Howard Marks, Oaktree Capital — 2022-05-26
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Memos from Howard Marks 2022-05-26T07:00:00.0000000Z" pubdate title="Time posted: >5/26/2022 7:00:00 AM (UTC)">May 26, 2022
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While I employ a great many adages and quotes in my writings, my main go-to list consists of a relatively small number. One of my favorites is widely attributed to Mark Twain: "History doesn't repeat itself, but it does rhyme." It's well documented that Twain used the first four words in 1874, but there's no clear evidence that he ever said the rest. Many others have said something similar over the years, and in 1965 psychoanalyst Theodor Reik said essentially the same thing in an essay titled "The Unreachables." It took him a few more words, but I think his formulation is the best:
There are recurring cycles, ups and downs, but the course of events is essentially the same, with small variations. It has been said that history repeats itself. This is perhaps not quite correct; it merely rhymes.
The events of investment history don't repeat, but familiar themes do recur, especially behavioral themes. It's these that I study.
In the last two years, we've seen dramatic examples of the ups and downs Reik wrote about. And I've been struck by the reappearance of some classic themes in investor behavior. They'll be the topic of this memo.
I want to mention up front that this memo has nothing to do with assessing the markets' likely direction from here. 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.
When I refer above to "a real bull market," I'm not talking about standard definitions such as these from Investopedia :
A period of time in financial markets when the price of an asset or security rises continuously
A situation in which stock prices rise by 20%, usually after a drop of 20%
The first of these is too bland, failing to capture a bull market's emotional essence, and the second attempts false precision. A bull market shouldn't be defined as a percentage price movement. For me, it's best described by what it feels like, the psychology behind it, and the behavior that psychology leads to.
(I started investing before the development of numerical criteria for bull and bear markets, and I consider such yardsticks meaningless. Take a look, for example, at a couple of recent newspaper articles. On May 20, the S&P 500 Index's decline from the top passed the "magic" 20% threshold; thus on May 21 the Financial Times wrote, "Wall Street stocks slumped into a bear market yesterday . . ." But because a late rally reduced the final decline to just under 20%, the headline of the same day's New York Times read, "S&P 500 Drops . . . but Evades Bear Market." Does it really matter whether the S&P 500 is down 19.9% or 20.1%? I prefer the old-school definition of a bear market: nerve-racking.)
Excesses and Corrections
My second book is Mastering the Market Cycle: Getting the Odds on Your Side . It's well known that I'm a student of cycles and a believer in cycles. I've lived through (and been schooled by) several significant cycles during my years as an investor. I believe understanding where we stand in the market cycle can give us a hint regarding what's coming next. And yet, when I was about two-thirds of the way through writing that book, a question dawned on me that I hadn't considered before: Why do we have cycles?
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.
When investors turn highly bullish, they tend to conclude that (a) everything's going to go up forever and (b) regardless of what they pay for an asset, someone else will come along to buy it from them for more (the "greater-fool theory"). Because of the high level of optimism:
Stock prices rise faster than company profits, soaring well above fair value ( excess to the upside ).
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.
The price declines generate further pessimism, and this process eventually causes prices to far understate the value of stocks ( excess to the downside ).
Resultant buying on the part of bargain-hunters causes the depressed prices to recover toward fair value ( correction ).
The excess to the upside makes for a period of above average returns, and the swing toward excess on the downside makes for a period of below average returns. There can be many other factors at work, of course, but in my view, "excesses and corrections" covers most of the ground. We saw a number of excesses to the upside in 2020-21, and now we're seeing corrections thereof.
Bull Market Psychology
In a bull market, favorable developments lead to price rises and lift investor psychology. Positive psychology induces aggressive behavior. Aggressive behavior leads to higher prices. Rising prices encourage rosier psychology and further risk-taking. This upward spiral is the essence of a bull market. When it's underway, it feels unstoppable.
We saw a classic collapse of asset prices in the early days of the pandemic. For example, the S&P 500 reached a then-all-time high of 3,386 on February 19, 2020 before falling by one-third in just 34 days to a low of 2,237 on March 23. After that, a number of forces combined to produce massive price gains:
The Federal Reserve cut the fed funds rate to roughly zero, and the Fed was joined by the Treasury in announcing massive stimulative measures.
These actions convinced investor