In his memo titled – Taking The Temperature, Howard Marks discusses the importance of “taking the temperature of the market” by observing patterns and cycles driven by investor psychology.

Study market history to recognize that extreme optimism or pessimism often leads to corrections. Cycles stem from excesses, where strong movements are typically followed by reversals. Success lies in contrarianism during emotional extremes, not blind disagreement with consensus.

To act contrarian effectively, understand herd behavior and its flaws. Markets are influenced by emotional swings, not mechanical processes. Resist emotional impulses, challenge illogical beliefs, and act rationally. Clear, objective observations matter more than data or complex calculations.

Here’s an excerpt from the memo:

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:

1. 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).
2. 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.”
3. 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.
4. Remember that in extreme times, because of the above, the secret to making money lies in contrarianism, not conformity.  When emotional investors take an extreme view of an asset’s future and, as a result, take the price to unjustified levels, the “easy money” is usually made by doing the opposite.  This is, however, very different from simply diverging from the consensus all the time.  Indeed, most of the time, the consensus is as close to right as most individuals can get.  So to be successful at contrarianism, you have to understand (a) what the herd is doing, (b) why it’s doing it, (c) what’s wrong with it, and (d) what should be done instead and why.
5. Bear in mind that much of what happens in economies and markets doesn’t result from a mechanical process, but from the to and fro of investors’ emotions.  Take note of the swings and capitalize whenever possible.
6. Resist your own emotionality.  Stand apart from the crowd and its psychology; don’t join in!
7. Be on the lookout for illogical propositions (such as “stocks have fallen so far that no one will be interested in them”).  When you come across a widely accepted proposition that doesn’t make sense or one you find too good to be true (or too bad to be true), take appropriate action.  See something; do something.

Obviously, there’s a lot to grapple with when taking the temperature of the market.  In my opinion, it has more to do with clear-eyed observations and assessments of the implications of what you see than with computers, financial data, or calculations.

You can read the entire memo here:

Howard Marks Memo – Taking the Temperature

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