This memo to clients from the chairman of Oaktree Asset Management, sums up perfectly why financial markets always overshoot. It’s a little long, my favorite part being:

But is it right to say Prince and Citigroup could have avoided trouble by refusing to go along? Let’s do what some DVDs let you do nowadays: go back and consider an alternative ending. It’s July 2005 instead of July 2007. Presciently, Chuck Prince says, “When the music stops, in terms of liquidity, things will get complicated. We’re not going to get caught in that trap. As of today, we’re adopting a conservative stance toward loans, mortgages, subprime, CDOs and SIVs. The others can dance all they want; we’re sitting this one out.”

What would’ve happened? Rather than lose his job in late 2007, he probably would have lost it sooner. Why? Because from whenever he made that statement until July 2007, Prince would have looked dumb. While other banks were gaining market share, Citi’s share would have been shrinking. And while other banks were borrowing on the cheap to make mortgage-related investments at seemingly attractive spreads, Citi would have been on the sidelines, forgoing easy profits. Shareholders would have been yelling for Prince’s scalp.”

I couldn’t agree more. I get annoyed whenever I hear people complaining that analysts in particular are paid to lie about the stocks they cover — that they stay bullish when they know otherwise. For the most part, nobody “forces” analysts to stay bullish on an overpriced theme. They might know it’s overvalued; they might know it could fall significantly. But the reality is as long as the music keeps playing, they better keep dancing. Otherwise, they’ll be wrong — and they’ll be out.