Financial analyst Howard Marks recently spoke with Professor Patrick Schotanus to discuss current market trends and the psychology behind them.

During downturns of the market such as the current one, many often wonder how to identify market cycles instead of falling victim to them.

In mid-June, Howard Marks, co-founder, and co-chairman of Oaktree Capital Management sat down with visiting professor of cognitive economics at the University of Edinburgh and lead developer of the Market Mind Hypothesis, Patrick Schotanus, to discuss the recent market conditions and the psychology behind those conditions.

Although it is difficult to pinpoint exactly why the market may go up or down on a specific day, Marks proposes variables that can help identify whether it is optimism or pessimism that currently undergirds the market.

Some variables to consider are: “do deals get sold out or do they languish? Are hedge fund managers welcome on TV or not? What is the media saying: ‘We’re going to the moon!’ or ‘We’re cratering forever.’”

According to Marks, investors that pay attention to such variables are more aware of where they stand in the cycle and where the market may go next. One thing to note about current conditions is that it is fairly obvious that investors are currently decidedly pessimistic.

In his description of the market’s life cycle, Marks compares the market to a pendulum that swings from one end to the other. Each end signifies a top or bottom in the market.

Marks’ metaphor of the market as a pendulum is meant to be interpreted more consistently with a swing than a mechanical pendulum with predictable variables of speed etc. The pendulum metaphor is not meant to be considered scientifically or predictably.

In his further description of the market as non-scientific and therefore non-mechanical, Marks quotes Yogi Berra, and states “[i]n theory there’s no difference between theory and practice, but in practice there is.” Meaning that the key is to reconcile the efficient market hypothesis with real-world considerations.

“Because of the concerted actions of so many investors, security prices are ‘right,’ meaning investors price securities so that you can expect a fair risk-adjusted return, no more, no less.”

That said, Marks claims the theory should work but does not in practice. Marks believes the truth lies somewhere in between this theory and its opposite since the theory fails due to the true psychology of investors as not solely rational and calculated as the theory poses.

Prices of assets reflect the public consensus at the time based on all the information known to the investors. However, these prices may not necessarily always be accurate because the market is subject to mass hysteria.

Marks explains that “[i]n the real world, things fluctuate between pretty good and not so hot. But in the markets, they go from flawless to hopeless.” It is the overreaction of investors that Marks describes that illustrates the flaw of the efficient market hypothesis,

Marks identifies two distinguishing features of superior investors: “[a] better comprehension . . . of the future;” and “a superior ability to process qualitative information.”

Marks goes on to explain market cycles and why they exist. He explains market cycles occur because of “excesses and corrections.” When investors consider prices to be too high, they over-correct in excess down passed the trendline. When investors believe prices are too low, they over-correct the price in excess the other way.

The excesses on both sides are a result of investors’ psychology – people either become too optimistic or too pessimistic. In this same manner, people become too credulous, then they become too skeptical.

One of the common effects of an overly pessimistic market – such as the current one – on investors is that investors become severely risk-averse. Marks explains that “it’s very important when you’re an investor to be a skeptic and not believe everything you hear.”

As a result of this well-known advice, investors often believe skepticism is only meant to deal with an overly optimistic market, not a pessimistic one. “But when it’s pessimism that’s excessive, being a skeptic means saying, ‘That’s too bad to be true.’” In other words, there must be “limits to negativism”.

Marks later makes the following point “[i]f everybody has all the same ‘readily available quantitative information with regard to the present,’ then being a superior investor has to be a matter of going beyond that.” By this, Marks emphasizes that virtually all investors have the same access to information.

Therefore, a superior investor must go beyond the readily available information to outperform other investors with the same information.

Marks elaborates on this point and explains that it seems there are two things that could set apart a superior investor: “[a] better comprehension . . . of the future;” and “a superior ability to process qualitative information.”

By “comprehension of the future” Marks refers to an individual’s ability to accurately predict where the future will lead and how the future will relate to those investments.

Regarding an “ability to process qualitative information”, Marks refers to a superior investor’s ability to interpret the mood of the market to determine whether conditions are ripe for buying opportunities or whether the optimism is excessive and therefore ripe for selling opportunities.

As an investor at the end of the day, it is important to remember that it is just as important to be a skeptic when the market is overly-optimistic as it is to be a skeptic when the market is overly pessimistic, as may very likely be the case currently. The goal of an investor should not be to follow the grain but to think critically about the future and the qualitative information gathered in any given market.