On the Couch, Jan-2016 (Notes on Memo by Howard Marks, Oaktree Capital Management)

On the Couch, Jan-2016

Notes on Memo by Howard Marks, Oaktree Capital Management
By Mudit Khetan, Jaipur
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This is only a humble first attempt to distill the knowledge of the greats with MY OWN perspective. It's not a commentary on the Memo or the great Marks, BUT ON HOW I TRY TO [OR AM LEARNING] to think and understand things.

The phrases/sentences in [] are my own. Many sentences are incomplete and are taken from a bigger one to drive home the larger point.

Your comments and suggestions are most welcome.
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NOTES

[Markets] On the Couch, Jan-2016 - [Understanding the psychology of the markets as a shrink]

Professor Richard Thaler of Univ. of Chicago is a leading expert on behavioral-economics and decision-making. He opens his new book 'Misbehaving', with Vilfredo Pareto's aasertion taht "the foundation of political economy and, in genera, of every social science is, evidently psychology." I'd apply that equally to the not-so-scientific field of investing.

It has been one of may constatnt refrains - that in order to be successful, an investor has to not just understand not just finance, accounting and economics, but also psychology. A thorough understanding of the how investors' minds work is essential if one is to figure out where a market is in its cycle, why, and what to tdo about it.

Somehow, market participants are able to live with uncertainties like these and retain their equanimity, sometimes for long periods. May be it's conviction, May be it's obliviousness, or May be it's denial.

As Doug Kass put it in mid-2014, we've been experiencing 'a bull market in complacency.' But eventually something else happens - perhaps the house of cards grows too high - and investors' serenity is pierced. A point is reached beyond which equanimity can no longer be maintained.

One of the most notable behavioral traits among investors is their tendency to overlook negetives or underrate their significance for a while, and then eventually to capitulate and overreact to them on the downside.

20/20 hindsight - 'Everyone knew' for years that the Chinese economy had been oversimulated with cheap financing, and that this had led to excessive investments in fixed assests. The effect was exceptional GDP growth, but also a large stock of unneeded buildings and infrastructure.

[Especially] during a downwardspiral of markets, many investors impute [assign/attibute] intelligence to market and look to it to tell them what's going on and what to do about it. This is one of the biggest mistakes you can make. As Ben Graham pointed out, the day-to-day market isn't a fundamental analyst; it's barometer of investor sentiments. You just can't take it too serioiusly.

Whatever the reason, the bottom line for me is that whereas risk tolerance had ruled through July 2015, risk aversion was reawakened in August. The tipping point finally arrives, a sudden wake-up call to the existence and importance of risks.

Investment Pendulum [intro in April, 1991 memo 'First Querter Performance']: Although the midpoint of its arc best describes the locationof the pendulum "on average," it actually spends very little of its time there. Instead, it is almost singinging toward or away from the extremes of its arc. But whenever a pendulum is near either extreme, it is inevitable that it will move back toward the mid-point sooner or later.

One of the most significant factors keeping investors from reaching approporiate conclusions is their rendency to assess the world with emotionalism rather than objectivity [rationally]. Their failings take two primary forms: selective perception and skewed interpretation. In other words, sometimes they take note of only positive events and ignore negetavi ones and sometimes the opposite is true. And sometimes they view events in a positive light (, while actually they are in negatives zone) and sometimes it's negative. But rarely are their perceptions and interpretations balanced and neutral.

[And] with the door opened to fearful interpretation, Pollyanna [someone with a very optimistic attitude/outlook] tolerance gave way to widespread negativism.

The bottom line is that investor psychology rarely gives equal weight to both favourable and unfavourable developments. Likewise, investor’s interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment. Most developments have bothe helpful and harmful aspects, but investors generally obsess about one or the other rather than consider the both.

First they exhibit high levels of optimism, greed, risk tolerance and credulousness, and their resulting behaviour causes asset prices to rise, potential returns to fall and risks to increase. But the, for some reason - perhaps the arrival of a tipping point - they switch to pessimism, fear, risk aversion and skepticism, and this causes asset proces to fall, prospective returns to rise and risk to decrease.

That's one of the crazy things: 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.' The pendulum careens [moves swiftly and in an uncontrolled way] from one extreme to other, spending almost no time at the 'the happy medium' and rather little in the range of reasonableness. FIRST THERE IS DENIAL, AND THEN THERE IS CAPITULATION [1. Surrender in the face of severe threat; 2. When investors give up any previous gains in stock price by selling equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines].

Confidence is one the key emotions [, that plays havoc with investor’s welath], and I attribute a lot of market’s recent volatility to a swing from too much of it a short while ago to too little more recently. The swing may [result] from disillusionment: it's particularly painful when investors recognize that they know far less than they had thought about thow the world works.

Confluence of Factors/Reasons: Investors can usually keep their heads in the face of ONE negative. But when they face more than one simultaneously, they often lose their cool.

Another area of error - be it the result of flawed perception or inadequate insight and analysis - can be seen in investors' repeated failure to understand the potential for ramifications and second-order consequences.

Prof. Thaler's book Misbehaving reviewed by Carol Tavris (15-May-2015 WSJ): As a social psychologist, I have long been amused by economists and their curiously delusional notion of the "Rational Man." Rational? Where do these folks live? Even 50 years ago, experimental studies were demonstrating that people stay with clearly wrong decisions rather than change them, throw good money after bad, justify failed predictions rahter than admit they were wrong, and resist, distort or actively reject information that disputes their beliefs.

The difficulty of understanding events, their significance and their potential ramifications comes in good part from the kinks [1. a sharp twist or curve in something that is otherwise straight. 2. cirk - twist or strain (in one's neck or back), causing painful stiffness] in investors' psyches, and it contribute to - and feeds back to exacerbate [make (a problem, bad situation, or negative feeling) worse.] - investors' responses.

Notions of market efficiency - the idea that most assets are priced 'right' - are based on belief in investor rationality and objectivity. But certainly those traits are little seen in real life. "Inefficiencies" - in everyday language "mispricings" - stem from biases against one asset in favour of another: legal, cultural, informational, and especially behavioral and emotional.

The important thing is not what oil price declines tell us about today [Jan-2016]. It's what it says about tomorrow. And to me, everything else being equal, I think low energy prices today will contribute to better economic growth tomorrow. Low prices today also imply higher prices eventually, through their impact on supply and demand.

ON FED'S IMMINENT INTEREST RATE HIKE SPECULATIONS - There's something wrong if an event that has been widely anticipated for years - and considered a near certainty for months - can be thought capable of significantly impacting the market when it becomes a fact. People's expectations should be incorporated into the prices they assign to the assets. So a negative reaction to imminence of a widely heralded interest-rate increase must imply either:

investors are too dense [read stupid] to have incorporated into prices before this;
the increase will be a bigger deal than what people thought; or
the market is irrational.

The difference in timing [to buy/sell now or buy/sell in a few month's time based on imminent increase/decrease in fed's rates] should have little effect on the choice of course of action. What matthers is how far the rates will go [QUANTUM OF INCREASE/ DECREASE is important] and how fast [SPEED OF SUCH INCREASE/DECREASE]. ... The issue of interest rates should not be viewed as binary - black or white - flat rates or rising. The essential questions are, 'how much will the rates rise?', and 'when the series of increases is over, will rates be high enough to meaningfully alter behaviour?' That's what counts.

As I wrote in Liquidity, March 2015, no investor should shoulder more illiquidity than its realities permit; and, in particular, no investment vehicle should promise more liquidity than is afforded by its underlying assets. Illiquid assets and the possibility of capital filght: there are fewer surer recipes of investment disasters.

Behavioral economics and its younger cousin, behavioral investing, are not theoratical. In fact, they are the essence of practical: they're about how human foibles cause real-life behavior to deviate from what theory might dictate.

There is a general sense among my colleagues that investors have gone from evaluating securities based on the attractiveness of their yield (with company fundamentsl viewed optimistically) to judging them on the basis of likely recovery in a restructuring (with the fundamentals viewed pessimistically). The capital markets begun their swing from generous to tight, as is their habit.

The change in investor attitudes creates investment opportunities, where they did not exit just a few months before - in some cases out of proportion to the changes in fundamentals.

[Distressed investor attitudes and prevailing pessimism] creates vastly improved buying opportunities. But note that we may be just in the early stages of a downward spiral in corporate performance and credit market behaviour. Thus, while it be "a time" to buy, I'm far from suggesting it's "the time" [to buy].

My Prescription

To help investors deal with their potential for 'huma error', the shrink would prescribe a number of elements that can help with the task:

Understanding - the importance of psychology and its influence on markets must be understood and dealt with.

Controlling one's emotions - absolutely essential to kee optimism and fear in the approporiate balance.

Control over one's circumstances - ...primarily [it] means structuring one's environment in such a manner so as to limit the impact of other people’s swings, on them. Examples [of other people’s moods swings] include inflows to and outflows from funds, fluctuations in market liquidity, and pressure for short-term performance. [At a more personal level, you should not be dependent on your stock investments for meeting out emergency, imminent and short-term requirements of up to at least 1-2 years - HAVE ALTERNATES AND EMERGENCY FUNDS READY].

Contrarianism - [the invertor's ability] to convert other invertors' emotional swings from a menace into a tool. Going beyond just fending off emotional fluctuation, it's highl desirable to become more optimistic when others become more fearful, and vice versa.

Three stages of a bull market:

the first, when only a few especially insightful people suspect improvements might occur; [NO optimism is involved, great bargains available]
the second, when most people accept that improve is actually taking place; and
the third, when everyone concludes that things are sure to improve FOREVER. [Optimism at terribly high levels, thus prices also at very high levels relative to fundamentals]

Between the first stage and the last, nothing has to have changed in terms of fundamentals. The difference lies in the perspective investors are bringing to their decisions. But clearly, it's great to be abuyer in the first stage and essential NOT TO BE [A BUYER] in the last.

If I could only know one thing about an investment I'm contemplating, it migt be how much optimism is embedded in price. I want to buy when I can benefit from herd's neuroses, not when they'll penalise me just as they do everyone else.

Now [jan 2016], as investor's optimism has deflated a bit, some negativity has come into the equation, and prices have moved lower. Depending importantly on which market we're talking about and how it has fared in recent months, we consider it appropriate to move forward with a little less caution [compared to the levels of caution we have been practicing since 2011].

ON China and Looming Crisis

What are the implications for the US and the rest of the world of China's weakness, and are we moving forward toward a new crisis of the magnitude of what we saw in 2008? ...as many potential problems mark the environment, it's important to figure out which if any are likely to present real problems.

Declining oil prices: the implications for non-oil prodicers seem mixed at worst;
A terrorist event: horrifying, but for any one person or location [not systematic risks involved]. I'd put it in the category of "improbable disaster";
The political picture [in US presidential elections]: we'll probably continue to muddle through no matter who's elected.

The possibility of a hard landing in China is of greatest significance when you combine magnitute, potential ramifications and the probability of it occuring.

First, ... China doesn't play a pivotal role in the US economy (other than as the provider of finished goods). [US exports to China are less than 1% of GDP and so is the contribution of China is the combined profits of S&P 500 companies].

Paul Krugman's analysis from NYT of 8-Jan-2016:

[Although China is one of the biggest importers of goods from across the world to the tune of $2 trillion]. But it's a big world with a GDP (excluding China's) of more than $60 trillion. Even a drastic fall in Chinese imports would be only a modest hit to world spending.
Financial Linkages: ... America's sub-prime crisis [of 2008] turned global [because] foreigners, especially European banks, were badly exposed to losses on US securities. But China has capital controls - so there's very little direct spillover [to the rest of the world] from plunging stock or even domestic debt defaults [in China].
... While China is in big trouble, the consequences for the rest of us should be manageable.
But I [Paul Krugman] have to admit that I'm not as relaxed about this as the above analysis says[/suggests] I should be. I lack the courage of my complacency. Why?
Business cycles across nations often seem to be more synchronised that they "should" be. For example, Europe and the US export to each other only a small fraction of what they produce, yet they often have recessions and recoveries at the same time. Financial linkages may be part of the story, but one also suspects that there is PSYCHOLOGICAL CONTAGION: good or bad news in one major economy affects animal spirits in others. So, I worry China may export its woes [through this contagion].

I want to highlight Krugman's reference to "psychological contagion." I consider it higly unlikely that such uniform delines [in stok markets world over recently] were the result of independent, objective analysis of the impact of events on each economy and company. Rather, I think they show the extent to which markets are linked by their investors' shared psychology.

The bottom line for me is that a rerun of the Global Financial Crisis (GFC) isn't in the cards:

We haven't had a boom (either in economy or stock markets), so I don't think we're fated to have a bust. Because most businesses have been particularly loath to expand their facilities, I don't think they'll be slammed if revenues flatten or turn down.
The leverage in the private sector [including banks] has been reduced. ... And of course, banks are barred from investing adventurously for their own account.
The main villain in the GFC were sub-prime mortgage backed securities. The raw material - the underlying mortgage - was unsound and often fraudulent. The structured mortgage vehicles were highly levered and absurdly highly rated. These risky tranches [earlier lapped up by banks when going was good] ended up in their protfolios, causing them to require rescue.
This time around I see no analog to sub-prime mortgages and MBS in terms of their combination of fragility and magnitude.

I don't mean to suggest there aren’t a lot of things to worry about: swollen central bank balance sheets [because of QEs]; complete ignorance as to how they will be unwound and how interest rates will be moved higher; the seemingly inability to generate economic growth and inflation; and many other macro negatives. China's hard landing and subtabtial devaluation could have far-reaching effects.

It’s important that investors (as well as economists) avoid using words like 'always', 'never', 'will', 'won't', 'has to' and 'can't' and I try to do just that. [NEVER BE SO MUCH SURE ABOUT FUTURE. It is better to be approximately right, thnn being absolutely wrong]. Remember, however, that I'm not a seer, and Oaktree and I never bet heavily on opinions regarding the future - MINE or anyone else's.

I want to make it abundantly clear that when I [make a] call [about future course of out actions like active buying, cautios treading, aggressive selling, etc.], I do it with considerable uncertainty. My conclusions are the result of my reasoning, applied with the benefir of my experience (and collaboration with my Oaktree colleagues), but I never consider them 100% likely to be correct, or even 80%. I THINKG THEY'RE RIGHT, OF COURSE, BUT I ALWAYS MAKE MY RECOMMENDATIONS WITH TREPIDATION.

...The key is that - for whatever reason - I'm able to stand up to my emotions and follow my conclusions. None of them can be documented or proved. If they could be, then most intelligent people would reach the same conclusions, with the same degree of confidence. These aren't the things about tehich the certainity is attainable. [EVERYONE HAS TO DRAW CONCLUSIONS RATIONALYY AND FOLLOW THEM THROUGH, HOWEVER UNCERTAIN THEYR'E ABOUT THEM]

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