Why the bear market is just beginning

Noah Solomon: Unfortunately that means more pain until total discouragement prevails

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Howard Marks, the founder of Oaktree Capital Management LP, the world’s largest investor in distressed stocks, has generated long-term annualized returns of 19 percent since 1995. So he may have something to teach us about volatility. . “When I see notes from Howard Marks in my mail, they are the first thing I open and read. I always learn something.” Warren Buffett once said.

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Marks believes that “the most important thing is to be aware of the cycles”. He argues that most great investors have an exceptional sense of how cycles work and where the markets are in the cycle at any given time.

More than any other factor, it is the ups and downs of human psychology that are responsible for changes in the investment environment. Sometimes investors only pay attention to positive events and ignore negative ones and sometimes the opposite happens.

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Buy before missing out is replaced by sell before it hits zero

One of the most time-honored market adages states that markets fluctuate between greed and fear. Marks adds an important nuance to this notion by stating that, “It didn’t take me long to realize that the market is often driven by greed. either fear.” He states:

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“Investor psychology seems to spend much more time at the extremes than at a happy middle ground. In the real world, things generally fluctuate between pretty good and not so good. But in the world of investing, the perception often swings between flawless and hopeless. In good times, we hear most people say, ‘Risk? What risk? I don’t see much that can go wrong – look how well things have gone. And anyway, risk is my friend: the more risk I take, the more money I’m likely to make.’ Then, in bad times, they switch to something simpler: ‘I don’t care if I never make another dime in the market; I just don’t want to lose anymore. Kick me out! Buying before missing out is replaced by selling before it hits zero.”

Valuation matters. Historically, when valuations have been at nosebleed levels, it was only a matter of time before misery set in. Conversely, when assets have declined to the point where valuations were convincing, strong returns soon followed. But it is important to distinguish cause from effect. Extreme valuations, whether cheap or rich, that herald bull and bear markets are themselves the result of extremes in investor psychology.

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Importantly, human emotions are fickle and impossible to measure accurately. Nobel Prize-winning physicist Richard Feynman articulately encapsulated this fact, stating, “Imagine how much more difficult physics would be if electrons had feelings!”

Another factor that contributes to irrational investment decisions, and by extension market cycles, is the tendency for people to forget the lessons of the past. According to famed economist John Kenneth Galbraith, “the extreme shortness of financial memory” prevents market participants from recognizing the recurring nature of cycles and thus their inevitability. In his book, A brief history of financial euphoriahe wrote:

“When the same or very similar circumstances occur again, sometimes in just a few years, they are hailed by a new generation, often young and always supremely self-confident, as a brilliantly innovative discovery in the world of finance and economics. large. There may be few fields of human endeavor where history counts as little as the world of finance. Past experience, insofar as it is part of memory, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

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In many ways, the markets resemble the swinging pendulum of a clock, which on average sits at its midpoint, but spends very little time there. Rather, it spends most of its time at different distances to the right or left of center. Similarly, most people would be surprised by both the frequency and magnitude by which stocks can deviate from their average performance.

Over the past 50 years, the average annual return of the S&P 500 Index is 12.6%. However, the index rose two percentage points above or below the average in only three of those years; within five percentage points above or below only nine times; and within 10 percentage points above or below 12.6 percent in 22 of the past 50 years. Lastly, the index posted a calendar-year return that was either 20 percentage points higher or 20 percentage points lower than its long-term average return in nine of the past 50 years, or 18 percent of the time.

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Also, when a pendulum swings back from the extreme left or right, it never stops at the midpoint, but continues to the opposite extreme. Similarly, markets rarely go from being overvalued or undervalued to fair prices. Instead, they typically touch equilibrium only briefly before snowball sentiment and momentum causes a progression to the opposite extreme.

The underlying causes behind repeated swings from one extreme to another are elegantly summarized by Marks, who describes the evolution of bull markets in three stages: first stage, when only a few unusually insightful people believe things will get better; second stage, when most investors realize that an improvement is really taking place; and the third stage, when everyone concludes that things will get better forever.

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Using the same framework, Marks lists three stages of bear markets: the first stage, when only a few thoughtful investors recognize that, despite prevailing optimism, things won’t always be rosy; second stage, when most investors recognize that things are deteriorating; third stage, when everyone is convinced that things can only get worse.

In his typically folksy but caustic manner, Buffett cuts to the chase in describing the progression of bull and bear markets, saying, “First come the innovators, then come the imitators, then come the idiots.”

It is hard to argue that we are still in the early stages of a bear market. The number of investors who have come to the conclusion that all is not well with the world has been large enough to cause a significant drop in prices. Still, there is no shortage of strategists and pundits who insist a strong rally is imminent, suggesting that a significant number of investors have yet to throw in the proverbial towel. So, by process of elimination, we are likely in the middle stage of a bear market, which means more pain until outright discouragement prevails.

Noah Solomon is Chief Investment Officer of Outcome Metric Asset Management LP.

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