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Understanding the Stages
May Save Fall From Cliff,
Afford Chance of Lifetime
March 21, 2008; Page C3

Everyone knows about the anticipation leading up to Warren Buffett’s annual shareholder letters. But for a certain Wall Street set, there are equally high expectations for the writings of Howard Marks.

Mr. Marks is the chairman of Oaktree Capital Management, the low-profile but powerful Los Angeles firm that manages more than $50 billion in alternative investments.

He has been writing memos to clients since 1990, but a cult following developed after a missive he penned in January 2000 sounded a warning a few months before technology stocks imploded.

In his latest memo, “The Tide Goes Out,” he provides perspective on bull and bear markets:

Fortunately, one of the most valuable lessons of my career came in the early 1970s, when I learned about the three stages of a bull market:

The first, when a few forward-looking people begin to believe things will get better,

The second, when most investors realize improvement is actually under way, and

The third, when everyone’s sure things will get better forever.

Buying during the first stage can be highly profitable, while buying during the last will carry you over the cliff with the rest of the herd. Relatively few people were eager to buy at the depressed prices of 2002-03. But buying grew in 2004-05 as prices rose and bargains became scarcer, and the pace became fevered in 2006 and the first half of 2007.

To aid in your consideration of the future, I’ve formulated the converse of the above, the three stages of a bear market:

When just a few prudent investors recognize that despite the prevailing bullishness, things won’t always be rosy;

When most investors recognize things are deteriorating; and

When everyone’s convinced things can only get worse.

Certainly we are well into the second of these three stages. There’s been lots of bad news and write-offs. More people recognize the dangers inherent in things like innovation, leverage, derivatives, counterparty risk and mark-to-market accounting. And increasingly the problems seem insolvable.

One of these days, though, we will reach the third stage, and the herd will give up on there being a solution. And unless the financial world really does end, we’re likely to encounter the investment opportunities of a lifetime. Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.