There are a few people who Warren Buffett says he’ll stop everything and listen to.

The ‘Oracle’s Oracle’ Howard Marks is one of them, and we mentioned just how fond Buffett is of Oaktree Capital Management’s co-founder a few months ago. 

Earlier in July, Marks published a piece in Financial Times with his latest thoughts.

Marks recognizes that fundamental analysis of companies is a vital part of evaluating investment decisions. While this holds true, there is another piece to the puzzle: market outlook.

You can analyze a company to death, understand everything about it, and still lose money investing in it if you don’t understand how other investors think. 

Investors like Marks understand that real results come when there’s a difference between how a company should perform and how the market expects it to perform. 

When you find a dislocation like that, it’s time to take advantage. 

Today, we’ll take a look at how Marks recommends identifying such a market condition. Plus, we’ll discuss one of the ways the market is signaling that it’s becoming dislocated from reality.

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Marks suggested the following framework to identify these types of situations.

First, you need to learn to recognize market patterns. Marks has worked in investments for over 50 years, and the more market history he learned, the easier it was for him to recognize similarities in the market today.  

One pattern that repeats time and time again is that markets will often correct due to excessive investor sentiment in both directions. That means the market will sometimes become too bearish or too bullish. 

According to Marks, the real money is made via contrarianism. Resist emotion in investing, do not follow the herd. When the market is bearish, it’s time to be bullish and vice versa. 

Therefore, to be successful in these situations, you need to understand what the rest of the market is thinking and why. If you spot the rest of the market acting truly irrationally, you can capitalize. 

All of these factors combine into one central idea: identify irrational behavior in the markets by distinguishing market movement from a psychological viewpoint. Try to make sense of the changes. 

Subscribers to our monthly newsletters have access to our Timetable Investor’s monthly macroeconomy update. We summarize the macro signals we are seeing right now for the market, and show how you need to be positioned for the next three to 24 months.

We focus on credit signals first and foremost. Those have us worried right now. Credit is constricted, and that could lead to a credit crunch at some point. 

The second signal we look at is corporate investments. This is so we understand how much companies are putting capital to work that can drive earnings going forward. Right now, earnings are forecast to shrink this year, and that’s not great.

There is one last component that needs to be considered. As Marks highlights, it’s important to understand if investors are too bullish or bearish given the market context.

All other macro signal metrics are turning negative. With this outlook, it would logically make sense that investors would have a bearish view of the market. 

Yet, that does not seem to be the case. Investors are excessively bullish right now.

We can use the National Association of Active Investment Managers (“NAAIM”) Exposure Index to visualize this sentiment.

The index gets its data from a weekly survey that tracks how much members are investing in equities. Results tend to fall between 0% and 100%. But they can be lower or higher than that if investors are shorting stocks or using leverage.

The long-term average allocation is between 60% and 65%. That means in an average market, active investors have 60% to 65% of their assets in stocks.

When allocations rise, investors are bullish. They’re pouring a lot of money into the stock market.

Investors are getting bullish, and fast. Total equity exposure reached 83% earlier this month. That’s way above the long-term average.