Why the bear market is only getting started

Noah Solomon: Unfortunately that means more pain until utter despondency prevails

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Howard Marks, the founder of Oaktree Capital Management LP, the world’s largest investor in distressed securities, has generated long-term annualized returns of 19 per cent since 1995. So, he might have something to teach us about volatility. “When I see memos from Howard Marks in my mail, they’re 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 being attentive to cycles.” He contends that most great investors have an exceptional sense of how cycles work and where in the cycle markets stand 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 investing environment. Sometimes investors only pay attention to positive events while ignoring negative ones, and sometimes the opposite is true.

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Buy before you miss out gets replaced by sell before it goes to 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, asserting that, “It did not take long for me to realize that often the market is driven by greed or fear. ” He states:

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“Investor psychology seems to spend much more time at the extremes than it does at a happy medium. 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. In good times, we hear most people say, ‘Risk? What risk? I do not see much that could go wrong: look how well things have been going. 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 do not care if I never make another penny in the market; I just do not want to lose any more. Get me out! ‘ Buy before you miss out gets replaced by sell before it goes to zero. ”

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

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

Another contributor 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, “Extreme brevity of financial memory” keeps market participants from recognizing the recurring nature of cycles, and thus their inevitability. In his book, A Short History of Financial Euphoria, he wrote:

“When the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as the world of finance. 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. ”

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In many ways, markets resemble the swinging pendulum of a clock, which on average lies at its midpoint, yet spends very little time there. Rather, it spends the vast majority of the time at varying distances to either the right or the left of center. In a similar vein, 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 per cent. However, the index increased within 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 per cent 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 per cent of the time.

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Also, when a pendulum swings back from the far left or far right, it never stops at the midpoint, but continues to the opposite extreme. Similarly, markets rarely shift from being either overpriced or underpriced to fairly priced. Instead, they typically touch equilibrium only briefly before snowballing sentiment and momentum cause 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 as consisting of three stages: first stage, when only a few unusually perceptive people believe things will get better; second stage, when most investors realize that improvement is actually taking place; and 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: first stage, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things will not always be rosy; second stage, when most investors recognize that things are deteriorating; third stage, when everyone is convinced things can only get worse.

In his typically folksy yet 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 first stage of a bear market. The number of investors who have concluded that all is not right in the world has been sufficiently large to cause a significant decline in prices. Still, there are no shortage of strategists and pundits insisting that a sharp rebound is imminent, which suggests that a significant number of investors have not yet thrown in the proverbial towel. So, by process of elimination, we are likely in the middle stage of a bear market, meaning more pain until utter despondency prevails.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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