Howard Marks, Chair­man, Oak­tree Cap­i­tal Man­age­ment, has recently pub­lished his lat­est memo The Lim­its to Neg­a­tivism, shar­ing his most recent per­spec­tive on the market. For a cer­tain strata of Wall Street denizens, Marks' writings are equally antic­i­pated to those of War­ren Buffett’s.

Marks is the chair­man of Oak­tree, the low-profile but pow­er­ful L.A-based firm that man­ages more than $50 bil­lion in alter­na­tive invest­ments, mostly in fixed-income strate­gies. He’s been writ­ing memos to clients since 1990, but a cult fol­low­ing devel­oped after a mis­sive he penned on Jan. 1, 2000 titled “bubble.com.” A few months before tech stocks imploded, Marks sounded a warn­ing. “To say tech­nol­ogy, Inter­net and telecom­mu­ni­ca­tions stocks are too high and about to decline is com­pa­ra­ble today to stand­ing in front of a freight train,” he wrote. “To say they have ben­e­fited from a boom of colos­sal pro­por­tions and should be exam­ined skep­ti­cally is some­thing I feel I owe you.”

Back on March 23, 2008 we pub­lished excerpts from Howard Marks memo, The Tide Goes Out. This most recent memo is a fas­ci­nat­ing read from one of the most impor­tant peo­ple in the mar­ket, and we feel that it is a must read. It is bro­ken out into sev­eral well defined sub­sec­tions, and we are sure that you will find it elo­quent and enlight­en­ing. Here are some excerpts from the memo of Octo­ber 15, 2008, The Lim­its to Neg­a­tivism.

The Swing of Psychology

The last few weeks wit­nessed the great­est panic I’ve ever seen, as mea­sured by its sever­ity, the range of assets affected, its world­wide scope and the neg­a­tiv­ity of the accom­pa­ny­ing tales of doom.  I’ve been through mar­ket crashes before, but none attrib­uted to the com­ing col­lapse of the world finan­cial system.

It's worth not­ing that few of the recent sharp price declines were asso­ci­ated with weak­ness in the depre­ci­at­ing assets or the com­pa­nies behind them. Rather, they were the result of mar­ket con­di­tions brought on by psy­chol­ogy, tech­ni­cal devel­op­ments and their inter­con­nec­tion. The worst of them reflected a spi­ral of declin­ing secu­rity prices, mark-to-market tests, cap­i­tal inad­e­quacy, mar­gin calls, forced sell­ing and failures.

For forty years I’ve seen the manic-depressive cycle of investor psy­chol­ogy swing crazily: between fear and greed – we all know the refrain – but also between opti­mism and pes­simism, and between credulity and skep­ti­cism.  In gen­eral, fol­low­ing the beliefs of the herd – and swing­ing with the pen­du­lum – will give you aver­age per­for­mance in the long run and can get you killed at the extremes.

The Black Swan

The mes­sage of The Black Swan is how impor­tant it is to real­ize that the things every­one rules out can still come to pass. That might be gen­er­al­ized into an under­stand­ing of the impor­tance of skepticism.

I'd define skep­ti­cism as not believ­ing what you're told or what "every­one" con­sid­ers true. In my opin­ion, it's one of the most impor­tant require­ments for suc­cess­ful invest­ing. If you believe the story every­one else believes, you'll do what they do. Usu­ally you'll buy at high prices and sell at lows. You'll fall for tales of the "sil­ver bul­let" capa­ble of deliv­er­ing high returns with­out risk. You'll buy what's been doing well and sell what's been doing poorly. And you'll suf­fer losses in crashes and miss out when things recover from bot­toms. In other words, you'll be a con­formist, not a mav­er­ick (an overused word these days); a fol­lower, not a contrarian.

Skep­ti­cism is what it takes to look behind a bal­ance sheet, the lat­est mir­a­cle of finan­cial engi­neer­ing or the can't-miss story. The idea being mar­keted by an invest­ment banker or bro­ker has been pret­tied up for pre­sen­ta­tion. And usu­ally it's been doing well, mak­ing the tale more cred­i­ble. Only a skep­tic can sep­a­rate the things that sound good and are from the things that sound good and aren't. The best investors I know exem­plify this trait. It's an absolute necessity.

Regard­ing Bear Markets

In "The Tide Goes Out" in March, I listed the stages of both bull and bear mar­kets. I said that in the ter­mi­nal third stage of a bull mar­ket, every­one is con­vinced things will get bet­ter for­ever. The folly of join­ing that con­sen­sus is obvi­ous; peo­ple who invest think­ing there'll never be any­thing to worry about are sure to get hurt.

In the third stage of a bear mar­ket, on the other hand, every­one agrees things can only get worse. The risk in that — in terms of oppor­tu­nity costs, or for­gone prof­its — is equally clear. There's no doubt in my mind that the bear mar­ket reached the third stage last week. That doesn't mean it can't decline fur­ther, or that a bull market's about to start. But it does mean the neg­a­tives are on the table, opti­mism is thor­oughly lack­ing, and the greater long-term risk prob­a­bly lies in not investing.

The excesses, mis­takes and fool­ish­ness of the 2003–2007 upward leg of the cycle were the great­est I've ever wit­nessed. So has been the result­ing panic. The dam­age that's been done to secu­rity prices may be enough to cor­rect for those excesses — or too much or too lit­tle. But cer­tainly it's a good time to pick among the rubble.

Marks often ends with a quote from War­ren Buf­fett, and often it’s the same one:

The less pru­dence with which oth­ers con­duct their affairs, the greater the pru­dence with which we should con­duct our own affairs.

Make sure you read the com­plete text. It is a must.

Thank you Mr. Marks.

Source: Howard Marks, Oak­tree, Octo­ber 15, 2008, The Lim­its to Negativism

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