The Tide is turning

• As is common knowledge, market cycles of excesses and scarcity are created by the optimism (Greed) or pessimism (Fear) of market participants. Secret to making good investments lies in contrarianism rather than conformity. However, the key lies in being able to understand when the psychology of market participants has overshot in either direction vs the fundamental valuations rather than just a directional change. 

• Howard marks has set out a fantastic dumbed down framework for an average investor who may not have the time, ability and resources to understand exactly where we are in the market cycle. He calls it taking the ‘Temperature of the market’ and the analysis is driven solely by investor psychology and herd mentality of the market participants rather extensive data crunching. It incorporates simple qualitative aspects like state of economy, growth outlook, behavior of  lenders and capital markets, liquidity, risk premium etc

• He lays down characteristics of market cycles

Overheated market - Abundant liquidity, Aggressive and optimistic market participants, plentiful capital providers, liberal terms from Capital providers (Lenders as well as Investors), Narrow spreads, Asset owners wanting to hold on, few sellers in market, strong asset performance, high asset prices, low expectation of future risk.

Bearish market - Scarce liquidity, neurotic market participants, tough terms from capital   providers, widening spreads, asset owners are rushing to the door, few buyers in the market, recent asset performance has been bad, lowering asset prices and a high perception of future risk.

• Understanding this simple framework can enable an average retail investor to drown out the conflicting signals and noise being generated by market participants and deploy capital judiciously.

• Applying these principles can help us make some sense on current state of Indian markets.

o   Liquidity – Was abundant, starting to dry out. 

o   Market participants – Turning cautious from overtly enthusiastic. 

o   Terms from Capital providers – Expected to get tougher, days of 2 outlet dealer agencies raising capital might be a thing of past

o   Spreads – While interest rates are expected to go down, spreads and risk premium looks to be getting tighter

o   Asset owners in marginal quality appear to be rushing to the exit. Flight to quality seems to be returning. Explains the rut in mid and small caps, 'Media channel Pundits' starting to talk about safety and reasonable valuations of blue chip companies finally. 

o   Recent asset performance was very good, correction of valuations which had run ahead of earnings has started.

o   Discussion on risks (vis-à-vis valuations) is making a comeback.

• Basis the above, looks like the temperature of the market is changing and we may be correcting from unbridled enthusiasm to sensibility on valuations which may further stretch to participants shunning risk-on asset class completely having burned their hands.

• That may be the time to start turning contrarian and make the best use of your preserved dry powder. 

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