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Click the link above to read the full article.
The author of this article is Howard Marks, a famous investor and writer that heads up Oaktree Capital. You can find more from Howard at Oaktree Capital Insights.
The article starts by quoting the famous Mark Twain: "History doesn't repeat itself, but it does rhyme."
Marks explains the market's gyrations over the past 65 years to excesses and corrections caused by the influences of psychology on investors decision making.
For example, if the S&P 500 has returned just over 10% a year on average over the 65 years since it assumed its present form in 1957, why doesn’t it just return 10% every year? And updating a question I asked in my memo The Happy Medium (July 2004), why has its annual return been between 8% and 12% just six times during this period? Why is it so far from the mean 90% of the time? After pondering this question for a while, I landed on what I consider the explanation: excesses and corrections. If the stock market was a machine, it might be reasonable to expect it to perform consistently over time. Instead, I think the substantial influence of psychology on investors’ decision-making largely explains the market’s gyrations.
The cycle that he outlines, as investors we have felt before.
1. Stock prices rise faster than company profits, soaring well above fair value (excess to the upside).
2. Eventually, conditions in the investment environment disappoint, and/or the folly of the elevated prices becomes clear, and they fall back toward fair value (correction) and then through it.
3. The price declines generate further pessimism, and this process eventually causes prices to far understate the value of stocks (excess to the downside).
4. Resultant buying on the part of bargain-hunters causes the depressed prices to recover toward fair value (correction).
Our most recent experience was March 2020. Marks outlines that experience as being unprecedented, and why history only rhymes.
The bull market of 2020 was unprecedented in my experience, in that there was essentially no first stage and very little of the second. Many investors went straight from hopeless in late March to highly optimistic later in the year. This is a great reminder that, while some themes do recur, it’s a big mistake to expect history to repeat exactly.
As euphoria in the market grows, he quotes an Anise Wallace New York Times Article from 1987,
The four most dangerous words in investing are “this time it’s different,” according to John Templeton, the 74-year-old mutual fund manager. At stock market tops and bottoms, investors invariably use this rationale to justify their emotion-driven decisions.
What keeps the stock market sane?
It’s essential to bear in mind that it’s risk aversion and the fear of loss that keep markets safe and sane.
In today's world there is no shortage of news. How does news affect investors psychology? This comic below seems more true then ever.
The key lies in the fact that investors are capable of interpreting virtually any piece of news either positively or negatively, depending on how it’s reported and on their mood. (The cartoon below, one of my all-time favorites, was published many decades ago – check out those rabbit ears and the depth of the TV set – but clearly the caption is relevant to this very moment.)
In conclusion, Marks provides us with some valuable lessons.
As always for students of investing, what matters most isn’t what events transpired in a given period of time, but what we can learn from these events. And there’s a lot to be learned from the trends in 2020-21 that rhymed with those in previous cycles. In bull markets:
+ Optimism builds around the things that are doing spectacularly well.
+ The impact is strongest when the upswing arises from a particularly depressed base in terms of psychology and prices.
+ Bull market psychology is accompanied by a lack of worry and a high level of risk tolerance, and thus highly aggressive behavior. Risk-bearing is rewarded, and the need for thorough diligence is ignored.
+ High returns reinforce belief in the new, the unlikely, and the optimistic. When the crowd becomes convinced of those things’ merit, they tend to conclude “there’s no price too high.”
+ These influences cool eventually, after they (and prices) have reached unsustainable levels.
+ Elevated markets are vulnerable to exogenous events, like Russia’s invasion of Ukraine.
+ The assets that rose the most – and the investors who over-weighted them – often experience painful reversals.
The article linked and mentioned above was posted on May 26, 2022 and written by Howard Marks of Oaktree Capital.
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