‘Mastering the Market Cycle – Getting the Odds on Your Side’

Key Insights by Howard Marks, Chairman, Oaktree Capital Management?

There are three key recurring themes behind most market excesses on the upside:

1.??????Too much optimism - Investors are human, and as such they tend to swing wildly in terms of psychology or emotion: between optimism and pessimism, fear and greed, and credulousness and skepticism. An asset’s price is a function of reality (its fundamentals) and how that reality is perceived (filtered through emotion, psychology, popularity). Excessively-positive perception causes prices to over-rate the fundamentals and become excessive. It’s essential that investors keep an eye out for excessive optimism that leads to peak valuations (as well as for excessive negativism that produces bargains).

2.??????Too little risk aversion – People should insist on the possibility of incremental returns (a “risk premium”) if they’re to accept investments that seem incrementally risky.

However, sometimes when enthusiasm is high, recent results have been good and the economic sky seems cloudless, investors drop their risk aversion. Since they’re less concerned about risk, they fail to insist on adequate risk premiums, allowing the prices of risk assets to go too high. When risk compensation is skimpy, investors should cut their risk as the expected return is low.

And sometimes, when investors are depressed, recent results have been poor and trouble seems to loom everywhere, investors’ risk aversion becomes exaggerated. When risk aversion is excessive, that negativity causes the level of risk compensation to likewise become excessive, and the prices of risk assets to be too low. When risk compensation is generous, investors should increase their risk as the expected return is high.

3.??????Too much capital availability - When things are going well, capital is available in vast amounts. Suppliers of capital make generous assumptions in their analysis, give borrowers and issuers the benefit of the doubt, see little risk, and thus forget to demand much in the way of return or safety. Heated bidding in the auction for opportunities to invest and lend causes prices to rise, prospective returns to fall, security structures to become weak, and risk to rise. Thus, easy capital availability is a warning sign.

So, to become better investors, let's use these three signposts to evaluate where Equity markets stand currently. What do you think - are we seeing any of these signs currently?