Howard Marks explains how to avoid crashes by learning to recognize signs of bull-market excess

Oaktree Capital founder Howard Marks is a bold name on Wall Street, as well known for his company’s performance as for his long letters to investors that he regularly publishes for free online to reach the widest possible audience.

As equities fell earlier this month, Marks, who built one of the most successful debt funds in modern history with Oaktree, turned to the financial press for a few words of caution. A year earlier, Marks had warned investors that the seemingly limitless optimism of the market had gone out of hand.

During the intervening months, Marks again proved his reason, and reminded his audience why Warren Buffett once described his notes as “must-reads” for anyone interested in the markets.

Thus, in keeping with his often countercyclical approach, Mark decided to explore the psychology behind bullish markets at a time when stocks were on the precipice of bearish territory.

In his latest letter to investors, Bull Market Rhymes, Marks, who began his career in finance before the bullish and bearish markets were defined as a move of 20 percentage points in either direction, explained that The “emotional essence” of The Bullish Market has less to do with the magnitude of the movement and more to do with mass psychology.

Old school bear market

Before the hysteria of the pandemic relief settled, Marks argues that the most recent true bullish market was the boom in the late nineties and early 2000s. shares rebounded during the period before the Great Financial Crisis, the market of those days only moved gradually and did not have the characteristic tone of unbridled optimism.

Bullish markets are described as “better by how you feel, the psychology behind it, and the behavior that psychology leads to,” Marks said. The same goes for bear markets: “Does it really matter if the S&P 500 SPX,
+ 1.99%
has it dropped 19.9% ​​or 20%? I prefer the old-school definition of a bear market: nervous. ”

To mark the thematic tone of his note, Marks began with one of his favorite sayings, paraphrased by Mark Twain: “History does not repeat itself, but it does rhyme.”

With that in mind, Marks delved into what he described as the three stages of a bullish market: during the first phase, a handful of forward-looking investors were committed to making things better. During the second, more investors realize that the underlying improvement is underway. And in the final stage, virtually every investor believes that the recent period of sparkling returns will continue forever.

One thing that set the bullish market apart from the pandemic of the dot-com boom and other periods of hysterical optimism was that there was essentially no first stage, and very little of the second. Instead, many investors “went straight from hopeless at the end of March to very optimistic at the end of the year.”

Super actions, crypto, SPAC

Bullish markets do not treat all stocks the same, Marks added. Instead, investor optimism typically revolves around a handful of “super stocks,” either the “Nifty Fifty” of the 1960s or the “FAAMGs,” a term for technology stocks. of megacap with Facebook Inc. FB,
+ 4.24%
the parent platform Meta Platforms Inc. and Google GOOG from Alphabet Inc.,
+ 2.32%
which boosted much of the market’s gains over the past decade (before leading the decline in stocks in recent months).

This time, the issue of “super stocks” was complicated by the arrival of cryptocurrencies, which introduced a new wrinkle to the old dynamic by increasing investor hysteria as millions pursued the almost unprecedented returns that investors had enjoyed. original cryptographic. The arrival of non-commission brokerage accounts introduced by Robinhood Markets Inc. HOOD,
+ 0.54%
and others were another innovation that set this market apart, Marks said.

While the 2020-2021 bullish market had many unique features, there were also features reminiscent of previous bullish markets. The main one of these was the crushing of public offerings with unprofitable companies. A relative rarity before the rise of dot-coms, this became increasingly common both during the dot-com explosion and more recently, as the SPAC boom presented investors with what it seemed like a “lossless proposition” (since investors were guaranteed to return the money with interest if the organizers didn’t get a deal or if investors didn’t like the deal they chose).

This notion is one of the most dangerous in the investment universe and a reliable sign that hysteria has taken over, Marks said.

Today, the average SPAC that has completed the process over the past two years is trading at just $ 5.25 per share, compared to SPAC’s standard $ 10 bid price. Sometime between that time and now, investors saw their rational fear of loss completely subdued by the fear of getting lost; this is often the final, and most dangerous, stage of the mania-driven bullish market. Its primacy is further consolidated by the “theory of the great fool”: the notion that even if prices do not make sense, someone would eventually be willing to pay more.

Towards the end of his note, Marks summed up his thought with another popular adage: “What the wise man does at the beginning, the fool does at the end.”

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