Howard Marks on Market Psychology

It read like a personal note from a friend or colleague. It made reference to things I’ve talked about in past memos, like the sea change in interest rates and the pendulum of investor psychology, and it used them in metaphors related to AI. It argued logically, anticipated points I might make in response, injected humor, and bolstered its credibility by candidly acknowledging AI’s limitations, just as I might do. I’ve asked AI questions before and gotten answers back, but I’ve never received a personalized explanation like I did in this case. Understanding AI Before moving on to the meat of the matter – recent changes in AI and its capabilities – I want to share some insights into AI’s essence that the tutorial delivered for me. Importantly, the tutorial taught me not to think of an AI model as a search engine that retrieves data and regurgitates it. Rather, it’s a computer system that’s capable of synthesizing data and reasoning from it. There are two phases in the life of an AI model. In the first, it is “trained” by reading a vast amount of text. The training phase must not be thought of as loading the model with information, which I had done until now; it goes far beyond that. It consists of teaching the model how to think. By absorbing text, the model learns: • how to understand reasoning patterns and form them, • how arguments are structured, • how to generate new combinations of ideas, and • how to apply learned reasoning patterns to novel situations.

Now the analysis errs in the opposite direction, with excessive pessimism and skepticism replacing eagerness and gullibility, and with sheer terror replacing the blind faith that enabled investment when everything was going well. The implications of AI for the software industry, limitations on liquidity in private assets, and uncertainty regarding the accuracy of direct lending funds’ pricing have been there for years. But, simply put, people may not have asked enough questions or paid enough attention in the good times . . . as usual. This has led to the current discomfort of investors in direct lending vehicles. Individual investors in a new phenomenon like direct lending are unlikely to fully grasp its potential complications, especially if it has never been seen in action during tough times. The inclusion of leverage in the vehicles may have been touted as profit-enhancing, and now investors are seeing it at work in the opposite direction. And the investment vehicles’ limitations on liquidity – which may have been glossed over with a representation that “most of the time, you’ll probably be okay” – has come into play with surprising effect. True believers make the most money in manias, and skeptics lose the least when they crash. But the key to the investment success we aim for lies in always maintaining a healthy balance between belief and doubt.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: to be learned from 1929, along the lines of my favorite books about market excesses: A Short History of Financial Euphoria by John Kenneth Galbraith (1994) and Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor (2000). My take from 1929 was that three things in particular were primarily responsible for the bubble that ended in the Great Crash: • the sale of stock to the public without regard for suitability, • the provision of heavy leverage to the buyers, and • the mismatch between the illiquidity of the assets bought and the short-term nature of the loans that financed the purchases. Individual investors were lured into the stock market following an ascent that had gone on for years; the major stock market averages had already risen by roughly 400% between 1921 and 1928. Brokerage firms, hungry for commissions and markups on larger transactions, provided margin loans for up to 90% of the purchase price. And those loans could be called – and the positions sold out – if a decline wiped out the investor’s 10% equity and additional cash couldn’t be posted. The story sounds familiar (and has been repeated several times since): • A lack of financial sophistication on the part of individual investors leaves them susceptible to promotions and too-good-to-be-true promises.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: The Calculus of Value On July 28, I flew to South America on a plane without Wi-Fi, leaving me without email or entertainment. What was I to do but start in on a memo? Interestingly, the things I wrote during that flight turned out to be the answers to many of the questions I received from clients after I landed, so writing what follows served me well. I hope it’ll do the same for you. * * * January 2 of this year was the 25 th anniversary of my memo bubble.com, the one that put my writing on the map, and I marked the occasion by publishing another memo, called On Bubble Watch. While the title may have raised concern for readers, my main conclusion was that the elevated U.S. stock market valuations at the time didn’t necessarily signal the existence of a bubble, mainly because I didn’t detect the extreme investor psychology I associate with bubbles. Security prices were “lofty but not nutty” is how I put it. Because a lot has taken place in the seven months since then, it’s time for an update on asset values. Before I start, please note that I’m talking about investing in general. My specific reference will be to public U.S. corporate securities – stocks and bonds – since they mark to market regularly and are the assets that most enter my consciousness.

© 2025 Oaktree Capital Management, L.P All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Is It a Bubble? Ours is a remarkable moment in world history. A transformative technology is ascending, and its supporters claim it will forever change the world. To build it requires companies to invest a sum of money unlike anything in living memory. News reports are filled with widespread fears that America’s biggest corporations are propping up a bubble that will soon pop. During my visits to clients in Asia and the Middle East last month, I was often asked about the possibility of a bubble surrounding artificial intelligence, and my discussions gave rise to this memo. I want to start off with my usual caveats: I’m not active in the stock market; I merely watch it as the best barometer of investor psychology. I’m also no techie, and I don’t know any more about AI than most generalist investors. But I’ll do my best. One of the most interesting aspects of bubbles is their regularity, not in terms of timing, but rather the progression they follow. Something new and seemingly revolutionary appears and worms its way into people’s minds. It captures their imagination, and the excitement is overwhelming. The early participants enjoy huge gains. Those who merely look on feel incredible envy and regret and – motivated by the fear of continuing to miss out – pile in.

Second-level thinking in the spring of 2025 required asking not just whether the tariff news was bad, but what was already in the price. Markets had moved sharply in response to the announcement, but the move was based on the immediate read of the policy text rather than on the eventual implementation. The gap between announcement and implementation is the gap in which second-level thinking operates. The market's initial response to a shock is typically a price action that reflects forced selling, mechanical de-risking, and the closure of crowded positions. That first move is rarely the right move to extrapolate. The second move — once the policy detail becomes clear and the structural positioning has been adjusted — is the move that more accurately reflects the fundamental impact. Investors who react to the first move as if it were the final word tend to sell at the worst prices and buy back at the worst prices. The psychology of a sudden regime announcement is a textbook illustration of recency bias. The market prices the new regime as if it will persist indefinitely, then prices the reversal as if the original regime is gone for good. Both impulses are usually wrong. The investor who can hold both possibilities in mind — that the new regime may persist or that it may be reversed — is better positioned than the one who commits fully to either narrative.

But since investors’ actions toward one group of assets and the resulting price movements influence other assets and other markets – and since they ensue largely from investor psychology, which is highly contagious – I think my comments are probably applicable to other asset classes, to private assets as well as public ones, and possibly to markets outside the U.S. I’ll start by laying out where I think investment value comes from and how it should be assessed. I don’t think I’ve ever done this before in this form. It’s a big topic, but I’ll try to cover it briefly. Value Investment assets – things such as stocks, bonds, companies, and buildings – have a value, which is sometimes referred to as their “intrinsic value”: what the asset is “worth” at a point in time. This value is subjective. It can’t definitively be found anywhere – not even by AI, as far as I know – and opinions will differ as to what it is. In my parlance, the value of an asset is derived from its “fundamentals.” The fundamentals of a company, for example, encompass a great many things. These include its current earnings, its earning power in the future, the steadiness or variability of its future earnings, the market value of its component assets, the skill of management, its potential to develop new products, the competitive landscape, the strength of its balance sheet, and the myriad additional factors that will influence the company’s future.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The main job of an investment analyst – especially in the so-called “value” school to which I subscribe – is to (a) study companies and other assets and assess the level of and outlook for their intrinsic value and (b) make investment decisions on the basis of that value. Most of the change the analyst encounters in the short to medium term surrounds the asset’s price and its relationship to underlying value. That relationship, in turn, is essentially the result of investor psychology. Market bubbles aren’t caused directly by technological or financial developments. Rather, they result from the application of excessive optimism to those developments. As I wrote in my January memo On Bubble Watch, bubbles are temporary manias in which developments in those areas become the subject of what former U.S. Federal Reserve Chairman Alan Greenspan called “irrational exuberance.’’ Bubbles usually coalesce around new financial developments (e.g., the South Sea Company of the early 1700s or sub-prime residential mortgage-backed securities in 2005-06) or technological progress (optical fiber in the late 1990s and the internet in 1998-2000). Newness plays a huge part in this. Because there’s no history to restrain the imagination, the future can appear limitless for the new thing.

We saw a very strong reaction in this case: notably, the stock prices of some prominent alternative asset managers were down 5-7% on October 16, close on the heels of the regional banks’ disclosures. The truth is that there are always defaults and not infrequently defalcations (how’s that for a good old- fashioned word?) Over my 47 years in the high yield bond market, more than 2% of all bonds by value have defaulted in a typical year, and many more during crises. If you apply that percentage to the number of sub-investment grade issuers, which runs in the thousands, it shouldn’t come as a surprise if there are a few dozen defaults in a normal year. So no, I don’t think this is necessarily the beginning of a trend. It’s not an indictment of the whole sub- investment grade debt market, or the whole private credit market. Rather, it’s just a reminder that the yield spreads people care about so much are there for a reason: because sub-investment grade debt entails credit risk. And thus a reminder that credit skills are always a necessity for debt investors . . . even if the need for those skills isn’t apparent in good times. The Cycle in Attitudes Toward Risk In 2016, when I first sat down to write my book Mastering the Market Cycle: Getting the Odds on Your Side, I had an idea what topics I would cover – the economic cycle, the profit cycle, the cycle in investor psychology, the credit cycle, the distressed debt cycle, and the real estate cycle.

And futures that are perceived to be limitless can justify valuations that go well beyond past norms – leading to asset prices that aren’t justified on the basis of predictable earning power. The role of newness is well described in my favorite passage from a book that greatly influenced me, A Short History of Financial Euphoria by John Kenneth Galbraith. Galbraith wrote about what he called “the extreme brevity of the financial memory” and pointed out that in the financial markets, “past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” In other words, history can impose limits on awe regarding the present and imagination regarding the future. In the absence of history, on the other hand, all things seem possible. The key thing to note here is that the new thing understandably inspires great enthusiasm, but bubbles are what happen when the enthusiasm reaches irrational proportions. Who can identify the boundary of rationality? Who can say when an optimistic market has become a bubble? It’s just a matter of judgment. Something that occurred to me this past month is that two of my best “calls” came in 2000, when I cautioned about what was going on in the market for tech and internet stocks, and in 2005-07, when I cited the dearth of risk aversion and the resulting ease of doing crazy deals in the pre-Global Financial Crisis world.

” It’s also called a “risk premium,” which is what it is: the incremental return you’re offered to accept incremental default risk. Thus, it’s the equivalent of an insurance premium: what policyholders pay to get auto insurers to shoulder the risk that they’ll crash their cars. Yield spreads primarily fluctuate with trends in, and investor psychology regarding, defaults. When more companies are defaulting and investors expect elevated defaults in the future, they’ll demand more protection in the form of wider spreads. They’ll do so to a lesser degree when they’re optimistic about creditworthiness. Thus, the spread is a good barometer of investor psychology, or a “fear gauge.” It’s worth noting the obvious: the spread doesn’t tell you what the actual default rate will be, as some mistakenly say. It tells you what investors think the default rate will be. The thoughtful investor has to evaluate that expression of opinion against what the reality is likely to be and assess whether investors are being too optimistic or too pessimistic. Are Today’s Yield Spreads Adequate? This is the question of the day. Let’s say high yield bonds yield 8% and a Treasury note of the same maturity offers 5%, for a yield spread of 3%, or 300 basis points. Which is the better deal? It all depends on the likelihood of default.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The important inferences aren’t with regard to economic or corporate events. They involve investor psychology. It’s not a matter of what’s happening in the macro world; it’s how people view the developments. When few people think there can be improvement, security prices by definition don’t incorporate much optimism. But when everyone believes things can only get better forever, it can be hard to find anything that’s reasonably priced. Bubbles are marked by bubble thinking. Perhaps for working purposes we should say that bubbles and crashes are times when extreme events cause people to lose their objectivity and view the world through highly skewed psychology – either too positive or too negative. Here’s how Kindleberger put it in the first edition of Manias, Panics, and Crashes: . . . As firms or households see others making profits from speculative purchases and resales, they tend to follow. When the number of firms and households indulging in these practices grows larger, bringing in segments of the population that are normally aloof from such ventures, speculation for profit leads away from normal, rational behavior to what have been described as “manias” or “bubbles.” The word “mania” emphasizes the irrationality; “bubble” foreshadows the bursting. (Emphasis added) For me, it’s psychological extremeness that marks a bubble.

And sometimes the mood is negative and marked by pessimism, skepticism, fear of loss, and excessive risk aversion. Whereas in real life things fluctuate between pretty good and not so hot, in the minds of investors things can go from flawless to hopeless and back. When the majority of investors are optimistic, they cause price to rise and potentially exceed value. And when the pessimists reign, they cause price to decline and potentially fall short of value. Thus, a preponderance of investor psychology on one side or the other – in lieu of the rationality and objectivity on which the Efficient Market Hypothesis is predicated – can create the bargains or over-pricings the hypothesis says can’t exist. Investors should be on the lookout for them. The price of an asset means nothing in isolation. You can’t tell whether a car is good buy at $40,000 unless you know about the things that determine its market value: its make, model, age, mileage and condition. It’s the same in investing; what matters is the relationship between an asset’s price and its value. Investors call that relationship the asset’s “valuation.”

This is so because an asset’s price at any given point in time is mostly determined by investor psychology, which can be irrational and unpredictable. Thus, while the current relationship of price to underlying value should move in the expected direction, it can only be counted on to do so in the long run at best. “More likely to be” is the key phrase in the above paragraph. An undervalued asset can remain cheap – or even get cheaper – for a long time, just as an overvalued asset can become more overvalued, and then extremely overvalued, and then crazily overvalued. It’s the ability of price to go to crazy extremes that causes bubbles and crashes. If price always stopped going up when it began to exceed value, we wouldn’t have extended bull markets and bubbles (and the ensuing crashes), and vice versa. People who bet heavily that price will move in the direction of value – which we call “converging” – can be carried out if they don’t have sufficient staying power. That’s why John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.” It’s intellectually sound to expect price to move toward value rather than diverge further from it, and even to bet that it will happen, but it’s unwise and potentially dangerous to bet heavily that it’ll happen soon. As Benjamin Graham said, in the short run the market functions like a voting machine, reflecting assets’ popularity. But in the long run, it’s a weighing machine, assessing assets’ value.

For example: • An AI stock can be a risky holding for the manager of a mutual fund that’s priced daily and subject to daily withdrawals – or for an investor who’s likely to panic during a market crash and sell at the bottom – but much less so for a sovereign wealth fund where the money is unlikely to be withdrawn and there’s no requirement to publish financials and satisfy public opinion. • An investor whose compensation is based on metrics that penalize volatility may consider a publicly traded bond riskier than a private loan from the same issuer that doesn’t mark to market, even though the risk of default is the same for both. If it’s true that an asset’s volatility can bring risk for some investors but not others, then clearly the risk doesn’t lie in the investment, but in something in the investor’s environment. While I think the risk of permanent loss is the most important investment risk, I recognize that volatility can be a material real-world risk for some investors. My experience with the pension fund session reminded me that rapidly fluctuating portfolio values can require fluctuating contributions from pension plan sponsors.legitimate

Thus, we can think in terms of a “calculus of value” that I find entirely logical and almost mathematical . . . except for the fact that it’s applied by people who aren’t: • Value is what you get when you make an investment, and price is what you pay for it. • A good investment is one in which the price is right for what the value turns out to be. • Due to the volatile nature of investor psychology, asset prices fluctuate much more than fundamental value. • Thus, most price changes reflect changes in investor psychology rather than changes in fundamental value. • Because of the key role psychology plays in setting asset prices, in order to have a sense for where price stands relative to value, investors should try to gauge prevailing psychology, not just quantitative valuation parameters.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: it seems many people consider the non-marking to market a plus, in that they can report that their investments didn’t go down much in a difficult environment. Private credit managers are supposed to mark their holdings to reality based on fundamentals, but that’s clearly less volatile (and less objective) than marking to a market. On the other hand, is it desirable that public asset prices reflect every up and down of investor psychology? Not marking to market may be unrealistic, but it may be welcome. (Investors in public securities could have the same experience if they refused to read the newspapers and tossed their brokerage statements in the drawer, but such behavior would be called irresponsible.) • For me, the most important observation about private credit is that it mostly emerged since 2011 in response to banks’ reduced lending activity after the Global Financial Crisis. Since then, the economy has witnessed an unusually long string of years without a recession (if you don’t count the two-month Covid 19-related recession that flared up and was reversed in mid-2020). To paraphrase Warren Buffett, the tide has never gone out on private credit, meaning we haven’t had an opportunity to see its flaws.

fiscal deficits and national debt show no sign of improvement, and worldwide concern over them seems to be increasing. • Nevertheless, with the outlook possibly diminished on balance, U.S. stock prices are up. While earnings are expected to rise, stock prices are up more. Thus, regardless of where it stood as this year began, the value proposition in U.S. stocks seems to be less appealing today than it was at year-end – and even then, it wasn’t great. What are the indicators of investor behavior and the resulting price/value relationship? • The elevated p/e ratio on the S&P 500 is the tentpole of the argument that valuations are optimistic. • According to the Financial Times (July 25), “Stocks in the S&P 500 are now valued at more than 3.3 times their [companies’] sales, according to Bloomberg, an all-time high.” • From the same FT article, “A Barclays ‘equity-euphoria indicator,’ a composite of derivative flows, volatility and sentiment, has surged to twice its normal level, into territory associated with asset bubbles.” • Warren Buffett’s favorite indicator – the ratio of the aggregate market capitalization of U.S. stocks to U.S. GDP – is also at an all-time high. It’s especially worth noting that the U.S. market cap has been restrained by companies’ tendency to wait longer these days before going public and by the fact that many companies have been taken private in buyouts. Thus, this elevated indicator could be even more troubling than it appears.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: and some investment banks have expressed expectations that are similarly in the low to mid-single digits. Obviously, today’s expected returns on credit are considerably higher. On January 27, an article on the front page of The Wall Street Journal said the following: “Stocks haven’t looked this unattractive, by at least one measure, since the aftermath of the dot-com era.” This wasn’t a reference to the elevated p/e ratio, but to the fact that the yield on the 10-year U.S. Treasury note is higher than the “earnings yield” on the S&P 500 stock index. (The earnings yield is the ratio of earnings to price, the inverse of the p/e ratio.) This doesn’t prove that bonds are going to beat stocks in the years ahead, but it’s one more argument. And if Treasurys are poised to out-yield the S&P 500, high yield bonds will do so to an even greater extent (assuming credit losses don’t exceed the historical experience). As I’ve written in other memos recently, the current level of offered yields implies higher returns from credit than the S&P 500, with returns that are contractual and thus subject to much less variability and uncertainty. This is true despite the return contraction that has been brought on by the swing from pessimism to optimism over the last two years, and even given today’s narrow spreads.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Mr. Market Miscalculates In his book The Intelligent Investor, first published in 1949, Benjamin Graham, who was Warren Buffett’s teacher at Columbia Business School, introduced a fellow he called Mr. Market: Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. Of course, Graham intended Mr. Market as a metaphor for the market as a whole. Given Mr. Market’s inconsistent behavior, the prices he assigns to stocks each day can diverge – sometimes wildly – from their fair value. When he’s overenthusiastic, you can sell to him at prices that are intrinsically too high. And when he’s overly fearful, you can buy from him at prices that are fundamentally too low. Thus, his miscalculations provide profit opportunities to investors interested in taking advantage of them.

This was still very low by historical standards, but, according to the suddenly popular “Sahm Rule” (don’t complain to me; I’d never heard of it either), since 1970, an increase in the three-month average unemployment rate of 0.5 percentage points or more from the low of the prior 12 months has never occurred without the economy already being in recession. Around the same time, Warren Buffett’s Berkshire Hathaway announced that it had sold off a good part of its massive holding of Apple shares. In all, this news constituted a triple whammy. The resulting flip-flop from optimism to pessimism set off a significant stock market rout. The S&P 500 fell on three consecutive trading days – August 1, 2, and 5 – by a total of 6.1%. The replay of the mistakes I’ve witnessed for decades was so obvious that I can’t resist cataloging them below. What’s Behind the Market’s Volatility? On the first two days of August, I was in Brazil, where people often asked me to explain the sudden collapse. I referred them to my 2016 memo On the Couch. Its key observation was that in the real world, things fluctuate between ‘pretty good’ and ‘not so hot,’ but in investing, perception often swings from ‘flawless’ to ‘hopeless.’ That says about 80% of what you need to know on the subject. If reality changes so little, why do estimates of value (that’s what security prices are supposed to be) change so much? The answer has a lot to do with changes in mood.

I wrote over 33 years ago, in only my second memo: The mood swings of the securities markets resemble the movement of a pendulum. . . . between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.” (First Quarter Performance, April 1991) Mood swings do a lot to alter investors’ perception of events, causing prices to fluctuate madly. When prices collapse as they did at the start of this month, it’s not because conditions have suddenly become bad. Rather, they become perceived as bad. Several factors contribute to this process: • heightened awareness of things on one side of the emotional ledger, • a tendency to overlook things on the other side, and • similarly, a tendency to interpret things in a way that fits the prevailing narrative. © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Although we should bear in mind that, once in a while, a result will be outside the usual range, we tend to forget about the potential for outliers. And importantly, as illustrated by recent events, we rarely consider outcomes that have happened only once a century . . . or never. Cycles in the Use of Leverage In my second book, Mastering the Market Cycle: Getting the Odds on Your Side, one of the longest chapters, and probably the most important, is one I hadn’t planned when I first sat down to write: “The Cycle in Attitudes Toward Risk.” Investor psychology has a dominant influence on the market in the short run, and the attitudes that motivate investment decisions are often cyclical in nature, driving markets to irrational extremes and then correcting in the opposite direction . . . to the opposite extreme. Attitudes that govern the use of debt capital are examples of this cyclical process. When things have been going well for a while – asset prices have been rising, investment returns have been positive, and the use of leverage has paid off in the form of higher returns – investors view leverage as benign. As a result: • the favorable aspects of leverage become well-recognized, • the negative potential is overlooked, • investors become interested in employing more, • lenders become willing to provide more, and • regulations and mores governing the use of leverage tend to become more permissive. But when events turn negative, this process goes into reverse.

It’s he who said, “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” I find myself using this quote all the time. Another of my favorite Galbraith quotes is from his book A Short History of Financial Euphoria. In describing the reasons for “speculative euphoria and programmed collapse,” he discusses two factors “little noted in our time or in past times. One is the extreme brevity of the financial memory.” I often cite this factor, too. © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: speculation. Long periods of easy money, wrote Fullarton, engender “a wild spirit of speculation and adventure.” Fullarton noted that financial euphoria occurred after a period of falling interest rates: “From the Bubble year [i.e., the South Sea Bubble of 1720] downwards, I question much if an instance could be shown of any great or concurrent speculative movement on the part of capitalists, which had not been preceded by a marked decline of the current rate of interest.” (TPOT) The risk-free rate is the point of origin, or jumping-off point, for returns and risk premia. When a central bank cuts the risk-free rate: • the rest of the yield curve usually follows; • the capital market line governing asset-class returns also shifts downward, especially if the desire for higher returns in the low-return environment causes riskier investments to be aggressively pursued as described above; • in addition to moving lower, the capital market line also can flatten, reducing risk premia, if investors are paying little heed to fundamental/credit risk; and • the liquidity premium – the increment in expected return for owning illiquid rather than readily saleable assets – can also shrink, as return-seeking investors embrace illiquid investments. In all these ways, the return increments associated with longer-term, riskier, or less-liquid assets can become inadequate to fully compensate for the increase in risk.

For years, I quoted Buffett as having warned investors to temper their enthusiasm: “When investors lose track of the fact that corporate profits grow at 7% on average, they tend to get into trouble.” In other words, if corporate profit growth averages 7%, shouldn’t investors begin to worry if stocks appreciate by 20% a year for a while (as they did throughout the 1990s)? I thought it was such a good quote that I asked Buffett when he said it. Unfortunately, he answered that he hadn’t. But I still think it’s an important warning. That inaccurate recollection reminds me of John Kenneth Galbraith’s trenchant reference to one of the most important causes of financial euphoria: “the extreme brevity of the financial memory.” It’s this trait that allows optimistic investors to engage in aggressive behavior, untroubled by knowledge of what such behavior led to in the past. Further, it makes it easy for investors to forget past errors and invest blithely on the basis of the newest miraculous development. © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Finally, the investment world might be less unstable if there were immutable rules – like the one governing gravity – that could be counted on to always produce the same results. But there are no such rules, since markets aren’t built on natural laws, but rather the shifting sands of investor psychology. For example, there’s a long-running adage that says we should “buy on rumor and sell on news.” That is, the introduction of favorable expectations is a buy signal, because expectations often continue to rise. That ends when the news arrives, however, because the impetus for gains has been realized and no further good news remains to take the market higher. But in the carefree environment of a month ago, I told my partner Bruce Karsh that maybe the prevailing attitude had become “buy on rumor and buy on news.” In other words, investors were acting as though it was always a good time to buy. Rationally, one shouldn’t price in the possibility of a favorable event twice: both when the possibility of the event is introduced and when the event occurs. But euphoria can get the better of people. Another example of the absence of meaningful guidelines can be seen in this excerpt from one of the oldest clippings in my file: A continuing pattern of consolidation and group rotation suggests that increasing emphasis should be placed on buying stocks on relative weakness and selling them on relative strength.

(What Does the Market Know?, January 2016) The market fluctuates at the whim of its most volatile participants: those who are willing (a) to buy at a big premium to the former price when the news is good and enthusiasm is riding high and (b) to sell at a big discount from the former price when the news is bad and pessimism is rampant. Thus, as I wrote in On the Couch, every once in a while, the market needs a trip to the shrink. © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: It’s important to note that, as my partner John Frank points out, in comparison to the total number who own each company, it takes relatively few people to drive prices up during bubbles or down during crashes. When shares in a company that was worth $10 billion a month ago trade at prices implying a valuation of $12 billion or $8 billion, it doesn’t mean the whole company would change hands at these prices; just a tiny sliver. Regardless, a few emotional investors can move prices much more than should be the case. The worst thing you can do is join in when other investors go off on these irrational jags. It’s far better to watch with bemusement from the sidelines, buttressed by an understanding of how markets work. But better still to see Mr. Market’s overreactions for what they are and accommodate him, selling to him when he’s eager to buy regardless of how high the price is, and buying from him when he desperately wants out. Here’s how Ben Graham followed the introduction of Mr. Market that I included on page 1: If you are a prudent investor or a sensible businessman will you let Mr. Market’s daily communication determine your view of the value of your $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.

And this gives me a great opportunity to reference one of my favorite quotations from John Kenneth Galbraith’s wonderful book on market excesses: Contributing to and supporting this euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. . . . There can be few fields of human endeavor in which history counts for so little as in the world of finance. (A Short History of Financial Euphoria) The lessons from past periods of easy money usually fall on deaf ears since they come up against (a) ignorance of history, (b) the dream of profit, (c) the fear of missing out, and (d) the ability of cognitive dissonance to make people dismiss information that is inconsistent with their beliefs or perceived self-interest. These things are invariably enough to discourage prudence in times of low interest rates, despite the likely consequences. As you no doubt know, Charlie Munger passed away on November 28 at the age of 99. I want to pay a small tribute to Charlie’s life and wisdom by sharing something he wrote me in 2001: “Maybe we have a new version of Lord Acton’s law: easy money corrupts, and really easy money corrupts absolutely.” Will We Go Back to Easy Money? Before I turn to the above question, I want to answer the one I’m asked most often these days: “Are you saying interest rates are going to be higher for longer?

Importantly, Oaktree had essentially no involvement with subprime mortgages or mortgage-backed securities. Moreover, those assets were traded in a relatively remote corner of the investment world, and we had little appreciation for what was taking place there. In other words, our cautious conclusions weren’t reached on the basis of subject-matter expertise but rather on an unusually good example of what I call “taking the temperature of the market” (see pages 9-10). Late 2008 The world seemed relatively tranquil as September 2008 began, but then Lehman Brothers’ bankruptcy filing, mentioned above, took place mid-month. The markets promptly fell apart, based on an apocalyptic view that Lehman’s failure was part of a logical progression that had started when Bear Stearns ceased to exist as an independent entity and could eventually lead to a meltdown of the worldwide financial system. Complacency gave way to panic, and the Global Financial Crisis – in capital letters – was upon us. Anticipating that the reckless behavior we were witnessing (see the previous section) would ultimately create significant buying opportunities for our distressed debt strategy, Oaktree organized an $11 billion “reserve fund” for distressed debt between January 2007 and March 2008. The fund was created to give us capital to invest if things reached crisis proportions, which by mid-2008, they had not.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: been made, and risks to be borne that otherwise wouldn’t have been accepted. There’s no doubt that this is true in general, and I’m convinced it accurately describes the period in question. Many articles about the problems at Silicon Valley Bank and First Republic Bank cite errors that were made in the preceding “easy-money” period. Rapid growth, unwise inducements to customers, and lax financial management were all encouraged in a climate with accommodative Fed policy, uniformly positive expectations, and low levels of risk aversion. This is just one example of a time-worn adage in action: “The worst of loans are made in the best of times.” I don’t think the Fed should return us to an environment that has been distorted to encourage universal optimism, belief in the existence of a Fed put, and thus a dearth of prudence. If the declining and/or ultra-low interest rates of the easy-money period aren’t going to be the rule in the years ahead, numerous consequences seem probable: • economic growth may be slower; • profit margins may erode; • default rates may head higher; • asset appreciation may not be as reliable; • the cost of borrowing won’t trend downward consistently (though interest rates raised to fight inflation likely will be permitted to recede somewhat once inflation eases); • investor psychology may not be as uniformly positive; and • businesses may not find it as easy to obtain financing.

Because its predecessor fund had only just become fully invested, we started to slowly invest the reserve fund prior to Lehman’s bankruptcy. In the market panic that followed Lehman’s collapse, our first job was to figure out how best to proceed. Should we continue to invest the fund’s capital or hold it in reserve? Or should we step on the gas? Was this the bottom? How could we determine what lay ahead? There was no history of financial sector meltdowns to rely on and no informed way to approach these questions given the uniqueness of the circumstances and the many unknowns. With the future unknowable, we applied the only analytical framework we could think of (simplistic though it was): I think the outlook has to be viewed as binary: will the world end or won’t it? If you can’t say yes, you have to say no and act accordingly. In particular, saying it will end would lead to inaction, while saying it’s not going to will permit us to do the things that always have worked in the past. © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

We ran into very few people outside Oaktree who were putting money to work or willing to grant that we might be doing the right thing. I told a reporter friend we were buying, and he said – incredulously – “You are!?!” Around the same time, I met with the CIO of a client institution as part of our efforts to raise equity to delever a fund that was perilously close to receiving a margin call, and although I had good responses to all the increasingly negative scenarios she posited, we never got to a point where she would grant that “it can’t be that bad.” This demonstration of unbridled pessimism – which appeared to be widespread at the time – convinced me that little optimism was embodied in the prices of the assets we were buying and thus that there was little chance of losing money. Here’s how I put it in a memo I wrote that day: Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive. . . . In the third stage of a bear market . . . 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. (The Limits to Negativism, October 15, 2008) © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Importantly, our confidence in investing the reserve fund’s capital was enhanced by the fact that (a) we were buying the senior-most debt of high-quality companies that had been the subject of recent buyouts and (b) we were buying at prices so low that our debt holdings would do fine even if the companies ended up being worth only one-quarter or one-third of what the buyout funds had just paid for them. Episodes like the visit with the apprehensive CIO told me the post-Lehman temperature of the market was too low. There was too much fear and too little greed, too much pessimism and too little optimism, and too much risk aversion and too little risk tolerance. Negative possibilities were being accepted as fact. When these things are true, it stands to reason that (a) investor expectations are low; (b) asset prices probably aren’t excessive; (c) there’s little possibility of investors being disappointed; and (d) thus there’s little likelihood of lasting loss and a good chance prices will work their way higher. In other words, this was the epitome of a buying opportunity. March 2012 After the TMT bubble burst in mid-2000, the S&P 500 dropped in 2000, 2001, and 2002, the first three- year stretch of negative returns since 1939. These declines caused many investors to lose interest in equities.

Just a few years earlier, there had been widespread faith that stocks could never perform poorly for a meaningful period. Now, all of a sudden, such a time seemed to be at hand. Stocks delivered disillusionment, which can be one of the strongest forces in markets, and investors turned against them. During the first few years of the aughts, the lack of appetite for equities – and for bonds, given how low the Fed had driven yields – caused many investors to conclude they couldn’t earn their targeted returns through traditional asset classes. This, in turn, caused capital to flow to alternative investments, first hedge funds and then private equity. Soon investors were confronted by the Global Financial Crisis and the fear of financial-sector meltdown described above, which added to their negativity. These developments weighed heavily on investor psychology, and as a result, the S&P 500 was essentially flat from 2000 through 2011, returning an average of only 0.55% a year for the 12 years. This is how things stood in March 2012, when I wrote the memo Déjà Vu All Over Again. My inspiration arrived when, sleepless while on a business trip in Chile, I reached into my Oaktree bag for something to read and came up with an old article I had wanted to revisit because I was sensing parallels between the current environment and the one the article described. It was “The Death of Equities,” one of the most important magazine articles on investing of all time.

In other words, expected pre-tax yields from non-investment grade debt investments now approach or exceed the historical returns from equity. And, importantly, these are contractual returns. When I shifted from equities to bonds in 1978, I was struck by a major difference. With equities, the bulk of your return in the short or medium term depends on the behavior of the market. If Mr. Market’s in a good mood, as Ben Graham put it, your return will benefit, and vice versa. With credit instruments, on the other hand, your return comes overwhelmingly from the contract between you and the borrowers. You give a borrower money up front; they pay you interest every six months; and they give you your money back at the end. And, to greatly oversimplify, if the borrower doesn’t pay you as promised, you and the other creditors get ownership of the company via the bankruptcy process, a possibility that gives the borrower a lot of incentive to honor the contract. The credit investor isn’t dependent on the market for returns; if the market shuts down or becomes illiquid, the return for the long-term holder is unaffected. The difference between the sources of return on stocks and bonds is profound, something many investors may understand intellectually but not fully appreciate. It’s been years since prospective returns on credit were competitive with those on equities. Now it’s the case again. Should the non-profit whose board I sit on put all its money into credit instruments? Perhaps not.

Here’s how I built up to the conclusion cited above: It’s easy to say that something approaching panic is present in the markets. We’ve seen record percentage declines several times within the last month (exceeded since 1940 only by Black Monday – October 19, 1987 – when the S&P 500 declined by 20.4% in a day). This week and last included down days as follows: -7.6%, -9.5%, -12.0%, and -5.2% yesterday. These are enormous losses. . . . . . . there has been a rush to cash. Both long positions and short positions have been closed out – a sure sign of chaos and uncertainty. Cash in money market funds has © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Paralysis wasn’t called for, but rather steps that could help us take advantage of most investors’ panic and the resulting dramatic price declines. Sometimes it’s as simple as that. When the knee-jerk reaction of most investors is to stand pat or sell, a contrarian decision to buy might well be called for. Doing so is never easy, though, and mid-March 2020 was one of the most challenging environments I’ve ever worked through. But the key, as Rudyard Kipling wrote in the poem “If,” is to “keep your head when all about you are losing theirs. . .” How Can You Do It? I spent the preceding pages describing these five calls not for purposes of self-congratulation but rather to lay the groundwork for a discussion of how one can make useful observations regarding the status of the markets. Hopefully we learn from our experiences as we go through life. But to really learn from them, we have to step back on occasion, look at an entire string of events, and figure out the following: (a) what happened, (b) is there a pattern that has repeated, and (c) what are the lessons to be learned from the pattern? Once in a while – once or twice a decade, perhaps – markets go so high or so low that the argument for action is compelling and the probability of being right is high. As my son helped me to recognize, I had identified five of those, and they paid off. But what if I’d tried to make 50 market calls in my 50 years . . . or 500?

To do that, the essential inputs aren’t economic data or financial statement analysis. The key lies in understanding prevailing investor psychology. For me, the things one must do fall under the general heading of “taking the temperature of the market.” I’ll itemize the most essential components here: • Engage in pattern recognition. Study market history in order to better understand the implications of today’s events. Ironically, when viewed over the long term, investor psychology and thus market cycles – which seem flighty and unpredictable – fluctuate in ways that approach dependability (if you’re willing to overlook their highly variable causality, timing, and amplitude). • Understand that cycles stem from what I call “excesses and corrections” and that a strong movement in one direction is more likely to be followed – sooner or later – by a correction in the opposite direction than by a trend that “grows to the sky.” • Watch for moments when most people are so optimistic that they think things can only get better, an expression that usually serves to justify the dangerous view that “there’s no price too high.” Likewise, recognize when people are so depressed that they conclude things can only get worse, as this often means they think a sale at any price is a good sale. When the herd’s thinking is either Pollyannaish or apocalyptic, the odds increase that the current price level and direction are unsustainable.

I had only been in this business for about a decade at that point, so (a) I didn’t have the experience needed to recognize the article’s error and (b) I had yet to develop the unemotional stance and contrarian approach needed to depart from the herd and rebel against its thesis. The best I can say is that my eventual development of those attributes enabled me to catch the same error when it arose again 33 years later. Pattern recognition is an important part of what we do, but it seems to require time in the field – and some scars – rather than just book learning. On cycles: In my book Mastering the Market Cycle, I defined cycles not as a series of up and down movements, each of which regularly precedes the next – which I believe is the usual definition – but as a series of events, each of which causes the next. This causality holds the key to understanding cycles. In particular, I think economies, investor psychology, and thus markets eventually go too far in one direction or another – they become too positive or too negative – and afterward they eventually swing back toward moderation (and then usually toward excess in the opposite direction). Thus, in my opinion, these cycles are best understood as stemming from “excesses and corrections.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: aggressiveness and defensiveness, and we have done so successfully in the past. In fact, I consider one of my principal responsibilities to be thinking about the proper balance for Oaktree at any given time. If we’re happy to vary our risk posture, then what does it mean when we say, “we’re not market timers”? For me, it means the following: • We don’t sell things we consider attractive long-term holdings to raise cash in expectation of a market decline. We usually sell because (a) a holding has reached our target price, (b) the investment case has deteriorated, or (c) we’ve found something better. Our open-end portfolios are almost always fully invested; that way we avoid the risk of missing out on positive returns. It also means buying usually necessitates some selling. • We don’t say, “It’s cheap today, but it’ll be cheaper in six months, so we’ll wait.” If it’s cheap, we buy. If it gets cheaper and we conclude the thesis is still intact, we buy more. We’re much more afraid of missing a bargain-priced opportunity than we are of starting to buy a good thing too early. No one really knows whether something will get cheaper in the days and weeks ahead – that’s a matter of predicting investor psychology, which is somewhere between challenging and impossible. We feel we’re much more likely to correctly gauge the value of individual assets.

The question I am asked most often by readers of my memos is when to sell. The honest answer is that selling is harder than buying, and that the rules for selling are less well-defined than the rules for buying. The temptation to equate activity with adding value is strong, but the evidence that activity adds value is thin. Most investors sell for the wrong reasons. They sell because a position has gone up and they want to lock in the gain; they sell because a position has gone down and they want to stop the pain; they sell because they have found something else they prefer. Only the third of these is a sound reason, and even it requires that the alternative be meaningfully better, not marginally different. The case for holding is structurally underrated. When you own something you understand at a price you find attractive, the burden of proof should be on the case for change, not the case for stasis. Transaction costs, taxes, and the friction of redeployment all work against the active seller. The investor who turns over the portfolio constantly pays these costs without necessarily earning the returns that justify them.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: The Pendulum in International Affairs As regular readers of my memos and books know, I’m strongly interested in – you might say obsessed with – the concept of the pendulum. The following is only a partial list of my writings on the subject: • My second memo, written in April 1991, was creatively titled First Quarter Performance. It talked about the oscillation in securities markets between euphoria and depression; between celebrating positive developments and obsessing over negatives; and thus between overpriced and underpriced assets. • On Regulation, written in March 2011, discussed the outlook for rulemaking stemming from the Global Financial Crisis. I said future developments were likely to be driven by the long-term pendulum-like swing in attitudes on that subject. Over time, those attitudes tend to fluctuate between “the markets best serve the country when they’re unfettered by rules” to “we need the government to protect us from participants’ misbehavior.” • In The Role of Confidence, from August 2013, I discussed the way shifts in fundamentals are translated into market volatility by often-excessive swings in investor confidence. • And in my 2018 book, Mastering the Market Cycle, I interrupted my discussion of the various cycles – in the economy, corporate profits, credit availability, etc.

Contrarianism is widely misunderstood as simply doing the opposite of what the crowd is doing. That is a recipe for buying everything that is going down and selling everything that is going up, which is a way to lose money consistently. Real contrarianism is the discipline of identifying when the crowd has moved too far in one direction and acting on that view with conviction. The pendulum metaphor I have used throughout my career is meant to capture this. Market psychology swings between greed and fear, between risk tolerance and risk aversion, between optimism and pessimism. The pendulum rarely spends time at the midpoint; it tends to swing to one extreme, then to the other. The contrarian acts at the extremes — when the pendulum is at one end and the next move is back toward the middle, not further out. What makes this hard is that the pendulum can stay at the extreme for longer than the contrarian's patience or capital allows. The investor who is right about the extreme being an extreme but wrong about the timing can be carried out before the vindication arrives. The discipline required is to size positions so that the journey to vindication does not break the portfolio, and to maintain the conviction through the period when the market is still moving against the thesis.

– to use the metaphor of a pendulum, not a cycle, to describe the swings of investor psychology. Because psychology swings so often toward one extreme or the other – and spends relatively little time at the “happy medium” – I believe the pendulum is the best metaphor for understanding trends in anything affected by psychology . . . not just investing. People frequently ask what caused me to start writing memos in 1990. My very first memo, The Route to Performance, resulted from two events I witnessed in short order, the juxtaposition of which led to what I thought was an important observation. Over the years, many memos have been prompted by connections I sensed between ostensibly unconnected events. At a recent meeting of the Brookfield Asset Management board, a discussion of Ukraine triggered an association with another aspect of international affairs – offshoring – which I first discussed in the memo Economic Reality (May 2016). Thus the inspiration for this memo. Background The first item on the agenda for Brookfield’s board meeting was, naturally, the tragic situation in Ukraine. We talked about the many facets of the problem, ranging from human to economic to military to geopolitical. In my view, energy is one of the aspects worth pondering.

The psychology of selling is dominated by the fear of giving back gains and the fear of realizing losses. Both fears are present in every investor, and both fears lead to systematic errors. The investor who sells winners too early and holds losers too long is not making a series of independent mistakes; he is making the same mistake in two different forms — the mistake of letting tax and behavioral considerations override the underlying investment case. Second-level thinking on the sell side requires asking what the next owner of the asset will pay and why. If the answer is that the next owner will pay more because the consensus view is improving, the case for holding is strong. If the answer is that the next owner will pay more only because the price is rising, the case for selling into strength is strong. Distinguishing between these is the work. The simplest rule I can offer is to sell when the investment case has changed — when the price has risen to reflect the value you originally identified, when the fundamentals have deteriorated beyond what you underwrote, or when you have found a meaningfully better alternative. To sell for any other reason is to substitute activity for judgment, and activity is no substitute for judgment.

The psychology that produces extreme pendulum swings is itself fascinating. The same investors who were cautious at the bottom become aggressive at the top, and the same investors who were aggressive at the top become cautious at the bottom. The reason is that the recent past is the most salient evidence in any investor's mind, and the recent past at the top is gains, while the recent past at the bottom is losses. The temptation to extrapolate the recent past is the engine of the pendulum. The second-level thinker recognizes this pattern and uses it. At the top, when the consensus believes the recent gains will continue, the second-level thinker asks what is already in the price and what would have to be true for the gains to continue. At the bottom, when the consensus believes the recent losses will continue, the second-level thinker asks the same questions in reverse. The work is symmetric; the emotional discipline required is not. I beg to differ with the consensus not because I am smarter but because I have spent a career studying how consensus views form and dissolve. The consensus at any moment is the product of recent experience, and recent experience is not a sound basis for forecasting the future. The investor who can step outside the consensus frame and ask whether the consensus itself is built on solid assumptions has a structural edge. The edge is not in information; it is in the discipline of asking better questions.

Events are unpredictable; they can be altered by unpredictable influences; and investors’ reactions to the events that occur are unpredictable. Due to the presence of so much uncertainty, most investors are unable to improve their results by focusing on the short term. It’s clear from observation that security prices fluctuate much more than economic output or company profits. What accounts for this? It must be the fact that, in the short term, the ups and downs of prices are influenced far more by swings in investor psychology than by changes in companies’ long-term prospects. Because swings in psychology matter more in the near term than changes in fundamentals – and are so hard to predict – most short-term trading is a waste of time . . . or worse. What Doesn’t Matter: The Trading Mentality Over the years, my memos have often included some of my father’s jokes from the 1950s, based on my strong belief that humor often reflects truths about the human condition. Given its relevance here, I’m going to devote a bit of space to a joke I’ve shared before: © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

• The price declines generate further pessimism, and this process eventually causes prices to far understate the value of stocks (excess to the downside). • Resultant buying on the part of bargain-hunters causes the depressed prices to recover toward fair value (correction). The excess to the upside makes for a period of above average returns, and the swing toward excess on the downside makes for a period of below average returns. There can be many other factors at work, of course, but in my view, “excesses and corrections” covers most of the ground. We saw a number of excesses to the upside in 2020-21, and now we’re seeing corrections thereof. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Bull Market Psychology In a bull market, favorable developments lead to price rises and lift investor psychology. Positive psychology induces aggressive behavior. Aggressive behavior leads to higher prices. Rising prices encourage rosier psychology and further risk-taking. This upward spiral is the essence of a bull market. When it’s underway, it feels unstoppable. We saw a classic collapse of asset prices in the early days of the pandemic. For example, the S&P 500 reached a then-all-time high of 3,386 on February 19, 2020 before falling by one-third in just 34 days to a low of 2,237 on March 23. After that, a number of forces combined to produce massive price gains: • The Federal Reserve cut the fed funds rate to roughly zero, and the Fed was joined by the Treasury in announcing massive stimulative measures. • These actions convinced investors that these institutions would do whatever it took to stabilize the economy. • The interest rate cut significantly reduced the prospective returns required to make investments look attractive in relative terms. • The combination of these factors forced investors to bear risks they had been running from just a short time earlier. • Asset prices rose: by late August, the S&P 500 had retraced its decline and surpassed its February high.

Many of the buyers were what my late father-in-law used to call “handcuff volunteers”: they didn’t buy because they wanted to; they bought because they had to, since the return on cash was so low. And once markets started to rise, people were afraid of being left behind, so they chased prices higher. Thus, the market gains seemed to be the result of the Fed’s manipulation of the capital markets, rather than positive corporate developments or optimistic psychology. It was only around the end of 2020 – when the S&P 500 was up by 16.3% for the year and 67.9% from the March bottom – that investor psychology caught up with the booming stock prices. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

The essential ingredient in Oaktree’s investments in distressed debt – bargain purchases – has emanated from the great opportunities sellers gave us. Negativity reaches a crescendo during economic and market crises, causing many investors to become depressed or fearful and sell in panic. Results like those we target in distressed debt can only be achieved when holders sell to us at irrationally low prices. Superior investing consists largely of taking advantage of mistakes made by others. Clearly, selling things because they’re down is a mistake that can give the buyers great opportunities. When Should Investors Sell? If you shouldn’t sell things because they’re up, and you shouldn’t sell because they’re down, is it ever right to sell? As I previously mentioned, I described the discussions that took place while Andrew and his family lived with Nancy and me in 2020 in Something of Value. That experience truly was of great value – an unexpected silver lining to the pandemic. That memo evoked the strongest reaction from readers of any of my memos to date. This response was probably attributable to (a) the content, which mostly related to value investing; (b) the personal insights provided, and especially my confession regarding my need to grow with the times; or (c) the recreated conversation that I included as an appendix. The last of these went like this, in part: Howard: Hey, I see XYZ is up xx% this year and selling at a p/e ratio of xx.

History amply demonstrates that when (a) markets exhibit bullish behavior, (b) valuations become excessive, and (c) the latest thing is accepted without hesitation, the consequences are often very painful. Everyone knows – or should know – that parabolic stock market advances are generally followed by declines of 20-50%. Yet those advances occur and recur, abetted by what I learned in high school English class to call “the willing suspension of disbelief.” Here’s another of my very favorite quotes: Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

(John Kenneth Galbraith, A Short History of Financial Euphoria, 1990 – emphasis added) I’ve shared that quote with readers many times over the last 30 years – since I think it so beautifully sums up a number of important points – but I haven’t previously shared my explanation for the behavior it describes. I don’t think investors are actually forgetful. Rather, knowledge of history and the appropriateness of prudence sit on one side of the balance, and the dream of getting rich sits on the other. The latter always wins. Memory, prudence, realism, and risk aversion would only get in the way of that dream. For this reason, reasonable concerns are regularly dismissed when bull markets get going. What appears in their place is often intellectual justifications for valuations that exceed historical norms. On October 11, 1987, Anise Wallace described this phenomenon in an article in The New York Times titled “Why This Market Cycle Isn’t Different.” Optimistic thinking was being embraced at the time to justify unusually high stock prices, but Wallace said it wouldn’t hold: © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

The price of an asset is based on fundamentals and how people view those fundamentals. And a change in an asset price is based on the change in fundamentals and the change in how people view those fundamentals. So, facts and attitudes. Any research that could capture changes in attitudes, I think is important. Now, what about quantifying these animal spirits? In one of the more jocular portions of my first book, The Most Important Thing, I include something I called “the poor man’s guide to market assessment.” I have a list of things in one column, and I have a list of things in the other column, and whichever list is more descriptive of current conditions tells you whether it’s optimism or pessimism that’s governing the market. There are things like, do deals get sold out or do they languish? Are hedge fund managers being welcomed on TV or not? Who does the crowd form around at cocktail parties? What is the media saying: “We’re going to the moon” or “We’re cratering forever”? I don’t know how to quantify these things. But these are among the very important things that I listen to in order to figure out where we stand in the cycle. And I believe where we are in the cycle plays a very strong role in figuring out where we’ll go next. (In fact, take the title of my second book, Mastering the Market Cycle. When I was thinking © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The anticipated effect of that recession on earnings dampened investors’ spirits. Thus, the fall of the S&P 500 over the first nine months of 2022 rivaled the greatest full-year declines of the last century. (It has now recovered a fair bit.) • The expectation of a recession also increased the fear of rising debt defaults. • New security issuance became difficult. • Having committed to fund buyouts in a lower-interest-rate environment, banks found themselves with many billions of dollars of “hung” bridge loans unsaleable at par. These loans have saddled the banks with big losses. • These hung loans forced banks to reduce the amounts they could commit to new deals, making it harder for buyers to finance acquisitions. The progression of events described above caused pessimism to take over from optimism. The market characterized by easy money and upbeat borrowers and asset owners disappeared; now lenders and buyers held better cards. Credit investors became able to demand higher returns and better creditor protections. The list of candidates for distress – loans and bonds offering yield spreads of more than 1,000 basis points over Treasurys – grew from dozens to hundreds.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: 1% for defaults, you still get 25%.” So she said, “What if it’s worse than that?” I said, “The high yield bond universe default rate has been 4% a year, so you’re still getting 22% net.” She says, “What if it’s worse than that?” And I said, “The worst five years in our default experience is 7½%, and if that happens, you’re still getting 19%.” She says, “What if it’s worse than that?”, and I said, “The worst year in history is 13%. If that recurs every year for the next eight years, you’ll still make 13% a year.” She says, “What if it’s worse than that?” And I said, “Do you have any equities?” She said, “Yes, we have a lot of equities.” I said, “If we get a default rate on high yield bonds of more than 13% a year every year into the future, what happens to your equities in that environment?” I describe myself as having run back to my office after that meeting to write that memo, The Limits to Negativism. What I wrote there was that it’s very important when you’re an investor to be a skeptic and not believe everything you hear. And most people think being a skeptic consists of dealing with excessive optimism by saying, “That’s too good to be true.” But when it’s pessimism that’s excessive, being a skeptic means saying, “That’s too bad to be true.” That particular investor couldn’t imagine any scenario that couldn’t be exceeded on the downside.

So, in other words, for that person, there was no limit to negativism. And when I conclude that the other people in the market, the people setting the market prices, are excessively negative and excessively risk averse, then I – an inherently conservative person – and my partner, Bruce Karsh, who runs our distressed debt funds – also an inherently conservative person – we go crazy spending money when we conclude there’s excessive pessimism, fear, and risk aversion incorporated in asset prices [meaning they’re lower than they should be]. So it’s not just the mechanical aspects that determine market prices – it’s psychology. It’s mass hysteria, which comes in waves from time to time, that leads to market cycles that prove excessive. PS: Before I go to my next question, I’d like to come back to your point where you say it’s hard to quantify mood. But perhaps that’s exactly the problem: that we’re trying to capture it with analytical tools like Excel and MATHLAB. Or it is when, for example, you talk about, we need to measure the temperature of the market, and when we’re perceptive, we can gauge it. And it seems to me almost like when you’re trying to assess a mood in a restaurant, it’s a qualitative aspect.

” People who buy in stage one of a bull market, when prices are low because of prevailing pessimism (such as during the Global Financial Crisis of 2008-09 and in the early days of the Covid-19 pandemic in 2020), have the potential to earn high prospective returns with little risk: the main prerequisites are money to spend and the nerve to spend it. But when bull markets heat up and good returns encourage investors’ optimism, the traits that are rewarded are eagerness, credulousness, and risk-taking. In stage three of a bull market, new entrants buy aggressively, keeping it aloft for a while. Caution, selectivity, and discipline go out the window just when they’re needed most. Particularly noteworthy is the fact that investors who are in a good mood and being rewarded for risk tolerance typically cease to practice discernment regarding investment opportunities. Not only do investors consider it a certainty that some examples of “the new thing” will succeed, but eventually they conclude that everything in that sector will do well, so differentiating is unnecessary. Because of all the above, the term “bull market psychology” isn’t a positive. It connotes carefree behavior and a high level of risk tolerance, and investors should find it worrisome, not encouraging. As Warren Buffett puts it, “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

Nevertheless, even if it compounds at just 7%, $1 invested today will grow to over $29 in 50 years. Thus, someone entering adulthood today is practically guaranteed to be well fixed by the time they retire if they merely start investing promptly and avoid tampering with the process by trading. I like the way Bill Miller, one of the great investors of our time, put it in his 3Q 2021 Market Letter: In the post-war period the US stock market has gone up in around 70% of the years . . . Odds much less favorable than that have made casino owners very rich, yet most investors try to guess the 30% of the time stocks decline, or even worse spend time trying to surf, to no avail, the quarterly up and down waves in the market. Most of the returns in stocks are concentrated in sharp bursts beginning in periods of great pessimism or fear, as we saw most recently in the 2020 pandemic decline. We believe time, not timing, is the key to building wealth in the stock market. (October 18, 2021. Emphasis added) What are the “sharp bursts” Miller talks about? On April 11, 2019, The Motley Fool cited data from JP Morgan Asset Management’s 2019 Retirement Guide showing that in the 20-year period between 1999 and 2018, the annual return on the S&P 500 was 5.6%, but your return would only have been 2.0% if you had sat out the 10 best days (or roughly 0.4% of the trading days), and you wouldn’t have made any money at all if you had missed the 20 best days.

And some people perhaps have this innate ability, whereas others would perhaps be helped with different methodologies and different tools, and we can try to grasp mood better in that way, because, nowadays, people talk about market sentiment and try to capture it by looking at the VIX or put/call ratios or things like that, which I think you would disqualify as market mood. That’s not market mood. HM: Those things are indicators or symptomatic, but they don’t all move in the same direction at the same time. Sometimes A and B will go up, and C won’t. Sometimes A and C will go up, but B won’t. So, clearly, they’re not reliable indicators, and they also can’t be dealt with in a mechanical sense. But I wrote in one of my memos – I think it was Risk Revisited Again in 2015 – I said superior investors have a better sense for the shape of the probability distribution that will govern future stock price movements, and thus a better sense for whether the expected return justifies taking on the potential negative events that lurk in the left-hand tail. I think that’s it, and there’s nothing in there about measuring, Patrick, or anything mechanical. You know, I was locked up with my son for several months during the pandemic. He and his family moved in with us, so we had a lot of time for talking. He’s an optimist. (He would say © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

But I assure you Oaktree isn’t going to bet money on that belief. What we do know is that inflation and interest rates are higher today than they’ve been for 40 and 13 years, respectively. No one knows how long the items in the right-hand column above will continue to accurately describe the environment. They’ll be influenced by economic growth, inflation, and interest rates, as well as exogenous events, all of which are unpredictable. Regardless, I think things will generally be less rosy in the years immediately ahead: • A recession in the next 12-18 months appears to be a foregone conclusion among economists and investors. • That recession is likely to coincide with deterioration of corporate earnings and investor psychology. • Credit market conditions for new financings seem unlikely to soon become as accommodative as they were in recent years. • No one can foretell how high the debt default rate will rise or how long it’ll stay there. It’s worth noting in this context that the annual default rate on high yield bonds averaged 3.6% from 1978 through 2009, but an unusually low 2.1% under the “just-right” conditions that prevailed for the decade 2010-19. In fact, there was only one year in that decade in which defaults reached the historical average. • Lastly, there is a forecast I’m confident of: Interest rates aren’t about to decline by another 2,000 basis points from here.

And, as a consequence, if we look at a chain of discovery through the economic system – starting with a scientist having an insight, and then an inventor having an invention, and an entrepreneur making an innovation, eventually ending up in financial markets valuing this stuff – when things become more and more mechanical through the growth of these strategies – which include high frequency trading, trend-following, smart beta, which you mentioned, and of course passive investing – we run the risk that the separation between Mr. Market and the real economy just increases … that, in other words, this chain becomes more vulnerable and can break? HM: You know, Patrick, I think the flaw in passive investing lies in the fact that you have to view passive investing – things like indexation, especially – as kind of a hitchhiker, a free-rider on the market. In other words, there are 1,000 people out here doing active investing and distilling all the information and thinking about the future of the company and thinking about the fairness of the price, and the result is a market price. And, as I said before, that price is the best everybody collectively can do in trying to value the company and its future. And then there are ten people over there who run index funds, and they just buy at the market prices because they think those prices are probably fair, or the best you can do, so why go to all the trouble and expense of doing fundamental analysis?

Defaults affected a large dollar amount of high yield debt securities, but default rates came nowhere near the highs that had been predicted and soon began to recede. Highly motivated selling was short-lived – essentially limited to the month of March – and we never saw the full-throated panic (accompanied by margin calls, meltdowns and forced selling) witnessed in prior crises. In just a few months: © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: based on the manic-depressive ups and downs of a character Benjamin Graham called “Mr. Market.” On any given day, Mr. Market can be exuberant or despondent, and he quotes prices for securities based on how he feels. The value investor understands that – rather than informing us as to what a given asset’s value is – Mr. Market is there to serve us by offering up securities at prices, which can be meaningfully disconnected from the actual value of a stake or claim in the underlying business. In doing so, he sometimes gives us the opportunity to snatch up shares or bonds at a meaningful discount from their intrinsic value. This activity requires independent thought and a temperament that resists the emotional pull of the market cycle, making for decisions based solely on value. Thus, to me the essential underlying principles of value investing are these: • the understanding of securities as stakes in actual businesses, • the focus on true worth as opposed to price, • the use of fundamentals to calculate intrinsic value, • the recognition that attractive investments come when there is a wide divergence between the price at which something is offered in the market and the actual fundamental worth you’ve determined, and • the emotional discipline to act when such an opportunity is presented and not otherwise. Value vs.

This is very different from the experience of those whose parents were born a decade or two later than mine, never lived with deprivation, and may never have heard those words. These influences and experiences led me to adopt a value approach and the persona of a “bargain hunter,” which has served me well in my chosen field, which now has come to be called “credit.” Andrew has a considerably different mindset. Clearly, his early experience was very different from mine, not marked by anything like the Depression. He was bitten by the investment bug early, and from a young age investing dominated our conversations. While he deeply appreciates some elements of my philosophy – such as the importance of understanding investor psychology, focusing on fundamentals, and contrarianism – he has forged his own path and ended up in a very different place. His first phase was spent as a “Buffett nerd,” consuming everything written by the Oracle and adhering strongly to his philosophy. But over time, he has developed his own perspective and transitioned to investing primarily in technology and other growth-oriented companies. He spends the vast majority of his time managing a venture firm called TQ Ventures with his two partners, but he also steers our family’s “upside-oriented investments” with great results. (I, fittingly, handle our more conservative investments). © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Many of the great bonanzas for value investors have come in periods of panic following the bursting of bubbles, and this fact has probably led value investors to be very skeptical of market exuberance, especially when concerning companies whose assets are intangible. Skepticism is important for any investor; it’s always essential to challenge assumptions, avoid herd mentality and think independently. Skepticism keeps investors safe and helps them avoid things that are “too good to be true.” But I also think skepticism can lead to knee-jerk dismissiveness. While it’s important not to lose your skepticism, it’s also very important in this new world to be curious, look deeply into things and seek to truly understand them from the bottom up, rather than dismissing them out of hand. I worry that value investing can lead to the rote application of formulas and that, in times of great change, applying formulas that are based on past experience and models of the prior world can lead to massive error. John Templeton warned about the risk that’s created when people say, “it’s different this time,” but he also © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

What happens to parts of the country that are left out of the new economy? Finally, much of the worry about whether we’re in a bubble relates to valuations. For the S&P 500, for example, the current ratio of price to projected 2021 earnings is roughly 22 (depending on which earnings estimates you use). This seems expensive compared to the historic average in the range of 15- 16. But knee-jerk judgments based on the relationship between current valuations and historic averages are too simplistic to be dispositive. Before making a judgment about today’s valuation of the S&P 500, one must consider (a) the context in terms of interest rates, (b) the shift in its composition in favor of rapidly growing technology companies, with their higher valuations, (c) the valuations of the index’s individual components, including those tech companies, and (d) the outlook for the economy. With these factors in mind, I don’t think most of today’s asset valuations are crazy. Of course, a big correction in speculative stocks could have a negative impact on today’s bullish investor psychology. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

• Inflation stayed low in the 2010s despite records being set in terms of duration of the economic recovery, deficits and low unemployment. However, inflation’s ability to remain so is uncertain. • The temperature of the market is elevated, and there are signs of euphoria and risky behavior. • Valuations are high relative to history, as security prices have run ahead of economic gains. High multiples are justified by today’s low interest rates but dependent on continued low rates. • Risk compensation is skimpy, as seen in the premium valuations of favored companies and in historically narrow yield spreads on credit. • Washington poses a risk because of one party’s control and the anti-capitalist policies of its most progressive members. My hope is that the narrow majorities render radical legislation less likely. • As to exogenous risks, President Biden will pursue greater harmony, but tension with China and Iran and the racial and social divisions at home continue to cloud the outlook. * -- The earnings yield on a stock or stock index is the ratio of its earnings to its price. Thus it’s the e/p ratio: the inverse of the p/e ratio, or 1 divided by the p/e ratio. A forward-looking p/e ratio of 22 equates to an earnings yield of 1 ÷ 22, or 4.5%. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

I also believe, as outlined earlier, that certain types of value opportunities have largely evaporated and, save for times of market panic when things become dislocated, are unlikely to deliver the returns they did in the past. In short, there are arguments for a resurgence in value investing and arguments for its permanent impairment. But, I think this debate gives rise to a false and unhelpful narrative. The value investor of today should dig in with an open mind and a desire to deeply understand things, knowing that in the world we live in, there’s likely more to the story than what appears on the Bloomberg screen. The search for value in low-priced securities that are worth much more should be just one of many important tools in a toolbox, not a hammer constantly in search of a nail. It doesn’t make sense for value investors to bar investments simply because (a) they involve high-tech companies that are widely considered to have unusually bright futures, (b) their futures are distant and hard to quantify, and (c) their potential causes their securities to be assigned valuations that are high relative to the historic averages. The goal at the end of the day should be to figure out what all kinds of things are worth and buy them when they’re available for a lot less. * * * © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Which Way Now? In the last six weeks the markets have seen the best of times and the worst of times: • From February 19 to March 23, the U.S. stock market saw the quickest meltdown in history, for a loss of 33.9% on the S&P 500. Then its 17.5% gain from Tuesday through Thursday of last week made for the best three-day stretch since the 1930s. • Of the 21 trading days between February 27 and March 27, a total of 18 days saw moves in the S&P 500 of more than 2%: eleven down and seven up. They included the biggest daily percentage gain since 1933 and the second-biggest percentage loss since 1940 (exceeded only by Black Monday in 1987). • From March 9 through March 20, issuing a new investment grade bond seemed inconceivable. Then, as our trader Justin Quaglia points out, last week’s news of the government’s rescue package enabled 49 companies to issue $107 billion of IG bonds. That made it the biggest week for issuance on record; part of the biggest month on record ($213 billion from 106 issuers); and part of the biggest quarter on record ($473 billion, up 40% from the first quarter of 2019). In fact, there was more issuance last week than in nine of the 12 months in 2019. • Finally, on March 26, Justin wrote, “It’s hard to believe I used the words ‘panic’ and ‘FOMO’ within two weeks of each other.

Eventually, productive capacity exceeded what was needed, stock prices exceeded underlying value, and shaky investment innovations were embraced. When these trends outstripped the fundamentals and became unsustainable, the result was a downturn. Often a recession triggered a market correction, and sometimes the impact of that recession was reinforced by negative exogenous events that further darkened the previously-blue skies. A good example is the first non-investment grade debt crisis Bruce Karsh and I managed through, in 1990-91. There was a recession, exacerbated by the shock of going to war to help Kuwait repel an invasion by Iraq. The newly developed high yield bond market experienced its first major spate of defaults, the result of a recession and credit crunch and exacerbated by the prosecution of Michael Milken and the failure of Drexel Burnham, precluding remedial bond exchanges that otherwise might have helped companies stay alive. Stocks declined, but high yield bonds went into free-fall. Notably, many of the prominent LBOs of the 1980s – which had been financed with perhaps 95% or so of debt – went bankrupt. Investor psychology collapsed and bondholders headed for the exits. A collapsing economy needs a good dose of stimulus to pull it out of its swoon, and that’s what occurred. Usually that’s enough.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: famous for saying he likes hamburgers, and when hamburgers go on sale, he eats more hamburgers. My roughly quarterly memos pale when compared to the output of Doug Kass, who writes at least daily. His March 11 note had a terrific title: “When the Time Comes to Buy, You Won’t Want To.” The best time to buy generally comes when nobody else will; other people’s unwillingness to buy tends to make securities cheap. But the factors that render others averse to buying will affect you, too. The contrarian may push through those feelings and buy anyway, even though it’s not easy. As I put it, “All great investments begin in discomfort.” One thing we know is that there’s great discomfort today. Latest Update – to clients March 19, on website March 24 This memo was issued with the S&P 500 down 29% and within a few days of the low (down 34%) that would be reached on March 23. The panic we were observing, and the great purchases we made that week, convinced me to take a firmer tone in arguing for buying. I took the position that it would be a mistake to wait for an ascertainable bottom before doing so. What do we know? Not much other than the fact that asset prices are well down, asset holders’ ability to hold coolly is evaporating, and motivated selling is picking up. I’ll sum up my views simply – since there’s nothing sophisticated to say: • “The bottom” is the day before the recovery begins.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: matter of days. The speed with which COVID-19 events are unfolding is astonishing, but so is the speed of the Fed’s response to financial strains. The Fed is in “whatever it takes” mode. Fiscal authorities will likely follow suit (especially when next week’s unemployment claims reading is a multiple of the highest reading we have ever seen in the past). The ECB joined the parade tonight. All these are appropriate actions. Hopefully we’ll see benefits from them and more. The Fed and Treasury will do everything they think might help. Clearly there’s little interest in abstaining simply because expenditures will add to the national deficit and debt. However, it’s unfortunate that there was no appetite for refraining from stimulus and restocking the tool kit during the period of prosperity that prevailed in recent years. No one knows whether that failure will inhibit the monetary and fiscal response. But I wish (for example) that we were cutting short rates from 5.0%, not 1.5%. Market Behavior A few observations regarding the markets: It’s easy to say that something approaching panic is present in the markets. We’ve seen record percentage declines several times within the last month (exceeded since 1940 only by Black Monday – October 19, 1987 – when the S&P 500 declined by 20.4% in a day). This week and last included down days as follows: -7.6%, -9.5%, -12.0% and -5.2% yesterday. These are enormous losses.

(Hao Hong, BOCOM International, a subsidiary of Bank of Communications, March 1) While we are merely days into it, this stress episode is already among the most substantial of the last 25 years, joining an elite group that includes Asian Contagion (1997), LTCM (1998), the WTC attack (2001), the Accounting Scandals (2002), the Big One (2008-2009), the Flash Crash (2010), the Eurozone Crisis (2011), the China “re-peg” (2015) and the VIX event (2018). (Dean Curnutt, Macro Risk Advisors, March 1) There’s no doubt about the fact that the coronavirus represents a major problem, or that the reaction so far has been severe. What really matters is whether the price change is proportional to the worsening of fundamentals. For most people, the easy thing is to say that (a) the disease is dangerous, (b) it will have a negative impact on business, (c) it has kicked off a major reaction to date, and (d) we have no way of knowing how far the decline will go, so (e) we should sell to avoid further carnage. But none of the above means selling is necessarily the right thing to do. All these statements reflect a measure of pessimism. However, there’s no way to tell whether that pessimism is appropriate, inadequate or excessive. I wrote in On the Couch, (January 2016) that “in the real world, things generally fluctuate between ‘pretty good’ and ‘not so hot.’ But in the world of investing, perception often swings from ‘flawless’ to ‘hopeless.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: become excessive at the top (and vice versa on the downside). But in the current case, a moderate recovery – marked by reasonable growth, realistic expectations, an absence of corporate overexpansion and a lack of investor euphoria – was struck down by an unexpected meteor strike. People also ask what’s different about this episode from those I’ve lived through in the past. • As described above, the normal cyclical progression of ups and downs – and the normal series of events, each of which causes the next – had nothing to do with it. The current downturn didn’t result from excessively optimistic business decisions or too-high growth expectations that were disappointed, but rather from an exogenous event that brought a sudden end to the expansion. Thus the factors that result in and normally characterize a cyclical recovery – most of all the recognition that negativism is excessive and stimulative measures are required to turn things around – are unlikely to do the trick this time. Since the root cause of the current problem is medical rather than economic, merely cutting interest rates and flooding the economy with liquidity may not kickstart a recovery as usual. Rather, the virus has to be brought under control.

(Equity capital raised by a company in bankruptcy is extremely likely to end up going straight to the creditors, whose improbability of otherwise being paid gave rise to the bankruptcy filing in the first place.) Large numbers of call options have been bought in recent days, and it was reported that small investors accounted for much of the volume. Developments like these suggest the influence of speculative fever and the absence of careful analysis. • There’s a widely held theory that government benefit checks have been behind some of the retail investors’ purchases. And that makes sense: in the last three months, there’ve been no games for sports bettors to wager on, and the stock market was the only casino that was open. • Importantly, fundamentals and valuations appeared to be of limited relevance. The stock prices of beneficiaries of the virus – such as digital service providers and on-line merchants – approached “no-price-too-high” proportions. And the stocks of companies in negatively affected industries like travel, restaurants, time-sharing and casinos saw massive recoveries, even though their businesses remained shut down or barely functioning. Investors were likely attracted to the former by their positive stories and to the latter by their huge percentage declines and the resulting low absolute dollar prices. In all these ways, optimistic possibilities were given the benefit of the doubt, making the terms “melt-up” and “buying panic” seem applicable.

Imagine what an actual trading floor would have been like. It basically became “duck and cover” if you were a market maker, as their risk-taking abilities are being hindered by the C-suite. Beside immediate needs, investors sold to prepare for quarter-end redemptions, FX movements, and to fund margin calls. Short settlements were rampant, and larger blocks cleared in high-quality BB credits. Most people don’t even want to guess what the mark is on CCC risk. This ultimately ended up being the first real day of panic we have seen in a long time. We’re never happy to have the events that bring on chaos, and especially not the ones that are underway today. But it’s sentiment like Justin describes above that fuels the emotional selling that allows us to access the greatest bargains. Oaktree Asset Classes To give you an indication of what has happened to date in U.S. credit, I’m going to provide data on prices, yields and performance as of yesterday’s close. This information will be to be out of date by the time it reaches you, but hopefully it will still be useful. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Yes, there had been something approaching a selling panic between mid-February and late March in response to the pandemic, with the S&P 500 collapsing and the yields on high yield © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: As recounted above, the negative case encompasses rising numbers of infections and deaths, unbearable strain on the healthcare system, job losses in the many millions, widespread business losses and mounting defaults. If these things arise, investors are likely to shift from the optimism of last week to the pessimism that was prevalent in the rest of March. Contributing factors may include: o negative psychology surrounding the combination of threats to the economy and life itself, o fear of more, and o a very negative wealth effect that depresses spending and investing. The Government Programs Last week the government enacted the CARES (Coronavirus Aid, Relief, and Economic Security) Act, with roughly $2 trillion of rescue and support. At the same time, the Fed will spend several trillion more to provide liquidity and buttress the financial system, and it has “committed to using its full range of tools.” I will dispense with listing all the provisions of the CARES Act, and merely note that J.P. Morgan’s description runs to eight pages. And as mentioned above, the list of ingredients and their magnitude are likely to grow. I’ll share a useful description of the economic situation and the government response from Conrad DeQuadros of Brean Capital, an economist I’ve taken to quoting: The CARES Act should not be thought of as fiscal stimulus but as an economic stabilization package.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: times of prosperity. No one wants a recession, but using up our ammunition preemptively may not have been smart. The Fed/government’s tool for fighting the economic impact of coronavirus are very limited. Thus I believe it’s undesirable to be highly sanguine about their powers at this juncture. What to Do? These days, people have been asking me whether this is the time to buy. My answer is more nuanced: it’s probably a time to buy. There can be no unique time to buy that we can identify. The only thing we can be sure of today is that stock prices, for example, are a lot lower in the absolute than they were two weeks ago. Will stocks decline in the coming days, weeks and months? This is the wrong question to ask . . . primarily because it is entirely unanswerable. Since we don’t have answers to the questions about the virus listed on page two, there’s no way to decide intelligently what the markets will do. We know the market declined by 13% in seven trading days. There can be absolutely no basis on which to conclude that they’ll lose another 13% in the weeks ahead – or that they’ll rise by a like amount – since the answer will be determined largely by changes in investor psychology. (I say “largely” because it will also be influenced by developments regarding the virus . . .

The opportunities for losses will be that much greater. Treasury is backstopping losses, but the taxpayer risks here are greater than what the Fed took on in 2008-2009. The Fed may feel all of this is essential to protect the financial system’s plumbing and reduce systemic risk until the virus crisis passes, but make no mistake that the Fed is protecting Wall Street first. The goal seems to be to lift asset prices, as the Fed did after the financial panic, and hope that the wealth effect filters down to the rest of the economy. The bank bailout of 2008 has been roundly cited as a case of the government putting Wall Street ahead of Main Street, and it contributed significantly to the populism that has riven American politics ever since. This recent step to rescue leveraged lenders may add further fuel to that fire. * * * The market seems to have passed judgment with regard to the future. U.S. deaths have reached 23,000 and continue to rise. Weekly unemployment claims are running at 10 times the all-time record. The GDP decline in the current quarter is likely to be the worst in history. But people are cheered by the outlook for therapies and vaccines, and investors have concluded that the Fed/Treasury will reduce the pain and bring on a V-shaped recovery. There’s an old saying that “you can’t fight the Fed” – that is, the Fed can accomplish whatever it wants – and investors are buying it.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Negative economic and corporate developments, collapsing markets and rising fear caused a credit crunch in which financing became impossible to obtain. • The combination of economic weakness and the unavailability of financing led to vastly increased defaults and bankruptcies. • Asset prices cratered. • Companies and investment entities marked by asset/liability mismatches and/or high levels of leverage experienced margin calls and meltdowns. • The downward spiral seemed unstoppable. • Pessimism ran rampant, leading to soaring risk aversion. • This led to panic selling of assets and rendered most investors absolutely unwilling to buy. • Because of all the above, it was possible to purchase assets at prices from which extremely high returns could be achieved, often with low attendant risk. Now, contrast that with the events of 2020. In mid-February, developments regarding the coronavirus pandemic and the lockdown implemented to fight it began to hammer the markets. Prices for equities and credit fell, and the mood turned darkly negative. From the all-time high reached on February 19, the S&P 500 fell 34% in only 33 days. The prices of high yield bonds and leveraged loans were hard-hit as well. Security issuance stopped cold. The pieces were in place for a crisis just like those described above, and things were moving in that direction in March.

But as everyone knows, the Treasury and Fed announced rescue programs in mid-March and an enlarged Fed program during the week of March 23: zero interest rates, bond buying, grants, loans and significantly enhanced unemployment payments. The total ran to multiple trillions of dollars. And the authorities made it clear that there was more behind that: that the available resources were unlimited. • People accepted that the recession would end and a recovery take its place in short order. • With short-term interest rates near zero, investors lined up to buy bonds in the quest for return. Thus rather than a credit crunch, there’s been record amounts of capital available. • Even though the rescue provided “liquidity but not solvency,” whole industries (like the airlines) were saved from sure bankruptcy. • There were none of the spectacular implosions that mark most crises. • Ditto for panic selling. • Pessimism was replaced by willingness to think about better times ahead. • With interest rates at zero, investors couldn’t afford to be risk averse. They had to embrace risk assets in order to have a shot at returns above the low single digits. • Thus asset prices recovered. To illustrate the effect, since April 1, investors in distressed debt have had opportunities to make large rescue loans to companies or entities needing a quick response to problems related to illiquidity or pending debt maturities, and there’s still a good pipeline.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: and we had those things when most didn’t. Other investors’ lack of money and nerve in past crises made them great times for buying. Today, thanks to the Fed and Treasury, everyone’s got a lot of both. That makes things much tougher. But what happens if people exhaust the support payments they’ve received, Washington fails to deliver sufficient additional assistance, widespread layoffs ensue (as seems to be beginning) and business slows again? Mightn’t we see a rise in defaults and bankruptcies and a softening of investor psychology and thus asset prices? The Potential Downside of the Rescue Along with the sweep of the Covid-19 epidemic and the magnitude of the recession that resulted from combatting it, the size and success of the Fed/Treasury rescue effort is one of the big stories of 2020. In the Global Financial Crisis, it took the authorities months to figure out what to do and do it. But this year, they dusted off the 2008 playbook and implemented it in a couple of weeks. We’ve never seen an economic environment like the one brought on by the lockdown. Many industries (plus other entities and institutions) with zero activity and no revenues, but still high costs. And millions of people without jobs or incomes. There’s a belief (never documented) that a large part of the American population lacks resources with which to survive a $400 emergency. How would they survive months without paychecks?

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  The obvious one: central banks in Europe and Japan want rates to be negative to stimulate their economies. (They want to supply more stimulus than had been afforded by the reduction of rates to near-zero, since that level of stimulus didn’t prove up to the task.)  “. . . central banks around the world are racing to cut interest rates in an effort to stay ahead of the Fed and support their economies by weakening their currencies.” (The Wall Street Journal, August 12)  Ongoing quantitative easing – central banks’ bond purchases – is pushing up the price of longer-dated bonds, and thus pushing their yields down into negative territory.  Quantitative easing means the central banks flood the financial system with money that needs investing. Since borrowers don’t have much demand for long-term capital, they won’t pay to use it. Thus holders have to pay a small fee to store that money.  Fearful investors have little interest in making investments that represent bets on their countries’ economies and companies. They certainly don’t want to borrow for that purpose.  Current economic weakness reinforces investors’ pessimism. Fear of increasing weakness in the future strengthens their desire for safe storage.  There’s so much money in the system that the excess of supply over demand drives down the price of money – borrowing rates – into negative territory.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: economies and central banks. This means the task of managing an economy is difficult, and its goals shouldn’t be thought of as dependably achievable. I think a recent article from The Times provides a great picture of how challenging the job is, and how many ways there are to be wrong. Here’s most of it: Heading into their policy decision and news conference Wednesday [June 19], there were a lot of ways Federal Reserve officials could have messed things up. One possibility was a repeat of the meeting in December, when markets judged Chairman Jerome Powell and the Fed to be oblivious about negative forces building in the markets and in the global economy, and sold off precipitously over the next days. But the opposite risk was present as well — that out of fear of repeating the December episode, Mr. Powell would exhibit too much of a hair-trigger reaction to recent signs of a slowdown in inflation pressures and industrial activity. If those turn out to be false alarms, a rate cut now would be counterproductive by signaling pessimism and making the Fed look jittery and perhaps even overly influenced by President Trump’s threats to try to demote Mr. Powell over interest rate policy. . . . In effect, Fed officials are indicating they think it’s pretty likely they will need to cut rates, but are waiting for more evidence.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: this subject with differing degrees of confidence. Yet I remain certain that none of them “know.” If I had to take a guess – and that’s all it would be – I’d say interest rates won’t go negative in the U.S. in the current cycle. If we go back to the possible reasons for them listed on page four, I think we’ll conclude that the factors at play in the U.S. make negative rates less likely:  Stronger current economic growth  Better growth prospects  Thus no need for emergency measures  Higher inflation expectations (especially given the tightness of the labor supply)  Less pessimism  Better uses for long-term capital So I don’t think current conditions in the U.S. call for negative rates. But that doesn’t rule them out. When you express an opinion, the real question is whether you’ll bet on it and whether you’ll give odds. I might put up $60 to win $50 from you if negative rates don’t materialize. But that’s not a sign of much confidence on my part. In particular, I wonder about monetary stimulus. The U.S. fed funds rate is below 2% as I write, thanks to the two recent rate cuts (and there might be another cut on the way soon). Yet most stimulus programs have entailed rate cuts totaling several percent. So there’s every possibility that in the future, the Fed’s response to economic weakness could take rates into negative territory. And the current slowdown in U.S.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: U.S. companies have been holding abroad. The results will generally be very positive for corporate profits, cash flows and perhaps capital investment (see below).  The unemployment rate is down to 4.1%, nearly the lowest level in 60 years, meaning we’re nearing “full employment” (albeit with an unusually low percentage of adults participating in the workforce). With so little employment slack remaining, it seems reasonable to think near-term GDP growth will translate into wage gains, and thus back into further increases in demand.  Although low, today’s prospective returns are described as being reasonable in the context of low interest rates.  The low levels of inflation worldwide mean central bankers needn’t rush to raise interest rates to restrain it. There’s no obvious reason to predict hyperinflation.  Thus the near-term rise in interest rates – while probable – can be expected to be gradual and limited in scope.  Except in pockets, investor psychology can’t be described as euphoric and imprudent (although it has been strengthening of late). For years the markets have been “climbing a wall of worry,” an old-fashioned phrase used to describe a healthy ascent that’s occurring not because of euphoria and risk-obliviousness, but rather despite a catalog of perceived ills.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: * * * In memos and presentations over the last 14 months, I’ve made reference to some specific aspects of the investment environment. These have included:  the FAANG companies (Facebook, Amazon, Apple, Netflix and Google/Alphabet), whose stock prices incorporated lofty expectations for future growth;  corporate credit, where the amounts outstanding were increasing, debt ratios were rising, covenants were disappearing, and yield spreads were shrinking;  emerging market debt, where yields were below those on U.S. high yield bonds for only the third time in history;  SoftBank, which was organizing a $100 billion fund for technology investment;  private equity, which was able to raise more capital than at any other time in history; and  cryptocurrencies led by Bitcoin, which appreciated by 1,400% in 2017. I didn’t cite these things to criticize them or to blow the whistle on something amiss. Rather I did so because phenomena like these tell me the market is being driven by:  optimism,  trust in the future,  faith in investments and investment managers,  a low level of skepticism, and  risk tolerance, not risk aversion. In short, attributes like these don’t make for a positive climate for returns and safety. Assuming you have the requisite capital and nerve, the big and relatively easy money in investing is made when prices are low, pessimism is widespread and investors are fleeing from risk.

The basic themes supporting the “melt-up” theory include (a) the existence of the fundamental positives listed above and (b) the arrival of euphoric psychology, which has been absent to date. For me the key points regarding the general market outlook are as follows:  The absence of widespread euphoria certainly is an important flaw in any near-term bearish view.  Thus there’s no reason for confidence in the existence of a soon-to-burst bubble.  Investor psychology continues to grow more confident, however.  Asset prices are already unusually high.  Future events remain unpredictable, but today’s high prices mean the odds are against a significant long-term upward move from here.  No one can say what’s going to happen in the short term. Asset prices and valuation metrics are certainly worrisome, but psychology and its implications – as well as timing – are unpredictable. I think that’s about all we can know. Thus Oaktree will continue to invest on the basis of value and its relationship to price, and to refrain from trying to time markets based on predictions regarding economies, markets or psychology. The “melt-up” school says securities that already are highly priced may become more so. We’d never bet on whether they will or won’t. Our post-2011 mantra remains in force: we’re investing when we find reasonable propositions, albeit with caution.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Question number five: “Is there anything innately wrong with ETFs and their popularity?” ETFs are just another vehicle for buying stocks and bonds. They’re neither good nor bad per se. But there is a way in which I worry about ETFs’ impact, and it has to do with the expectations of the people who invest in them. My thinking goes back to the reason ETFs gained popularity in the first place: the ability to buy or sell them anytime the market is open. I’d bet a lot of the people who make use of ETFs do so for the simple reason that they think they’re “more liquid.” There are a couple of problems with this. First, as I wrote in “Liquidity” (March 2015), the fact that something is able to be sold legally, or the fact that there’s a market for it, can be very different from the fact that it can always be sold at a price that’s intrinsically fair or close to the last price at which it sold. If bad news or a downturn in investor psychology causes the market to drop, invariably there’ll be a price at which an ETF holder can sell, but it may not be a “good execution.” The price received may represent a discount from the value of the underlying assets, or it may be less than it would have been if the market were functioning on an even keel. If you withdraw from a mutual fund, you’ll get the price at which the underlying stocks or bonds closed that day, the net asset value or NAV.

The good news about quantitative investing is that it corrects many of the shortcomings of active management:  It can do much of what people do, generally without making “human mistakes.”  It can handle infinitely more data.  It excludes emotion; it never buys on euphoria or sells in panic.  It never forgets to rebalance: to sell the things that are expensive and buy the things that are cheap. Quantitative investing makes good use of the ability of computers to handle vast amounts of data and their freedom from human error. In short, I think computers can do more than the vast majority of investors, and do it better. Now for limitations. I think of quantitative investing as also a free-riding strategy: it profits from disequilibria caused by others. The supply of “nickels and dimes” is limited to the extent of those disequilibria, and thus only a limited amount of capital can be run this way to great advantage. There has to be a reason why the best quant firm – Renaissance Technologies – has returned all outside capital from its flagship Medallion Fund; if an investment approach is infinitely scalable, by definition it’s never economic to limit the capital under management. (Of course, all “alpha strategies” are based on taking advantage of the errors of others; thus the opportunities are limited to the scale of the errors – see “It’s All a Big Mistake” from June 20, 2012.)

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: I feel strongly that it’s possible to improve investment results by adjusting your positioning to fit the market, and Oaktree was able to do so by turning highly cautious in 2005-06 and highly aggressive in 1990-91, 2001-02 and immediately after the Lehman bankruptcy filing in 2008. This was done on the basis of reasoned judgments concerning: • how markets have been acting, • the level of valuations, • the ease of executing risky financings, • the status of investor psychology and behavior, • the presence of greed versus fear, and • where the markets stand in their usual cycle. Is this effort in conflict with the tenet of Oaktree’s investment philosophy that says macro-forecasting isn’t key to our investing? My answer is an emphatic “no.” Importantly, assessing these things only requires observations regarding the present, not a single forecast. As I say regularly, “We may not know where we’re going, but we sure as heck ought to know where we stand.” Observations regarding valuation and investor behavior can’t tell you what’ll happen tomorrow, but they say a lot about where we stand today, and thus about the odds that will govern the intermediate term. They can tell you whether to be more aggressive or more defensive; they just can’t be expected to always be correct, and certainly not correct right away.

Here’s what I wrote with respect to the difficulty of doing this in “On the Couch” (January 2016): I want to make it abundantly clear that when I call for caution in 2006-07, or active buying in late 2008, or renewed caution in 2012, or a somewhat more aggressive stance here in early 2016, I do it with considerable uncertainty. My conclusions are the result of my reasoning, applied with the benefit of my experience (and collaboration with my Oaktree colleagues), but I never consider them 100% likely to be correct, or even 80%. I think they’re right, of course, but I always make my recommendations with trepidation. When widespread euphoria and optimism cause asset prices to meaningfully exceed intrinsic values and normal valuation metrics, at some point we must take note and increase caution. And yet, invariably, the market will continue to march upward for a while to even greater excesses, making us look wrong. This is an inescapable consequence of trying to know where we stand and take appropriate action. But © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

The idea that you would do something different with a March expectation rather than a December expectation ignores the likelihood that the expectation of a March rate rise would begin to be reflected in asset prices well before March. That means the likely date of a rate rise is not a very useful piece of information. What could go wrong? – For years it has felt to most people that we’ve been in a Goldilocks environment: neither too hot nor too cold. The economy hasn’t grown slowly enough to cause recession or deflation, or fast enough to bring on hyperinflation and the need for restrictive action. The markets have been strong enough to bode well, but not so strong as to suggest a bubble. Ditto for investor psychology. Most people don’t want to tempt fate by saying things will go well forever, and in fact they know they won’t. It’s just that they can’t decide what it is that will go wrong. The truth is that while I can enumerate them, the obvious candidates (changes in oil prices, interest rates, exchange rates, etc.) are likely to already be anticipated and largely priced in. It’s the surprises no one can anticipate that would move markets most if they were to happen. But (a) most people can’t imagine them and (b) most of the time they don’t happen. That’s why they’re called surprises.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: First of all – admittedly I’m being picky here – people rarely specify which game they’re asking about. Is it the economic recovery, the credit expansion, the string of low-default years, the upswing in investor psychology, or the stock market rise? Certainly the answer could be different for each. But, more importantly, the question assumes we know how long each game will go on. A standard baseball game consists of nine innings, so “second inning,” “sixth” or “ninth” has a clear meaning. But with the things we’re wondering about here, we never know how long the game will run. So rather than “what inning,” I’d suggest investors ask whether things are or are not in an extended state. Is psychology depressed, average or euphoric? Is the capital market shut tight, normal or unthinkingly generous? These are questions that can be answered in a helpful way, not how close the game is to being over. No one knows the answer to the latter. What’s the outlook for country xyz? – The bottom line for me here is that people tend to confuse general intelligence, good investment records, expertise in specific areas, and all-around insight. Thus I’ll reiterate that I’m no economist (and even if I were, my chances of being right would be limited). And then I’ll add that being experienced as an investor and even hopefully intelligent says nothing about being able to divine a specific country’s macro potential.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: This is a very important point. If you believe the market has some special insight that exceeds the collective insight of its participants, then you and I have a fundamental disagreement. The thinking of the crowd isn’t synergistic. In my view, the investment IQ of the market isn’t any higher than the average IQ of the participants. And everyone who transacts gets a volume-weighted vote in setting an asset’s price at a given point in time. People of all different levels of ability act together to set the price. They vary all over the lot in terms of knowledge, experience, insight and emotionalism. The market doesn’t give the ones who are superior in these regards any more influence than the others, especially in the short run. My bottom line on this subject is that the market price merely reflects the average insight of the market participants. That’s point number one. If anything, I think it’s emotion that’s synergistic. It builds into herd behavior or mass hysteria. When 10,000 people panic, the emotion seems to snowball. People influence each other, and their emotions compound, so that the overall level of panic in the market can be higher than the panic of any participant in isolation. That’s something I’ll return to later. Now let’s think about the first goal of investing: to buy low.

We want to buy things whose price underestimates the value of the underlying assets or earnings (value investing) or the future potential (growth investing). In either case, we’re looking for instances when the market is wrong. If we thought the market was always right – the efficient market hypothesis – we wouldn’t spend our lives as active investors. Since we do, we’d better believe we know more than the consensus. So by definition we must not think the market – that is, the sum of all other investors – knows everything, or knows more than we do, or is always right. That’s point number two. And that leads logically to point number three: why take instruction from a group of people who know less than you do? In “On the Couch,” I wrote that it all seems obvious: investors rarely maintain objective, rational, neutral and stable positions. Do you agree with that or not? Is the market a clinical and rational fundamental analyst, or a barometer of investor sentiment? Does the market’s behavior these days look like something a mature adult should emulate? It seems clear to me: the market does not have above average insight, but it often is above average in emotionality. Thus we shouldn’t follow its dictates. In fact, contrarianism is built on the premise that we generally should do the opposite of what the crowd is doing, especially at the extremes, and I prefer it. A Case in Point – The Crash of 2008 The year 2008 culminated in the greatest panic I’ve ever seen.

Some compared it to the “China Syndrome”: a 1979 movie with Jane Fonda and Michael Douglas in which an out-of-control nuclear reaction threatens to propel reactor components through the earth’s core, from the U.S. to China. Thus the stock of panic-ridden Morgan Stanley (for example) fell 82%, to less than $10. But it’s important to note that the negative feedback loop described above was able to continue without reference to – and not necessarily in reasonable relationship to – actual developments at the banks or changes in their intrinsic value. Eventually, however, the Treasury restricted short selling in the stocks of 19 financial institutions deemed “systemically important.” Morgan Stanley secured a $9 billion injection of convertible equity from Mitsubishi UFJ Financial Group. The panic subsided. The economy and capital markets recovered. And Morgan Stanley’s stock traded at $33 a year later. Do you wish you had taken the market’s instruction in 2008 and sold bank stocks? Or do you wish you had rejected its advice and bought instead? In short, did the market know anything? There are three possible answers:  The market was flat wrong in 2008 when it took Morgan Stanley’s stock so low.  The market was right; it properly reflected the possibility of a meltdown that could have happened but didn’t.  The market was wrong in the case of Morgan Stanley in 2008, but most of the time it isn’t. I like the first, and the second is appealing as well.

The level of economic activity is determined by the nation’s productiveness. Central bank actions can encourage or accelerate economic activity, but they can’t create economic activity that otherwise wouldn’t occur. Much of what central banks do consists of making things happen today that otherwise would happen sometime in the future. It’s not clear that the effects are long-lasting or anything more than an acceleration of events within the confines of a zero-sum game. What is beneficial, however, as Professor Randall Kroszner of the Chicago Booth School of Business wrote me, is the fact that: [Central banks] can help to prevent a complete financial meltdown and the negative economy-wide externalities associated with a financial collapse. In these circumstances, and if done appropriately, their actions can do more than just move up future production to the present by helping to avoid economic activity losses due to a panic. In the old days, when cars often failed to start, there were fluids we could squirt into the carburetor to get them going. But they weren’t fuel for long-term operation. For example, lending people money can enable them to buy things today that they otherwise mightn’t have bought until later (if at all). If a consumer buys a boat today with money made available through a low-interest loan, that’s a boat he won’t buy next year.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In 2015 we saw old problems get worse, new ones arise, and a general absence of anything to feel good about. The sense of hopelessness regarding problems like ISIS and runaway immigration is something investors handle particularly poorly. In August, the events in China sparked a revival of risk aversion and fear, with effects that carried around the world for a couple of weeks. And with the door opened to fearful interpretation, Pollyanna tolerance gave way to widespread negativism. The bottom line is that investor psychology rarely gives equal weight to both favorable and unfavorable developments. Likewise, investors’ interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment. Most developments have both helpful and harmful aspects. But investors generally obsess about one or the other rather than consider both. And that recalls another classic cartoon: It all seems so obvious: investors rarely maintain objective, rational, neutral and stable positions. First they exhibit high levels of optimism, greed, risk tolerance and credulousness, and their resulting behavior causes asset prices to rise, potential returns to fall and risk to increase. But then, for some reason – perhaps the arrival of a tipping point – they switch to pessimism, fear, risk aversion and skepticism, and this causes asset prices to fall, prospective returns to rise and risk to decrease.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: All other things being equal, as something falls in price, you should want to own it more, not less. The buy-and-hold value investor is stalwart, ignoring price fluctuations. Even better, the contrarian moves opposite to the market, buying when the price falls and selling when it rises. Second, if not on the basis of fundamentals, how does one make the decision to sell for the third reason listed above? Essentially, two things give rise to changes in asset prices: changes in the outlook (macro or asset-specific) and changes in attitudes toward the asset. In other words, fundamentals and valuation. Fundamentals are dealt with above. If you’re going to try to benefit from changes in price that are unrelated to changes in fundamentals, you’re left having to predict investor psychology. If “On the Couch” wasn’t successful in convincing you this isn’t possible, this memo probably won’t be, either. My bottom line is that markets don’t assess intrinsic value from day to day, and certainly they don’t do a good job during crises. Thus market price movements don’t say much about fundamentals. Even in the best of times, when investors are driven by fundamentals rather than psychology, markets show what the participants think value is, rather than what value really is. Value is something the market doesn’t know any more about than the average investor.

And advice from the average investor obviously can’t help you be an above average investor. What Does a Falling Market Say About Psychology? Fundamentals – the outlook for an economy, company or asset – don’t change much from day to day. As a result, daily price changes are mostly about (a) changes in market psychology and thus (b) changes in who wants to own something or un-own something. These two statements become increasingly valid the more daily prices fluctuate. Big fluctuations show that psychology is changing radically. And, I said on page two, emotional fluctuations – swings in market sentiment or psychology – do seem to be synergistic. That is, in crowd psychology, 2 + 2 = 5. While I don’t think the price of an asset reflects more wisdom than is possessed by the average of its market’s members, I do believe mass psychology will make a group swing to reach greater emotional extremes than its members would separately. In short, people make each other crazy. And when times are bad – like now – they depress each other. That was a factor in the edge enjoyed by our distressed debt team in 2008: they were able to buy at the market’s lows because they weren’t in New York, where everyone was trading scary stories and getting each other down. Again, we can gain insight through logic. We all know we want to buy (not sell) at the lows, and sell (not buy) at the highs. So then how can it be right to sell because of a decline or buy because of a rise?

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: medium” and rather little in the range of reasonableness. First there’s denial, and then there’s capitulation. The Sources of Error To explain why these bipolar episodes occur, I want to spend a little time on some of the factors behind investor psychology. For the most part they’re easily observed and dissected, and not mysterious. I discussed some of them in “It’s Not Easy”: Emotion is one of the investor’s greatest enemies. Fear makes it hard to remain optimistic about holdings whose prices are plummeting, just as envy makes it hard to refrain from buying the appreciating assets that everyone else is enjoying owning. Confidence is one of the key emotions, and I attribute a lot of the market’s recent volatility to a swing from too much of it a short while ago to too little more recently. The swing may [result] from disillusionment: it’s particularly painful when investors recognize that they know far less than they had thought about how the world works. It’s important to remain moderate as to confidence, but instead it’s usually the case that confidence – like other emotions – swings radically. While China was the “proximate cause” of the recent volatility, other things often contribute, and last month was no exception. The word that always comes to mind for me is “confluence.” Investors can usually keep their heads in the face of one negative.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: financing,” now it’s hard for companies – especially those experiencing any degree of difficulty – to obtain capital. On December 7, Oaktree held a dinner in New York for equity analysts who follow our publicly traded units. Bob O’Leary, a co-portfolio manager of our distressed debt funds, planned to be among the hosts. But he called me on December 3 with a question I hadn’t heard in a long time from my distressed debt colleagues: “Would you mind if I don’t come? There’s too much going on for me to leave the office.” The change in investor attitudes had created investment opportunities where they hadn’t existed just a few months before – in some cases out of proportion to the change in fundamentals. Developments like these are indicative of rising pessimism, skepticism and fear. They’re largely what Oaktree hopes for, since – everything else being equal – they make for vastly improved buying opportunities. But note that we may be just in the early stages of a downward spiral in corporate performance and credit market behavior. Thus, while this may be “a time” to buy, I’m far from suggesting it’s “the time.” My Prescription To help investors deal with their potential for “human error,” this shrink would prescribe a number of elements that can help with the task:  The first essential element in coping with markets’ irrationality is understanding.

In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different. . . . For your performance to diverge from the norm, your expectations – and thus your portfolio – have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking. Second-level thinking is what immediately pops into my mind when I think about Charlie’s observation. And it’s a good general heading under which to discuss the great many things that make superior investing a challenge. In short, to borrow from Charlie, anyone who thinks it’s easy must be a first- level thinker. Let me use some simple examples from the book to illustrate the difference.  First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”  First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”  First-level thinking says, “I think the company’s earnings will fall; sell.

Like any other form of risk, it’s advantageous to bear illiquidity when the incremental return for doing so is high, but a bad idea when it’s not. And, needless to say, the liquidity premium is neither always there nor always generous. In my view, some endowments emulated Yale to excess in the years before the crisis, taking on too much illiquidity in the belief that (a) as ultra-long-term investors they could bear it and (b) they were sure to be well paid for doing so. But risk premiums arise from risk aversion, meaning they may not exist when investors are risk-tolerant. The willing acceptance of illiquidity in the early to mid-2000s caused the premium for bearing it to be inadequate, and investors who did so were penalized, not rewarded.  On the other hand, at the right time, investors can make tremendous amounts of money simply by being willing to supply liquidity (or accept illiquidity). When everyone else is selling in panic or © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

What this proves – about most things – is that to Dornbusch’s quote above we should append the words “. . . and they go much further than you thought they could.” The extent of the price decline seems much greater than the changes in supply and demand would call for. Perhaps to understand it you have to factor in (a) Saudi Arabia’s ceasing to balance supply and demand in the oil market by cutting production, after having done so for many years, and (b) a large contribution to the decline on the part of psychology. (In the “conspiracy theory” department, consider the rumor that Saudi Arabia is allowing or abetting the price drop in order to either punish Iran, Iraq and ISIL; put the U.S. shale oil industry out of business; or discipline the more profligate members of OPEC . . . take your pick.) The price of oil thus may have gone from too high (supported by OPEC and by Saudi Arabia in particular) to too low (depressed by negative psychology). It seems to me with regard to the latter that the price fell too far for some market participants to maintain their equanimity. I often imagine participants’ internal dialogues. At $110, I picture them saying, “I’ll buy like mad if it ever gets to $100.” Because of the way investor psychology works, at $90 they may say, “If it falls to $70, I’ll give serious thought to buying.” But at $60 the tendency is to say, “It’s a falling knife and there’s no way to know where it’ll stop; I wouldn’t touch it at any price.

” It feels much better to buy assets while they’re rising. But it’s usually smarter to buy after they’ve fallen for a while. Bottom line, as noted above: there’s little logic in investor psychology.  I said it about gold in All That Glitters (November 2010), and it’s equally relevant to oil: it’s hard to analytically put a price on an asset that doesn’t produce income. In principle, a non- perishable commodity won’t be priced below the variable production cost of the highest-cost producer whose output is needed to satisfy total demand. But in reality and in the short run, strange things can happen. It’s clear that today’s oil price is well below that standard. It’s hard to say what the right price is for a commodity like oil . . . and thus when the price is too high or too low. Was it too high at $100-plus, an unsustainable blip? History says no: it was there for 43 consecutive months through this past August. And if it wasn’t too high then, isn’t it laughably low today? The answer is that you just can’t say. Ditto for whether the response of the price of oil to the changes in fundamentals has been appropriate, excessive or insufficient. And if © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Here are a few:  the importance of risk and risk control  the repetitiveness of behavior patterns and mistakes  the role of cycles and pendulums  the volatility of credit market conditions  the brevity of financial memory  the errors of the herd  the importance of gauging investor psychology  the desirability of contrarianism and counter-cyclicality  the futility of macro forecasting Most or all of these have to do with behavior that’s observed in the markets over and over. When I see it recur and want to comment, I’m often tempted to dust off an old memo, update the details, and just insert the word “ditto.” But I don’t, because there’s usually something worth adding. Cycles One of the most important themes in investing – and one I often find worthy of discussion – relates to cycles. What is a cycle? Dictionaries define it as “a series of events that are regularly repeated in the same order” or “any complete round or series of occurrences that repeats or is repeated.” And here’s the definition of the term “business cycle”: “The recurring and fluctuating levels of economic activity that an economy experiences over a long period of time.” © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved.  Bad times cause the level of building activity to be low and the availability of capital for building to be constrained. Or, as we said in computer programming in the 1960s, “go to top” and begin again. This process is highly illustrative of the cyclical chain reaction I’m talking about. Each step in this progression doesn’t merely follow the one that preceded it; it is caused by the one that preceded it. Cycles and Risk This memo is devoted to the cycle in attitudes toward risk. Economies rise and fall quite moderately (think about it: a 5% drop in GDP is considered massive). Companies see their profits fluctuate considerably more, because of their operating and financial leverage. But market gyrations make the fluctuations in company profits look mild. Securities prices rise and fall much more than profits, introducing considerable investment risk. Why is that so? Primarily, I think, because of the dramatic ups and downs in investor psychology. The economic cycle is constrained in its fluctuations by the existence of long-term contracts and the fact that people will always eat, pay rent, buy gasoline, and engage in many other activities. The quantities involved will rise and fall, but not without limitation. Likewise for most companies: cost reductions can mitigate the impact of sales declines on earnings, and there’s often some base level below which sales are unlikely to go.

In other words, there are limits on these cycles. But there are no checks on the swings of investor psychology. At times investors get crazily bullish and can imagine no limits on prosperity, growth and appreciation. They assume trees will grow to the sky. Nothing’s too good to be true. And on other occasions, correspondingly, despondent investors can’t think of any limits to how bad things can get. People conclude that the “worst case” scenario they prepared for isn’t negative enough. Highly disastrous outcomes are considered plausible, even likely. Over the years, I’ve become convinced that fluctuations in investor attitudes toward risk contribute more to major market movements than anything else. I don’t expect this to ever change. The Source of Investment Risk Much (perhaps most) of the risk in investing comes not from the companies, institutions or securities involved. It comes from the behavior of investors. Back in the dark ages of investing, people connected investment safety with high-quality assets and risk with low-quality assets. Bonds were assumed to be safer than stocks. Stocks of leading companies were considered safer than stocks of lesser companies. Gilt-edge or investment grade bonds were considered safe and speculative grade bonds were considered risky. I’ll never forget Moody’s definition of a B-rated bond: “fails to possess the characteristics of a desirable investment.” All of these propositions were accepted at face value.

(The wild card, as described in “Ditto,” January 7, 2013, is that the actions of central banks to lower interest rates have caused even unconfident investors to engage in pro-risk behavior, setting the stage for the market declines of June and perhaps for additional pain in the future.) I’ve previously told the story of having been in New York on 9/11, and of requiring several days to get back to Los Angeles. When I eventually reached home, my son Andrew asked me, “Dad, is the world less safe than it used to be?” My answer was, “Maybe it’s less safe than it used to be, or maybe it was never as safe as everyone thought it was.” Certainly it’s healthier to recognize and accept uncertainty than to act as if the world is a safe place if it’s not. That goes double for the world of investing. The Pendulum in Confidence I probably write more about the pendulum of investor psychology than I do anything else. It was the subject of my second memo, in 1991, and my belief in its impact has grown unabated ever since. The pendulum swings with regard to many facets of the market, and it often swings to extremes:  between optimism and pessimism,  between greed and fear,  between euphoria and depression,  between credulousness and skepticism,  between risk tolerance and risk aversion, and thus  between reckless aggressiveness and excessive caution. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. when it was published on July 16, I changed the title to “It’s All Good.” In the memo I complained that every asset class, every asset and every region was appreciating. In terms of amplitude, breadth and potential ramifications, I consider it the strongest, most heated upswing I’ve witnessed. A lot of this is because people seem to think everything’s good and likely to stay that way. As I saw it, overconfident investors were ignoring the possibility of things going down as well as up, swallowing promises of limitless potential, suspending disbelief, accepting financial innovation as sure to work, and embracing the trend toward increased leverage. Of course, this house of cards fell apart in short order. Thus that memo was followed by “It’s All Good . . . Really?” two weeks later, on July 30, and then by “Now It’s All Bad?” on September 10. In just eight weeks, confidence had evaporated and been replaced by widespread pessimism. And just a year after that, we witnessed the bankruptcy of Lehman Brothers and the onset of the worst financial crisis in 80 years. What this reminds us is how dangerous the world can be when confidence is too high and people are too comfortable. Also, the speed with which things can reverse demonstrates, as my partner Sheldon Stone says, that the air goes out of the balloon much faster than it goes in.

© Oaktree Capital Management, L.P. All Rights Reserved.  When things are going well, investors swing to excessive euphoria, under the assumption that everything’s good and can only get better.  And when things are bad, they swing toward depression and panic, viewing everything negatively and assuming it can only get worse.  When the outlook is good and their mood is ebullient, investors take security prices to levels that greatly overstate the positives, from which a correction is inevitable.  And when the outlook is bad and they’re depressed, investors reduce prices to levels that overstate the negatives, from which great gains are possible and the risk of further declines is limited. The excessive nature of these swings in psychology – and thus security prices – dependably creates opportunities of over- and under-valuation. In bad times securities can often be bought at prices that understate their merits. And in good times securities can be sold at prices that overstate their potential. And yet, most people are impelled to buy euphorically when the cycle drives prices up and to sell in panic when it drives prices down. “Buy and hold” used to be a popular approach among investors, and it performed admirably when the markets rose almost non-stop from 1960 to 1972 and from 1982 to 1999. But thanks to the lackluster results of the last thirteen years, it has nearly disappeared.

© Oaktree Capital Management, L.P. All Rights Reserved. should. That’s bad for them. But if we’re not cognizant of the implications, it can also be bad for the rest of us. Where does investment risk come from? Not, in my view, primarily from companies, securities – pieces of paper – or institutions such as exchanges. No, in my view the greatest risk comes from prices that are too high relative to fundamentals. And how do prices get too high? Mainly because the actions of market participants take them there. Among the many pendulums that swing in the investments world – such as between fear and greed, and between depression and euphoria – one of the most important is the swing between risk aversion and risk tolerance. Risk aversion is the essential element in sane markets. People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they’ll (a) approach risky investments with caution and skepticism, (b) perform thorough due diligence, incorporating conservative assumptions, and (c) demand healthy incremental return as compensation for accepting incremental risk. This sort of behavior makes the market a relatively safe place. But when investors drop their risk aversion and become risk-tolerant instead, they turn bold and trusting, fail to do as much due diligence, base their analysis on aggressive assumptions, and forget to demand adequate risk premiums as a reward for bearing increased risk.

If the herd is doing the wrong thing, and if you’re capable of seeing that and doing the opposite, it’s still highly unlikely that the wisdom of what you do will become apparent immediately. Usually the crowd’s irrational euphoria will continue to take prices higher for a while – possibly a long while – or its excessive negativism © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

All that‟s required is another good year or two for stocks and a switch in investor psychology from “stocks are unlikely to do anything but extend the „lost decade‟ ” to “hey, I‟m afraid I might not be positioned adequately to participate in the next bull market.” A move upward can be powered by a switch from the fear of losing money to the fear of missing opportunity. When attitudes are moderate and allocations are low, it doesn’t take much. * * * In the mid-1970s I was fortunate to happen upon one of the first of the time-worn pearls of wisdom that contributed so much to my education as an investor. It described 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 underway, and the third, when everyone‟s sure things will get better forever. In “The Tide Goes Out,” written in March 2008, several months before the lows of the financial crisis, I applied the same thinking to the converse – the three stages of a bear market: the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won‟t always be rosy, the second, when most investors recognize things are deteriorating, and the third, when everyone‟s convinced things can only get worse. Hindsight always makes it clear what was going on at a particular point in time.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Memo to: Oaktree Clients From: Howard Marks Re: Déjà Vu All Over Again What good is history? After all, it‟s in the past. The truth is, history can be one of our greatest aids . . . in investing as in life. Here in the fifth decade of my investment career, I feel a lot of my ability to add value comes from the amount of history I‟ve witnessed and the significance I‟ve extracted from it. Regular readers know I often include time-tested quotations in my memos. Why wouldn‟t I? They‟ve endured precisely because they‟re so relevant and so well put. Why try to reinvent the wheel, rewriting them, only to come up short? On this subject, several stand out. I‟ve used them all before, some more than once: Those who cannot remember the past are condemned to repeat it. (George Santayana) The farther back you can look, the farther forward you are likely to see. (Winston Churchill) History doesn‟t repeat itself, but it does rhyme. (Mark Twain) Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again . . . they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery . . . .

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. performance. While we can’t know these things with certainty, specialized expertise can help us do a better job of assessing prospects and estimating intrinsic value.  We can try to find bargains and avoid overpriced securities. By applying a disciplined approach to security selection, a manager should be able to judge the relationship between the price of each security and its intrinsic value. This can’t be done flawlessly, of course, and at any rate the impact of this relationship on performance is often outweighed in the short run by trends in investor psychology and perception. Thus, like everything else, this won’t work every time. But on balance the superior manager should be able to assemble portfolios whose holdings have a higher collective probability of moving in the right direction.  We can limit risk. The risk in investing increases along with the degree to which the future is unknowable. Recognizing this, managers who acknowledge the limits on their foresight tend to incorporate a good measure of risk control in their portfolios. They try to make fewer investments whose success is heavily dependent on knowing what the future holds, thereby creating an increased margin of safety. This approach to investing shouldn’t be expected to maximize return – especially in good times – but rather to maximize risk-adjusted return. This is a mission-critical part of the investment manager’s job.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved.  The simplest signs surround valuation. What’s the yield spread between high yield bonds and Treasurys? And between single-B and triple-C? Where are the yields and premiums on convertibles? Are distressed senior loans selling at 60 cents on the dollar or 90? Is the S&P 500 selling at 30 times earnings or 12? These things tell us whether markets – and investor ardor – are overheated or ice cold.  We find nothing as terrifying as the ability to easily do dumb deals (see “The Race to the Bottom,” February 14, 2007). When large numbers of transactions occur that leave us shaking our heads, it’s a strong signal that the market is lacking in the risk aversion and skepticism that are needed to keep it safe and sane.  Equally worrisome is the presence of investor ebullience. When results are good and everyone’s certain that more of the same must lie ahead, the pendulum of investor psychology invariably swings to extremes of greed, optimism, confidence and credulousness – the raw material for bubbles and subsequent crashes. I constantly go back to Warren Buffett’s formulation: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”  It’s also troubling if aggressive investment vehicles are popular and over-subscribed. For the value-conscious investor, the seven scariest words in the world are “too much money chasing too few deals.

© Oaktree Capital Management, L.P. All Rights Reserved. entailed. Although there’s far less historic data, the same seems true of senior loans and mezzanine debt.  Real estate prices have corrected from the peak of 5-6 years ago and are largely back to the pre-bubble levels of a decade ago. Residential real estate prices are well down from the peak, and the same is true for commercial real estate in all but a half dozen first-tier cities. And why is this true? Because of the third factor: investor psychology that is much curtailed from pre-crisis levels. This is very healthy from a buyer’s point of view. The Psychological Environment These are uncertain times – there’s no doubt about it. The macro outlook is quite unclear, and the level of investor confidence is commensurately low. This reminds me of something that happened – in the larger, non-investment world – eleven years ago this week. I was in New York on 9/11, and I experienced the uncertainty, fear and confusion firsthand. When I finally got to California several days later, I sat down with my son Andrew, then fourteen years old, to make sure he was okay given what had transpired. He asked me, with his usual perceptiveness, “Dad, is the world less safe than it used to be?” The right answer came to me: “Maybe it’s less safe than it used to be . . . and maybe it was never as safe as people thought it was.

© Oaktree Capital Management, L.P. All Rights Reserved. On one hand, we face a lackluster general economic outlook and the threat of further negative developments that could be impactful but hopefully are not overwhelmingly likely. On the other, these worries may be offset to a degree by the lowness of asset prices and investor psychology. The former elements argue strongly against aggressive investing, but the latter – and the low promised returns on highly safe investments – argue that one’s investment program should include some forward movement. When I attended the University of Chicago it was very fashionable to use the qualifier ceteris paribus: “all other things being equal.” So I can flatly state that, ceteris paribus, an outlook characterized by slow growth, potential serious problems and great uncertainty should call for (a) more fixed income investments than equities, (b) more pursuit of value today than growth tomorrow and (c) more safe investments and less use of leverage. However – and it’s the biggest possible “however” – all else is far from equal today. Safe investments have been bid up, such that the returns available on them are paltry at best. If you buy the ten-year U.S. Treasury note today at 1.7%, it’s hard to imagine environments other than depression and deflation in which you’ll be happy with the outcome. So one of the more important conclusions is that this isn’t a black-and-white world in which it’s reasonable to insist on safety and eschew risk.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Memo to: Oaktree Clients From: Howard Marks Re: How Quickly They Forget In January 2004 I received a letter from Warren Buffett (how’s that for name dropping?) in which he wrote, “I’ve commented about junk bonds that last year’s weeds have become this year’s flowers. I liked them better when they were weeds.” Warren’s phrasings are always the clearest, catchiest and most on-target, and I thought this Buffettism captured the thought particularly well. Thus for Oaktree’s 2004 investor conference we used the phrase “Yesterday’s Weeds . . . Today’s Flowers” as the title of a slide depicting the snapback of high yield bonds. It showed the 45% average yield at which a sample of ten bonds could have been bought during the Enron-plus-telecom meltdown of 2002 and the 6% average yield at which they could have been sold in 2003; on average, the yields had fallen by 87% in just thirteen months. The idea went full- circle in 2005, when Warren used our slide at the Berkshire Hathaway annual meeting to illustrate how rapidly things can change in the world of investing. And that’s the point of this memo. Asset prices fluctuate much more than fundamentals. This happens because, rather than applying moderation and balancing greed against fear, euphoria against depression, and risk tolerance against risk aversion, investors tend to oscillate wildly between the extremes.

They apply optimism when things are going well in the world (elevating prices beyond reason) and pessimism when things are going poorly (depressing prices unreasonably). Shortness of memory plays a major part in abetting these swings. If investors remembered past bubbles and busts and their causes, and learned from them, the swings would moderate. But, in short, they don’t. And they may be forgetting again. High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful. The Importance – and Shortcomings – of Investment Memory A number of my favorite quotations are on the subject of history and memory, and I’ve used them all in past memos. Humorist and author Mark Twain talked about the relevance of the past: © Oaktree Capital Management, L.P.Reserved

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved History doesn’t repeat itself, but it does rhyme. The philosopher Santayana stressed the penalty for failing to attach sufficient importance to history: Those who cannot remember the past are condemned to repeat it. And economist John Kenneth Galbraith described the shabby way investors treat history and those who consider it important: Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. String together these three pearls of wisdom and you get a pretty accurate picture of investment reality. Past patterns tend to recur. If you ignore that fact, you’re likely to fall prey to those patterns rather than benefit from them.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. So S&P and Egan-Jones downgraded U.S. debt (while Moody’s and Fitch didn’t). There was one main moving part on August 5: that’s the day S&P labeled U.S. debt less safe. What was the upshot? A buying panic in U.S. Treasury securities, with the yield on the 10-year note falling below 2%. As an aside, let’s spend a minute thinking about that reaction. If there had been near unanimity about anything, it was that a downgrade would raise the yield demanded on U.S. debt. Certainly the fact that so many people could be wrong about this supposedly simple linkage should disabuse investors of the notion that they know how markets work. The expected reaction was much more logical than the one that actually played out: after it was labeled less safe, the yield demanded on U.S. debt declined markedly. I find the explanation fully worthy of Yogi Berra: the downgrade of Treasurys made people so worried about the elevated risk in the world that they ran to Treasurys for safety. So much for the supposed rationality of markets. The bottom line for me in all the above is that, while on an emotional basis I find the debt situation depressing, intellectually I believe U.S. Treasury obligations will prove money good. At bottom I agree with former Treasury secretary Hank Paulson: While the players in Washington certainly haven’t performed at AAA level, I would certainly take U.S. Treasuries over other AAA sovereigns any day.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved It’s easy to gauge bond investors’ attitudes. Here are the yield to maturity and yield spread versus Treasurys on the average high yield bond at a few points in the recent past and today: Yield to Spread vs. Maturity Treasurys “Normal” – December 31, 2003 8.2% 443 b.p. Bubble peak – June 30, 2007 7.6 242 Panic trough – December 31, 2008 19.6 1,773 Recovered – March 31, 2010 9.0 666 Shrinking again – April 30, 2011 7.5 492 The yield spread on the average high yield bond is still on the generous side relative to the 30-year norm of 350-550 basis points, a range of spreads that has given rise to excellent relative returns over that period. On the other hand, (a) spreads have fallen back to the normal range from the crisis-induced stratosphere and (b) the lowness of today’s interest rates means that reasonable spreads translate into promised returns that are low in the absolute. The story’s the same for many asset classes. I don’t mean to pick on high yield bonds. I use them here as my prime example only because of my familiarity with them and because their fixed-income status facilitates quantification of attitudes toward risk. In fact, high yield bonds still deliver above average risk compensation, and they remain the highest returning contractual instruments and excellent diversifiers versus high grade bonds.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved Much of the money that normally would be invested in the giant Treasury market simply couldn’t stay there because the yields were so low. Thus large amounts flowed toward smaller markets where they were quite capable of lifting prices. Nothing can reduce returns, worsen terms or raise risk faster than “too much money chasing too few deals.” It’s disproportionate flows of capital into a market that give rise to the disastrous race to the bottom such as we saw in 2005-07. Greater sums are provided to weaker borrowers at lower interest rates and with looser terms. Higher prices are paid for assets: first less of a discount from intrinsic value, then the full intrinsic value, and eventually premiums above intrinsic value. These processes account for many of the trends decried here. In addition, I would point out that the pain of the crisis was surprisingly short-lived. The real panic began on September 15, 2008, the day Lehman Brothers filed for bankruptcy. Until then, the world seemed to be coping and investors retained their equanimity. But Lehman, Fannie Mae, Freddie Mac, Merrill Lynch, Washington Mutual and AIG fell like dominoes in short order, and in the last fifteen weeks of 2008 people were paralyzed by fear of a global financial meltdown. And then things turned in the first quarter of 2009, primarily, I think, because people were coerced to move further out on the risk curve as described above.

 The worrisome elements gain sway over investor psychology, and the positives are forgotten.  Disillusionment replaces sanguineness: “How could I ever have put so much trust in the markets?”  Money flows out of the markets rather than in; it’s sellers who influence prices rather than buyers; and securities eventually move from dear toward cheap. Certainly some of these developments have taken place. Nobody waves a banner when assets have gotten cheap enough, but it’s incumbent on investors to recognize things like these and react appropriately, rather than follow the herd. Thus right now I would be a better buyer, albeit in moderation since fundamentals still pose threats. * * * © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Since then the markets have risen dramatically from their lows. In distressed debt, for example, the post-Lehman days and weeks were characterized by terror, uncertainty, forced selling, illiquidity and huge mark-to-market losses. But if you look back, you see that the panic and pain – and thus the greatest buying opportunity – really lasted only fifteen weeks, through the end of 2008. Prices continued downward in the first quarter of 2009, but without the deluge of supply brought on by the previous quarter’s forced selling. By April prices were headed up. So the lesson was painful but short-lived and, apparently, easily forgotten. As usual, the cyclical upswing is circular and self-reinforcing. It takes on the appearance of a virtuous cycle that will proceed non-stop, and it does so . . . until it fails. Here’s an example of the process at work:  The pursuit of return caused people to move from Treasurys to high yield bonds.  The revival of demand enabled companies to raise money.  The reopening of the capital markets made it possible for companies to do bond exchanges and refinancings: extending maturities, extinguishing covenants and capturing bond discounts, converting them into reduced amounts of debt outstanding. In some cases equity could be issued to delever balance sheets.  These remedial actions improved companies’ creditworthiness and brought down the default rate on high yield bonds from 10.8% in 2009 to a startling 1.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved  The resulting price appreciation produced profits for those who’d bought, turning investor psychology more rosy and producing envy – and thus a rush to join in – among those who had been slow to invest.  And the combination of these things convinced people that conditions had improved, making them still more willing to take on increased risk. I thought the lessons of 2007-08 had been etched into people’s psyches, and that the return to pro-risk behavior would therefore be slow. But clearly that hasn’t been the case. Prudent Behavior in a Low-Return World The 2005 memo I mentioned earlier, “There They Go Again,” proceeded from the discussion of the low and flat risk/return curve contained in “Risk and Return Today” to ponder what investors might do in times of low prospective returns and risk premiums. The possibilities fell into just a few categories:  Go to cash – not a real alternative for most investors.  Ignore the lowness of absolute returns and pursue the best relative returns.  Forget that elevated prices might imply a correction, and buy for the long run.  Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.

Memo to: Oaktree Clients From: Howard Marks Re: Warning Flags For about a year, I’ve been sharing my realization that there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can’t eliminate both. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasize the right one at the right time. Rather, at the extremes they usually obsess about the wrong one . . . and in so doing make the other the one deserving attention. During bull markets, when asset prices are elevated, there’s great risk of losing money. And in bear markets, when everything’s at rock bottom, the real risk consists of missing opportunity. Everyone knows these things. But bull markets develop for the simple reason that most people are buying – ignoring the risk of loss in order to keep from missing opportunity – just when elevated prices imply losses later. Likewise, markets reach their lows because most people are selling, trying to avoid further losses and ignoring the bargains that are everywhere. The Never-Ending Cycle Why do people buy when they should sell, and sell when they should buy? The answer’s simple: emotion takes over. Price increases excite investors and encourage them to buy, and price declines scare them into selling.

Memo to: Oaktree Clients From: Howard Marks Re: Open and Shut Mark Twain is described as having said, “History doesn’t repeat itself, but it does rhyme.” Thanks to the tendency of investors to forget lessons and repeat behavior, it sometimes seems there’s no longer a need for me to come up with new ideas for these memos. Rather, all I have to do is recycle components from previous memos, like a builder reusing elements from old houses. I’m willing to try an experiment along those lines for this memo. Here are my building blocks: From “First Quarter Performance,” April 11, 1991: The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. . . . This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at the “happy medium.” From “The Happy Medium,” July 21, 2004: The capital market oscillates between wide open and slammed shut. It creates the potential for eventual bargain investments when it provides capital to companies that shouldn’t get it, and it turns that potential into reality when it pulls the rug out from under those companies by refusing them further financing. It always has, and it always will. From “You Can’t Predict. You Can Prepare.

Ballyhoo took over from logic – excitement from value-consciousness – and these growth stocks’ prices reached 80 and 90 times earnings. The nifty-fifty stocks were tested – and found wanting – when the tide went out in the 1970s. Prosperity shifted to recession. The Arab oil embargo, a period of strong cost-push, and self- reinforcing cost-of-living adjustments created hyperinflation to which few people saw a chance for an end. Those growth stock p/e ratios went from 80 or 90 to 8 or 9. And stocks, Wall Street and the general economy went through a truly dreary decade, culminating in a BusinessWeek cover story entitled “The Death of Equities,” in August 1979. For evidence of the cyclicality of attitudes toward stocks, consider its final paragraph: Today, the old attitude of buying stocks as a cornerstone for one’s life savings and retirement has simply disappeared. Says a young U.S. executive: “Have you been to an American stockholders meeting lately? They’re all old fogies. The stock market is just not where the action is.” In the investment world, lows in sentiment usually coincide with lows in price, and the late Seventies were no exception. Because of the dreadful environment, you could buy an existing company in the stock market for less than it would cost to start one. I was fortunate to become a portfolio manager in mid-1978, and thus to benefit from the subsequent recovery of investor psychology from its nadir.

” For most investors, no assumption was too negative to be true, and no potential return made the risk of loss worth bearing. High yield bonds at 19% yields. First lien leveraged loans at 18%. Investment grade bonds at 11%. None of these was sufficient to induce risk-taking. As I wrote in “The Limits to Negativism” (October 15, 2008), “Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.” By the fourth quarter of 2008, risk aversion ruled and risk tolerance had disappeared. A skeptical view toward excessive pessimism was called for at a time of unprecedented low asset prices, but few people could muster it. The credit markets offered the highest returns in their history, but fear of losing money kept most investors from seizing the opportunity. In the middle of this decade we saw a manic period in which losses were unimaginable. The resultant shortages of risk aversion and skepticism caused investors to buy at highs and assume unprecedented risks in order to avoid missing opportunity. This was followed – as usual – by a collapse in which no negative event could be ruled out and no return was high enough to induce buying, all because investors wanted nothing other than to avoid losing money.

The results are well known: the first three-year decline for stocks since the Great Depression; a peak-to-trough decline of 51% for the S&P 500; massive losses for tech investors; shrunken 401-k accounts; and general disillusionment with stocks. Basically, I think equity investors had their hearts broken, as happens from time to time in the investment world. The promise of easy money turned out to be empty – as usual – and investors who had adopted overblown expectations promised “never again.” A good economy, low interest rates and resurgent general psychology brought stocks back between 2002 and 2007, but just to their 2000 peak. Versus the 11% prospective return they were sure of in 1999, by 2003 many investors expected only 6-7% from stocks (despite the fact that they were now much cheaper). With the bloom off the rose, people looked elsewhere – to private equity, real estate, hedge funds and mortgage backed securities, for example – for the next solution. I didn’t hear any investors say, “We don’t have enough stocks.” Their glory truly had faded. But having recovered to their previous high, stocks were buffeted again in the credit crisis. They fell 58% from their 2007 peak to their 2009 trough. Stocks weren’t singled out for punishment; non-government bonds, real estate, mortgage securities and private equity all shared the pain as panic and loss of confidence were everywhere. © Oaktree Capital Management, L.P.Reserved

greatest of our lifetimes – and to vast capital destruction. Structured and levered investment vehicles melted down, bringing unprecedented losses to those who had provided their capital, and forcing the sale of holdings regardless of price. Financial institutions flirted with potential insolvency, requiring their capital to be rebuilt via government programs. Money market funds and commercial paper had to be buoyed as well. Lehman Brothers went under. General Motors and Chrysler went bankrupt and required bailouts, and companies such as Fannie Mae, Freddie Mac, Merrill Lynch and Bear Stearns had to be supported or absorbed. All of this stemmed in large part from the too-easy availability of capital and from market participants’ irresponsible behavior in the middle of the decade. The result was a massive flight to quality and widespread refusal to take risk. In 2009, miraculously in my opinion, the responses of governments caused investor psychology to turn positive, and the pursuit of return caused risk tolerance to be restored. Risk capital became available again, enabling financial institutions to raise equity capital and highly indebted companies to access the capital markets, extending maturities and capturing the discounts on their debt. As a result – thanks to the rise in risk appetites – many markets showed their greatest gains ever.

With the panic now gone, stocks have recovered, but only about half their 2007-09 losses. The S&P 500 stands at a level that was first reached in 1998, meaning over the last twelve years, the average stockholder’s paltry return of less than a percent a year came entirely from dividends. People talk about the “lost decade in equities,” and still no one seems to feel he owns too few stocks. A Brief History of Bonds The recent history of bonds requires less telling. Bonds were the bedrock of investment portfolios in the first half of the last century. Along with Treasurys, utilities and corporates, business was brisk in railroad and streetcar bonds. Graham and Dodd’s classic, Security Analysis, devoted more than 200 pages to “fixed-value investments” including preferred stock, of which next to nothing is heard today. The story of bonds in the last sixty years is the mirror opposite of what happened to stocks. First bonds wilted as stocks monopolized the spotlight in the 1950s and ’60s, and at the end of 1969, First National City Bank’s weekly summary of bond data died with the heading “The Last Issue” boxed in black. Bonds were decimated in the high-interest-rate environment of the ’70s, and even though interest rates declined steadily during the ’80s and ’90s, bonds didn’t have a prayer of standing up to equities’ dramatic gains. By the time the late 1990s rolled around, any investment in bonds rather than stocks felt like an anchor restraining performance.

June 30 to June 30 2007-08 2008-09 2009-10 three years 10-year Treasury bond 12.6% 7.3% 8.3% 30.8% Barclay’s Govt/Credit 7.2 5.3 9.7 23.8 Citi High Yield Index -0.5 -4.2 24.7 18.8 S&P 500 -13.1 -26.2 14.4 -26.6 MS EAFE Index -22.5 -26.1 7.1 -38.7 MS Emerging Markets 2.6 -30.0 20.6 -13.4 Clearly, the recent performance edge of bonds over stocks has been dramatic. What’s Going On Today? Now, suddenly, investors seem to have awakened to bonds’ attractions. This after failing to do so in time for the crisis, when holding bonds would have been of great value. Is this just another case of investors driving while looking in the rearview mirror? And are they shifting from stocks to bonds at just the wrong time? The headlines are dramatic and the facts are clear. In just the last few weeks, we’ve seen newspaper stories like these: “Investors Fleeing Stocks with Cash Flow Lure JP Morgan” (Bloomberg, August 16), “Treasury Bears Cave as Bond Yields Keep Tumbling” (The Wall Street Journal, August 16), and “Growing Concern over Bond Bubble” (Financial Times, August 21). Bloomberg reported as follows: About $33 billion flowed out of funds owning U.S. shares this year . . . About $185 billion was sent to bond funds through July 31, the most on record, according to the Investment Company Institute. These statistics relate to mutual funds and their retail investors. While not necessarily the same for institutions, they are indicative of trends in investor psychology.

Renewed economic uncertainty is testing American’s generation-long love affair with the stock market. . . . Small investors are “losing their appetite for risk.” . . . “Like everyone else, I lost” during the recent market declines [an individual investor] said. I needed to have a more conservative allocation.” . . . Investors pulled $19.1 billion from domestic equity funds in May, the largest outflow since the height of the financial crisis in October 2008. (August 22, 2010) Turning conservative after a crisis smacks of closing the barn door after the horse has left, but it’s a regular feature of investor psychology. Of course, there has to be a fundamental rationale for investor behavior, and the current low opinion of stocks is based on the spreading belief that the recovery will be anemic and there could be a double dip. Also behind it may be the expectation that tax rates on dividends and long-term capital gains will rise relative to the rates on ordinary income. And why is so much capital flowing to bonds? The analogy to hemlines serves well in this regard. Take a long-established style, stir in changed circumstances, and add a significant swing in psychology. Bonds became passé over a long period of time, and stocks caught everyone’s attention. When these trends had gone as far as they could, and the error of the fashion extreme ultimately was exposed, bonds came back into style.

The acquisition of Fidelity, which has a market capitalisation approaching $10 bn and about $3 bn in debt, would be the largest leveraged buyout since the credit crisis struck. . . . Bankers and buyout executives said the resurrection of large buyouts was being driven by a booming high-yield bond market. With low interest rates in Europe and the US, investors are more willing to take the risk of weaker credits because it allows them to secure yields unavailable in other forms of lending. (“Are dealmakers ready for another white-knuckle ride?” Financial News, May 10) On investor psychology – Irrational equanimity is back. Not only are developed market stocks back to pre-Lehman levels, but investors’ comfort levels are in a zone not seen since the eve of the credit crisis in early 2007. Apart from US stock indices, this shows up in the price investors will pay to insure © Oaktree Capital Management, L.P.Reserved

It’s obvious in retrospect that all one had to do was take heed and lean in the opposite direction. But observations regarding the past are no help for purposes other than education. For observations to be profitable, they must relate to the present and the future. Investors have made a substantial move back in the direction of pre-crisis behavior. That behavior has to be recognized and monitored. The pendulum has moved away from the depression, panic, skepticism and excessive risk aversion we saw in the fourth quarter of 2008, and with the disappearance of those characteristics have gone the great bargain opportunities. Uncertainty and fundamental weakness at the depth of the crisis were offset by irrationally low prices and the potential for a rebound in risk tolerance, making most assets a screaming buy. With most of the great bargains gone – along with excess risk aversion – macro uncertainties should no longer be overlooked. Thus the caution, discipline, patience, selectivity and discernment that were so unnecessary in 2009 are absolutely essential today. © Oaktree Capital Management, L.P.Reserved

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: The Long View Many of my memos over the last year and a half have touched on the developments in 2003-07 that brought on the current financial crisis. By now, everyone understands the role of innovation, risk tolerance and leverage in the boom that led to the bust, so I think it’s now time to look back considerably further. The Importance of Cycles In my opinion, there are two key concepts that investors must master: value and cycles. For each asset you’re considering, you must have a strongly held view of its intrinsic value. When its price is below that value, it’s generally a buy. When its price is higher, it’s a sell. In a nutshell, that’s value investing. But values aren’t fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity. Further, security prices are greatly affected by investor behavior; thus we can be aided in investing safely by understanding where we stand in terms of the market cycle. What’s going on in terms of investor psychology, and how does it tell us to act in the short run? We want to buy when prices seem attractive.

© Oaktree Capital Management, L.P. All Rights Reserved investment was facilitated through the extension of credit at all levels, contributing to economic expansion but also sowing the seeds for the current situation. Popularization of Investing – Back in 1968, working in investment management was no different from entering banking or insurance. Investing wasn’t the high-profile area it’s been the last two decades. “Famous investor” was an oxymoron; none were household names, like Warren Buffett, George Soros and Peter Lynch would become. Investment firms weren’t the B-school employer of choice, and investment managers didn’t dominate magazine covers and the top income brackets. But over the last forty years, increased attention was paid to equities, mutual funds, hedge funds and alternative niche markets. Even homes came to be viewed as investment vehicles. Investor Psychology – Attitudes morphed over time. Instead of a generation scarred by the Great Depression, people became increasingly confident, optimistic and venturesome. Experience convinced prospective investors that stocks could be counted on for high returns. In the last few decades, there’ve been times when people concluded the business cycle had been tamed. During Alan Greenspan’s reign, people came to believe inordinately in his ability to keep the economy growing steadily.

© Oaktree Capital Management, L.P. All Rights Reserved Many of the investment techniques that were embraced in 2003-07 represented quantitative innovations, and people seemed to think of that as an advantage rather than a source of potential risk. Investors were attracted to black-box quant funds, highly levered mortgage securities critically dependent on computer models, alchemical portable alpha, and risk management based on sketchy historical data. The dependability of these things was shaky, but the risks were glossed over. As Alan Greenspan wrote in The Wall Street Journal of March 11: It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently. Warren Buffett put it in simpler terms at this year’s Berkshire meeting. “If you need a computer or a calculator to make the calculation, you shouldn’t buy it.” And Charlie Munger added his own slant: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you, but it doesn’t. They teach that in business schools because, well, they’ve got to do something.” To close on this subject, I want to share a quote I recently came across from Albert Einstein.

© Oaktree Capital Management, L.P. All Rights Reserved Today’s Rhetoric I think people in government who’re addressing the situation have a difficult row to hoe:  First and most immediately, they’ve had to play up the emergency in order to convince legislators (and the voters who put them in office) that the situation is dire and strong action is required. Thus we’ve heard words like “catastrophe,” “collapse” and “worst since the Great Depression.”  Second, however, they’re well advised to play down the threat. Franklin D. Roosevelt receives a lot of credit for having said, “The only thing we have to fear is fear itself.” Given the crucial role of confidence in the functioning of an economy, it’s not a great idea to spread panic. The rational response of frightened people is to save rather than spend, and to sell investments rather than buy, making things worse.  Third, the President likely wants to create modest expectations. If there’s a feeling that a valid response should work right away, slow progress will look like failure. No one wants consumers and businesses to further pull in their horns if economic recovery isn’t forthcoming in 2009. It’s hard not to be sympathetic to this dilemma. It shows another of the ways in which conflicting goals have to be compromised in the real world of economics and politics.

it’s improbable events that brought on the credit crisis. Lots of bad things happened that had been considered unlikely (if not impossible), and they happened at the same time, to investors who’d taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn’t been skeptical – or pessimistic – enough. But that [realization] triggered an epiphany: Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive. (“The Limits to Negativism,” October 15, 2008) The swing of the pendulum to one extreme or another is a constant in the investment world: from optimism to pessimism, from credulous to skeptical, from sanguine to panicked, from wide-open capital markets to windows slammed shut, from more buyers than sellers to more sellers than buyers and, consequently, from overpriced to underpriced. Thus I was thrilled when an article by my friend James Grant provided a quotation that beautifully sums up the end result of this process: To the English economist Arthur C. Pigou is credited a bon mot that exactly frames the issue. “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.” (The Wall Street Journal, September 19, 2009, emphasis added) Optimism thrives in bubbles.

That’s what they’re built on, with optimism and rising prices reinforcing each other. Likewise, crises are brought on by an extreme turn toward pessimism. Falling prices and pessimism contribute to each other on the way down.

© Oaktree Capital Management, L.P. All Rights Reserved In the years just before the crash, no view was considered too optimistic. There were few skeptics around to point out that a notion might be too good to be true. And then, as Pigou says, the opposite became true post-Lehman Brothers. There was no scenario of which someone wouldn’t suggest, “But what if it’s worse than that?” Now no idea was considered too negative to be true. The error is clear. The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom. Pigou makes an excellent additional point. Bubbles usually build gradually over time, the result of a steady accretion of logical basis, favorable developments, high returns being achieved, platitudes taken to extremes, willing suspension of disbelief, rising optimism and the recruitment of new buyers. But when the bubble’s faulty underpinnings are exposed, it tends to collapse in a rush. The excess of pessimism does arrive quickly, “born a giant.” Or as my partner Sheldon Stone puts it, “the air goes out of the balloon a lot faster than it went in.

” A recent report by Ian Kennedy and Richard Riedel of Cambridge Associates, entitled “Behavioral Risk,” provides an excellent explanation for this process and describes its effect: [During good times,] we suffer from what James Montier characterizes as “the illusion of control: the belief that if things go wrong, we will be able to sort them out.” When that illusion is shattered during a selling panic, we don’t know where to turn or what to think. . . . What happens when we humans (and, indeed, other animals) are slammed by shock? Unless trained otherwise, our instincts tell us to retreat, conserve, seek the comparative safety of groups, and search for a path out of danger. These are ancient survival instincts, hard-wired. Slammed by financial shock, the same instincts result in heightened risk aversion (gimme cash!), a dramatic foreshortening of our normal investment time horizon, an overwhelming impulse to flee with the herd, a tendency to extrapolate current trends all the way to Armageddon . . . In times of crisis, when risk aversion spikes, panicked investors tend to stampede for the exits. The temptation to join them is well-nigh irresistible because the whole financial edifice seems to be collapsing. Carefully wrought models are rendered irrelevant overnight, as correlations converge on 1.0, and “fat tail” risk wags the dog. . . . When markets are falling, we instinctively feel that risk is rising, and when markets are rising, that risk is ebbing.

That’ll be worse for business, right?” For the short run and for managers who failed their clients, it likely will. But in the long run, it’ll make for a much healthier environment for all of us. The Importance of the Long View As usual, some of the most important lessons concern the need to (a) study and remember the events of the past and (b) be conscious of the cyclical nature of things. Up close, the blind man may mistake the elephant’s leg for a tree – and the shortsighted investor may think an uptrend (or a downtrend) will go on forever. But if we step back and view the long sweep of history, we should be able to bear in mind that the long-term cycle repeats and understand where we stand in it. The failure to do so can be most painful. John Kenneth Galbraith provided a reminder in A Short History of Financial Euphoria: Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance.at

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: The Limits to Negativism The markets acted on Monday as if the credit crisis is behind us – how incredible it is to be able to even write those words, whether true or not. Whichever is the case, however, it’s important to reflect on what can be learned from the recent events. (I developed these thoughts last week but just wasn’t quick enough to turn them into a memo. So I’m reduced to discussing what we all hope is history rather than displaying foresight.) UThe 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. It was readily apparent that such a spiral was underway, and no one could see how or when it might end.

The panic of late 2008 was a textbook illustration of the pendulum swinging to its extreme. The same investors who had been eager buyers of complex structures at thin spreads became eager sellers of high-quality assets at distressed prices. The psychology moved from greed to fear in a period of weeks, and the price action reflected that swing far more than any change in underlying asset values. The contrarian case for buying in that environment was obvious in the abstract and difficult in the execution. The reason it was difficult is that the prices were falling every day, and every day the decision to wait looked smarter than the decision to act. The investor who bought on October 10, 2008 was down meaningfully by November; the investor who waited until March 2009 captured better prices but missed the chance to deploy capital in size before the rebound began. There is no clean resolution to this tension. The practical answer is to scale in — to deploy gradually as prices fall, knowing that you will look wrong at every step, but trusting that the average entry price will be attractive in retrospect. The investor who requires certainty before acting will never act in a crisis, and the investor who never acts in a crisis will miss the dislocations that define a generation of returns.

© Oaktree Capital Management, L.P. All Rights Reserved 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. Two or three years ago, the world was so different as to be almost beyond remembering. It was ruled by greed, optimism and credulity. In short, it was the opposite of the last few weeks: no story was too positive to be believed.  “There’s a worldwide ‘wall of liquidity’ that can never dry up.”  “Triple-A CDOs are as safe as triple-A corporate debt but will deliver higher returns.”  “Leverage holds the key to better investment results.”  “Tranching and selling onward are spreading the risk, thereby eliminating it.”  “Decoupling has reduced nations’ economic reliance on the U.S.” Boy, what a good time that was for a dose of skepticism! What benefits it could have provided (in terms of losses avoided). But when conventional wisdom is rosy, few can stand against it. People who do so too early look woefully wrong and are swept aside. That discourages others from trying the same thing, even as the cycle swings further to the positive extreme.

© Oaktree Capital Management, L.P. All Rights Reserved consumer incomes, propelling the economy ahead but rendering households increasingly leveraged. As this process moved onward, it depended on a continued supply of the underlying ingredients: confidence, liquidity, leverage, risk tolerance and acceptance of untested structures. The resulting “virtuous circle” was described in glowing terms just as its perpetuation was growing increasingly unlikely. Bust It took five years or so for the bullish background described above to be established in full. As usual, far less time was required for the excesses to be exposed and the process of their unwinding to begin. The air always goes out of the balloon a lot faster than it went in. Regular readers know that if there’s one thing I believe in, perhaps more strongly than anything else, it’s the fact that cycles will prevail and excesses will correct. For the bullish phase described above to hold sway, the environment had to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness. But these traits will not govern a market forever. Eventually they will give way to fear, pessimism, prudence, uncertainty, skepticism, caution, risk aversion and reticence. A lot of this has happened. Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.

© Oaktree Capital Management, L.P. All Rights Reserved 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. UThe White Swan Most people probably took away from The Black Swan the same lessons I did (and the lessons mentioned in “The Aviary”): “unlikely” isn’t the same as “impossible,” and it’s essential for investors to be able to get through the low spots. Of course, it’s improbable events that brought on the credit crisis. Lots of bad things happened that had been considered unlikely (if not impossible), and they happened at the same time, to investors who’d taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn’t been skeptical – or pessimistic – enough. But that triggered an epiphany: USkepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessiveU. I’ll write some more on the subject, but it’s really as simple as that.

Unquestioning euphoria gives way to full-blown depression. Mark-to-Market Accounting If you watch enough cop shows on TV, you know that investigators of suspicious fires use the term “accelerant” for the chemical used by an arsonist to encourage the spread of a blaze. The current capital market cycle has been accelerated by an element that was added to the capital market equation in the 1990s: mark-to-market accounting. In the simpler but still not totally stable financial world I entered forty years ago, stability was desired in financial institutions. So, for example, banks and insurance companies were allowed to carry a loan or a bond at cost on their balance sheets as long as it was (a) fundamentally unimpaired and (b) intended to be held to maturity. Even if its market value fell temporarily, it was assumed that a creditworthy claim would be repaid in full at maturity. Thus, price fluctuations were ignored as long as fundamentals were sound. More recently, “transparency,” “accountability” and “market signals” became more highly prized. A lot of this had to do with skullduggery unearthed at companies like Enron. As a result, accounting increasingly came to require that assets be valued at actual or estimated market prices. I’d had a preview of this in 1990 when, as part of efforts to “get” the high yield bond industry (and Drexel and Milken), S&Ls were required to market price their holdings of high yield bonds – dooming many of them in a time of price weakness.

Contrarianism – doing the opposite of what others do, or “leaning against the wind” – is essential for investment success. But as the credit crisis reached a peak last week, people succumbed to the wind rather than resisting. I found very few who were optimistic; most were pessimistic to some degree. Some became genuinely depressed – even a few great investors I know. Increasingly negative tales of the coming meltdown were exchanged via email. No one applied skepticism, or said “that horror story’s unlikely to be true.” Pessimism fed on itself. People’s only concern was bullet-proofing their portfolios to get through the coming collapse, or raising enough cash to meet redemptions. The one thing they weren’t doing last week was making aggressive bids for securities. So prices fell and fell – the old expression is “gapped down” – several points at a time. The key – as usual – was to become skeptical of what “everyone” was saying and doing. One might have said, “Sure, the negative story may turn out to be true, but certainly it’s priced into the market. So there’s little to be gained from betting on it. On the other hand, if it turns out not to be true, the appreciation from today’s depressed levels will be enormous. I buy!” The negative story may have looked compelling, but it’s the positive story – which few believed – that held, and still holds, the greater potential for profit.

In sum, entities that had borrowed short to invest in longer-term, potentially illiquid assets fell victim to their funding mismatch. The precariousness of this position is easy to overlook when all is going well, asset prices are firm and capital is freely available. But it regularly leads to ruin when financial crises take hold.  With these developments, psychology turned from positive to negative overnight. Lenders became more nervous, requiring repayments, raising lending standards and refusing to roll over maturing loans. In particular, there was a dramatic contraction in the market for commercial paper backed by assets (rather than by promises from creditworthy firms).  Among other things, the investment banks found their balance sheets clogged with debt for buyouts that they had promised to place (“bridge loans”) before the music stopped, and the debt became unsalable on the agreed terms. This cut into their ability to make new loans. Discount sales were talked of, and funds were formed to buy up the loans.  Central banks stepped in to calm the waters. The European bank injected significant capital. The Fed cut short-term rates. The Bank of England guaranteed deposits at Northern Rock, a building society (S&L), and extended emergency loans. And so the panic eased. The reaction seemed to be “boy, I’m glad that’s over.” But the calm lasted only from early September to mid-October.

© Oaktree Capital Management, L.P. All Rights Reserved Even understanding Lehman’s current trading positions was tough. Lehman’s roster of interest-rate swaps (a type of derivative investment) ran about two million strong . . . What kind of effort would it require to understand the significance of two million derivatives positions: are they thoroughly hedged, or bullish or bearish on balance? And what about Lehman’s millions of other derivatives and complex securities? This opacity, combined with heavy leverage, reliance on short-term funds, liquidity and conscious risk taking, is the reason why a loss of confidence is conceivable at any financial institution in times of panic. What will the Wall Street of the future look like? We read – and I don’t doubt – that for at least a while it will be smaller, less leveraged, less profitable, and more highly regulated. But I also think it will be less competitive and less risky. In the course of my career, Wall Street went from being (1) brokers handling riskless trades for commission to (2) dealers buying and selling inventory for a spread to (3) block traders purchasing large amounts of stock when market liquidity was inadequate to (4) proprietary traders risking their own capital in pursuit of profit for the house. Backing down this progression wouldn’t be the worst thing in the world. U What Will Start the Recovery? Eventually, someone will walk out of the crowd and take advantage of the lows.

© Oaktree Capital Management, L.P. All Rights Reserved As we all know, buying during the first stage can be highly profitable, while buying during the last euphoric stage usually leads to disaster. Then I went on to create the converse of the above, the three stages of a bear market:  the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won’t always be rosy,  the second, when most investors recognize things are deteriorating, and  the third, when everyone’s convinced things can only get worse. In the final stage, you can buy assets at prices that reflect little or no optimism. There can be no doubt that we are in the third stage with regard to many financial institutions. Not necessarily at the bottom, but in a serious period of unremitting pessimism. No one seems able to imagine how the current vicious circle will be interrupted. But I think we must assume it will be. It must be noted that, just like two years ago, people are accepting as true something that has never held true before. Then, it was the proposition that massively levered balance sheets had been rendered safe by the miracle of financial engineering. Today, it’s the non-viability of the essential financial sector and its greatest institutions. Everyone was happy to buy 18-24-36 months ago, when the horizon was cloudless and asset prices were sky-high.

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.*

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Now It’s All Bad? I’m a great believer in the cyclical nature of the markets, but I never cease to be amazed at how far they can go in one direction and for how long; the extremes they can reach, despite logical arguments to the contrary; and the swiftness of the swing back. It all reminds me of a point I made in my second memo, “First Quarter Performance” (April 1991): Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead it is almost always swinging toward or away from the extremes of its arc. Just seven weeks ago, I complained in “It’s All Good” that investors were acting as if nothing could go wrong. “Priced for perfection” was the concept underlying values, and people were more than willing to pay prices set that way. Now, of course, the prevailing attitude appears to have swung from “it’s all good” to “it’s all bad.” Pessimism has replaced optimism, perhaps also to excess. There are days on which no one seems able to tell me how the developing credit crisis might be resolved in short order and a full-scale meltdown avoided, and when no one seems able to find a ray of sunshine in the current situation (other than bargain hunters). It’s like the aspiring actor who takes acting classes, waits on tables and hustles auditions for a decade . . .

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: No Different This Time – The Lessons of ‘07 On July 16, I published a memo called “It’s All Good.” I wrote it while on vacation in late June and early July, and then it took a week after my return to get it out. It reviewed the excesses that had occurred in the preceding few years and the extent to which people were overlooking them, thinking instead that everything was ideal and would stay that way. It discussed the recurring tendency of investors in bullish times to feel that “it’s different this time” – that the process which caused past cyclical highs to correct wouldn’t apply in the current instance. The bullish balloon remained unpunctured as of July 16, and some may have thought my memo unduly pessimistic. It’s a good thing it didn’t take another week or two to put it out, however, because by July 30, things had started to go bad, set off by defaults among subprime mortgages and downgrades of securities based on them. “An isolated development,” the bulls replied, as is usual when the first crack in the dam appears. It’s hard to believe that less than five months later, the effects are widespread, significant losses have been registered, and negativism has taken over from euphoria. No one doubts that we’re in the throes of a full-fledged credit crunch. But in that way, it truly is no different this time.

A lot of this is because people seem to think everything’s good and likely to stay that way. UCycles in the World of Investing The basics of cycles are simple. The economic cycle gives rise to recessions and recoveries, creating the business environment. This produces a business cycle marked by rising and falling sales and profits. The credit cycle swings more radically, such that capital market conditions alternate between irrationally generous and unfairly restrictive. Likewise, market cycles fluctuate much more than do the more “fundamental” economic and business cycles, due largely to the volatile cycle in investor psychology. In this latter regard, I’ll reprint a few paragraphs from “First Quarter Performance,” the 1991 memo cited above. I think they capture investors’ pattern of behavior. The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward the extreme itself that supplies the energy for the swing back.

© Oaktree Capital Management, L.P. All Rights Reserved Investment markets make the same pendulum-like swing:  between euphoria and depression,  between celebrating positive developments and obsessing over negatives, and thus  between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at the “happy medium.” UPolar Opposites My 2004 memo, “The Happy Medium,” took its title from this last phrase and went beyond the three listed above to discuss additional pairs of opposites between which the investment pendulum oscillates:  between greed and fear,  between optimism and pessimism,  between risk tolerance and risk aversion,  between credence and skepticism,  between faith in value in the future and insistence of concrete value in the present, and  between urgency to buy and panic to sell. I find particularly interesting the degree to which the polarities listed above are interrelated. When a market has been rising strongly for a while, we invariably see all nine of the elements listed first. And when the market’s been declining, we see all nine of the elements listed second. Rarely do we see a blend of the two sets, given that the components in each are causally related, with one giving rise to the next.

Usually, when either set of polar extremes is in the ascendancy, that fact is readily observable, and thus the implications for investors should be obvious to objective observers. But of course, the swing of the market pendulum to one set of extremes or the other occurs for the simple reason that the psyches of most market participants are moving in the same direction in a herd-like fashion. Few of the people involved actually are objective. To continue a thread from my last memo, “Everyone Knows,” expecting widespread clinical observation during a market mania makes about as much sense as saying “everyone knows the market has gone too far.” If many people recognized that it had gone too far, it wouldn’t be there. Between the two sets of cyclical extremes, I have no doubt that the environment of the last few years has been marked by the elements listed first above, not second: euphoria, greed, optimism, risk tolerance and credence; not depression, fear, pessimism, risk aversion and skepticism. Certainly it’s been the recent consensus of investors that, “It’s all good.”

Our active distressed debt funds gained 20% that month, and the markets never looked back. Investors in all asset classes forgot the panic that had gripped them just a few months earlier and became preoccupied with making money. Because only modest returns were expected from high grade bonds (with their 4-5% yields) and U.S. common stocks (following the 2000-02 bear market), investors sought solutions in non-traditional investments with brief track records at best, and thus little or no clarity regarding the risks involved. Vast sums flowed to hedge funds, and thousands of new ones were formed. High yield bonds and leveraged loans began to be issued again . . . because now there were buyers. This enabled buyouts to be financed and then recapitalized, and quick payouts to equity holders resulted in eye-popping IRRs, attracting more capital to buyout funds. Real estate attracted vast amounts of capital, too, even when “cap rates” – current cash yields – sunk below 5%; what could be better than a tangible asset providing inflation protection? Borrowing power became virtually unlimited, as is often the case when providers of capital are eager to put money to work. Thus the financial environment reflected (1) a vast ability to leverage, (2) an uninhibited search for return, and (3) investors competing to make investments by accepting lower returns and decreased safety. This combination supported new investment techniques, which grew rapidly despite being untested.

© Oaktree Capital Management, L.P. All Rights Reserved  If portfolio holdings have to be sold to reduce leverage or raise cash to meet actual or feared withdrawals, this has a depressant effect on asset prices that reinforces the cycle.  Lower asset prices may lead to margin calls, and thus possibly to fire sales.  Forced sellers sell what they can sell, not necessarily what they want to sell. As a result, the prices of assets that are entirely unrelated to the fundamental problem can join the downward spiral. It’s for this reason that they say, “In times of crisis, all correlations go to one.” Every one of the above factors has been seen in the last few weeks – all growing from just the subprime seed. The economy is still showing good strength overall and most companies are doing fine; the default rate among high yield bonds continues to run at 25-year lows. But strong fundamentals mean little if technical factors combine with a fundamental problem to profoundly depress investor psychology. It’s important to remember the extent to which these factors interrelate. Fundamentals influence psychology, which determines technicals, which feed back to further affect fundamentals. Just as these things can create a virtuous circle on the upside – such as the one that has prevailed since late-2002 – they’re now behind the apparent start of a vicious circle on the downside.

UMetastasis The fundamental, psychological and technical influences described above devastated the market for subprime investments, of course, but they also spread quickly to other assets and markets and metastasized into new forms of trouble. Investor psychology turned in all markets, even those totally unconnected to subprime loans. Caution replaced optimism. Risk aversion took over from risk tolerance (or risk- blindness). Skepticism and the concept of capital preservation were resurrected. Concern over being under-invested gave way to fear of buying too soon. Cash came to be viewed as a source of security and buying power, not a drag on results. All over the investment world, people started to think more about what can go wrong rather than what can go right. In short, the things that contributed to the virtuous circle began to be reversed, in ways that were unimaginable just two months ago. Bridge financing for buyouts represents an outstanding example. Buyouts were an area of great enthusiasm – and some of the greatest excesses, I think – in the 2002-07 up leg:  Vast sums were raised in buyout funds, likely increasing the managers’ motivation to buy companies.  Purchase prices for target companies were lifted by stock market strength, bidding wars and the demands of stockholders and boards.

© Oaktree Capital Management, L.P. All Rights Reserved I’m not saying you can’t invest profitably when the inputs are garbage. But only after critically assessing the reliability of assumptions can sufficient allowance for risk be built in via demands for an appropriate risk premium. In the last few years, people bought “safe” securities where they really had little understanding of their workings or foundations. The results are now clear. UI’m Shocked . . . Shocked Given that market upswings are often accompanied by insufficient skepticism, it’s not unusual for lofty expectations to be disappointed. A story on Citibank’s results in the Wall Street Journal of November 2 contained words such as “unnerved” and “unsettled.” Few things have a more corrosive effect on investor psychology than disillusionment like we’re seeing today. I remember getting a kick out of an article that ran in the Wall Street Journal around 1991. After taking big losses in high yield bonds, a mutual fund investor was quoted as saying, “I thought I was investing in a high yield bond fund. If I’d known it was a junk bond fund, I never would’ve bought it.” It’s common for investors to act without adequate understanding, and for them to feel betrayed when their hopes are unfulfilled. This time they’re saying, “It was rated triple-A, and now no one can tell me what it’s worth.” The disillusionment has been swift and dramatic (not to mention terrifying).

© Oaktree Capital Management, L.P. All Rights Reserved benefit of his wisdom firsthand. This quote, however, is from his invaluable book, “A Short History of Financial Euphoria.” It seems particularly apt under the current circumstances: Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. The second is Warren Buffett’s bedrock reminder of the need to adjust our financial actions based on the investor behavior playing out around us. Fewer words, but probably even more useful: The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

© Oaktree Capital Management, L.P. All Rights Reserved 6. In heady times, capital is devoted to innovative investments, many of which fail the test of time. Bullish investors focus on what might work, not what might go wrong. Eagerness takes over from prudence, causing people to accept new investment products they don’t understand. Later, they wonder what they could have been thinking. 7. Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, non-fundamental factors such as margin calls, frozen markets and a general rise in risk aversion can become dominant, affecting everything similarly. 8. Psychological and technical factors can swamp fundamentals. In the long run, value creation and destruction are driven by fundamentals such as economic trends, companies’ earnings, demand for products and the skillfulness of managements. But in the short run, markets are highly responsive to investor psychology and the technical factors that influence the supply and demand for assets. In fact, I think confidence matters more than anything else in the short run.

Anything can happen in this regard, with results that are both unpredictable and irrational. 9. Markets change, invalidating models. Accounts of the difficulties of “quant” funds center on the failure of computer models and their underlying assumptions. The computers that run portfolios primarily attempt to profit from patterns that held true in past markets. They can’t predict changes in those patterns; they can’t anticipate aberrant periods; and thus they generally overestimate the reliability of past norms. 10. Leverage magnifies outcomes but doesn’t add value. It can make great sense to use leverage to increase your investment in assets at bargain prices offering high promised returns or generous risk premiums. But it can be dangerous to use leverage to buy more of assets that offer low returns or narrow risk spreads – in other words, assets that are fully priced or overpriced. It makes little sense to use leverage to try to turn inadequate returns into adequate returns. 11. Excesses correct. When investor psychology is extremely rosy and markets are “priced for perfection” – based on an assumption that things will always be good – the scene is set for capital destruction. It may happen because investors’ assumptions turn out to be too optimistic, because negative events occur, or simply because too- high prices collapse of their own weight. 12. Investment survival has to be achieved in the short run, not on average over the long run.

My advice: expect CEOs, regulators, rating agencies and other market participants to make mistakes. Expect things to go wrong and cycles to swing to extremes and then recover. Worry about outcomes, and hire worriers. Doing these things is sure to stand between you and top returns in up-cycles, but it will deliver some degree of safety when things turn bad. Ensuring the protection of capital under adverse circumstances is incompatible with maximizing returns in good times, and thus investors must choose between the two. That’s the real lesson. The things discussed above are just a few of the details. What Next? Lots of people are asking whether this is going to get ugly. Is this the beginning of a credit crunch? Will it lead to a recession? How bad will it get? When will the bottom be reached? How long will the recovery take? The answer’s simple: no one knows. Some of the psychological and technical preconditions for a challenging market environment have been met. The bubble of positive investor psychology has been pricked and could become seriously deflated. When others are aggressive, we should be worried, but when others are worried, we can be confident. That’s the essence of contrarianism, and by that standard these are better times. The easy-money machine has had some sand thrown in its gears and seems to be grinding to a halt. Previously, anyone could get any amount of money for any purpose.

© Oaktree Capital Management, L.P. All Rights Reserved Certainly the magnitude of this summer’s crisis has been out of proportion to its underlying fundamental cause: the increase in subprime delinquencies. Instead, a standard combination has proved perfectly incendiary:  underlying greed,  good returns in the up-leg of the cycle,  euphoria and complacency,  a free-and-easy credit market,  Wall Street’s inventiveness and salesmanship, and  investors’ naiveté. This formula often results in crushing losses. Or as Marc Faber put it, a surplus of cash leads to a shortage of sense. An obscure economist named Hyman Minsky is having his fifteen minutes of fame in the current environment. Here’s how The Wall Street Journal summarized his views on August 18: When times are good, investors take on risk; the longer those times stay good, the more risk they take on, until they’ve taken on too much. Eventually they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values,” Mr. Minsky wrote. When investors are forced to sell even their less- speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. The foregoing aptly describes the current cycle. . . and, I think, the way things always are.

the things I haven’t thought of. First, I want to point out that these things are not unrelated. A reduction in lenders’ willingness to lend may stem from an economic slowdown. An economic slowdown could be brought on by an exogenous event. It’s when there’s a confluence of these things that the debt market gets into real trouble, as was the case in 1990 and 2002. Second, these things are often unpredictable. I like to remind people that the best buying opportunity we ever had in distressed debt arose in the summer of 2002, when recession, credit crunch, 9/11, Afghanistan, telecom meltdown and the scandals at Enron et al. occurred all at once. Few if any of these were predictable twelve months earlier. And third, the one we should worry about most is number five. Investors can cope with the things they can anticipate, analyze and discount. They have more trouble with the rest. I love hearing people from the “I know” school say, “I’m not anticipating any surprises.” Those are the developments that can knock a market into a cocked hat. As Martin Wolf wrote in the Financial Times on May 2, “The most obvious reason for taking today’s euphoria with a barrel of salt is that nobody ever expects shocks. That is what makes them shocks.” Where do we stand in the cycle? In my opinion, there’s little mystery. I see low levels of skepticism, fear and risk aversion.

© Oaktree Capital Management, L.P. All Rights Reserved 11BUComplexity in Risk Assessment It is my purpose in this section to highlight a few reasons why risk assessment is not simply a matter of one number (as implied by the attention paid to volatility), but multi-dimensional instead. Rick Funston of Deloitte pointed out in our board briefing materials that risk assessment requires us to deal with four complicating factors:  Scenarios  Offsets  Correlations  Domino effects By “scenarios,” Rick refers to alternative or abnormal future scenarios that go beyond the normal range of outcomes – in his words, “the possible but unusual.” “Offsets” translate in the investment world into something very familiar: diversification. Intelligent diversification means not just investing in a bunch of different things, but in things that respond differently to the same factors. In a well-diversified portfolio, something that negatively influences investment A might have a positive and offsetting influence on investment B. “Correlations” are somewhat the opposite. The term refers to the chance that a number of investments will respond in the same way to a given factor. Be alert, however, to the fact that when things in the environment turn really negative, seemingly unconnected investments can be similarly affected. “In times of panic,” they say, “all correlations go to one.

Interestingly in this connection, Wachovia Structured Products reports that as of April, of the 47 Collateralized Loan Obligations that had gone full cycle, 30 generated positive returns for their equity. Put the other way around 17, or 36%, had lost money. I doubt that was the expectation on which they were sold. And that in relatively good times. My favorite investment adage warns about the things “the fool does in the end.” Clearly, turning over the administration of credit to appraisers, raters and structurers who know relatively little about the underlying assets they’re dealing with – and who are hired hands without their own capital at risk – signals a dangerous late stage of the inevitable cycle. UIt’s Time to Hedge Given the laxness, euphoria and credulousness that I detect in the market for money today, it’s time for caution. Where better to find it than in funds that hedge? Well, of course, today the term “hedge fund” has nothing to do with hedging and everything to do with incentive fees. In no way does that label connote risk control. And whereas the shortcomings of the structured entities described above go along with the activities fitting their charter, most hedge funds have unlimited charters and can roam free in search of return. Here are a few recent trends:  Hedge funds are making “second lien loans” in large numbers. In some cases, however, there are no assets left (after the claims of first lien loans) to have a lien against.may

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: There They Go Again Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. . . . There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. John Kenneth Galbraith A Short History of Financial Euphoria, Viking, 1990 The above observation has appeared in lots of my memos, second only to Warren Buffett’s reminder that our need for prudence in a given situation is inversely proportional to the amount of prudence being displayed by other investors. Neither of these favorite quotations says much for the average investor: Buffett urges us to adopt behavior that is the opposite of John Q. Investor’s, and Galbraith points out how prone John Q. is to repeating the mistakes of the past. It may sound cynical, but most outstanding investors – especially members of the “us school” (see “Us and Them,” May 7, 2004) – understand that the path to superior results lies in taking advantage of other people’s mistakes. (The alternative is to think everyone can succeed simultaneously.)

© Oaktree Capital Management, L.P. All Rights Reserved As usual, James Grant supplies a trenchant analysis, this time in the April 25 issue of Forbes. His summary of what’s going on in real estate highlights time-honored mistakes that are being repeated: Markets look forward, except when they look backward. At this moment the real estate market is looking backward. . . . Mistaking the past for the future, people are pouring money into houses, shopping centers, office buildings, hotels, anything with a front door and a roof. They are paying some of the fanciest prices on record. Property bulls come in all sizes, shapes and net worths. “We are living with the greatest liquidity ever,” an eminent REIT promoter was quoted as saying in March in the New York Sun. “We’re not going to have a crash in the real estate market, there is too much liquidity.” Liquidity is a term of art. It means lots of money. It can also mean – and, in 2005, does mean – “low interest rates,” “E-Z financing terms,” “low dollar exchange rate” and “value investors go away.” In an evident state of liquidity-induced euphoria, a Miami Realtor recently proclaimed to The New York Times, “South Florida is working off a totally new economic model than any of us has ever experienced in the past.” Not true. The “South Florida economic model” is the oldest in the book. An excess of dollars leads to a drop in interest rates. And a drop in interest rates to a rise in real estate prices.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: The Happy Medium My second general memo to clients was dated April 11, 1991 and imaginatively titled “First Quarter Performance.” It primarily discussed the swing of the market pendulum. I may be biased, but I’m pleased with what it says and, thirteen years later, wouldn’t change a word. The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward the extreme itself that supplies the energy for the swing back. Investment markets make the same pendulum-like swing:  between euphoria and depression,  between celebrating positive developments and obsessing over negatives, and thus  between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at the “happy medium.

© Oaktree Capital Management, L.P. All Rights Reserved operating profits change more than revenues) and financial leverage (such that net income changes more than operating profits).  The credit cycle moves dramatically, usually oscillating between periods when the capital markets are wide open and periods when they’re slammed shut.  The market cycle reacts violently, as investor psychology magnifies all of the above. Security prices yo-yo in what can often be described as extreme over-reaction. Everyone’s aware of these cycles and their influence on the markets, but it’s important that their essence and origin be thoroughly understood. For me that means delving into human nature and emotion. The theme of this memo will be that the cyclical phenomena that so heavily influence our investment outcomes aren’t caused by the operation of institutions or physical laws. Rather, they largely result from people’s frailties and excesses. A thorough understanding of these things can increase an investor’s ability to achieve gains and avoid losses. 1BUGreed or Fear When I was a rookie analyst, we heard all the time that “the stock market is driven by greed and fear.” When the market environment is in healthy balance, a tug-of-war takes place between optimists intent on making money and pessimists seeking to avoid losses. The former want to buy stocks, even if they have to pay a price a bit above yesterday’s close, and the latter want to sell them, even if it’s on a downtick.

Whereas in 1999 pie-in-the-sky forecasts for a decade out were embraced warmly, in 2002 investors chastened by the corporate scandals said, “I’ll never trust management again” and “How can I be sure any financial statements are accurate?” Thus almost no one wanted to buy the bonds of the scandal-plagued companies, for example, and they sunk to giveaway prices. It’s from the extremes of the cycle of fear and greed that arise the greatest investment profits, as distressed debt demonstrated last year. 0BURisk Tolerance or Risk Aversion In my opinion, the greed/fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk. The academics consider investors’ attitude toward risk a constant, but certainly it fluctuates greatly. Finance theory is heavily dependent on the assumption that investors are risk-averse. That is, they “disprefer” risk and must be induced – bribed – to bear it. That’s the reason why the capital market line slopes upward to the right: investors have to be offered higher expected returns in order to induce them to make investments entailing higher risk. Of course, these higher returns can’t be a sure thing, because in that case the investments wouldn’t actually be riskier.

Thus investors are attracted more (or repelled less) by risky investments than perhaps might otherwise be the case and require less risk compensation to move to them. Third, investors perceive risk as being quite limited today. Because rising inflation isn’t seen as a significant risk, bond investors don’t require much of a premium to extend maturity. And because the combination of a recovering economy and an accommodating capital market has brought default rates to record lows, investors are unconcerned about credit risk and thus are willing to accept below-average credit spreads. Prospective return exists to compensate for perceived risk, and when there isn’t much perceived risk, there isn’t likely to be much prospective return. In summary, to use the words of the “quants,” risk aversion is down. In May 2003 we at Oaktree began to worry about investors’ indiscriminate behavior (of course, we’re usually early in worrying about overheated markets). We were struck by the rapidity with which the terrified investors of less than a year earlier had become confident and aggressive. “Stressed” bonds that we had bought at yields of 30% to 70% in the summer of 2002 now could be sold at yields of 6% to 9%. Somehow, in that alchemy unique to investor psychology, “I wouldn’t touch it at any price” had morphed into “looks like a solid investment to me.

The market is a big arena where optimists and pessimists engage in a tug of war. When optimism is rising relative to pessimism, meaning more money wants to get put to work than wants to exit, prices rise (and vice versa). The market has been going roughly sideways for the last few months, meaning the two camps are in rough balance. But that doesn’t mean they’re not both out there. Everyone had a great year in 2003, and “they” seem to think it’s going to continue. They’re cheered by signs of economic recovery, corporate profit gains and job growth. “We,” on the other hand, worry about the things that could result in disappointment, like the lackluster economic and employment gains, and the trade and budget deficits. We also worry about structural issues, such as the US’s reliance on foreign capital, the questionable outlook for the dollar, and the consumer’s high level of indebtedness and low level of savings. Lastly, we feel the possibility of domestic terrorism hangs out there like a sword of Damocles. A particularly striking difference can be seen in current attitudes toward interest rates. Rates do a great deal to influence the vitality of the economy and the price and relative attractiveness of market sectors. Today’s low rates encourage growth and borrowing. They also reduce the competition to stocks posed by bonds and money market securities.

© Oaktree Capital Management, L.P. All Rights Reserved Certainly much of the fluctuation in the performance of one school versus the other stems from their relative price attractiveness: one group of stocks may be perceived as the cheaper of the two and thus begin to be bought more strongly. This buying makes it appreciate relative to the other until it gets ahead price-wise, and then it declines (or at least pauses) while the other catches up. But the two schools’ relative performance also depends to a great extent on attitudes that fluctuate cyclically. Optimistic growth investors with big dreams for the future bid up the stocks of companies that they expect to exhibit rapid growth, as they did in 1998-99. Eventually their buying power is spent, their hopes are dashed, or their optimism wanes. Then value investors with their more limited expectations regarding the future have their day in less buoyant times, as they did in 2000-01. USelling Panic (and Its Less-Recognized Brother) As the pendulum makes its periodic swing from positive to negative, the resurgence of fear, risk aversion, and attention to things missing from the glass combine to bring down prices. Most investors see their resolve evaporate, along with all their reasons for holding the things in their portfolios. They go from being confident partisans, to worriers, eventually to sellers – and sometimes to panic sellers.

In November 2000, I wrote about “A Framework for Understanding Market Crisis,” an insightful article by Richard Bookstaber, then of Moore Capital Management, that analyzed the behavior of panic sellers. Rather than reinvent the wheel, I’ll excerpt from my earlier memo:  Most people think security price movements result primarily from the market’s discounting of information about corporate, economic or geopolitical events – so-called “fundamentals.” If you sit with a trader, however, it’s easy to observe that prices are always moving in response to things other than fundamental information.  Bookstaber says, “the principal reason for intraday price movement is the demand for liquidity . . . . In place of the conventional academic perspective of the role of the market, in which the market is efficient and exists solely for informational purposes, this view is that the role of the market is to provide immediacy for liquidity demanders . . . . By accepting the notion that markets exist to satisfy liquidity demand and liquidity supply, the framework is in place for understanding what causes market crises, which are the times when liquidity and immediacy matter most.”  “Liquidity demanders are demanders of immediacy.” I would describe them as holders of assets in due course, such as investors and hedgers, who from time to time have a strong need to adjust their positions. When there’s urgency, “the defining characteristic is that time is more important than price . . . .

© Oaktree Capital Management, L.P. All Rights Reserved falling price, instead of deterring people from selling, triggers a growing flood of selling, and instead of attracting buyers, a falling price drives potential buyers from the market (or, even worse, turns potential buyers into sellers.)” This phenomenon can occur for reasons ranging from transactional (they receive margin calls) to emotional (they just get scared). The liquidity demanders increase in number, and they become more highly motivated.  In times of crisis, liquidity suppliers become scarce. Maybe they spent their capital in the first 10% decline and are out of powder. Maybe the market’s increased volatility and decreased liquidity have reduced the price they’re willing to pay. And maybe they’re scared, too. “Information did not cause the dramatic price volatility. It was caused by the crisis- induced demand for liquidity at a time that liquidity suppliers were shrinking from the market.” Speaking of panics, we all recognize the carnage that occurs when the desire to sell far exceeds the willingness to buy. But I think Bookstaber’s analysis applies equally to the opposite – times when the desire to buy outstrips the willingness to sell. It amounts to a “buying panic” and represents no less of a crisis, even though – because the immediate result is profit rather than loss – it is discussed in different terms. Certainly 1999 was just as much a year of irrational, liquidity-driven crisis as was 1987.

I discussed the general progression of a market cycle:  Favorable developments and positive investor psychology cause prices to rise.  Reports of price appreciation attract momentum players, who shout, "We'd better get in; who knows how far this can go." Their purchases of already-appreciated assets move prices still higher on a trajectory that appears capable of rising forever.  Eventually, prices get so high that they vastly exceed intrinsic values.  A few value-conscious investors step into the crowd to sell. Prices turn down, sagging under their own weight or perhaps because fundamental developments begin to be less favorable.  Less-favorable developments and less-favorable psychology combine to force prices below intrinsic values.  The pain of losses becomes so great that investors flee and prices reach giveaway levels. This time it's, "We'd better get out; who knows how far this can go."  The first iron-nerved contrarians recognize that good values are available and start to buy.  Others soon follow, and eventually the number of new buyers exceeds the number of sellers. Prices stop falling . . . and begin to rise.

For the six months from November through April, the total estimated gain has been more than 55% (and more than 41% net of fees and expenses). This was yet another example of the schizophrenic swing of the investment pendulum: Trust replaced skepticism. Gain replaced loss. Greed replaced fear. And, incredibly, panic buying replaced panic selling. The cycle had swung from morosely negative to ebulliently positive in less than a year. And thus the Tyco bonds we bought in May 2002 at a 24% yield became gilt-edge securities that could be sold in January 2003 – at yields of 4%-plus. We've seen the same cycle in high yield bonds. Last July, because investors had developed allergies to high yield bonds, the average bond had to provide more than 1,000 basis points more yield than a Treasury note of comparable maturity to induce investors to buy it. But now, investors have come to lust after high promised returns, and they are willing to buy the average high yield bond at a spread of just 600 basis points or so. The resulting estimated net return on our high yield bond portfolios: more than 15% for the 6 months November through April. UBut Why? Most observers are familiar with the returns reported above, and with the changed attitudes toward credit risk that lie behind them. But I think the behavior of distressed debt and high yield bonds should be viewed in a broader context, not in isolation. There are big-picture influences behind these trends.

Certainly investor behavior has turned bearish. Selling sometimes seems indiscriminate. Every better performing group gets its turn in the barrel. The value stocks that outperformed for the last two years are sharing the pain of the growth stocks. It seems there's no place to hide. Investors complain that they can't take it and have started to throw in the towel. Maximum panic usually coincides with minimum prices. Thus these may be signs that capitulation, the exhaustion of selling, and a bottom are near. UNegative Arguments On the other hand – as any good politician would say – there are counter-arguments to many of the above, and a large number of additional negatives to be considered. In my opinion, just as the strongest positive is seen in the failure of the market to reflect the ending of the recession, I think the counter to that – and the strongest negative – lies in the matter of valuation. In short, the fact that stocks are down since the end of the recession, and down a great deal from their peak, doesn't mean they're cheap. In fact, most rumination on the market's future direction touches on the correction, investor psychology and the economy, but not whether stocks are rich or cheap, always a difficult subject to plumb.

© Oaktree Capital Management, L.P. All Rights Reserved of a superior ability to see the future, but rather because he regularly holds extreme positions (or perhaps he's a dart thrower) and this time the phenomenon went his way. Rarely if ever is that person right twice in a row. So forecasts are unlikely to help us gain an advantage, but that doesn't make people stop putting their faith in them. It's unsettling to realize how much in the dark we investors are concerning future developments. But there's one thing worse: to ignore the limits of our foresight. The late Stanford behaviorist Amos Tversky put it best: "It's frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what's going on." UThirdU, I think it's essential to remember that just about everything is cyclical. There's little I'm certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don't grow to the sky. Few things go to zero. And there's little that's as dangerous for investor health as insistence on extrapolating today's events into the future. The economy will not rise forever. Industrial trends won't continue indefinitely. The companies that succeed for a while often will cease to do so. Company profits won't increase without limitation. Investor psychology won't go in one direction forever, and thus neither will security prices.

© Oaktree Capital Management, L.P. All Rights Reserved  Macro fears still loom in the background, and they gain more credence when people feel less good about things. The threat of further terrorism, unending violence in the Middle East, nuclear and biological weapons in the hands of rogue states, and even Japanese-style deflation – none of these fears can be put to rest conclusively. Of course, like almost everything else, these psychological factors have two sides. They're negatives to the extent they contribute to fear and skepticism and thus discourage buyers. But they're positives if they induce panic selling and take prices low enough to form a bottom. Lastly, I think we all should worry about Washington. Where's the political payoff today? It lies in decrying corruption and calling for extreme reforms. The backlash against corporate malfeasance I cited in "Learning From Enron" certainly threatens to become a witch-hunt, raising great risk of tampering with a system that's essentially sound. Regardless of whether properly motivated or not, the government should not be in the business of codifying rules in areas such as accounting and compensation. Foreseeing second-order consequences is difficult, and particularly so for politicians and regulators. Not only are they often unknowable, but also they exist in the long term, whereas people in politics are governed by short-term considerations – like getting re- elected.

© Oaktree Capital Management, L.P. All Rights Reserved opportunity for unusual profits. Unskeptical belief that the silver bullet is at hand eventually leads to capital punishment. USeventhU, you must be aware of what's going on around you in terms of investor psychology. I don't believe in the ability of forecasters to tell us where prices are going, but an understanding of where we are in terms of investor psychology can give us a hint. When investors are exuberant, as they were in 1999 and early 2000, it's dangerous. When the man on the street thinks stocks are a great idea and sure to produce profits, I'd watch out. When attitudes of this sort make for stock prices that assume the best and incorporate no fear, it's a formula for disaster. I find myself using one quote, from Warren Buffett, more often than any other: "The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs." When others are euphoric, that puts us in danger. When others are frightened and pull back, their behavior makes bargains plentiful. In other words, what others are thinking and doing holds substantial ramifications for you. And that brings us full circle to the importance of contrarianism. * * * I've cataloged above the "mental arsenal" I feel is needed in the battle for investment success.

They build their records on high batting averages and the absence of losers, rather than on occasional homeruns within a hit-or-miss pattern of returns. Most of them are hard working and driven. They take their jobs very seriously and think about their portfolios night and day. They tend to talk investments with each other, not football or movies. Many are "early adapters" who use technology to access diverse information sources in order to gain a knowledge advantage. They look for hard asset values or under-appreciated situations. They buy with confidence in their analysis, and if the price of the asset falls, they tend to like it more – and buy rather than sell. Most important is that intangible something – they just "get it" better than others. While going over this list of the characteristics I'd look for in a manager, I want to take a moment for an essential caveat. One thing these criteria guarantee is that there'll be times when investors from the "I don't know" school will look terrible. In times of euphoria, qualities like emphasis on value, contrarianism, skepticism and defensiveness are guaranteed to produce performance that sorely lags the hot sectors and the risk takers. This was amply demonstrated in 1998-99, when the best managers I know watched from the sidelines as others got rich . . . temporarily.

UThe Role of Luck To end this memo on returns, I want to spend a few pages discussing the part played by randomness (or luck or chance). A new book on this subject is being passed around the alpha manager world more than Playboy was passed around when I was in the ninth grade. It's "Pooled By Randomness" by Nassim Taleb, a Ph. D. hedge fund manager and self-described aesthete. My "Realist's Creed" list of required ingredients for intelligent investing started with membership in the "I don't know" school; progressed through contrarianism, humility and skepticism; and ended with awareness of prevailing investor psychology. Taleb's book reminded me of one other essential: being conscious of the role of luck. This book can be difficult to read. Here are just two examples: Popper believed that any idea of Utopia is necessarily closed in the fact that it chokes its own refutations. . . . to be technical, these "randomizations" are frequently done during optimization problems, when one needs to perturbate a function.

© Oaktree Capital Management, L.P. All Rights Reserved  attention to the cyclical nature of things  consciousness of timeframe  concentration on valuation  disdaining the hunt for the silver bullet  awareness of prevailing investor psychology You can go with opinions about the future. Everyone's got them, and what they call for in terms of investment behavior usually is obvious. In other words, the "I know" school makes investing sound easy – although in my opinion it's not often right. Or you can join me in the "I don't know" school, where you must:  face up to the uncertainty that surrounds the macro future;  concentrate on avoiding pitfalls;  invest in a few areas of specialization based on in-depth analysis, conservatively estimated tangible values and modest purchase prices; and  be prepared for returns that trail the risk-takers when markets are hot. This may be the less common path, and certainly the less rosy, but it's the one I'd much rather count on for success in the long run. May 31, 2002

© Oaktree Capital Management, L.P. All Rights Reserved I was struck by a New York Times article saying these terrorists are not insane. They are extremists who follow a dogma that most Muslims do not. They are highly indoctrinated and perhaps brainwashed. But they are intelligent, highly trained soldiers who will carry out orders to destroy what they believe is their enemy. We count on others to act in their own self-interest; this makes them predictable and helps us know how to deal with them. It is not there in the case of the terrorists, in that they care little about their own survival. This adds greatly to the danger they pose. UReactionU – I left Oaktree's New York office Tuesday afternoon to collect my daughter and the children of friends in a natural desire to assure safety and feel the sorely-mis ability to create order. I walked north through streets that were strangely normal but not quite. The tourists were there, with their cameras and maps. There was no smoke and no ash. There were a few more people than usual, and almost all were moving in one direction: north, away from the WTC. There was no screaming or crying, no running or panic, just occasional knots of people gathered around radios. sed Only knowledgeable onlookers would have detected the differences. Few people were talking. Eyes didn't meet – which is not unusual in New York. There clearly were no smiles.

That's because while the participants develop new tools and techniques, the ball never adjusts and the course doesn't fight back. But investing is dynamic, and the playing field is changing all the time. The actions of other investors will affect the return on your strategy. Just as nature abhors a vacuum, markets act to eliminate an excessive return. USo Then What Do We Do Now? I have a few things to suggest that may help in the years that lie ahead. None of them will prove easy to implement, however. None will give you that sure thing. UAccept changeU – Among the important elements that clients, consultants and managers must possess is adaptability. The only thing you can count on is change. Even if the fundamental environment were to remain unchanged – which it won't – risk/return prospects would change because (a) investors will move the prices of assets, certainly in relative terms, and (b) investor psychology will change. That's why no strategy, tactic or opinion will work forever. It's also why we have to work with cycles rather than ignore or fight them. USearch for alphaU – In doing so, however, it's essential to understand:  what alpha is,  what markets permit it, and  who has it.

© Oaktree Capital Management, L.P. All Rights Reserved Finance professors would say that these fluctuations reflect changes in the discount rate being applied to the cash flows or, in other words, changes in valuation parameters. Practitioners would agree that changes in p/e ratios are responsible, and we all know that p/e ratios fluctuate much more radically than do company fundamentals. The market has a mind of its own, and its changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves in a highly cyclical manner. For decades – literally – I've been lugging around what I thought was a particularly apt enumeration of 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 underway, and  the third, when everyone concludes everything will get better forever. Why would anyone waste time trying for a better description? This one says it all. Stocks are cheapest when everything looks grim. The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions. Maybe their buying attracts some attention, or maybe the outlook turns a little less depressing, but for one reason or another, the market starts moving up.

But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back. Investment markets make the same pendulum-like swing:  between euphoria and depression,  between celebrating positive developments and obsessing over negatives, and thus  between overpriced and underpriced. The swing of the pendulum? The oscillation of the cycle? Either way's fine – just don't tell me it'll be a straight line. In 1999, the Wall Street Journal ran a number of OpEd pieces by James Glassman and Kevin Hassett trumpeting the theory behind the book "Dow 36,000." I couldn't think of anything that made less sense. By last month, it seemed the Journal's story had changed: With economic conditions turning downward so quickly, pushed along by the events of Sept. 11, a lot of business books have been rendered irrelevant, even silly. Anyone remember "Dow 36,000"?

Expectations (and stock prices) that assume there won't be any are dashed sooner or later, and optimism turns to disappointment. I date this cycle's turning point in investor psychology to the third quarter of 1998, with the Russian default and the collapse of Long-Term Capital Management. Before that, investors seemed to consider risk their friend. They blithely interpreted the upward- sloping path of the Capital Market Line to mean that bearing more risk would reliably bring more return. (For example, one consultant told me his firm wouldn't recommend Oaktree's high yield bond management because they "wanted to maximize risk" and knew they couldn't accomplish that with us.) But the Russia and Long-Term fiascoes popped that balloon and reminded participants that risk-taking isn't always profitable. Here's an illustration of the impact of these events on psychology. According to CSFB, from the end of 1996 to the middle of 1998, the face amount of "distressed" bonds yielding more than 20% (and thus indicating grave concern over credit) grew just $6 billion per year on average. But in the 2-1/3 years following Russia and Long-Term, from mid-l998 through October 31, 2000, the amount increased by an average of $38 billion per year. Actual defaults grew only half as much over that period, ($18 billion per year), but investors' sharply reduced willingness to bear risk caused the distressed bond count to explode upward.

I hope you'll recognize in the above some of the elements behind the Oaktree approach, as exemplified by our work with distressed debt.  We look for Bookstaber's “liquidity demanders,” with their exogenous motivations. We call them forced sellers, and they provide our best bargains.  We take advantage when “noneconomic” market conditions increase the pressure to sell even as asset prices move lower.  And we rarely approach holders to buy, preferring to wait until they call us. In that way we are “liquidity suppliers” rather than eager buyers. Take it from me, the latter pay more. Many of us may have had thoughts like Bookstaber's, and in my 30+ years in money management I've had plenty of chances to watch liquidity demand soar, liquidity supply dry up, prices collapse and diversification fail. But I respect someone who can put into a rigorous framework that which “everybody knows.” Speaking of panics, we all recognize the carnage that occurs when the desire to sell far exceeds the willingness to buy. But I think Bookstaber's analysis applies equally to the opposite - times when the desire to buy outstrips the willingness to sell. It's called a buying panic and represents no less of a crisis, even though - because the immediate result is profit rather than loss - it is discussed in different terms. Certainly 1999 was just as much of an irrational, liquidity-driven crisis as 1987.

© Oaktree Capital Management, L.P. All Rights Reserved (If I'm right in saying risk tolerance turned to risk aversion in 1998, you might ask how the tech/media/telecom boom could have continued into 1999 and early 2000. The answer: it's the exception that proves the rule. Even as investors were turning more conservative and capital was being withdrawn from hedge funds and banks' and brokers' proprietary portfolios, the crowd took to TMT investing in a way that ignited the IPO boom and everything that followed. It's often said that at the end of a bull market the vast majority of stocks weaken while one popular sector goes on to a highly extended extreme before collapsing. Certainly that's what happened in 1999, when the tech-dominated NASDAQ rose 86% at the same time that the S&P 500 excluding technology was up only 3% (Wall Street Journal, December 21). In 2000, the last holdouts – the TMT aficionados – finally realized that they had overstated their companies' potential, ignored their dependence on a benign environment, understated the danger implied by the market's manic volatility and paid too much for their stocks. All of the positives of 1999 turned into negatives, with catastrophic results. The declines in the TMT stocks in 2000 provide a tangible reminder that psychology can change much faster than fundamentals. A little fundamental deterioration, when mixed with increased pessimism, can wreak absolute havoc with asset prices. UNow What?

© Oaktree Capital Management, L.P. All Rights Reserved UNever forget valuationU – The focus may shift from dividend yield to p/e ratio, and people may stop looking at book value, but that doesn't mean valuation is irrelevant. In the tech bubble, buyers didn't worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, the "greater fool theory" only works until it doesn't. Valuation eventually comes into play, and those who are holding the bag when it does are forced to face the music. UBe conscious of investor psychologyU – I don't believe in the ability of forecasts or forecasters to tell us where prices are going, but I think an understanding of investor psychology can give us a hint. When investors are exuberant, as they were in 1999 and early 2000, it's dangerous. When the man on the street thinks stocks are a great idea and sure to produce profits, I'd watch out. When attitudes of this sort make for stock prices that assume the best and incorporate no fear, it's a formula for disaster. I find myself using one quote, from Warren Buffett, more often than any other: "The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs." When others are euphoric, that puts us in danger. When others are terrified, the prices they set are low, and we can be aggressive.

* * * Robertson, Soros, Druckenmiller, Brinson and Buffett succeeded for decades because the markets they worked in (1) were driven by UbothU fear and greed, (2) responded eventually to reason, and (3) rewarded disciplined analysis more than they did naked aggressiveness. That's the kind of climate we at Oaktree prefer. In the late 1990s, markets were propelled (and the big money was made) by people who, in my opinion, substituted optimism, risk tolerance and love of a good story for reason, caution and skepticism. If investors have been chastened by the events of the last few weeks, I think we'll see more of the latter in the future.2000

© Oaktree Capital Management, L.P. All Rights Reserved day at $100 and be at $200 in six months.” Would you play? Could you stand the risk of saying no and being wrong? The pressure to buy can be immense. There have always been ideas, stocks and IPOs that produced great profits. Yet the pressure to participate wasn't as great as it is today because in the past the winners made millions, not billions, and it took years, not months. The upside in the deals that've worked so far has been 100-to-l (give or take a zero). With that kind of potential, (a) the upside becomes irresistible and (b) it doesn't take a very high probability of success to justify the investment. I have said in the past that while the market is usually driven by fear and greed, sometimes the strongest motivator is the fear of missing out. Never was that as true as today. This only intensifies the pressure to join in and crawl further out on that limb of risk. With broader relevance than just the dot-com stocks, the relative performance chart below from Barron's of September 27 (already quite outdated) shows two things: 1. over the last two decades, technology stocks have had periods of both underperformance and overperformance relative to the large-cap universe, and 2. the recent outperformance is unparalleled even in this bullish period. Nothing in this chart suggests that it'll be easy money in technology from here.

© Oaktree Capital Management, L.P. All Rights Reserved For free markets to operate at equilibrium, there must be healthy tension between two motivating factors: fear and greed. If a participant feels both, greed will push him to take chances but fear will put limits on the risk he assumes. However, the two are not always in balance -- one or the other is often in the ascendancy. For the last few years, too little fear has been present, and greed and risk-taking have dominated. Long-Term's managers' brainpower may have let them consider their process foolproof, so that they felt too little fear and took on too much risk. In every era, one prominent participant becomes emblematic, and Long-Term is likely to be known for a long time as the "poster boy" of the 1990s. I think investors are always looking for “the silver bullet.” They seek a course of action that will lead to large profits without risk -- and thus they pursued Nifty-Fifty investing in the 1970s, portfolio insurance in the '80s and market-neutral strategies in the '90s. Often, they align themselves with "geniuses" who they hope will make it easy for them -- be it Joe Granville, Elaine Garzarelli, David Askin or John Meriwether. But the silver bullet doesn't exist. No strategy can produce high rates of return without some risk. And nobody has all of the answers; we’re all just human. Brilliance, like pride, often goes before the fall.

Something always goes wrong eventually. Those who see high returns often mistake risk bearing for genius. The swings of the credit cycle can overwhelm all other factors. Every boom carries within itself the seeds of decline (just as every bust lays the groundwork for recovery). Forget forecasting -- you'll be well ahead if you simply bear in mind the lessons of the past. We've all heard George Santayana's famous observation that "Those who cannot remember the past are condemned to repeat it." And yet, how many of today's mistakes are just replays of the past? Thirty years ago, the stocks of "the best companies" reached P/Es of fifty and more from which they eventually collapsed. Ten years ago, highly leveraged investments were financed with bridge loans which investment bankers were stuck with when the financing window closed. Five years ago, banks got into big trouble with derivatives. All of these are causing problems again in 1998 for those who forgot history or rationalized its irrelevance in the "new paradigm." I've previously recommended John Kenneth Galbraith's excellent little book, A Short History of Financial Euphoria. Although I don't appreciate its swipes at high yield bonds, I consider it must reading for anyone who wants to think and invest against the grain. Galbraith says: Contributing to ... euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory.

Memo to: Oaktree Clients and Friends From: Howard Marks Re: Are You An Investor or a Speculator? All of Oaktree's activities follow from our conviction that what matters most in determining the success or failure of an investment isn't whether it's in a fast-growing company, a desirable asset or a highly-rated security, but rather the relationship between the price you pay and what the asset is worth. We think no asset is so bad that there's not a price at which it's attractive for purchase, and no asset is so good that it can't be overpriced. Thus, we think in order to invest successfully you have to know both the value of the asset and how the price relates to that value. The relationship in the marketplace of price to value is highly dependent on how things are being viewed at the time -- on the attitudinal factors determining investor behavior. We spend a lot of our time thinking (and some time writing) about the investor behavior embedded in asset prices, as we feel this will prove highly determinative of the success of the investments we make. In an April 1991 memo entitled "The Pendulum," we discussed the market's usual oscillation between euphoria and depression, and thus between overpriced and underpriced. We think this swing, like other forms of cyclical fluctuation, is one of the few things in the investment world on which we can depend. And it's essential that we keep in mind where we stand in regard to that arc.

Bought when "riskless," this paper proved to be a disaster; purchased off the trash heap, we found it very attractive. That leads us to the $64,000 question (although many of you already know my answer): Where do we currently stand? What attitudes and behavior characterize today's investors? We think many "investors" have been buying with euphoria and belief rather than hesitance and skepticism. Many investors seem to be most afraid of being uninvested and missing out on the gains others are enjoying; that is, they're most worried about the risk of not taking enough risk. Although many valuation indicators are at all-time highs and price gains in July set record after record, investors are quite willing to accept platitudinous rationalizations like "technology has brought a new era," "globalization offers unlimited opportunities for growth" and "we have nothing to worry about from the business cycle." Some analyses suggest that prices are fair today, implying that future returns will be proportional to the risks involved; by many other standards, prices are too high. We find it very difficult, however, to conclude that stocks are underpriced, and thus that the potential exists for high and dependable returns from here. We find particularly troubling the oft-repeated mantra that "because the outlook continues to call for low inflation and stable interest rates, stocks can continue to rise."

But I recoil any time I hear a prediction that trees will grow to the sky, or that centuries of history are irrelevant. When I hear people say the valuation measures of the past no longer matter, I think John Kenneth Galbraith put it well, stating that in a speculative episode, Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. (UA Short History of Financial EuphoriaU, Viking, 1990) And I feel cyclicality is one of the few constants in the economy and markets. Cycles are the result of human behavior, herd instinct and the tendency to psychological excesses, and these things are unlikely to evaporate. Galbraith cites "the extreme brevity of the financial memory" in explaining why markets are able to move to extremes of euphoria and panic. And few adages have been borne out as often as "What the wise man does in the beginning, the fool does in the end." It is rare for trends to be curtailed at a reasonable point before swinging to the excesses from which they invariably correct. Today, there are some signs just as worrisome as the bullish arguments are constructive. We detect the decline of skepticism and discipline and the aggressive extension of credit which regularly precede corrections. Capacity expansion has been strong in some industries, and construction seems about to resume.

Put these two phenomena together and what do you have? I think the answer is an environment in which risk-taking is greatly encouraged. It is often said that the market runs on fear and greed, but I believe it usually runs on fear or greed; that is, at most points in time, one or the other predominates. Right now, because of the two trends cited above, greed is greatly elevated and, perhaps more importantly, fear is in short supply.fund,

© Oaktree Capital Management, L.P. All Rights Reserved An investment that "everyone" knows to be undervalued is an oxymoron. If everyone knows it's undervalued, why haven't they bought it and driven up its price? And if they have bought, how can the price still be low? Yogi Berra said, "nobody goes to that restaurant; it's too popular." The equally oxy-moronic investment version is "Everybody likes that security because it's so cheap." 5. Book the bet that no one else will. If everyone likes the favorite in a football game and wants to bet on it, the point spread will grow so wide that the team -- as good as it is -- is unlikely to be able to cover the spread. Take the other side of the bet -- on the underdog. Likewise, if everyone is too scared of junk bonds to buy them, it will become possible for you to buy them at a yield spread which not only overcompensates for the actual credit risk, but sets the stage for their being the best performing fixed income sector in the world. That was the case in late 1990. The bottom line is that one must try to be on the other side of the question from everyone else. If everyone likes it, sell; if no one likes it, buy. 6. As Warren Buffet said, “the less care with which others conduct their affairs, the more care with which you should conduct yours." When others are afraid, you needn't be; when others are unafraid, you'd better be. It is usually said that the market runs on fear and greed.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Clients From: Howard Marks Trust Company of the West Re: First Quarter Performance The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum "on average," it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back. Investment markets make the same pendulum-like swing: - between euphoria and depression, - between celebrating positive developments and obsessing over negatives, and thus - between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a "happy medium." In late 1990, the securities markets were at a negative extreme as concerns about the economy and Iraq produced exaggerated risk aversion and thus drastic under-valuation of all securities considered to be of less than "gilt-edge" quality. The subsequent first quarter swing toward more reasonable valuations imparted to our portfolios some of the best quarterly performance in our history.