118 Comments 2024-09-05

Howard's Memo: Misjudgment of "Mr. Market" Amid Global Turmoil

In the more enigmatic market environment of this year, Howard Marks's memos have been coming more frequently than last year.

Inspired by the global market turmoil in the first week of August, he wrote a piece titled "Mr. Market Miscalculates" on August 22.

From this title alone, we should be able to discern his perspective on the matter.

Howard took us through a refresher of Graham's precise description of "Mr. Market" from years past.

This profound understanding and high-level generalization from 75 years ago is entirely applicable today, as "the market is not based on the laws of nature, but on the unpredictable psychology of investors."

And the volatile psychology, distorted perceptions, overreactions, cognitive dissonance, rapid contagion, irrationality, wishful thinking, forgetfulness, and lack of reliable principles... these maladies are all too familiar.

Howard said that to deal with the inevitable fluctuations in the market, a better approach is to recognize "Mr. Market's" overreactions and adapt to them.

"Sell to him when he is eager to buy, regardless of how high the price, and buy from him when he is desperate to sell out."

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This is a memo full of golden phrases, and Howard's sharing of his own collection of market cartoons is also quite interesting.

As Warren Buffett's teacher at Columbia Business School, the renowned Benjamin Graham introduced a character he called "Mr. Market" in his book "The Intelligent Investor," first published in 1949: Suppose you own a small portion ($1,000) of a non-public company.

One of your partners (named "Mr. Market") is indeed a very enthusiastic person.

Every day, he tells you the value of your equity based on his own judgment, and he also allows you to sell all your shares to him or buy more shares from him based on this value.

Sometimes, his valuation seems to match the development and prospects of the enterprise you are aware of; on the other hand, in many cases, Mr. Market's enthusiasm or worry is excessive, and the value he estimates seems somewhat foolish to you.

Of course, Graham wanted to use "Mr. Market" as a metaphor for the entire market.

Given Mr. Market's inconsistent behavior, his daily pricing of stocks may be far from fair value, sometimes even very far.

When he is too enthusiastic, you can sell to him at an excessively high price.

And when he is too fearful, you can buy from him at a price far below the fundamentals.

Thus, his mistakes provide profit opportunities for investors interested in exploiting market misjudgments.

There is much to say about the weaknesses of investors, and over the years, I have shared a lot.

However, the rapid decline and rebound we saw in the market in the first week of August prompted me to summarize previous remarks around this topic, as well as some invaluable investment cartoons I have collected, and add some new observations.

First, let's review the recent events.

Due to the COVID-19 pandemic, soaring inflation, and rapid interest rate hikes by the Federal Reserve, 2022 was the worst year for stock and bond portfolio performance.

Investor sentiment hit its lowest point in mid-2022, with everyone feeling depressed due to the pervasive pessimistic outlook: "We are facing inflation, which is bad.

And raising interest rates to combat inflation will definitely lead to a recession, which is also bad."

Investors could hardly think of any positive factors.

Then, the mood gradually eased.

By the end of 2022, investors began to discuss around a positive narrative: slow economic growth will lead to a decline in inflation, which will allow the Federal Reserve to start lowering interest rates in 2023, thus bringing vitality to the economy and market gains.

The stock market began to rise sharply and continued almost non-stop until this month.

Despite the expected interest rate cuts in 2022 and 2023 not yet materializing, the optimistic sentiment in the stock market has been on the rise.

As of July 31, 2024, the S&P 500 stock index had risen by 54% over the past 21 months (excluding dividends).

On that day, Federal Reserve Chairman Jerome Powell confirmed that the Federal Reserve was moving towards interest rate cuts, and the situation of further economic growth and stock market appreciation seemed to be improving.

But on the same day, the Bank of Japan announced the largest increase in short-term interest rates in 17 years (up to 0.25%).

This shocked the Japanese stock market, where enthusiasm had been sustained for more than a year!

More importantly, this had a severe impact on investors engaged in the "yen carry trade."

For years, Japan's extremely low (usually negative) interest rates meant that people could borrow in Japan at a low cost and invest the borrowed funds in any number of assets, whether in Japan or elsewhere.

These assets promised higher returns, thus obtaining "positive arbitrage" (also known as "free money").

As a result, a lot of money has established highly leveraged positions.

A quarter-point interest rate hike requires the closure of some of these positions.

It may seem strange, but that is indeed the case.

As carry traders began to reduce leverage, there was active selling across various asset classes.

Starting from the next day, the economic news released by the United States was mixed.

On August 1, we learned that the manufacturing purchasing managers' index had declined, and the number of first-time jobless claims had risen.

On the other hand, corporate profitability continued to maintain good momentum, and productivity growth was surprisingly strong.

A day later, we learned that employment growth had slowed, and the increase in the number of hires was below expectations.

The unemployment rate at the end of July was 4.3%, higher than the low of 3.4% in April 2023.

By historical standards, this is still very low, but according to the suddenly popular "Sam's Rule" (don't complain to me, I haven't heard of it either), since 1970, there has never been a case where the three-month average unemployment rate has risen by 0.5 percentage points or more from the low point of the previous 12 months without the economy falling into a recession.

Around the same time, Warren Buffett's Berkshire Hathaway announced that it had sold a large part of its holdings in Apple.

In summary, this news brought a triple blow.

The flip from optimism to pessimism triggered a significant decline in the stock market.

The S&P 500 fell for three consecutive trading days on August 1, 2, and 5, totaling a 6.1% decline.

The repetition of mistakes I have witnessed over the decades is so obvious that I can't help but list them below.

What is the real reason behind market fluctuations?

In the first two days of August, I was still in Brazil, where people often asked me how to explain the sudden collapse.

I referred them to my 2016 memo "On the Couch."

The main point is: In the real world, things fluctuate between "quite good" and "not so good," but in investment, opinions often swing between "perfect" and "hopeless."

This highly summarizes 80% of what you need to know on this topic.

If the change in reality is so small, why does the assessment of value (securities prices should be like this) change so much?

The answer is closely related to changes in sentiment.

As I wrote in my second memo 33 years ago: The emotional swings in the securities market are similar to the pendulum's swing... between excitement and depression, between celebrating positive developments and indulging in negative developments, resulting in the swing between overpricing and underpricing.

This fluctuation is one of the most reliable characteristics of the investment world, and investor psychology seems to be more in extreme states than in the "middle way."

(April 1991) Emotional swings can greatly change investors' views of events, leading to sharp price fluctuations.

When prices plummet as they did at the beginning of this month, it is not because the situation suddenly got worse, but because people think it is very bad.

There are several factors that contribute to this process: · Increased awareness of one side of the emotional ledger; awareness of one side of the emotional ledger, · A tendency to ignore the other side of things; · And people tend to interpret things in a way that fits the mainstream narrative.

This means that in times of economic prosperity, investors will focus on positive factors, ignore negative factors, and make favorable interpretations of things.

Then, when the pendulum swings, they will do the opposite, creating a dramatic effect.

An important foundational idea in economics is the theory of rational expectations, which Investopedia describes as follows: The theory of rational expectations... posits that individual decisions are based on three main factors: human rationality, accessible information, and past experiences.

If securities prices really were the result of rational, calm assessments of data, then a piece of negative information might cause the market to fall a bit, and the next piece of negative information would cause the market to fall further, and so on.

But that is not the case.

We see that an optimistic market can ignore individual bad news until the bad news reaches a critical point.

Then, the optimists surrender, and the rout begins.

Rudiger Dornbush's famous saying about economics is very applicable here: "... things take longer to happen than you think, and they happen faster than you think."

Or as my partner Sheldon Stone said, "The speed at which a balloon deflates is much faster than the speed at which it inflates."

The nonlinear nature of this process indicates that there is something very different from rationality involved.Here is the translation of the provided text into English: **Especially, just like many other aspects of life, cognitive dissonance plays a significant role in the psychology of investors.

The human brain is naturally inclined to ignore or reject input data that contradicts prior beliefs, and investors are particularly adept at this.

As we discuss the topic of irrationality, I have been waiting for an opportunity to share the following screenshot from June 13, 2022: This was a tough day for the market: due to the actions of the Federal Reserve and other central banks, interest rates rose, and asset prices consequently came under tremendous pressure.

But look at this table.

Every country's stock index plummeted.

Every currency fell against the dollar.

Every commodity fell.

Only one thing went up: bond yields... which means bond prices were also falling.

Was there not a single asset or country whose value did not fall that day?

What about gold, which should perform well in difficult times?

My point is that during significant market fluctuations, no one engages in rational analysis or makes distinctions.

They simply throw out the baby with the bathwater, mainly due to psychological swings.

As the saying goes, "In times of crisis, all correlations tend to 1."

Additionally, the data in the table also shows another phenomenon that often occurs in extreme trends: contagion.

The U.S. market had problems; European investors took it as an omen of trouble and sold off; Asian investors sensed negative developments on the horizon and sold off overnight; and when U.S. investors entered the market the next morning, they were spooked by the negative developments in Asia, which confirmed their pessimistic inclinations, so they sold off.

It's much like the game of telephone we played as children: information can be distorted as it is passed along, but it still encourages unfounded actions.

When psychological swings are intense, even nonsensical statements are taken seriously.

During the three-day downturn at the beginning of this month, it was observed that foreigners sold more Japanese stocks than they bought, and the investors' reaction seemed to imply something.

But if foreigners sold overall, then Japanese investors must have bought overall as well.

Should these two phenomena be considered more significant than the other?

If so, which one is more significant?

According to rational analysis, what is more complex is that most developments in the investment field can be interpreted as positive or negative, depending on the prevailing sentiment at the time.

Another classic cartoon summarizes this ambiguity in fewer words.

It is very applicable to expressing market turmoil, which is the reason for this memo.

** **Another cause of misjudgment is investors' optimistic tendencies and wishful thinking.

The average investor—especially stock investors—must be optimists by definition.

Who else would be willing to forgo today's money based on the possibility of greater returns in the future, except for those with positive expectations (or a strong desire to increase wealth)?

Warren Buffett's late partner, Charlie Munger, often quoted the ancient Greek politician Demosthenes: "Nothing is easier than self-deception.

For what each man wishes, that he also believes to be true."

A great example is the "Goldilocks thinking": believing that the economy will neither be strong enough to cause inflation nor weak enough to fall into recession.

Sometimes things do develop this way—perhaps this is the case now—but not nearly as often as investors imagine.

** **A tendency toward positive expectations encourages investors to take positive actions.

If such behavior is rewarded in good times, it usually leads to even more positive behavior.

Investors rarely realize: (a) the emergence of good news is limited, or (b) the rise may be too strong, making a downturn inevitable.

For years, I have quoted Buffett warning investors to restrain their enthusiasm: "When investors overlook the fact that corporate profits grow at an average rate of 7%, they often get into trouble."

In other words, if corporate profits grow at an average rate of 7%, shouldn't investors start to worry if stocks rise 20% per year over a period of time (as they did throughout the 1990s)?

I thought this statement was excellent, so I asked Buffett when he said it.

Unfortunately, he replied that he had not said it.

But I still think it is an important warning.

This inaccurate memory reminds me of John Kenneth Galbraith's sharp mention of one of the most important causes of financial mania: "Financial memory is extremely short."

It is this trait that allows optimistic investors to take positive actions without worrying about what the consequences of such actions have been in the past.

Additionally, it makes it easy for investors to forget past mistakes and invest recklessly based on the latest wonders.

** **Finally, if there were immutable rules—like gravity—that can be counted on to produce the same results forever, then perhaps the investment world would not be so unstable.

But no such rules exist.

Because markets are not built on natural laws, but on the unpredictable psychology of investors.

For example, there is an old adage that we should "buy the rumor, sell the news."

That is, the emergence of favorable expectations is a signal to buy, as expectations tend to continue to rise.

However, when the news comes out, this ends, as the momentum for the rise has been realized, and there is no other good news to drive the market higher.

But in the carefree environment of a month ago, I told my partner Bruce Karsh that perhaps the mainstream attitude has become "buy the rumor, buy the news."

In other words, investors behave as if it is always a good time to buy.

** **Rationally speaking, people should not factor in the likelihood of favorable events into the price twice: once when the possibility of the event arises, and once when the event occurs.

But exuberance will triumph over human nature.

Another example of the lack of meaningful guiding principles can be seen from the oldest clipping in my files:** **Continued consolidation and group rotation patterns suggest that more emphasis should be placed on buying stocks when they are relatively weak and selling when they are relatively strong.

This contrasts sharply with some periods when emphasizing relative strength has proven to be effective.

(Loeb, Rhoades & Co., 1976) In short, sometimes the stocks that have risen the most are expected to continue to rise the most, and sometimes the stocks that have risen the least are expected to rise the most.

** **Many people might say "how strange."

In a word: there are few effective rules that investors can follow.

Exceptional investing always comes down to skillful analytical ability and excellent insight, not to sticking to the rules.

** **Volatile psychology, distorted perception, overreaction, cognitive dissonance, rapid spread, irrationality, wishful thinking, forgetfulness, and lack of reliable principles...

This is a long list of maladies.

They collectively form the main reasons for the extreme ups and downs of the market, and lead to violent fluctuations between them.

Ben Graham said that in the long run, the market is a weighing machine, assessing the value of every asset and giving the appropriate price.

But in the short term, it is just a voting machine, driven by the violent fluctuations of investor sentiment, with little rationality, and the daily prices often reflect little wisdom.

** **I don't want to do futile work, I just want to repeat some of the content I said in the past two memos: Especially during the down period, many investors regard the market as wisdom and expect the market to tell them what is happening and how to deal with it.

This is one of the biggest mistakes you may make.

As Graham pointed out, the daily market is not a fundamental analyst, but a barometer of investor sentiment.

You can't take it too seriously.

Market participants have limited understanding of the true situation of the fundamentals, and any wisdom behind their buying and selling is obscured by their emotional fluctuations.

Interpreting the recent global decline as the market "knowing" that there will be difficult times ahead is a big mistake.

("It’s Not Easy", September 2015)** **My bottom line is that the market does not assess intrinsic value every day, and certainly not well during crises.

Therefore, market trends do not indicate the fundamentals.

Even in the best of times, when investors are driven by fundamentals rather than psychology, the market will show what participants think the value is, not what the true value is.

The market knows no more about value than the average investor.

And the advice of the average investor obviously cannot help you become an above-average investor.

** **Fundamentals (the prospects of the economy, companies, or assets) do not change much every day.

Therefore, daily price changes are mainly related to: (a) changes in market psychology and (b) who wants to own something or give up something.

The greater the daily price fluctuations, the more sense these two statements make.

Large fluctuations indicate that psychology is undergoing fundamental changes.

("What Does the Market Know?

", January 2016)** **Market fluctuations depend on the will of the most unstable participants.

These people are willing to: (a) buy at a higher price than the original when the news is good and the market is enthusiastic, and (b) sell at a lower price than the original when the news is bad and pessimism is high.

** **Therefore, as I wrote in "On the Couch," every now and then, the market needs to see a psychologist.

**It is worth noting, as my partner John Frank has pointed out, that compared to the total number of shareholders of each company, there are relatively few people who drive up stock prices during bubble periods or drive down stock prices during crash periods.

When the stock of a company that had a market value of $10 billion a month ago is traded at a price that implies a valuation of $12 billion or $8 billion, it does not mean that the entire company will be traded at these prices; it's just a small part.

Regardless, the impact of a few emotional investors on prices far exceeds the actual situation.

The worst thing is to join in when other investors fall into this irrational frenzy.

A good approach is to stand by and watch blankly on the basis of understanding how the market operates.

But an even better approach is to see through Mr. Market's overreactions and adapt to him, selling to him no matter how high the price when he is eager to buy, and buying from him when he is desperate to exit.

Here is Graham's advice when talking about Mr. Market: If you are a prudent investor or a rational businessman, would you decide the value of your $1,000 equity in a business based on the information Mr. Market provides every day?

You would only do this if you agree with his views or want to trade with him.

You would be willing to sell to him only when he offers an outrageously high price; similarly, you would be willing to buy from him only when he offers a very low price.

However, for the rest of the time, it is best to think about the value of the equity you hold based on the overall business operations and financial reports of the enterprise.

In other words, the main task of investors is to pay attention to when the price deviates from intrinsic value and to find ways to deal with it.