, and they’re likely to bring harm to additional sectors of the economy. For their downward spiral to be arrested, I see four things that have to happen:  Home prices have to stop going down.  Home mortgages have to be made available.  Financial institutions have to stop experiencing incremental write-offs.  Financial institutions have to be able to raise additional capital with which to rebuild their balance sheets. The problem I see is that each of these four things is dependent on the occurrence of another – a classic chicken-or-the-egg problem. Write-offs won’t stop until home prices stop going down. Prices won’t stop going down until mortgages become available. Mortgages won’t become available until lenders can raise capital. And capital won’t be freely available until write-offs stop coming. Which will happen first, facilitating the others? What will cause it to happen? When? These things will happen, of course. Maybe for reasons we can’t foresee. Maybe for no apparent reason. And maybe just because things got so bad they couldn’t get any worse. I go through this only to show why I don’t see an easy or quick solution. But then I’m rarely an unbridled optimist.

© Oaktree Capital Management, L.P. All Rights Reserved techniques and structures depended on the future looking like the past. And many of the “modern miracles” that were relied on were untested. UA Dearth of Skepticism Unlike market bottoms, where investors are too skeptical, during upswings most people believe too much, worry too little and fail to apply enough skepticism. Since all investors want a good deal – and see the people around them making money so easily – they tend to jump aboard. They want to see the good times roll on, not to pour cold water on the party by questioning what’s going on. Everyone dreams of easy riches – of high returns earned without risk. Wall Street comes up with surefire solutions to which the hopeful flock, such as portfolio insurance in the 1980s and dot-com IPOs in the 1990s. In the current decade, investors became convinced that securitized mortgages and highly leveraged entities offered the magic solution. People who long ago stopped believing in Santa Claus jumped aboard, and now they’re disappointed. But past results never deter new generations of dreamers from chasing the next silver bullet. In the last few years, people accepted myths that now have been exposed. Let’s review a few:  In 2006-07, we heard a lot of talk to the effect that disintermediation had reduced risk.

© Oaktree Capital Management, L.P. All Rights Reserved UUnusual Breadth In the past we’ve seen bull markets in equities, commodities and real estate. And we’ve seen bull markets in the U.S., Japan and the emerging markets. But this time around, we’ve been seeing a near-global bull market, where the participating sectors vastly outnumber those left out. In his April letter to investors, entitled “The First Truly Global Bubble,” Jeremy Grantham summed up the worldwide nature of the good times. Never before have UallU emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere – emerging or developed – out of the 42 listed by The Economist grew its GDP by less than Switzerland’s 2.2%! Amazingly uniform strength, and yet another sign of how globalized and correlated fundamentals have become, as well as the financial markets that reflect them. Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong “animal spirits,” reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take.

A critical part of the bubble is the reinforcement you get for your optimistic view from those around you. And of course, as often mentioned, this is helped along by the finance industry, broadly defined, that makes more money when optimism and activity are high. . . . To say the least, there has never ever been anything like the uniformity of this reinforcement. The March issue of Marc Faber’s Gloom, Boom & Doom Report described the pervasiveness of the positive effect on markets. He listed four “bubbles of epic proportions” that he has witnessed: metals, mining and energy in the 1970s; Japanese equities and real estate and Taiwanese equities in the late 1980s; emerging markets in the 1990s; and TMT at the end of the 1990s. In contrast to the present experience, he pointed out, . . . all had one common feature: they were concentrated in just one or very few sectors of the economic or investment universe and were accompanied by a poor performance in some other asset classes. . . . Currently, looking at the five most important asset classes – real estate, equities, bonds, commodities, and art (including collectibles) – I am not aware of any asset class that has declined in value since 2002! Admittedly some assets have performed better than others, but in general every sort of asset has risen in price, and this is true everywhere in the world.

” This time around, the answer is “lots of people.” The Magic of Leverage It’s obvious that the key element in many of the errors that tripped up investors this time around was cheap and easy credit, utilized without much awareness of risk. An oversupply of capital looking for a home in non-traditional investments caused vast sums to be pushed into mortgage loans at low-cost teaser rates to un-creditworthy homebuyers who often weren’t required to document their incomes. It let hedge funds bulk up on the carry trade and buyout funds bid enough to acquire world-class companies, taking on enough leverage to target high expected returns. And it was the building block supporting CLOs, CDOs, CDO2s, conduits, SIVs and other highly leveraged entities. The Fed delivered cheap credit for the best of reasons: to counter the depressing effects of the emerging market crisis, 9/11, the tech bubble bust, the first three-year stock market decline since the Depression, Y2K, the telecom meltdown, concern about deflation, and whatever else was on its mind. Interest rates were the lowest most of us had ever seen, anchored by 1% on cash. The low rates both (a) drove down returns on investments at the safe end of the risk curve and (b) provided the fuel for elevated risk taking. One must never forget that leverage doesn’t make investments better; it just magnifies the gains and losses.

© Oaktree Capital Management, L.P. All Rights Reserved significant overlap – have negated the old limits and made vast amounts of leverage available to investors and asset buyers. This leveraging up was the greatest single element in the asset surge of the last few years. In fact, the breadth of the gains tells me we didn’t have an “asset bubble,” but rather a “leverage bubble.” As Jeremy Grantham points out in his latest letter, leveraged loans (so-called “bank loans” often funded by hedge funds rather than banks) are a good candidate for the “bubble” label, as their volume in the first half of 2007, at $545 billion, was up 60% over the same period in 2006, which showed a similarly dramatic increase over 2005. Leverage (along with the lowered standards that resulted from eagerness to put borrowed capital to work) was the common thread in much of the appreciation that took place across asset classes and regions. Now we’re having a chance to see – once again – that the process works in both directions. And as so often is the case, the air tends to come out of the balloon far faster (and more violently) than it went in. The process is mesmerizing – like watching a train wreck happen. UThe Engine of Growth Seizes Up The pervasiveness of leverage throughout the financial system means the slowing process comes in many forms and takes many twists and turns. It’s not possible – or necessary – to enumerate all of them. All we need are a couple of examples.

© Oaktree Capital Management, L.P. All Rights Reserved been looking for new ways to make money.” But when the market has been moving down and people are tallying their losses, they tend to be much less open to new ideas. In the financial world, the mother of invention isn’t necessity, its salability. In the roaring 1960s we saw Nifty-Fifty investing, dual shares from mutual funds and discounted shares issued through unregistered private placements without any mechanism for subsequent liquidity. In the ’80s we saw portfolio insurance – a surefire way to enjoy the appreciation potential that comes with large commitments to equities, but with much less risk. And in the ’90s, no one could think of a reason why every dot-com, e-tailer, media aggregation and venture capital fund wouldn’t be successful. Of course, all of these things failed to function as promised and either disappeared forever or experienced severe corrections. And what have we seen in the last few years? CDOs, CLOs, CPDOs, SPACs and securitizations of every type. In the current environment – marked by decent returns; disinterest in conventional, safe assets; and openness to risky investments – few people seem to dwell on the reasons why something new might not work. No one asks why, if a $2 billion fund was successful, a $20 billion fund shouldn’t be as well. Derivatives deserve particular attention in this regard.

“It can only go up” and “if it stops working, I’ll get out” – two phrases that are heard in the course of virtually every financial mania – proved once again to be highly flawed. To avoid the trap in residential real estate, one needed a memory of events that occurred more than ten years earlier, the ability to understand their implications, and the discipline to resist joining the herd. Many failed the test and succumbed to yet another investment craze. Just think about the many things everyone agreed on in the last decade, and how overdone these fads turned out to be – or may turn out to be in the future.  “Everyone” loved emerging markets in the mid-90s, with their concept of per capita consumption catch-up . . . until the Russian debt debacle and the collapse of Long-Term Capital Management busted that bubble for a while.  A fellow member of a non-profit investment committee insisted in 1999 that we had to invest the endowment in a hi-tech fund . . . just before its portfolio lost more than 90%.  Hedge funds were widely touted as the surefire solution to the weakness that stocks demonstrated in 2000-02, in time to see the average return recede to unexciting single digits. Great recent performance and a failure to detect risky patterns have cost investors money on several recent occasions . . . and always will. Now silver bullets ranging from private equity to art are being touted as ways to make big money without risk . . .

My advice: expect CEOs, regulators, rating agencies and other market participants to make mistakes. Expect things to go wrong and cycles to swing to extremes and then recover. Worry about outcomes, and hire worriers. Doing these things is sure to stand between you and top returns in up-cycles, but it will deliver some degree of safety when things turn bad. Ensuring the protection of capital under adverse circumstances is incompatible with maximizing returns in good times, and thus investors must choose between the two. That’s the real lesson. The things discussed above are just a few of the details. What Next? Lots of people are asking whether this is going to get ugly. Is this the beginning of a credit crunch? Will it lead to a recession? How bad will it get? When will the bottom be reached? How long will the recovery take? The answer’s simple: no one knows. Some of the psychological and technical preconditions for a challenging market environment have been met. The bubble of positive investor psychology has been pricked and could become seriously deflated. When others are aggressive, we should be worried, but when others are worried, we can be confident. That’s the essence of contrarianism, and by that standard these are better times. The easy-money machine has had some sand thrown in its gears and seems to be grinding to a halt. Previously, anyone could get any amount of money for any purpose.

Stimulative action that looked like an investor bailout would contribute further to moral hazard and the expectation that the Fed will always protect investors on the downside. This is an unhealthy expectation, as each bailout encourages risk taking and thus increases the likelihood that another will be needed. But the Fed is being importuned for a rate cut, and there are few people to argue on the other side, for a good dose of unpleasant medicine. I’m usually cautious, so I might as well keep my record intact. The economy should weaken. Deals built on optimistic assumptions and paid for with a lot of borrowed money shouldn’t all thrive. Generous capital markets should not be expected to bail out ailing companies. Bargain hunters and distressed debt investors will have more to do. Eventually. But no one at Oaktree would advise you to act as if these views are sure to be correct. We certainly won’t. * * * TAn observation I made last October regarding the meltdown of Amaranth, in “Pigweed,” is equally applicable to the recent problems: TOrin [Kramer] notes that Amaranth “occurred when the skies were blue; the fund unraveled because a small and volatile commodity behaved in an unpredicted fashion.” This collapse didn’t require an adverse economic environment or a market crash. The combination of arrogance, failure to understand and allow for risk, and a small adverse development can be enough to wreak havoc.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Returns, Absolute Returns and Risk U What’s In a Name? My memos often touch on the subject of investors’ foibles, one of the worst of which consists of their tendency to pay too much attention to labels (and too little to substance).  Enthusiasm for “growth stock investing” carried investors to the ridiculous conclusion that for the stocks of the fastest-growing companies, no price is too high. That was just before the “nifty-fifty” stocks of America’s best companies lost up to 90% of their value in 1973-74.  “Portfolio insurance” assured investors they could participate fully in stock market gains with protection against declines if they would simply commit to automatically enter sell orders pursuant to an algorithm. But in the crash of October 1987, investors found themselves unable to make those sales, and the ineffectiveness of the “insurance” (combined with the outsized positions it had encouraged) cost them dearly. And at any rate, portfolio insurance, like any mechanical risk-limiting device, should have been expected to limit long-term return as well as risk. After all, there rarely is a free lunch.  “Market neutral” funds were supposed to be insensitive to market fluctuations, but the so- described Granite Fund of mortgage-backed securities melted down in just a few weeks when it turned out not to be insulated from the rapid rise of interest rates in 1994.

I often say there is no investment so good that it can’t be ruined by too-high an entry price. There’s also no investment so safe that can’t be rendered risky by buying too much of it with borrowed money. TDiversification has long been considered a pillar of conservative investing. It’s a simple concept: “Don’t put all your eggs in one basket.” Spreading your capital among a number of assets or strategies reduces the likelihood of a disaster. TIn the 1960s, Bill Sharpe pointed out that adding in a risky but uncorrelated asset can reduce a portfolio’s overall riskiness. It has become accepted wisdom that overall risk can be reduced (and return increased) by adding alternative investments to a portfolio of stocks and bonds. TBut people don’t always take note of a dangerous outgrowth of these dicta: that diversifying into uncorrelated assets with borrowed money can increase, not reduce, the risk of the portfolio. TLet’s say you have $100 invested in U.S. stocks. You realize how undiversified your portfolio is, and that a market crash can bring a substantial loss. So you sell off $75 worth of stocks and put $25 each into emerging market stocks, high yield bonds and natural gas futures. Now your portfolio is invested equally in four asset classes rather than one and thus probably safer. TBut what if, instead, you hold onto your $100 worth of U.S. stocks and borrow another $300, investing $100 in each of those three new asset classes.

In fact, since many of the best investors stick most strongly to their approach – and since no approach will work all the time – the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett in 1999. That year, underperformance was a badge of courage, because it denoted a refusal to participate in the tech bubble.)

© Oaktree Capital Management, L.P. All Rights Reserved TA crash that wipes out one of the four asset classes in the diversified $100 portfolio will reduce your net worth by 25%. But that same crash, when experienced in the leveraged and equally diversified $400 portfolio, will eliminate your entire net worth. So investors should always consider the combined effect of diversification and leverage. Amaranth was much safer when it was all in convertible arbitrage than after it increased its leverage in order to diversify into energy trading. Diversification is a good thing, but a lot depends on how you finance it. T“Multi-strategy” is one of today’s hot buzz words. But as Orin Kramer puts it (see page 12 for who he is), “Amaranth is a reminder that a multi-strategy structure is not a proxy for risk diversification.” That is, I think, multi-strategy + risk control = protective diversification, while multi-strategy + leverage = more ways to lose. UGenerating Alpha I want to say up front that I have absolutely no idea how one dependably achieves above average profits from trading or investing in commodities, precious metals or currencies. That’s not to say it can’t be done. There are people who’ve gotten very rich that way, managing both their own money and that of others.

© Oaktree Capital Management, L.P. All Rights Reserved 3BUAn Inefficient Market in Investment Advice Bruce Karsh and I recently had an opportunity to sit down to lunch with Charlie Munger. As usual, our conversation was most enjoyable, straying over a large number of topics. I think a few of them – plus some comments from Warren Buffett’s latest annual report – can be woven into something of relevance to this memo and of interest to you. Bruce started off by observing that with practically everyone able to start up a billion dollar hedge fund, and with the leading private equity managers able to raise funds of $10 to $15 billion, jobs in those fields are in great demand as the way to get rich quick. It occurred to me that if large numbers of people are convinced that a given field is sure to give them instant wealth, something must be wrong. That’s a “bubble expectation.” Getting rich – if it can be accomplished at all – is supposed to come from some combination of proven skill, hard work, risk bearing and luck. No one should be able to count on it, and especially not in the short run. And given the operation of market forces, such an opportunity shouldn’t last long. Then I remembered that for decades I’ve argued that exceptional risk-adjusted returns can only be achieved in inefficient markets, and even then not all the time or by everyone. And by “inefficient markets,” I’ve always meant markets where mistakes are being made.

TOrin also notes that Amaranth “occurred when the skies were blue; the fund unraveled because a small and volatile commodity behaved in an unpredicted fashion.” This collapse didn’t require an adverse economic environment or a market crash. The combination of arrogance, failure to understand and allow for risk, and a small adverse development can be enough to wreak havoc. It can happen to anyone who doesn’t spend the time and effort required to understand the processes underlying his portfolio.2006

Later, a few more years of good returns had raised the historic figure – and thus expectations for future returns – to the range of 10-11%. And from the late 1960s through the late 1990s, nothing – and I mean nothing – was more universal than the belief that stocks could be relied on for 9-11% per year. I don’t think I’ve ever seen an assumption that was less questioned than this one. The next step in cementing this expectation was the publication of “Stocks For the Long Run” by Wharton’s Jeremy Siegel, one of the nation’s highest-rated professors. Siegel’s message had the effect of minimizing worry about the variability of equity returns. He demonstrated with past data that stocks could be depended on to beat cash, bonds and inflation over the long term. In the popular perception, this morphed into an expectation that stocks could be depended on to beat cash, bonds and inflation . . . period. Along with the boom in tech/media/telecom stocks and the first-day gains of IPOs, Siegel’s data contributed to one of the greatest equity manias of all times. Of course, it evaporated after the TMT stocks collapsed in 2000 and was buried as the major stock averages did the unthinkable, declining for three straight years for the first time since the Great Crash. So what do people expect from stocks today?

© Oaktree Capital Management, L.P. All Rights Reserved they conclude they may have to look just to profits growth for their returns, and that’s likely to be in the mid-single digits as usual. As a result, in my view, everyone’s thinking 6-7%. No one’s talking about 9-11% anymore. What changed? There’s nothing new about the argument contained in the paragraph just above. The cautious were making it in the 1990s. When stocks were rolling along, however, it had little persuasive power. With stocks high, expectations regarding future returns were high. The S&P 500 is 20% lower today than it was in 2000, on higher earnings, so it’s demonstrably cheaper in p/e ratio terms (even if not necessarily cheap). And with stocks lower, expectations regarding future returns are lower. Can there be a more clear-cut case of hindsight prevailing? I don’t think so. And by the way, in the late ’90s, people were sure stocks held the key to investment performance, and were pushing up their allocations. Some got to 80% just in time for the crash. I may not travel in the right circles, but it’s been years since I last heard of an institutional investor that wants to increase its allocation to domestic equities. If they’re correct now, what were they thinking in the late ’90s? 1BUIf Not Stocks, Then What? Since no one wants to increase allocations to U.S. stocks (or high grade bonds, for that matter), where’s the money going? The answer is, just about anyplace else.

” They’re lining up to buy houses (often before they’re built) that they never expect to occupy, for holding periods too short to repay the transaction costs in the absence of substantial appreciation, and they’re financing them with maximum floating-rate mortgages, minimum amortization and little or no money down. On March 25, 2004, The New York Times compared attitudes toward home buying today and the “dot-com frenzy” of the late 1990s: . . . perhaps the most troubling similarity, some analysts say, is the claim that the rules have somehow changed. In an echo of the blasé attitude that “new economy” investors took toward unprofitable companies, the growing ranks of real estate investors are buying houses they never expect to be able to rent at a profit. Instead, they think the prices of houses will just keep rising. This paragraph points up a key error. In 1999, impassioned investors bought dot-com stocks, not to participate in the underlying companies’ profit streams, but to sell them at higher prices. But what could be depended on to make their prices go higher, if not favorable trends in profits? In the same way, rational investors won’t count on being able to sell a house at a profit because someone else will pay more for it, but rather because of an increase in its economic value (which usually can be seen in the obtainable rent).

How many of the investor errors enumerated on pages 2-3 do you see below? It’s driven by the same forces [as drove the dot-com stocks]: that investments can’t go bad; that it has the potential to make you rich; that you’ll regret it if you don’t do it; that it looks expensive but really is not. . . . a limited supply of land coupled with demand from baby boomers and foreigners [will] prolong the boom indefinitely. I don’t think prices are going to fall, and I don’t think they’re even going to be flat. It really is a very hot real estate market, and I don’t know how long it’s going to continue. But in the short run, why not profit from it? I look at this as a short-term investment and plan to unload it as soon as things look dangerous. I’d bet none of the people quoted above lost money in the last real estate cycle or learned the lessons of the past. It’s for that reason that they’re prone to mistake the up-leg of yet another cycle for a new and permanent miracle. And so it goes. The commercial, retail and residential properties that professionals buy have escalated also – although not as crazily or with as much disregard for valuation. Nevertheless, cap rates are down in response to the general decline in interest rates, demanded returns and risk premiums. With returns on Treasury bonds at 4-5%, fully leased class “A” office buildings apparently look good at 6-7%.

© Oaktree Capital Management, L.P. All Rights Reserved As usual, James Grant supplies a trenchant analysis, this time in the April 25 issue of Forbes. His summary of what’s going on in real estate highlights time-honored mistakes that are being repeated: Markets look forward, except when they look backward. At this moment the real estate market is looking backward. . . . Mistaking the past for the future, people are pouring money into houses, shopping centers, office buildings, hotels, anything with a front door and a roof. They are paying some of the fanciest prices on record. Property bulls come in all sizes, shapes and net worths. “We are living with the greatest liquidity ever,” an eminent REIT promoter was quoted as saying in March in the New York Sun. “We’re not going to have a crash in the real estate market, there is too much liquidity.” Liquidity is a term of art. It means lots of money. It can also mean – and, in 2005, does mean – “low interest rates,” “E-Z financing terms,” “low dollar exchange rate” and “value investors go away.” In an evident state of liquidity-induced euphoria, a Miami Realtor recently proclaimed to The New York Times, “South Florida is working off a totally new economic model than any of us has ever experienced in the past.” Not true. The “South Florida economic model” is the oldest in the book. An excess of dollars leads to a drop in interest rates. And a drop in interest rates to a rise in real estate prices.

But no groundswell formed behind it, and other issues have taken center stage, and we haven’t heard anything on this subject for months. One way or the other, I think retirees in the future will receive less from Social Security than the system promises today. So what about private pensions? Defined Benefit plans are declining in popularity among employers, and a not-insignificant number are headed for insolvency. Defined Contribution plans are taking their place in many cases, but some of the bloom is off the rose now that “401-k” and “Acapulco” have ceased to be synonymous. Certainly their benefits are expected to be less lavish and less dependable now than was thought to be the case while the equity bubble of 1998-99 was in full flower. And that leaves personal savings . . . which as a percent of income just went negative in July. I am amazed when I read about the people who spend all of their income and more on lifestyle. Maybe they think old age won’t come, but that’s not a solution I’d be eager to rely on. What about the millions – with no savings – who each year spend thousands of dollars more on their credit cards than they earn. How do they think this movie will end? Anyway, early Baby Boomers like myself are probably well taken care of, because we partook of the post-war economic miracle before it had to be shared broadly and heeded the lessons of thrift taught by our Depression-era parents.

© Oaktree Capital Management, L.P. All Rights Reserved Clearly that’s what happened to tech stocks in 1999. Greed was the dominant characteristic of that market. Those who weren’t participating were forced to watch everyone else get rich. “Prudent investors” were rewarded with a feeling of stupidity. The buyers moving that market felt no fear. “There’s a new paradigm,” was the battle cry, “get on board before you miss the boat. And by the way, the price I’m buying at can’t be excessive, because the market’s always efficient.” Everyone perceived a virtuous cycle in favor of tech stocks to which there could be no end. But eventually, something changes. Either a stumbling block materializes, or a prominent company reports a problem, or an exogenous factor intrudes. Prices can even fall under their own weight or based on a downturn in psychology with no obvious cause. Certainly no one I know can say exactly what it was that burst the tech stock bubble in 2000. But somehow the greed evaporated and fear took over. “Buy before you miss out” was replaced by “Sell before it goes to zero.” And thus fear comes into the ascendancy. People don’t worry about missing opportunities; they worry about losing money. Irrational exuberance is replaced by excessive caution.

© Oaktree Capital Management, L.P. All Rights Reserved  He seems happiest when betting against the herd. For example, on the subject of distressed bonds, he says “yesterday’s weeds” (which yielded 30-50% in 2002), are being priced as “today’s flowers” (and thus yielding 4-6%). He’s written me that he “liked them better when they were weeds.”  Certainly he’s a patient long-term investor (and, in fact, UnotU much of a profit taker; he recently expressed some regret about having not sold during The Great Bubble).  He is very conscious of the effect of increased capital on investment returns. “When [a manager] tells you that increased funds won’t hurt his investment performance, step back: His nose is about to grow.” There are lots of ways to skin the cat, and certainly there are successful investors among “them.” But the characteristics enumerated above have provided the foundation for Warren Buffett’s incredible record, and that makes them good enough for me. * * * To help you see the picture I’m suggesting and evaluate the investors you come across, I’ve prepared the quick-and-dirty checklist that appears on the following page. Few people will hit every point on the head, but I think you’ll recognize in the list on the left a lot of the “they” school investors you know, and on the right, hopefully, a few from the “us” school. Each year – especially in good times – the headlines will go to those on the left who guess correctly.

© Oaktree Capital Management, L.P. All Rights Reserved o concern over the impact of hedge fund short selling; o and, of course, the outright fraud that occasionally arises and always is a threat. UThe Outlook for Hedge Fund Investing As I said earlier, despite the troubling factors enumerated above, I do not envision a boom-bust scenario for hedge fund investors. After all, hedge funds spread their investment over almost all asset classes, and most funds are fairly disciplined in sticking to low-priced investments. So there isn’t a single asset or group of assets where we have to worry about hedge funds creating bubble-like appreciation and the usual subsequent collapse. No, the excesses aren’t in the prices of the assets in which hedge funds invest. The excesses are in the trends affecting the industry: too much money coming too fast; too many funds managed by people of uneven skill; and too-high fees relative to the limited excess return the average fund is likely to generate. I do not expect a debacle, just a disappointing experience. The sad fact is that, on average, hedge funds may go down as just another former silver bullet. The high single digit return for which I think people invested wasn’t a figment of anyone’s imagination. It was probably reasonable looking back at the period preceding the current hedge fund boom.

© Oaktree Capital Management, L.P. All Rights Reserved 5BUSo What’s The Point? I don’t begrudge people wanting to make money by expressing views that are beyond their ken and of no value. I guess it’s human nature. My complaint, however, is that it’s misleading and injurious to bystanders when people use serious platforms to state their unfounded views. They make it seem so easy to understand economic and market developments, and thus to profit from them. Just as no one should give legal advice or medical diagnoses on TV, the media should desist from providing economic and market analysis as well. I think some of the greatest contributors to the 1998-99 bubble were the talking heads of the media. For every event they provided a without-a-doubt explanation and quantified its profit implications. These “experts” were free with recommendations and exuded 100% certainty. As I’ve said before, there are a few things they never said: “darned if I know,” “it’s hard to predict these things,” and “but I could be wrong.” Nobody was well served by the veneration of the “I know” school in the late 1990s: Main Streeters were lured to invest in Wall Street without an understanding of the skills required or the risks entailed. The market and thus the economy were put through an extreme boom-bust cycle. Risk- taking investment gunslingers were anointed, and cautious value seekers were rendered irrelevant.

© Oaktree Capital Management, L.P. All Rights Reserved UWhere Were the Strategists? Another group that’s no longer riding quite as tall in the saddle are the brokerage house strategists. They attracted a lot of respect in the ‘90s, and some even attained “household name” status. But I don’t know of any who helped their clients avoid the pain of the last three years. I think the test is simple: Did they call the TMT bubble? It’s obvious in retrospect that many of the tech/media/telecom companies and their strategies were somewhere between fanciful and fictitious; the valuation multiples were ridiculous; investor behavior was nuts; and Wall Street had turned into a machine for short-term appreciation. If it’s so obvious in retrospect, lots of the strategists (whose sole job it is to figure out what’s going on and what it means for the future) should have had an inkling at the time. Since this was the most extreme event of our investment lifetime thus far, and since it built up in plain sight over a period of years (as opposed to being the result of a sudden and surprising exogenous influence), shouldn’t the strategists have seen it? The emperor was as naked as he’s ever been, but the brokerage strategists failed to point it out. Abby Joseph Cohen was the most prominent of the strategists, having made a real name for herself by correctly predicting stock price gains for a decade or more.

© Oaktree Capital Management, L.P. All Rights Reserved  Of course, the industry stands for the delivery of active investment management to the masses (although some firms also provide passive management through index funds). Sales are achieved on the basis of comparisons against other mutual funds. Little is said about the long-run ability (or inability) of funds to beat the market.  Some mutual fund families offer so many funds, of such an amazing variety, that it's not illogical to wonder whether their motivations don't include a desire to always have something in the top quartile, and something to advertise with four stars.  The funds in the bottom quartile, on the other hand, have a striking tendency to be merged out of existence – causing their performance records to disappear.  The industry can be criticized for hyping (and selling) funds in whatever market sector is "hot." Certainly we don't see any warning labels to the effect that "hotness" can be synonymous with elevated prices, and thus with the potential for subsequent losses. The mutual funds that were on magazine covers during the tech bubble buried their clients. It's not a coincidence that the average fund investor does worse than the average fund; it's because investor money is constantly being lured into the funds that have been performing best, and thus are the most precarious.  Lastly, compensation arrangements at mutual fund sales organizations can be adverse to the clients' best interests.

© Oaktree Capital Management, L.P. All Rights Reserved On the other hand, these don’t:  Iraq refuses to admit inspection teams.  People start traveling again; airlines and hotels prove rewarding investments.  Technology and telecom equipment orders improve.  Post-Enron populism sweeps the U.S.; Democrats take control of both houses of Congress. Byron’s list shows us that (a) it is possible to predict some coming surprises, but (b) it isn’t possible to do so with high reliability. Thus it’s not clear that betting on his list of potential surprises – or any such list – would be profitable. UHere’s A Non-Consensus Forecast for You If you’re looking for an idiosyncratic, non-consensus forecast to make some money on, see Robert Prechter. As the February issue of “Bloomberg Markets” magazine stated: Forget about the Dow Jones Industrial Average returning to 11,000. Try Depression-era levels of less than 1,000. And don’t flock to bonds for safety: Municipalities will default and corporate bonds will be wracked by downgrades. Even the U.S. government’s credit status may sink low enough to make Treasury bills shaky. You’ve heard of extreme sports; Prechter’s recent record probably represents the norm for an extreme forecaster. He joined the pantheon of famous forecasters by being right the obligatory once in a row (but in a big way): he predicted a crash two weeks before October 19, 1987 made him right. Then, according to Bloomberg, “he missed the almost decade-long bull market.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Learning From Enron The investigation was not completed until June . . . The testimony had brought to light a shocking corruption, . . . a widespread repudiation of widespread standards of honesty and fair dealing . . . and a merciless exploitation of the vicious possibilities of intricate corporate chicanery. The public had been deeply aroused by the spectacle of cynical disregard of fiduciary duty . . . Part of a draft post-mortem for Enron? Could be, but it's not. It's a passage from one of my favorite books, "Wall Street Under Oath." The book was written in 1939 by Ferdinand Pecora, who served as Counsel for the Senate Committee on Banking and Currency investigating the Crash of '29 and went on to become a Justice of the Supreme Court of New York. It recounts the outrageous 1920s conduct of commercial/investment bankers that inspired the creation of the Securities and Exchange Commission and the enactment of securities laws that govern our industry to this day. The bankers' conduct was rife with self-dealing, conflicts of interest and gross dishonesty. In other words, reviewing the 1920s reminds us of history's tendency to repeat. U What Can We Learn From Enron? An article about Enron in the December 5 Wall Street Journal made a big impression on me.

I know my views on the market's direction aren't worth betting on. But while I can't tell you what lies ahead, perhaps I can be of service in my usual way, by marshalling the arguments on both sides and giving you my take on them. UStarting Point This attempt to provide insight into the market's future course should be understood in light of a few caveats. The most important are these: First, we are living through the most extreme boom-bust episode of my 33-year investment career and, I think, the most extreme since the Roaring Twenties and subsequent market crash. The magnitude and craziness of the bull market and tech- media-telecom bubble of the 1990s dwarfed every up-leg I've seen, and the correction that started 28 months ago already ranks with the greatest down-legs. Thus all bets for "normalcy" are off. A huge decline like we've had doesn't necessarily create bargains if preceded by a huge advance.

© Oaktree Capital Management, L.P. All Rights Reserved insight, however, for them to comprehend that their switching will be, in itself, among the things that change performance. When people switch to the better-performing group, their buying bids up the prices of those securities. That bidding-up prolongs the outperformance somewhat, but it also reduces the prospective return and increases the probability of a correction. (The higher the price you pay, the worse your prospects for profit. This seems like a simple concept, but it's forgotten once in a while – as it was in the tech bubble.) At the same time, the switchers will sell worse-performing securities to finance their move into the hot group. That will lower the prices of the laggards, and at some point they'll be so cheap that they become destined to outperform. UFor How Long Will the Fast Lane Go Fast?U – The pedal-to-the-metal momentum crowd saw the tech and telecom stocks moving fastest in 1999 and extrapolated their outperformance to infinity. In essence, they assumed one lane could go faster forever. Of course, they ignored the fact that the stocks were being bid up to prices from which collapse would be inevitable. They also failed to notice that the "slow lane" value stocks they were selling would eventually become primed for acceleration. How long can outperformance continue? How long can one lane be the fastest, one strategy be the best? Clearly, there's no rule.

The momentum players behind the bubble proved with certainty that fast rising stocks will keep rising until they stop. They also proved, to their surprise, that few people are capable of getting off just as the upward trajectory peaks out. As I've said many times, anything can work for a while, but nothing can work forever. Sometimes large cap works, and sometimes small cap works. Sometimes domestic works, and sometimes international works. Sometimes buying leaders works, and sometimes buying laggards works. Wall Street has pushed out some incredible gibberish over the years, but nothing quite like that embodied in another yellowed clipping from 1976 (maybe this is why there's no more Loeb, Rhoades): 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. I guess that's a fancy way to say that sometimes the stocks that have been doing best continue to do best, and sometimes the stocks that have been doing worst start to do best. (Really, I don't make this stuff up.) UThe Tactics Others AdoptU – The fact that crowded highways are efficient allocators of space doesn't mean people don't try to beat them.

An investment style that does best (or worst) in one period is unlikely to do so again in the next. That was really the problem with the technology bubble. Investors were willing to pay prices that assumed success forever. They ignored the economic cycle, the credit cycle and, most importantly, the corporate life cycle. They forgot that profitability would bring imitation and competition, which would cut into – or eliminate – profitability. They overlooked the fact that the same powerful force that made their companies attractive – technological progress – could at some point render them obsolete. And they failed to consider that the investing fads in favor of these technologies, companies and stocks could reverse, with dire consequences. UFourthU, investors should bear in mind the role played by timeframe. It seems obvious, but long-term trends need time in order to work out, and time can be limited. Or as John Maynard Keynes put it, "Markets can remain irrational longer than you can remain solvent." Whenever you're tempted to bet heavily on your conviction that a given phenomenon can be depended on in the long run, think about the six-foot tall man who drowned crossing the stream that was five feet deep on average. One of the great delusions suffered in the 1990s was that "stocks always outperform." I agree that stocks can be counted on to beat bonds, cash and inflation, as Wharton's Prof. Jeremy Siegel demonstrated, but only with the qualification "in the long run."

Already companies are scrambling to show they're clean in terms of accounting, governance, and executive compensation.)  Certainly the belief in the inevitability of stock market profits has been dispelled. Who still believes that "stocks can be counted on to beat bonds and cash"? (Okay, nothing has changed regarding the long run, but investors have learned that living through a negative short run isn't that much fun.) And who still believes that the "efficient market" can be relied on to price stocks right? For these reasons, I think millions who were suckered into investing without the necessary expertise or awareness of risk will drop out for a while.  Likewise, the 1999 mantra of buying on dips has been laid to rest. Those who tried it in the last 28 months have paid a high price for investing on autopilot, and they are unlikely to rise up and counter the bears' selling any time soon. Sure, stocks will rise again, but few of the burned investors are worried about missing the first ten percent.  The leaders that people counted on to make them rich in 1998-99 are gone from the scene, and no one's likely to win investors' confidence anytime soon. Alan Greenspan's words no longer have the same soothing effect; now he's blamed for fostering too much liquidity, too great a market bubble, and then too-high interest rates. Likewise, investors have learned painfully that bullish statements from analysts and strategists precede up markets UandU down markets alike.

© Oaktree Capital Management, L.P. All Rights Reserved The need for time came into play in another way for the technology and telecommunications entrepreneurs. Many raised the money they needed for a year or two and proceeded to burn it up. They counted on being able to raise more later, but in 2000-02 capital has been denied even to worthwhile ideas. Lots of companies never got the chance to reach profitability. They simply ran out of time. UFifthU, you must never forget the key role played by valuation. Investment success doesn't come primarily from "buying good things," but rather from "buying things well" (and the difference isn't just grammatical). It's easy for most people to tell the difference between a good company and a bad one, but much harder for them to understand the difference between a cheap stock and an expensive one. Some of the biggest losses occur when people buy the stocks of great companies at too-high prices. In contrast, investing in terrible companies can produce huge profits if it's done at the right price. Over time, investors may shift their focus from dividend yield to p/e ratio, and they may stop looking at book value, but that doesn't mean valuation can be considered irrelevant. In the tech bubble, buyers didn't worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, this "greater fool theory" only works until it doesn't.

 Politicians will keep battling to show who's less tolerant of corruption. Democrats will pick on Republicans for their closeness to business, and Republicans will strive to show they're just as tough as Democrats. I think this is overwhelmingly likely to last through the November elections.  The media will throw gasoline on the fire as always, rising up in indignation whenever they detect a sensational story. The stories are too good, the targets are too rich and attractive, and the rewards for resisting sensationalism are few and far between. Reporters who were pro-investment and pro-free market just a few years ago now see the greatest gains in calling for scalps. And I can just hear the talking heads on CNN and MSNBC saying, "I never liked the stock market anyway." When I put it all together, I come down, as usual, on the cautious side. I'm not confident that the excesses of the bull market of 1982-1999 and the enormous tech bubble could have been corrected in just 28 months. Stocks' current swoon need not go on without end, but I see fundamental, valuation and psychological problems that will take time to fix. Maybe there'll be some lackluster years rather than a continuous collapse. It's said the investors who were burned in the excesses of the 1920s didn't return to the market until 1955 – or was it their kids?

 An investor may take an appropriately cautious stance – let’s say toward tech stocks in 1997 or residential mortgage backed securities in 2005 – only to see an irrationally overpriced market become more so, as prices soar for years. He looks terrible, a victim of the old adage that “being too far ahead of your time is indistinguishable from being wrong.”  Further, in a special case of being wrong as to timing although perhaps not fundamentals, an investor may take a concentrated position in a laughably underpriced stock, using a huge amount of borrowed money. But before the expected appreciation can take place, a market crash brings on a margin call, and he’s wiped out. As John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.”  Last year marked the passing of Joe Granville, a technical analyst whose warning in 1976 was followed by a 26% two-year decline, winning him respect and fame. But his next accurate call wouldn’t come for 24 years, when he told people to sell tech stocks in 2000. Was it skill back in 1976, or a lucky call that turned out right when events went his way? Regardless, he became one of many in the investment business who get famous for having been “right once in a row.” © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved  Because the cost of option programs never shows up in the income statement, their cost is considered in a distorted way. Option grants amount to giving a portion of the company to the employees, but no net income effect is ever seen under current GAAP.  Stock price declines introduce the unattractive dilemma of option repricing. When a stock falls precipitously, management often proposes a commensurate reduction of the exercise price on options. With shareholders having taken a big loss, it seems unfair to exempt executives from the pain. But it is true that old options that are way out of the money won't serve to retain and motivate employees. And with option grants "free," repricing often is irresistible. It seems obvious that the option culture, the stock market bubble and the advent of mega-compensation have combined in the worst of cases to encourage short-term fixes and artful – even fraudulent – accounting. I think it's no coincidence that our high yield bond portfolios encountered two examples of accounting fraud in February 2001 alone, more than in the previous twenty years put together. Moving away from the subject of options, the New York Times of March 1 indicated another way in which compensation incentives can be counterproductive. Early in 2001, the Times reported, Enron executives and other employees received hundreds of millions of dollars in bonuses tied to earnings and stock price performance. . . .

How many are unemotional enough to resist buying into a fast-rising bubble, or selling in a crash when the price of an asset appears to be on the way to zero? The bottom line for me is that (a) you mustn’t ignore the concept of efficiency, and at the same time, (b) you mustn’t accept it as universally true. As I wrote in What’s It All About, Alpha (July 2001): If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it’s possible to know more than everyone else and regularly beat heavily populated markets. . . . But swallowing theory whole can make us turn the process over to a computer and miss out on the contribution skillful individuals can make. Rather than expect markets to routinely provide a free lunch, I think there should be a presumption that they’re efficient. The burden of proof should be on anyone who thinks a market provides underpriced investments that no one else is smart enough to detect and pursue. It’s safer to be skeptical of the existence of freebies than to assume unappreciated bargains are rife for the taking. It’s important to note, however, that market efficiency shouldn’t be considered something that’s universally applicable, but rather what Bruce Karsh has taught me to call a “rebuttable presumption.” You should start out thinking it’s the general rule, but its applicability can be disproved in individual situations. The possibility of inefficiency shouldn’t be ignored.

UMarket efficiencyU – A great deal of how one views the investment world depends on one's position on the subject of market efficiency. Rather than reinvent my own wheel, I'll lift parts of my memo "Irrational Exuberance" from May 2000. (Thankfully, when you copy from yourself it's not plagiarism.) First, I'll provide my take on the efficient marketeers' view. Then, I'll describe my own version of market efficiency. I'll admit again that academicians don't share my view and theory says I'm wrong. But my approach works for me, and I'll restate it below. While at Chicago, one of the first things I studied was the Efficient Market Hypothesis, which states:  There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, highly motivated and hard working. Their analytical models are widely known and employed.  Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset.

Overpermissive providers of capital frequently aid and abet financial bubbles. There have been numerous recent examples where loose credit contributed to booms that were followed by famous collapses: real estate in 1989-92; emerging markets in 1994-98; Long-Term Capital in 1998; the movie exhibition industry in 1999-2000; venture capital funds and telecommunications companies in 2000-01. In each case, lenders and investors provided too much cheap money and the result was over-expansion and dramatic losses. In "Fields of Dreams" Kevin Costner was told, "if you build it, they will come." In the financial world, if you offer cheap money, they will borrow, buy and build – often without discipline, and with very negative consequences. The credit cycle contributed tremendously to the tech bubble. Money from venture capital funds caused far too many companies to be created, often with little in terms of business justification or profit prospects. Wild demand for IPOs caused their hot stocks to rise meteorically, enabling venture funds to report triple-digit returns and attract still more capital requiring speedy deployment. The generosity of the capital markets let companies sign on for huge capital projects that were only partially financed, secure in the knowledge that more financing would be available later, at higher p/e's and lower interest rates as the projects were further along. This ease caused far more capacity to be built than was needed, a lot of which is sitting idle.

© Oaktree Capital Management, L.P. All Rights Reserved Friday's Wall Street Journal carried an incredible, eloquent tribute to the bravery of New York's firemen. It said "In the academy, recruits learn that a firefighter performs but one act of bravery in his career, and that's when he takes the oath of office. Everything after that, it is said, is simply in the line of duty." I cannot read this without being moved profoundly. Last week proved that America is rich in heroes: The man who carried a woman he didn't know down fifty flights of WTC stairs. The people who drove hundreds of miles to offer their services in the rescue and cleanup effort. And the ultimate heroes, the passengers who crashed United flight 93 in Pennsylvania rather than let it be used as another terrible bomb. Who among us could crash the plane we're on to save hundreds or thousands of strangers? ULossU – As I wrote last week, Oaktree was fortunate in having no losses. Teresa O'Hagan's husband and his four brothers are New York firemen; some were m incommunicado for periods of time, but all turned up safe. I lost it when I spoke with her and felt the emotion flowing through both of us. Noreen Keegan and Zenobia Walji have husbands who are policemen, and they, too, are fine. It took a while longer, but Eric Livingstone's girlfriend and Nilsa Veras's mother also proved to be safe. issing or Most of us, however, knew someone who was not as lucky, and that brings it home.

So in the end, I feel it all goes back to confidence. Consumer and business spending will pick up at some point, and the government can encourage it, but it can't make it happen. UInvestor ReactionU – On September 17, after a four-day hiatus, the nation's financial markets reopened, with the Dow falling 685 points, or 7%. When I heard about that first day's loss, my reaction was immediate: "That's not so bad – just a quarter of the percentage decline in the crash of 1987." And after declining further in that first week of trading, stocks have recovered most of their losses. Clearly, the interest rate cuts are helping stock prices. They make investors feel the Fed is doing something to improve the outlook. They contribute to economic activity at the margin. By reducing floating-rate mortgage payments they leave people with more spending money. And by lowering fixed income returns they reduce the competition that comes from cash and bonds, thus making stocks more attractive in relative terms. But no one knows what the economic future will look like. No one knows what corporate earnings will be in 2001 or 2002, although they appear likely to decline. In addition, geopolitical uncertainties dot the horizon. Thus with the Dow off less than 6% from its September 10 pre-attack close, I wonder whether investors weren't shaken enough, or whether complacency has returned too quickly.

© Oaktree Capital Management, L.P. All Rights Reserved  the current low level of inflation, and  the looming scarcity of Treasury securities as budget surpluses erase the Federal debt (I'm not quite sure I buy that one). Third, high-grade corporates have not been an unfailing source of safety. The February 7 Journal story referenced above included the observation that "of corporate bonds rated investment grade, an unprecedented 3% fell 30% or more in price last year, according to Merrill Lynch & Co." UThe punditsU - As usual, the cresting of stocks in 1999/early 2000 was caused and/or accompanied by the vesting of special powers in "experts." I have previously railed against the brokerage house analysts who set price targets based on where they guessed a stock could sell and gave out "buy" ratings to drum up corporate finance business. The current targets for my wrath are the talking heads from CNBC and its competitors. I resent the role they played in the popularization of equity investing, in the bubble that developed, and in the debacle that followed. They're glad to opine on what stocks are worth, why they went up or down yesterday, and what they're going to do tomorrow. But the more I listen, the more I feel the absence of a few key phrases like "beats the heck out of me" and "darned if I know."

I think one of the elements that roped in so many people and convinced them they could invest safely despite their lack of expertise was the media's repeated message that these things were knowable. Some of the confidence of these personalities has evaporated of late. UThe FedU – The trend of personalizing described above reached its apogee in the deification of Alan Greenspan. For almost fourteen years, Greenspan has done an excellent job at the Fed. He kept a weather eye out for signs of inflation and took steps to avert it when needed. He wisely injected liquidity into the financial system in times of crisis. And he made every effort to keep a steady hand on the economy, trying to avoid sudden moves that could unsettle the participants. He has presided over a terrific economy; I can't imagine a better one. I phrase that carefully, because it will be debated whether he made it great or it made him great. People who know things I don't will decide the question. In January, the markets demonstrated their great faith in Greenspan by leaping forward when the first interest rate cut was announced. "Surely Greenspan will be able to avoid a cessation of growth." Investors were highly confident that he would be able to save them. Yet in 1998-9, when he as good as said "I’m going to slow the economy and rein in this irrational exuberance," no one acted as if he could, and the market continued to roar.

After a while, the outlook seems a little less poor. People begin to appreciate that improvement is taking place, and it requires less imagination to be a buyer. Of course, with the economy and market off the critical list, they pay prices that are more reflective of stocks' fair values. And eventually, giddiness sets in. Cheered by the improvement in economic and corporate results, people become willing to extrapolate it. The masses become excited (and envious) about the profits made by investors who were early, and they want in. And they ignore the cyclical nature of things and conclude that the gains will go on forever. That's why I love the old adage "What the wise man does in the beginning, the fool does in the end." Most importantly, in the late stages of the great bull markets, people become willing to pay prices for stocks that assume the good times will go on ad infinitum. But they cannot. When the tech bubble was roaring ahead in late 1999, no one could think of any development that might be capable of bringing it to an end. Technology was certain to revolutionize everyday life, creating a new investment paradigm. Revenue growth (or at least the growth in "eye-balls") was strong. Capital was freely available, enabling expansion to continue and new, innovative companies to be formed. Cash flows into mutual funds and 401(k)s guaranteed steady demand for the stocks.

© Oaktree Capital Management, L.P. All Rights Reserved portfolio manager could take the risk of under-owning these stocks; they had to buy them regardless of price! Eureka! There was no way they could stop going up. The perpetual motion machine had been built. But somehow, the stocks did stop going up. And then they started going down. I don't think anyone can say just what it was that caused the tech bubble to burst. Certainly I can't think of any one thing – even in hindsight, which is usually 20:20. Maybe the groundwork was laid for declines when it was shown merely that the rise could slow. Maybe a few smart people, to paraphrase the third of the three stages, concluded that everything Uwouldn'tU get better forever. The best explanation probably is that the prices just collapsed under their own weight. Anyway, the market proved – once again – that it can't move in one direction forever. It has to be appreciated in cyclical terms, with increases followed by decreases, and in fact with increases UcausingU decreases. In April 1991 , in just my second general memo to clients, I described the market as follows: The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the position of a pendulum "on average," it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc.

UCycles and How To Live With Them No one knew when the tech bubble would burst, and no one knew what the extent of the correction could be or how long it would last. But it wasn't impossible to get a sense that the market was euphoric and investors were behaving in an unquestioning, giddy manner. That was all it would have taken to avoid a great deal of the carnage. Having said that, I want to point out emphatically that many of those who complained about the excessive market valuations – including me – started to do so years too soon. And for a long time, another of my old standards was proved true: "being too far ahead of your time is indistinguishable from being wrong." Some of the cautious investors ran out of staying power, losing their jobs or their clients because of having missed the gains. Some capitulated and, having missed the gains, jumped in just in time to participate in the losses. So I'm not trying to give the impression that coping with cycles is easy. But I do think it's a necessary effort. We may never know where we're going, or when the tide will turn, but we had better have a good idea where we are.2001

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Irrational Exuberance Recent years have witnessed great excesses in the stock market. The postmortems have begun to be written, and I'm determined not to lag. Thus I will attempt below to combine a number of ideas and bits of empirical data I've stored up over recent weeks in a memo which expresses my views and hopefully is of value to you. My ideas are disjointed, but I hope to be able to fashion a common thread. Postmortem? Do I mean to say the market's rise is over? You know I don't make predictions of that sort. I am not ringing the bell on stock prices, but hopefully on a style of investing without reason. The stock market's record-breaking rise through March 10 was driven by the tech stocks. The tech stocks, in turn, were driven by optimistic, get-rich-quick buying that was totally lacking in skepticism and caution. What I think may (and should) be on the wane is the belief that it is perfectly reasonable:  to borrow in order to buy stocks that have already risen 500% and are selling at infinite P/E ratios,  to rely exclusively on advice from friends, CNBC and Internet bulletin boards when investing in companies whose business you know nothing about, and  for companies valued at billions of dollars to lose tens of millions per year, because investors can be counted on to give them more. These attitudes have certainly signaled irrational exuberance.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Investment Miscellany Because I've been encouraged by the response to my “bubble. com” and venture capital memos, I'm going to keep writing. Over time, I collect ideas that I'm tempted to pass on to you - nothing major, but miscellany that may be of interest. Sharing them might become a habit; let me know if you think it should. UCan't Get Any Respect The behavior of IPOs and hot tech stocks in the last few years perverted everything that traditionally had held true. The episode that crested in March must have been the greatest bubble of all times. Certainly money was made in amounts and at speeds never seen before. Companies went from business plan to IPO in a year or two, with billions of dollars assigned to them in market capitalizations or bestowed on their founders and venture capital backers. In the last twelve months, technology entrepreneurs and investors on both coasts bought homes costing several tens of millions of dollars. The line of eager buyers pushed up prices for private planes, yachts and beachfront homes. The market for art and antiques grew white hot. In short, as a friend of mine says, “money was disrespected.” Traditional investing values were equally disrespected. Risk was viewed as the investor's friend, and caution as unnecessary and unavailing. Profits - and even profit projections - were considered superfluous.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: bubble.com The book "Devil Take the Hindmost" by Edward Chancellor does an excellent job of chronicling the history of financial speculation. In doing so, it recounts the story of "the South Sea Bubble" and provides a backdrop against which I'd like to examine some of the events of today. The South Sea Company was formed in 1711 to help deleverage the British government by assuming some of the government's debt and paying it off with the proceeds of a stock offering. In exchange for performing this service for the Crown, the company received a monopoly for trading with the Spanish colonies in South America and the exclusive right to sell slaves there. Demand for the company's stock was strong due to the expectation of great profits from these endeavors, although none ever materialized. In 1720, a speculative mania took flight and the stock soared. Sir Isaac Newton, who was the Master of the Mint at the time, joined many other wealthy Englishmen in investing in the stock. It rose from £128 in January of l720 to £1,050 in June. Early in this rise, however, Newton realized the speculative nature of the boom and sold his £7,000 worth of stock. When asked about the direction of the market, he is reported to have replied “I can calculate the motions of the heavenly bodies, but not the madness of the people.

The father's dumbfounded silence clearly reflected his sudden realization that he knew less than he had thought. Obviously, in 2000, millions of investors across the board realized that they knew less than they thought they did, and that lots of what they had been sure of was wrong. * * * A year ago, I wrote in "bubble. com" that tech stocks had benefited in 1999 from a boom of colossal proportions. They exhibited all of the elements of a market bubble, with an attractive story providing the foundation for a gravity-defying escalation of prices far beyond reason, and for manic behavior on the part of investors.assets

On December 5, 1996, with the Dow at 6,437, Alan Greenspan coined that phrase, of which we're unlikely to have heard the last. Acting in the classic role of a central banker trying to jawbone against trends inimical to economic health, he asked: How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions? Did Greenspan want to stop people from having fun and making money? No. He wanted to keep stocks from running too far too fast and thus avoid an excessive wealth effect.

” By September 1720, the bubble was punctured and the stock price fell below £200, off 80% from its high three months earlier. It turned out, however, that despite having seen through the bubble earlier, Sir Isaac, like so many investors over the years, couldn't stand the pressure of seeing those around him make vast profits. He bought back the stock at its high and ended up losing £20,000. Not even one of the world's smartest men was immune to this tangible lesson in gravity! * * * It's obvious from “Devil Take the Hindmost” that many elements of speculative behavior were present during the South Sea Bubble. I'll cite some of its passages below and point out the parallels to today that I see: “The ideology of self-interest had recovered after the battering it received after the crisis of the mid-1690s ... its thesis [was] that private vices - avarice, prodigality, pride and luxury - produced public benefits.” [Sounds like the "greed is good" rationalization of the 1980s.]

© Oaktree Capital Management, L.P. All Rights Reserved To illustrate, take the case of high yield bonds, whose prices have been sagging, partly because of steady capital flows out of high yield mutual funds (for redeployment in equity funds). I was asked the other day when flows into high yield bonds would resume. My answer: When people realize once again that 11 % is a good return. But this disrespect for traditional investment thinking shall pass--and in fact it appears to be in the process of doing so. In general, the portfolios that did best last year have done worst so far this year, and vice versa. Traditional investing values will be respected again. I can even imagine a day when words like “prudence” return to investors' everyday speech. UIt Restores Your Faith If common sense and logic don't work, how are we to run our lives? In “bubble.com” I battologized (look that up in your Funk & Wagnall's) regarding the dot-coms’ divergence from the old-fashioned notion that only if revenues exceed expenses is a business attractive. Instead, in 1999 business models were based on giving away products as a way to get ads in front of eyeballs, or on selling things for less than they cost. WebHouse Club is a poster child for failed giveaways. A spin-off of Priceline.com, it let customers name their own price for groceries and gas. There was a problem: manufacturers were unwilling to supply goods at the prices customers wanted to pay, so WebHouse made up the difference. In “bubble.

© Oaktree Capital Management, L.P. All Rights Reserved to remain so for a long time. I certainly had no idea that the excesses I saw in the market would be remedied as quickly as they have. UThe Bubble Bursts In every regard enumerated in "bubble. com" and more, the tech-media-telecom extremes of 1999 were reversed in 2000. I must say I've never seen anything quite like it. UBusiness models questioned U– A year ago, I went to great lengths criticizing dot-com business models that valued eyeballs over profits and viewed operating losses as a good investment. This year, investors realized that the emperor was naked. The first signs came in articles like "Burning Up" (Barron's, March 20), which cited the rate at which Internet companies were using their finite cash to fund operating losses. More recently, "The Giveaway Is Going Away On Web Sites" (Wall Street Journal, December 4) stated that "many of the online companies that are in a sad state today can blame their woes on the cornucopia of free stuff and services they have been doling out to build market share." So now it's "p-to-p," or path-to-profit . . . just a little late. Technology entrepreneurs went through their cash, secure in the expectation that they could always raise more by selling shares to eager buyers. In today's market, as the British say, that's simply not on. UTechnology firms disrespectedU – Prospective investors (not to mention bankers, suppliers and landlords) now want to see profit potential.

© Oaktree Capital Management, L.P. All Rights Reserved The success of South Sea spawned talk of any number of speculative schemes, some of which was probably apocryphal. “The most famous of the legendary bubble companies was that ‘for carrying on an undertaking of great advantage but no one to know what it is.’” [I can't understand what it does, but that's okay; just tell me the name, II. or maybe the symbol's enough.] Despite their lack of profits, companies like South Sea were able to finance their operations by issuing stock at higher and higher prices. “The circularity inherent in the scheme made a rational calculation of the shares' fair value difficult to compute. Some argued that the higher the shares rose, the more they were actually worth .... ‘Was there ever such a delusion from the beginning of the world ... according to this Way of Computing, no Person can Purchase at too high a Rate, since his Profit will increase in Proportion to the Price he gives.’” [There's no such thing as too high a price if the concept is right, and the ability to issue stock at rising prices will lead to profitability.] "Adam Anderson, a former cashier of the South Sea Company, later claimed that many purchasers of shares ... bought knowing that their long-term prospects were hopeless, since they aimed to get 'rid of them in the crowded alley to others more credulous than themselves.'" [The greater fool theory is nothing new.]

© Oaktree Capital Management, L.P. All Rights Reserved “Wealth effect” is the term used to describe the impact on the economy of major increases in the prices of stocks or other assets. When asset prices rise, people feel richer and spend more. When the resulting demand outstrips supply, inflation heats up. Further, when the upward trend of asset prices inevitably turns down, the wealth effect works in reverse, putting a damper on economic growth (although Greenspan is more likely to have been worried about inflation than economic softness). Prior to expressing his concern about exuberance, Greenspan was credited with the power and wisdom needed to keep the economy rising forever. So how did investors react to his remark? In the first half-hour of trading the next day, they took the Dow down by 145 points (which used to be considered a big move). But the exuberance of which he had warned soon reasserted itself, with the Dow closing the year virtually unchanged from its pre-critique level and moving 1000 points higher over the next six months. If it was irrational exuberance that had taken the Dow to 6,437 in late 1996, what would describe the rise to 7,437, and eventually to 11,497, in relatively short order? And what accounts for Greenspan's two subsequent years of silence on the subject? My guess is that he was feeling pressure from people – perhaps with a political stake in the continuing rise of the stock market-who castigated him for being a wet blanket.

The laws of business are being enforced, meaning that money-losing companies can't attract additional capital. Scores of firms have closed, and tens of thousands of employees have lost their jobs. In perhaps the height of indignity, the Internet has been turned against its own, as dot-coms have been formed to chronicle the collapse of dot-coms. Log on to dotcomfailures.com for a list of more than eighty. UTech/media/telecom stocks brought low U– Of course, the stocks that soared in 1999 tanked in 2000. The 86% gain of the NASDAQ Composite in 1999 was the greatest in history for any major average. Its 39% loss in 2000 was the greatest in its history and, in terms of major averages, trailed only the 1931 drops in the Dow and S&P. Throughout my 30-plus years in the investment business, I have seen one localized boom after another. Each time, the end was marked by a Wall Street Journal table cataloging once-hot stocks that had fallen more than 90% from their highs. Conglomerates (late 1960s), computer software and services (1969-70), the Nifty-Fifty (1973-4), oil stocks (early '80s) and biotech (early '90s) – they've all been there, and I felt certain that TMT stocks would join them sooner or later. The only difference is that in 2000, the top ten losers on the NASDAQ all declined more than 99%! The 14 stocks mentioned a year ago in "bubble.com" provide a pretty good sample; they're down 82% on average from their year-end 1999 prices and 87% from their highs in 2000.

“As Edward Ward observed in his poem ‘A South Sea Ballad’: Few Men who follow Reason's Rules, Grow fat with South-Sea Diet, Young Rattles and unthinking Fools Are those that flourish by it.” [The profits went to those unrestrained by reason or experience.] Robert Digby wrote “The South Sea Company is continually a source of wonderment. The sole topic of conversation in England revolves around the shares of the Company, which have produced vast fortunes for many people in such a short space of time. Moreover it is to be noted that trade has completely slowed down, that more than one hundred ships moored along the river Thames are for sale, and that the owners of capital prefer to speculate on shares than to work at their normal business.” [The name of the company was on everyone's lips, the fortunes it created were front-page news, and the average Joe was willing to give up his day job to participate ... sound familiar?] * * * I will devote the rest of this memo to what certainly seems to me to be another market bubble. Before doing so, however, I must point out a few things: First, as usual, little that I will write will be original; instead, I hope to add value by pulling together ideas from a number of sources. Second, a single word suffices to describe my recent caution regarding the stock market: wrong.and

© Oaktree Capital Management, L.P. All Rights Reserved UIPOs no longer a sure thingU – If you ask me, the most important single contributor to the tech stock bubble was the mania for Initial Public Offerings. When new issues began to double, triple and more on their first day of trading - and then triple again from there - a gold rush started. When the stock market valued profitless new ventures, only months after their formation, at multiples of their sales (and, illogically, at multiples of the price at which founders were gladly to sell), anything was possible. The lottery was on, and the improbable but huge payoffs going to the winners made every ticket valuable. Later, investors ignored the odds against success and acted as if all of the companies - even head-to-head competitors-would be winners. The perpetual motion machine eventually lost its momentum, of course, and it turned out that there's no sure thing. Although the IPOs of 2000 averaged a first-day gain of 55%, about two-thirds of them are now trading below their issue price. UVenture capital rendered mortal U– 1999 witnessed the wildest single market phenomenon I've ever seen: an asset class with a triple-digit annual return. The overheated IPO market provided an exit for the venture capitalists and contributed greatly to their fabulous profits.

The company was RCA, and as the industry leader its stock rose from $8 in mid-1927 to $114 in mid-1929. While part of the stock's appreciation was due to the market boom in which it shared, certainly part was also due to an overvaluation of its potential. After the onset of the Great Crash, RCA's stock fell from that high of $114 to $2½ within three years. The Depression can be blamed for some of this decimation, but it is worth noting that even 25 years after the 1929 peak, when the Depression and World War II were well over and the post-war recovery was underway, RCA's stock had yet to get back to a third of its earlier high. The times, the industries and the companies are certainly different today, but it makes one wonder whether investors aren't again overpaying for the ability to change the world. Similarly, a recent article in Fortune reported Warren Buffet's observation that airplanes and automobiles had been expected to change the world and did ... and almost all of the manufacturers of both are now gone. Few things have had the impact on the world that aviation did, but from its founding through 1992, the cumulative profit of the airline industry was zero!

It's now clear the analysts added little insight in terms of either fundamentals or valuation. The December 18 Wall Street Journal revisited six price targets. On average, the analysts predicted a 64% gain, but the stocks UdeclinedU 88% instead. For me, the most telling thing was one analyst's alibi: "By setting [the target] only about 25% higher. . . we were indicating there was only a little more upside in the stock." I seem to remember when calling for a 25% gain was a bullish statement, not a warning. But then again, all kinds of nutty behavior typified this bubble. UOdds and ends at the extremeU - Numerous other elements, large and small, captured the excesses of the tech stock mania and their reversal.

© Oaktree Capital Management, L.P. All Rights Reserved As usual, Buffet puts it as succinctly as anyone could: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” (Emphasis added) (Three years ago, everyone wanted to be Warren Buffet, or at least read books about him. Now, appearing to have missed out on the technology movement, he and his investment approach are dismissed as passe by the dot-com gang.)  Altered lives -- During the South Sea bubble, as described above, boats were put up for sale and people with capital shifted from being workers to being investors. In a striking parallel, the Internet-commerce revolution is also changing lives. Of course, we know that thousands of Americans have become on-line traders either full- or part-time. Articles describe people who are trying to "ride the trend" of hot stocks and benefit from their momentum, but there's little indication that they have any idea what makes companies do well or stocks go up (or even what some of their companies do).

The Wall Street Journal of December 7 cited an individual who has spent his full time in the prior five months trading the stock of one company, CMGI, which invests in Internet ventures; he doesn't know the CEO's name. Also striking is the effect this is having on business education and young careers. A front-page article in the New York Times of November 28 reported that applications at many business schools were flat or down, the number of Americans taking the GMAT exam was down sharply, and not-insignificant numbers of MBA students were dropping out after the first year to join the hot fields. As a professor of entrepreneurship told me, all of the e-commerce claims will be staked out in the next year or two; students can't risk staying in school and seeing someone else act on their ideas. Five years ago, the hot area for new MBAs was investment banking. Now, I hear, investment banks can't get the top students to sign up for interviews and are having trouble meeting their recruiting goals. The pressure to move toward the high-change areas is great, and people are succumbing. Everyone in the investment profession knows (or knows of) somebody who has made hundreds of millions (or a billion) this year on a dot-com investment. One can imagine that this makes the buyout specialists who built fortunes over a lifetime feel like underachievers. Private equity firms are getting involved in companies at earlier stages, and with the dot-coms.

” What they offer is liquidity; providing liquidity entails risk to them (which increases as the market's volatility increases and as its liquidity decreases); and the profit they expect to make is their price for accepting this risk. “To liquidity suppliers, price matters much more than time.”  Usually when the price of something falls, fewer people want to sell it and more want to buy it. But in a crisis, “market prices become countereconomic,” and the reverse becomes true. “A falling price, instead of deterring people from selling, triggers a growing flood of selling, and instead of attracting buyers, a falling price drives potential buyers from the market (or, even worse, turns potential buyers into sellers.)” This phenomenon can occur for reasons ranging from transactional (they receive margin calls) to emotional (they get scared). The number of liquidity demanders increases, and they become more highly motivated. “Liquidity demanders use price to attract liquidity suppliers, which sometimes works and sometimes does not. In a high-risk or crisis market, the drop in prices actually reduces supply [of liquidity] and increases demand.”  In times of crisis, liquidity suppliers become scarce. Maybe they spent their capital in the first 10% decline and are out of powder. Maybe the market's increased volatility and decreased liquidity have reduced the price they're willing to pay. And maybe they're scared, too. Bookstaber recalls the Crash of 1987.

© Oaktree Capital Management, L.P. All Rights Reserved  In 1999, incubators (CMGI and Internet Capital Group), technology industry participants (Intel and Amazon) and outsiders (Starbucks) were piling up profits in venture investments. This year, of course, it was losses that fell to the bottom line.  The potential for stock option profits made dot-com jobs compellingly attractive last year, and old economy firms had no way to compete. This year, employees wanted cash instead, and what we read about is the negative effect of stock options on companies' finances.  Last year, the media told of executives jumping from the old economy to dot- coms. This year's stories described surprise firings and careers left in the lurch.  In 1999, brokerage house Internet conferences drew big crowds. 2000 saw conferences postponed and cancelled.  Whereas tech stocks commonly reached triple-digit prices in 1999, now they're falling below $1 and being delisted by NASDAQ.  Instead of experiencing dramatic capital inflows and perhaps closing to new investors, tech and Internet mutual funds are diversifying into other areas, merging with other funds or shutting down.  Finally, in the most visible indicator, we'll see on January 28 that dot-coms will run only about 10% of the commercials during the Superbowl, down from 50% last year.

© Oaktree Capital Management, L.P. All Rights Reserved In the last six weeks, however, the imbalance has been on the sell side. This time, investors' inability to find others willing to trade with them has forced prices down drastically, and they UareU calling it illiquidity. In other words, radical upward movement was greeted warmly, but radical downward movement is being attributed somewhat to a failing on the part of the market. Certainly the behavior of stocks in 1999 was viewed more benignly than it should have been. Momentum investors irrationally planned to get out when the music stopped, but the market wasn't able to accommodate all of them. * * * I want to turn now to the subject of market efficiency, something that's very important to us at Oaktree and that I have been looking for a chance to discuss. In recent weeks I've heard good things about a new book, fittingly titled “Irrational Exuberance.” Its author, Robert J. Shiller, a Yale economist, has taken on the theory that the stock market is efficient, saying stocks' swings are too violent to suggest that they are always accurately valued. On that famous Tuesday four weeks ago, the Nasdaq Composite traded at both 3,649 and 4,138 within seventy minutes. It's certainly hard to believe the underlying stocks were fairly valued at both levels. No, says Shiller, the stock market is not efficient; stock prices are set irrationally.

© Oaktree Capital Management, L.P. All Rights Reserved Anyone who bought in those declines benefited from the rallies that surely followed. Of course, that didn't work quite so well in 2000. The dips in March-April, May and July were all followed by rallies, but they were traps for unsuspecting buyers. Only "sell the rallies" proved correct. URespect cyclesU – There's little I'm certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don't grow to the sky. Few things go to zero. That was really the problem with the bubble. Investors were willing to pay prices that assumed success forever. They ignored the economic cycle, the credit cycle and, most importantly, the corporate life cycle. They forgot that profitability will bring imitation and competition, which will cut into – or eliminate – profitability. They overlooked the fact that the same powerful force that made their companies attractive, technological progress, could at some point render them obsolete. U Worry about timeU – Another element that investors ignore in their optimism is time. It seems obvious, but long-term trends need time in order to work out, and time can be limited. Or as John Maynard Keynes put it, "Markets can remain irrational longer than you can remain solvent." Whenever you're tempted to bet everything on a long-run phenomenon, remember the six-foot tall man who drowned crossing the stream that was five feet deep on average.

How will the post-deal prices hold up when the lock-up periods end and the founding entrepreneurs and venture capitalists start selling the 80-90% of the stock that they still own? And what will happen when the options used to attract employees - and to pay service providers - begin to be exercised and the shares sold? What price will supply/demand dictate when the supply of stock increases five or ten times? Today, it seems companies are formed and start-up financing is raised not through discussions of the companies' profit potential, but with reference to the possible timing and pricing of an IPO. The recent book "The New, New Thing" by Michael Lewis, about the career of venture capitalist Jim Clark (Silicon Graphics, Netscape, Healtheon), makes it clear that in many cases, today's entrepreneur isn't thinking idea/startup/company as might have been the case in the past; rather, it's idea/startup/IPO. Cashing in used to be the result of successful company-building. Now it's often the end in itself. It's the IPO that's “the thing.”  How will the companies make money? -- Many o f the new firms have great ideas for making money, but it's appropriate to wonder whether they'll work, how the competition in each “space” (that's the dot-com term for a business niche) will develop, whether profits will materialize, and whether they'll be sufficient to justify today's stock prices.

© Oaktree Capital Management, L.P. All Rights Reserved UNever forget valuationU – The focus may shift from dividend yield to p/e ratio, and people may stop looking at book value, but that doesn't mean valuation is irrelevant. In the tech bubble, buyers didn't worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, the "greater fool theory" only works until it doesn't. Valuation eventually comes into play, and those who are holding the bag when it does are forced to face the music. UBe conscious of investor psychologyU – I don't believe in the ability of forecasts or forecasters to tell us where prices are going, but I think an understanding of investor psychology can give us a hint. When investors are exuberant, as they were in 1999 and early 2000, it's dangerous. When the man on the street thinks stocks are a great idea and sure to produce profits, I'd watch out. When attitudes of this sort make for stock prices that assume the best and incorporate no fear, it's a formula for disaster. I find myself using one quote, from Warren Buffett, more often than any other: "The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs." When others are euphoric, that puts us in danger. When others are terrified, the prices they set are low, and we can be aggressive.

© Oaktree Capital Management, L.P. All Rights Reserved P.S.: I've learned the hard way that it's not easy to be right about the future, as I've been complaining about market excesses for far too long. That being the case, I'm not going to miss the opportunity to celebrate the correctness to date of my last memo, “bubble. com.” The table below lists the stocks mentioned in that memo and their declines from its publication at year end, and from the highs reached since then, to the April trough. %Chg % Chg Company Ticker 12/31/99 2000 high 4/14/00 12/31/99 2000 high to 4/14/00 to 4/14/00 Akamai Tech. AKAM $328 $321 $ 65 -80% -80% Amazon.com AMZN 76 89 47 -38 -48 America Online AOL 76 83 55 -28 -34 Charles Schwab SCH 38 65 41 6 -38 CMGI CMGI 138 163 52 -62 -68 E*Trade EGRP 26 33 19 -27 -41 Egreetings Network EGRT 10 12 3 -68 -74 Etoys ETYS 26 26 5 -82 -81 Priceline.com PCLN 47 96 59 24 -39 Red Hat RHAT 106 141 24 -77 -83 theglobe.com TGLO 8 9 3 -64 -67 VA Linux Sys LNUX 207 193 29 -86 -85 Webvan WBVN 17 18 6 -66 -69 Yahoo! YHOO 216 238 116 -46 -51 Average -50% -61%

© Oaktree Capital Management, L.P. All Rights Reserved First, will the Internet and dot-com companies be able to charge enough for their products to make money? Front page articles in The New York Times (October 14) and The Wall Street Journal (July 28) discussed the fact that many of the Internet's offerings are free. Decades ago, merchants discovered that they could sell more if they cut prices. The Internet firms have taken that one step further: they can move even more merchandise if they give it away. As the CEO of Egreetings Network says, “Charging for [greeting] cards was a small idea. Giving them away is a really big idea.” Says a venture capitalist, “.... it's a fact of life on the Internet: People expect a lot of things for free. And if you don't give it away, some other start-up will.” Internet firms are giving away faxes, long-distance phone calls, music, web browsers and even Internet service itself. "The marginal cost of adding another user is practically zero," says one venture capitalist. The trouble as I see it is that the marginal revenue is exactly zero. Obviously, these firms are giving their services away in order to build traffic, tie up market share early and/or sell advertising space. It's far from clear that profits will follow. As I read the articles mentioned above I was reminded of a great series of jokes my father told when I was young: “I lose money on everything I sell.” “Then how do you stay in business?” “I make it up on volume.

On December 22, in "Consumer Mood Swings to Angst," the New York Times employed a new phrase: "irrational anxiety." If that sentiment does come to be widespread, replacing irrational exuberance, it can signal a buying opportunity. UCheck your own mindsetU – For me, mindset holds many of the keys to success. We at Oaktree believe strongly in contrarianism. As suggested in the paragraph above, that means leaning away from the direction chosen by most others. Sell when they're euphoric, and buy when they're afraid. Sell what they love, and buy what they hate. Closely related to contrarianism is skepticism. It's a simple concept, but it has great potential for keeping us out of trouble. If it sounds too good to be true, it probably is. That phrase is always heard UafterU the losses have piled up – be it in dot-coms, portfolio insurance, "market neutral" funds or the "Asian miracle." Oaktree was founded on the conviction that free lunches do exist, but not for everyone, or where everyone's looking, or without hard work and superior skill. Skepticism needn't make you give up on superior risk-adjusted returns, but it should make you ask tough questions about the ease of accessing them. We think humility is essential, especially concerning the ability to know the future. Before we act on a forecast, we ask if there's good reason to think we're more right than the consensus view already embodied in prices. As to macro projections, we never assume we're superior.

” “I lose money on everything I sell.” “Then how do you stay in business?” “I'm closed Sundays.” “I sell everything at cost.” “Then how do you stay in business?” “I buy below cost.” The riddle of profitability is very much present in this area. I'm sure some firms will solve it - but far from all of them. Second, how practical are the business models of the dot-com firms? It seems like ancient history, but I seem to remember that doing business in cyberspace was going to eliminate the need for conventional advertising, and “virtual inventories” were expected to replace brick-and-mortar warehouses filled with merchandise. Now we read about the huge sums Amazon.com is spending on warehouses, and media advertising is sold out at high prices because the Internet firms are bidding for it so aggressively. EToys will do business without stores and will just own warehouses, but what is a Toys 'R' Us store other than a warehouse with the front prettied up? Webvan Group sell groceries over the Internet, saving on store costs but providing free delivery. According to the December 15 Journal, however, “as of Sept. 30, Webvan's average order size was $72 -too small to absorb the costs of home delivery.Webvan

© Oaktree Capital Management, L.P. All Rights Reserved to earth. At Oaktree, we're guided more by one principle than any other: if we avoid the losers, the winners will take care of themselves. These are the things that Oaktree is built on, and that got our clients through 2000 in one piece. We can't promise that all of our investment decisions will be correct, but we can assure you they will embody these crucial ingredients for success in 2001 and beyond. December 31, 2000 Stocks Mentioned In "bubble.com" – January 1, 2000 % Chng. % Chng. 12/31/99 2000 high Ticker Price 2000 Price to to UCompanyU USymbol U12/31/99 UHigh U12/31/00 U12/31/00 U12/31/00 Akamai Tech. AKAM $328 $346 $ 21 -94% -94% Amazon.com AMZN 76 92 16 -80 -83 America Online AOL 76 83 35 -54 -58 Charles Schwab SCH 26 45 28 +11 -37 CMGI CMGI 138 164 6 -96 -97 E*Trade EGRP 26 33 7 -72 -78 Egreetings Network EGRT 10 13 # -97 -98 Etoys ETYS 26 28 # -99 -99 Priceline.com PCLN 47 104 1 -97 -99 Red Hat RHAT 106 148 6 -94 -96 Theglobe.com TGLO 8 10 # -96 -97 VA Linux Sys LNUX 207 208 8 -96 -96 Webvan WBVN 17 19 # -97 -97 Yahoo! YHOO 216 250 30 U-86 U-88 Average -82% -87% # = below 50¢

© Oaktree Capital Management, L.P. All Rights Reserved had a $95 million loss on revenue of just $4.2 million.” Lastly, what will be the effect of competition? It will take time, and there will be big cannibalization issues, but eventually the incumbents in each area will move to defend their businesses against the e-commerce firms. Merrill Lynch bit the bullet and decided to enable customers to trade on line as a response to E*Trade. Albertson's and Kroger have announced that they'll mount experimental home delivery systems rather than let firms like Webvan have the grocery business. The December l7 L.A. Times reported that Toys 'R' Us and Walmart had opened online shopping sites in competition with EToys. (EToys' stock is now off 70% from its high three months ago, wiping out $7.1 billion of market value). Dot-com companies will get there early, make inroads and drive up costs for the conventional firms, but they will face determined competition from incumbents fighting for their lives. Even among just the dot-coms, competition is bound to delay and limit profitability. Most of today's e-commerce companies can, at best, boast of early entry and leading market share (the so-called "first-mover advantage"). Rarely is there patent protection, meaningful product differentiation or other substantial barriers to entry. The companies can't count on brand loyalty, because it's all just about low price.

There'll always be someone waiting in the wings to cut price (perhaps to zero) for market share, and given the ease of gathering information on the Web, consumers will always be able to immediately find the lowest price. Location won't matter, because in cyberspace, everyone is everywhere. I think factors like these are likely to render profitability elusive and transitory.  What are the companies worth? - Eventually, this is what it comes down to. It's not enough to buy a share in a good idea, or even a good business. You must buy it at a reasonable (or, hopefully, a bargain) price. Vast amounts of ink have been devoted to the valuations being put on the new companies. For The New York Times's time capsule, David Letterman compiled a list of The Top 10 Things People in the Year 3000 Should Know About Us. As a sign of the times, he included “If you wanted a billion dollars, all you had to do was think of a word and add dot com.”  Priceline.com, which auctions off discount air tickets, (September quarter sales of $152 million, net loss of $102 million) has a market capitalization of $7.5 billion, while United and Continental Airlines ($7.1 billion sales, $469 million earnings) are worth a combined $7.3 billion.

In this valuation parameter vacuum, a “lottery ticket mentality” seems to govern the purchase decision. The model for investments in the tech and dot-com companies isn't the likelihood of a 20% or 30% annual return based on projected earnings and p/e ratios, but a shot at a 1,000% gain based on a concept. The pitch might be “We're looking for first-round financing for a company valued at $30 million that we think we can IPO in two years at $2 billion.” Or maybe it's “The IPO will be priced at $20.the

© Oaktree Capital Management, L.P. All Rights Reserved day at $100 and be at $200 in six months.” Would you play? Could you stand the risk of saying no and being wrong? The pressure to buy can be immense. There have always been ideas, stocks and IPOs that produced great profits. Yet the pressure to participate wasn't as great as it is today because in the past the winners made millions, not billions, and it took years, not months. The upside in the deals that've worked so far has been 100-to-l (give or take a zero). With that kind of potential, (a) the upside becomes irresistible and (b) it doesn't take a very high probability of success to justify the investment. I have said in the past that while the market is usually driven by fear and greed, sometimes the strongest motivator is the fear of missing out. Never was that as true as today. This only intensifies the pressure to join in and crawl further out on that limb of risk. With broader relevance than just the dot-com stocks, the relative performance chart below from Barron's of September 27 (already quite outdated) shows two things: 1. over the last two decades, technology stocks have had periods of both underperformance and overperformance relative to the large-cap universe, and 2. the recent outperformance is unparalleled even in this bullish period. Nothing in this chart suggests that it'll be easy money in technology from here.

© Oaktree Capital Management, L.P. All Rights Reserved Barton Biggs, Chairman of Morgan Stanley Dean Witter Asset Management, is a well- respected observer who has been somewhat cautionary to date (and wrong). His November 29 strategy piece was without equivocation. I'll let him sum up. The technology, Internet and telecommunication craze has gone parabolic in what is one of the great, if not the greatest, manias of all time ... The history of manias is that they have almost always been solidly based on revolutionary developments that eventually change the world. Without fail, the bubble stage of these crazes ends in tears and massive wealth destruction ... Many of the professional investors involved in these areas know that what is going on today is madness. However, they argue that the right tactic is to stay invested as long as the price momentum is up. When momentum begins to ebb, they will sell their positions and escape the carnage. Since they have very large positions and since they all follow the same momentum, I suspect they are deluded in thinking they will be able to get out in time, because all other momentum investors will be doing the same thing. (Emphasis added) * * * I am convinced that a few essential lessons are involved here. 1. The positives behind stocks can be genuine and still produce losses if you overpay for them. 2.

This may happen because markets and systems don't work (in the Crash of 1987, portfolio insurers couldn't get their stop-loss sales off), because external events aren't fully anticipated (inverse floaters tanked in 1994 because interest rates rose at annual rates of 600 or 700 basis points that had been considered impossible), or simply because of the unreliability of the human participants (scared people often fail to step forward with cash at the times that matter most). A relationship's failure to hold often comes just when faith in it has reached an excessive level and huge sums have been bet on it. For whatever reason, we have seen m any instances when probabilistic models turned out not to have made sufficient allowance for an “improbable disaster.” As Long-Term's Meriwether wrote in his September 2 letter to investors, “the Fund added to its positions in anticipation of convergence, yet ... the trades diverged dramatically.” In other words, sometimes things that are cheap just get cheaper and things that are dear get dearer.

That is, the participants must be motivated just by economics and willing to either buy or sell depending on price. If every owner wants to (or must) sell a given good and won't become a buyer no matter how low the price goes, the price of that good can fall below the "fair" level and it will become possible to find bargains. Conversely, prices can go too high when everyone wants to own something . . . whether it's tulip bulbs, South Sea pearls or nifty-fifty stocks. And that brings us to the high yield bond market which remains, in our opinion, decidedly inefficient. High yield bonds continue to offer 350-400 basis points more yield than "riskless" Treasury bonds to compensate for the risk of losing 50-150 basis points per year to credit problems. And high yield bonds have the best performance record of any major sector of the fixed income universe for virtually every period through today. One would certainly expect these facts to attract buyers and raise prices. In 1984, I was sure this market would become efficient in five years. But it hasn't done so ten years later, despite the high historic and prospective returns. Why haven't enough buyers stepped forward to eliminate the excessive risk premium, render these bonds fairly priced and correct the inefficiency?

© Oaktree Capital Management, L.P. All Rights Reserved * * * The most noteworthy feature of the recent correction may be the role of some prominent hedge fund managers. It was reported on February 25 that George Soros's Quantum Fund had lost $600 million on its yen position in one day. On April 1, we read that Michael Steinhardt had lost $1 billion of his $5 billion under management, due largely to the drop in bond prices, and that in the last two months, investors in Askin Capital Management's Granite Funds may have lost 100% of their $600 million capital in mortgage backed securities. Hedge funds occupied a meaningful part of our February 17 memo because they were felt to exemplify (to a power of ten) the risk-tolerant behavior of investors in general. Thus their subsequent experience can offer us some valuable and highly magnified insights. The important observations, applicable to all investment behavior, are as follows: - Words alone mean very little. Just as "portfolio insurance" turned out in the 1987 Crash not to insure much, today's startling losses indicate that many "hedge funds" don't really hedge enough to make a difference, and that the Granite Fund, which described itself as "market neutral," was anything but. - Following from the above, we are reinforced in the belief that some investors don't know what their managers are doing, or how much risk they're taking.

Yet investors, normally quick to snap up anything offering better yields than CDs and money-market funds are staying away. Assets of convertible funds stood at $2.36 billion on June 30, up just $ 100 million since the start of the year, and way below their peak of $5.3 billion just before the 1987 crash. Reaction was negative, and convertible mutual fund assets dropped to $3.2 billion at year-end 1989 and only $2.2 billion today, down 62% from the 1987 level. If strong inflows are, as I believe, a precursor of poor performance (and vice versa), then the outlook today should be excellent. Convertibles are getting no respect and attracting no inflows. That leaves bargains for those willing to act as contrarians. We hope you will consider convertibles an attractive way to hold an increased portion of your commitment to equities. October 8, 1992 Between 1977 and 1984, the number of convertible mutual funds was constant at seven, and at the end of that period their total assets stood at the princely sum of $452 million. By the end of 1987 there were thirty funds with assets of $5.8 billion, for a thirteen-fold increase. It can clearly be seen in retrospect that the strong flow of capital into convertibles in 1985-87 “poisoned the well” and led to a loss of price discipline, to purchases of over-priced securities, and to poor performance.