Howard Marks, the brilliant money manager at Oaktree Capital, has just published must-read memo titled “
The Role of Confidence.“
In the markets and the economy, confidence is often a good thing because it drives stock prices higher and it encourages consumers to spend.
“Taken together, the ingredients I see in confidence — belief, optimism and certainty — combine to create a feeling of well-being,” wrote Marks. “Confident investors are sure big returns lie ahead.”
But at extremes, confidence can be a very reliable contrarian indicator of good and bad things to come.
For example, lack of confidence is creates a great opportunity to buy stocks. Here’s Marks:
The essential raw material for a bull market is cheapness, and that cheapness exists in stage one precisely because there are so few believers and so little confidence that favourable developments and good times lie ahead. Thus stage one provides the launching pad for a bull market.
Equally, in the third stage the bull market is primed to end — with the bubble popping and a down-cycle setting in — for the simple reason that there are too many believers (and too few sceptics). In short, there’s too much confidence and too little cheapness. It’s this imbalance that creates market tops. The extremeness of the bull-market upswing — just like the downswing of its bear-market counterpart — gives investors what should be an important signal.
“I often say the riskiest thing in the world is widespread belief that there’s no risk,” wrote Marks. “And certainly that was the prevailing condition in the pre-crisis years of 2005-07, as well as during the tech bubble of the late 1990s. In both instances the “era of well-being” was followed by a significant economic slowdown and market decline.”
“A feel-good environment characterised by strong confidence creates pleasant current conditions but encourages dangerous behaviour and an ascent (in the economy and the markets) from which a correction becomes inevitable,” he continued. “In that way, the less confident attitudes of 2013 create a lackluster, less enjoyable environment, but also a preferable and more prudent base for the future.”
Marks discussed broadly what has concerned him in the past, what concerns him today, and what concerns him in the long-run.
“While conditions, confidence and asset prices all seem moderate today, meaning there’s nothing brilliant to say about the short-term outlook, the long term remains worrisome,” warned Marks. “Because the U.S. is still able to attract capital from abroad and print money, our financial problems aren’t pressing at the moment. But the combination of intractable deficit spending, unsustainable entitlement promises and a total dearth of responsible action in Washington certainly raises alarms regarding the future.”
That’s the short of it. But if you have a few minutes, Marks’ letter is definitely worth a read.
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