Mastering the Market Cycles, by Howard Marks
Is it a good time to invest? This is definitely a common question among investors. Everyone would like to know what the market will look like in the near future. However, as Warren Buffett used to say: the only value of stock forecasters is to make fortune-tellers look good. What an investor can opt for is to embrace the mindset of Haward Marks: (1) look for a clear understanding of where we are now in the market cycle, (2) develop an above the average understanding of future tendencies and (3) position our portfolio accordingly. But who is Howard Marks? He is not one of those popular American investment gurus: he is the CEO and co-founder of Oaktree Capital Management, a company that focuses on a particular niche market: distressed debt and equity. In Howard Marks’ word, he helps companies with a good business but a bad balance sheet. In the last 40 years, his analysis (Memos) have been closely studied by clients and great investors like Warren Buffett.
In his recent publication – Mastering the Market Cycles, getting the odds on your side – he distils his experience in analyzing the nature of cycles and how to better position an investment portfolios for what is likely to happen.
For Howard Marks, investing is a matter of preparing for the financial future. We assemble portfolios today that we hope will benefit from the events that unfold in the years ahead. One of his philosophy’s foundational elements is the conviction that we can’t know nor predict what the “macro future” looks like in terms of economies, markets, and geopolitics. We may never know where we are going, but we’d better have a good idea of where we are in the economic cycle.
The author suggests investing our time and energy in 3 areas:
- Security analysis: know more than others about “the knowable”, the fundamentals of industries, companies, etc.
- Value investing: identifying the correct price to pay for an investment, taking advantage of discrepancies between the market price and the intrinsic value of a share.
- Understand the investment environment (cycles) and how to position our portfolios accordingly
There are two main tools in portfolio management: (a) Cycle positioning is the process of deciding on the risk posture of your portfolio in response to your judgment regarding the principal cycles, and (b) asset selection is the process of deciding which markets, market niches and specific securities or assets to overweight and underweight.
On such information, investors assemble their portfolios with the immediate goal to hold investments offering the best available value proposition: the assets with the best ratio of upside potential to downside risk. The author suggests properly positioning a portfolio for what’s likely to happen in the market in the years immediately ahead by optimizing the balance between aggressiveness and defensiveness. Such optimization should then be calibrated over time in response to changes in the environment and where several elements stand in the cycles.
In the investment world, he states that investors talk about risks as:
- The likelihood of losing money
- The volatility of asset prices or returns
- The opportunity risk: the risk of missing out on potential gains
Risk is the main moving piece in investing: the way investors collectively view risk and behave regarding it is of overwhelming importance in shaping the investment environment. We need to understand which attitudes toward risk stand in the cycles and act accordingly. Overall, the author summarizes risk as to the possibility of things not going the way we want. In life, like in investing, there can be many different outcomes: uncertainty and risk are inescapable. As such, the future should be viewed as a range of possibilities and, hopefully, based on insight into their respective likelihoods, as a probability distribution that will guide our actions. While superior investors – like everyone else – don’t know exactly what the future holds, they do have an above-average understanding of future tendencies.
The best way to optimize our portfolio’s positioning is by deciding what balance it should strike between aggressiveness and defensiveness by calibrating the amount invested, its allocation, and the riskiness of each investment. If we are getting value cheap, we can be aggressive. If we are getting value expensive, we should pull back. The odds change as our position in the cycles changes.
If we apply some insight regarding cycles, we can increase our bets and place them on more aggressive investments when the odds are in our favour, while we can take the money off the table and increase our defensiveness when the odds are against us. When cycles are at dangerous extremes, the odds are against us, meaning the likelihoods are less good: there is less chance of gain and more chance of loss.
In the graphs below, Howard Marks shows the changes in returns based on the positioning: favourable vs unfavourable cycles.
THE MECHANICS OF CYCLES
Let’s now dive into the mechanics of cycles. Howard Marks states that some patterns and events recur regularly in our environment, influencing our behaviour and lives. We regularly use our ability to recognize and understand patterns to make our decisions easier. Economies, companies and markets also operate according to patterns. Some of the patterns are commonly called cycles. Cycles vary in terms of reasons and details, timing and extent. Still, the ups and downs will occur forever, producing changes in the investment environment and the behaviour called for. They arise from:
1) naturally occurring phenomena
2) from the ups and downs of human psychology and the resultant human behaviour.
Cycles are not as regular as expected. As such, they are also not dependable and predictable. Otherwise, there would not be such thing as superiority in seeing them. Nevertheless, if we pay attention to cycles (listen to cycles), we can come out ahead, and we have less of a chance of being blindsided by events. In an investor who listens in this sense, he will convert cycles from a wild, uncontrollable force that wreaks havoc into a phenomenon that can be understood and taken advantage of.
Howard often shares this drawing among his clients to explain cycles and their phases:
a) recovery from a low extreme
b) the continued swing passes the midpoint and lead toward a high extreme
c) achievement of a high extreme
d) downward correction toward the midpoint
e) downward movement passes the midpoint in the direction of a new low extreme
f) achievement of a low extreme
g) once again, recovery from a low extreme, in the direction of the midpoint
h) again, the continued swing passes the midpoint and lead toward new extremes
The cycles oscillate around the midpoint. The midpoint of a cycle is generally thought of as the secular trend, thought of as the norm, mean, and in some sense, the right and proper. The extremes of the cycle are thought of as aberrations or excesses to be returned from, and generally, they are. While the thing that’s cyclical tends to spend much of the time above or below it, eventual movement back in the direction of the mean is usually the rule and is called: the regression toward the mean, a powerful and very reasonable tendency in most walks of life.
Interesting to say, the swing back from a high or low rarely halts at the midpoint, regardless of how “right” the midpoint may be. For example, markets rarely go from underpriced to fairly priced and stop there. Usually, the rising optimism that causes markets to recover from depressed levels remains in force, causing them to continue to overprice.
Events in the life of cycles should not be viewed merely as each being followed by the next but much more as each causing the next. There is not a single starting point or ending point for a cycle. As such, is improper to ask “what caused the cycle to begin?” or “are we close to the end of the cycle?” because cycles never begin nor end. It is better to ask, “what caused the current up-leg to begin?” or “how far are we gone since the beginning of the up-cycle”? are we close to the end of the down-leg?
As Mark Twain is reputed to have said, “history doesn’t repeat itself, but it does rhyme”. The sentence helps in understanding the cycles in finance and financial crises: they vary in terms of reasons and details, and timing and extent, but the ups and downs will occur forever, producing changes in the investment environment and thus in the behaviour that is called for.
It is important to understand that:
- cyclical developments in one area also influence cycles in others: economic cycles influence profit cycles, investors attitude influence markets, and so on. Cyclical events are influenced by both endogenous developments and exogenous developments (events that occurred in other areas).
- Cycles are inevitable. Cycles are also self-correcting: the reason the reverse rather than going on forever is that trends create the reasons for their own reversal. Success carries within itself the seeds of failure, and failure the seeds of success. Busts follow booms. Somehow, fewer grasp that the bust is caused by the booms.
- Cycles are often viewed as less symmetrical than they are: negative fluctuations are called “volatility”, while positive fluctuations are called “profit”. Collapsing markets are called “selling panic”, while surges should also be called buying panic.
- Cycles have more potential to wreak havoc, the further they progress from the midpoint (the greater the aberrations or excesses): advances are followed by corrections, and bull markets by bear markets. But boom and bubbles are followed by much more harmful busts, crashes and panics.
- There are several types of interconnected cycles that we can monitor: the economic (business cycle), the cycle in profits, the cycle in attitudes toward risk, the credit cycle, the distressed debt cycle and the real estate cycle. Some are long term cycles, some short term.
The themes that provide warning signals in every boom-bust are the general ones:
- excessive optimism is a dangerous thing;
- risk aversion is an essential ingredient for the market to be safe;
- ultimately overly generous capital markets lead to unwise financing, and thus too dangerous participants.
Let’s look at a few consequences in the investment environment:
- Booms usually won’t be followed by modest, gradual and painless adjustments: “the air goes out of the balloon much faster than it went in.”
- It is unlikely to have a bust if we haven’t had a boom.
- Markets that have benefitted from fabulous appreciation are much more likely to succumb to a cyclical correction than they are to appreciate ad infinitum
- In good times people become more optimistic, abandon their caution and settle for risky investments. They tend to lose interest in the safer end of the risk/return continuum. It should not be a surprise that more unwise investments are made in good times than in bad. Risk is high when investors think the risk is low. Risk compensation is at a minimum just when risk is at a maximum! Quite counter-intuitive!
- The greatest source of risk is the belief that there is no risk. The safest time to buy is usually when everyone is convinced there is no hope.
- The fluctuation – or inconstancy – in attitudes toward risk is both the result of some cycles and the cause or exacerbation of others. And It will always go on since it seems to be hard-wired into most people’s psyches to become more optimistic and risk-tolerant when things are going well, and then more worried and risk-averse when things turn downward. That means they are most willing to buy when they should be most cautious and most reluctant to buy when they should be most aggressive. Superior investors recognize this and strive to behave as contrarians.
- Investor psychology has a very pronounced cycle of rising optimism (and price appreciation) followed by rising pessimism (and price declines). Betting against those tendencies can be very profitable.
- Changes in the availability of capital or credit constitute one of the most fundamental influences on economies, companies and markets. Even if the credit cycle is less well known to the man on the street than most other cycles, it has a profound influence. The credit window opens and close.
- Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on. Looking for the cause of a market extreme usually requires rewinding the videotape of the credit cycles of some months or years. The key in dealing with credit cycles lies in recognizing that it reaches its apex when things have been going well for a while, news has been good, risk aversion is low, and investors are eager. That makes it easy for borrowers to raise money and causes buyers and investors to compete for the opportunity to provide it. The result is cheap financing, low credit standard, weak deals and unwise extension of credit. Borrowers hold the cards when the credit windows are wide open.
- The opposite comes true to the other extreme of the cycle: when risk aversion is higher, and investor are depressed. During those times, no-one wants to provide capital, the credit market freezes up. The cards are in the hands of the providers of capital. This is a time to apply a rigorous standard in investing, using the right margin of safety. In such scenarios, investors can swing into an aggressive mode.
- Superior investing does not come from buying high-quality assets, but buying when the deal is good, the price is low, the potential return is substantial, and the risk is limited. These conditions are much more when the credit markets are in the less euphoric leg of the cycle.
- The merits of the asset in question (it’s quality) matter only so much and can not always justify its price, which is inevitably transported to levels that are extreme and unsustainable.
- A bull market is composed of 3 stages:
- when only a few realize things will get better
- when most investors realize that improvement is actually taking place
- when everyone concludes things will get better forever
As such, those who invests in the first stage will buy assets at bargain prices, from which substantial appreciation is possible, while those who buy at the third stage pay high prices for the market’s excessive enthusiasm and loses money as a result.
- It is crucial to note that maximum psychology, maximum availability of credit, the maximum price of assets, minimum potential return and maximum risk all are reached at the same time.
- The bottom of a cycle is the last day on which sellers wants to sell more than the buyer wants to buy. Before reaching the bottom, investors are scared of buying: they don’t want to try to catch a falling knife. Buyers want to wait for the bottom to be reached, the uncertainty has been resolved. But when it happens, the bargains will be gone because buyers will face growing competition.
- Exiting the market after a decline – and thus failing to participate in a cyclical rebound – is truly the cardinal sin in investing.
For Howard Marks, (1) the investor’s goal is to position capital to benefit from future developments. (2) In the absence of the ability to see the future, it is necessary to understand where the market stands in its cycle and what that implies for its future movements. Economies and markets have never moved in a straight line in the past, and neither will they do so in the future. And that means investors with the ability to understand cycles will find profit opportunities. (3) To know where the pendulum of psychology and the cycle in valuation stand will give us an edge to act in front of opportunities: It is in fact when dealing with pronounced extremes that we should expect the highest likelihood of success. (4) To refuse to buy when optimism and prices are too high, and to buy when panic creates bargains; quoting Sir John Templeton: to buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest rewards”.
Howard Marks ultimately believes that markets will continue to rise and fall, and he thinks to know why and what makes these movements more or less imminent. He will never know when they will turn up or down, how far they will go after they do, how fast they’ll move when they’ll turn back toward the midpoint, or how far they’ll continue on the opposite side. But he believes that the little we know about cycle timing will give us a great advantage relative to the majority of investors.
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