Howard Marks is the founder of Oaktree Capital. He has been writing memos about markets to his clients since 1990 (they are all published on their website). Marks’ first book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor” is a collection of the best insights from his memos.
Marks’ latest book, “Mastering the Market Cycle: Getting the Odds on Your Side” was published in October 2018. It focuses on one thing: market cycles. Why they occur, how to spot them, and how investors should use them to improve their returns. The book goes into great depth on the minutiae of cycles, and can often appear quite repetitive. While I recommend reading the book this article is my attempt at summarising the most important insights from the book.
Why study cycles?
Marks contends that if as investors we have the same information as each other, analyse the information in the same way, reach the same conclusions and use the same investment strategy as everyone else then quite clearly one shouldn’t expect to outperform the market.
When it comes to macroeconomics it is nigh on impossible to be able to forecast what the future holds, at least on a consistent basis. Furthermore, very few successful investors, if any are known for using forecasts to direct their investment strategy. Instead, Marks suggests you focus on three key areas:
- trying to know more about the fundamentals than other investors about industries, companies and securities;
- being disciplined as to the price to pay and the size of the investment; and
- understanding the current investment environment, what that might imply for the future and how to position a portfolio in order to benefit from it.
“Simply being right about a coming event isn’t enough to ensure superior performance if everyone holds the same view and as a result everyone is equally right. Thus success doesn’t lie in being right, but rather in being more right than others.”
Marks describes the market cycle as a sort of lottery ticket generator. While no one has an analytical or behavioural edge that they can deploy consistently over time Marks suggests that the greatest way to optimise a portfolio is to focus on the third of the three key areas – the investment environment and its market cycles.
“The odds change as our position in the cycle changes. If we don’t change our investment stance as these things change, we’re being passive regarding cycles; in other words we’re ignoring the chance to tilt the odds in our favor. But if we apply some insight regarding cycles, we can increase bets and place them on more aggressive investments when the odds are in our favor, and we can take money off the table and increase our defensiveness when the odds are against us.”
The best investors use cycles to maximise the edge they have accumulated in understanding fundamentals and honing their behaviour in interacting with the market.
“Superior investors are people who have a better sense for what tickets are in the bowl, and thus for whether it’s worth participating in the lottery. In other words, 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 nature of cycles
There is no starting or indeed end point to a market cycle. The recovery from an excessively depressed lower extreme towards the mid-point tends to be followed by a move straight through and onto a an upper extreme or the attainment of a new high. From there prices correct downwards through the mid-point and onto a lower extreme or the attainment of a new low. Once again the cycle reverts as prices rebound back to the mid-point. Each part of the cycle causes the next:
“The events in the life of a cycle shouldn’t be viewed merely as each being followed by the next, but – much more importantly – as each causing the next.”
As such market cycles oscillate around a mid-point – the secular trend, the average or just some apparently happy medium. The extremes of the cycle are viewed as excesses and tend to be termed bubbles or depressions. Over time though the mid-point exerts a “kind of magentic pull” that brings prices back towards what might be described as normal.
“Cycles are self correcting, and their reversal is not necessarily dependent on exogenous events. The reason they reverse (rather than going on forever) is that trends create the reasons for their own reversal. Thus I like to say success carries within itself the seeds of failure, and failure the seeds of success.”
As Mark Twain is supposed to have said: “History doesn’t repeat itself, but it does rhyme.” As Marks outlines, the details driving each cycle “are unimportant and can be irrelevant. But the themes are essential and they absolutely tend to recur.”
The economic cycle
“The output of an economy is the product of hours worked and output per hour; thus the long-term growth of an economy is determined primarily by fundamental factors like birth rate and the rate of gain in productivity (but also other changes in society and environment). These factors usually change relatively little from year to year, and only gradually from decade to decade.”
But of course economic growth is not a straight line. Both endogenous (decisions by individual actors in the economy, often influenced by their state of mind), and exogenous factors (government decisions such as taxes and wars but also natural events such as drought and pandemics) affect economic growth.
Economic forecasts are of little use to the investor. As Marks’ outlines, “Most economic forecasts consist of extrapolations of current levels and long term trends. And since the economy usually doesn’t depart much from those levels and trends, most extrapolation forecasts turn out to be correct.”
“Its tempting to act on economic predictions, especially since the pay-off for correct ones theoretically could be high. But the difficulty of being able to do so correctly and consistently mustn’t be underestimated.”
It’s important to study past economic and financial cycles. The business cycle typically lasts around a decade and so relying solely on personal experience is not sufficient to understand the realm of tell-tale signs indicative of different parts of the market cycle, and the second order effects that can occur.
Related article: Why do economists have an abysmally poor prediction record?
The credit cycle
Changes in the availability of capital or credit constitute one of the most fundamental influences on economies, companies and markets. Despite being less well known to most investors, Marks argues that its of paramount importance and profound influence.
Here’s what happens at the bottom of the credit cycle:
“Its nadir is reached when developments are unpleasant, risk aversion is heightened, and investors are depressed. Under such circumstances, no one wants to provide capital, the credit market freezes up, and proposed offerings go begging. This puts cards into the hands of providers of capital rather than borrowers.”
The exact opposite happens at the top of the cycle.
The pendulum of investor psychology
Asset prices are affected primarily by developments in two areas: fundamentals and psychology.
- Fundamentals include company earnings, cash flow and their outlook. They are affected by trends in the economy, profitability and the availability of capital.
- Psychology is all about how investors feel about fundamentals. It’s affected by investors level of optimism and attitude to risk.
“…security prices generally fluctuate much more than earnings. The reasons of course are largely psychological, emotional and non-fundamental. Thus price changes exaggerate and overstate fundamental changes.”
This is how it starts to evolve in a downturn or bear market:
-Events fail to live up to expectations for some reason, but perhaps because optimism was just too high.
-Cooler investor heads conclude that prices have reached levels that are unjustified.
-Prices fall when events are less positive, or come to be viewed less positively.
Asset prices continue to decline until a point where they set the stage for their recovery.
The relationship between fundamentals and psychology can work in both directions, even simultaneously. Events may cause psychology to change, and sometimes psychology can influence events. For example, rising asset prices make investors feel good, encouraging them to go out and spend in the real economy, this in turn drives earnings which drives asset prices higher, which in turn reduces the cost of capital to business, which in turn increases profitability.
The investor pendulum swings further away, until it stops. Before it gets to this point a few thoughtful investors recognise that despite the prevailing sentiment things won’t always appear this way. Gravity eventually takes hold. There are no more buyers in a bull market, and no more sellers in a bear market. The pendulum begins to move towards the mean.
Most investors of course fail to take the right action at the right time. They the compound the error much later when it has become absolutely the wrong thing to do – capitulation. According to Marks:
“What the wise man does in the beginning, the fool does in the end.”
or as Warren Buffet describes.
“First the innovator, then the imitator, then the idiot.”
How to cope with market cycles
Understanding market cycles can be greatly aided by looking at how other investors are behaving. The key though is to do this dispassionately, and not get caught up in the emotions of others:
“To respond to market cycles and understand their message, one realization is more important than all others: the risk in investing doesn’t come primarily from the economy, the companies, the securities, the stock certificates or the exchange buildings. It comes from the behaviour of the market participants. So do most of the opportunities for exceptional returns.”
Everyone reads, sees and hears the same media. But very few make the effort to understand what those events and opinions say about how people are feeling.
The psychological requirements to cope with market cycles can be enormous, and shouldn’t be underestimated:
“To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the highest reward.” – Sir John Templeton
Here’s Warren Buffet’s take:
“The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.”
Just as there are limits to positivism, there are also as Marks outlines limits to negativism. You just need to look:
“No greed, only fear. No optimism, only pessimism. No risk tolerance, only risk aversion. No willingness to interpret things positively, only negatively. No ability to imagine good outcomes, only bad.”
Marks outlines how investors should think about trying to time their investments to catch the bottom of the market:
“I think its helpful to take an organized approach to what I call the “twin risks”. What I’m talking about here is the fact that investors have to deal daily with two possible sources of error. The first is obvious: the risk of losing money. The second is a bit more subtle: the risk of missing opportunity. Investors can eliminate either one, but doing so will expose them entirely to the other. So most people balance the two.
That is really down to you in terms of your priorities and the length of your outlook. What tends to happen at the bottom of the market is that investors are scared and tend to want to wait until the dust has settled before dipping a toe back in the market. Marks rejects this approach for the following tow reasons:
“First, there’s absolutely no way to know when the bottom has been reached. There’s no sign that lights up. the bottom can be recognised only after it has been passed, since it is defined as the day before the recovery begins.”
And second, it’s usually during market slides that you can buy the largest quantities of the things you want, from sellers who are throwing in the towel and while the non-knife catchers are hugging the sidelines. But once the slide has culminated in a bottom, by definition there are few sellers left to sell.”
The future of cycles
No matter how much we may think we have tamed the business cycle it always comes back to bite. Whenever we think new technology or some financial innovation means we have a better handle on risk than our ancestors it usually means we are being complacent.
“The tendency of people to go to excess will never end. And thus, since those excesses eventually have to correct, neither will the occurrence of cycles. 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 opportunities for profit.”
That’s why this book is one I recommend. For as long as humans decide what to buy and sell there will always be opportunities to take advantage of swings in the market cycle.