Mastering the Market Cycle - Howard Marks
Author: Howard Marks
Status: Draft - still adding to it
Topics covered:
Why Study Circles
The Nature of Cycles
The Regularity of Cycles
The Economic Cycle
Government Involvement with the Economic Cycle
The Cycle in Profits
The Pendulum of Investor Psychology
The Cycle of Attitudes Toward Risk
The Credit Cycle
The Distressed Debt Cycle
The Real Estate Cycle
Putting It All Together-The Market Cycle
How to Cope with Market Cycles
Cycle Positioning
Limits on Coping
The Cycle in Success
The Future of Cycles
The Essence of Cycles
Why Study Cycles?
Generating average investment performance, is easy. Generating above average investment performance is hard.
Few people actually know the macro future better than others
Only when you know better than others can you achieve better than average returns
So trying to predict macro future and using that to achieve superior investment results is unlikely.
So what areas should we spend trying to understand more:
Trying to know more than others about what I call “the knowable”: the fundamentals of industries, companies and securities,
Being disciplined as to the appropriate price to pay for a participation in those fundamentals, and
Understanding the investment environment we’re in and deciding how to strategically position our portfolios for it.
The first 2 topics Is essentially security analysis and value investing
Figuring out what an asset can produce into the future (usually in terms of earnings or cashflow), and what those prospects make the asset worth today.
Value investors are trying to take advantage of the discriepancy between “price” and “value”.
They do this by Quantifying an asset’s intrinsic value and how it’s likely to change over time”
Assess how the current market price compares with the asset’s intrinsic value
Then build a portfolio with these value investments with minimised downside risk.
The best way to optimise the positioning of a portfolio at a given point in time is through deciding what balance it should strike between aggressiveness and defensiveness.
Aggressiveness and defensiveness balance should be adjusted over time in response to change in the state of the investment environment where a number of elements stand in their cycles.
It is key to understand the “tendencies” of market cycles
If factors that influence investing were regular and predictable we would talk about what “will happen”.
Rather we talk about what might happen - “tendencies”
Risk is often talked about, but there is no universal agreement of what risk is or what it should imply for investors’ behaviour
Some people think risk is the likelihood of losing money
Others think risk is the volatility of asset prices or returns (academic thinking)
Howard Mark (and Warren Buffet) lean towards the first. Which is the likelihood of permanent capital loss.
There is also Opportunity Risk
The likelihood of missing out on potential gains.
Needs to be finished
The Nature of Cycles
Events of a cycle shouldn’t be viewed merely as each being followed by the other. Each even causes the next.
Cycles vary in terms of reasons and details, and timing and extent, but the ups and downs (and the reasons for them) will occur forever, producing changes in the investment environment - and thus in the behaviour that’s called for.
Often the reason for cycles:
In the short term: investor psychology has a large impact.
Image of market cycles from, Mastering the Market Cycle by Howard Marks, page 25
Description of each point in the market cycle from, Mastering the Market Cycle, Howard Marks, page 26.
There is no clear “end” or “start” to a cycle.
Cycles oscillate around the midpoint.
There is usually a secular trend that the cycle oscillates around
Often when extremes occur there is reversion to the mean.
But often the trend doesn’t stay at the midpoint, it continues on, sometimes onward to the next extreme.
The details vary - the timing, duration, speed and power and reasons for the swings
Markets rarely go from “underpriced” to “fairly priced” and stop there.
Usually the fundamental improvement and rising optimism that causes markets to recover from depressed levels remain in force, causing them to continue right through “fairly priced” and onto “overpriced”.
The Real Estate Cycle
The period between the start of planning and the opening of a building is often long enough for the economy to transition from boom to bust. Projects started in the good times often open in bad times, meaning their space adds to vacancies, putting downward pressure on rents and sale prices. Unfilled space hangs over the market.
Then bad times cause the level of building activity to be low and the availability of capital for building to be constrained.
Initiating a realestate project in boom times can be a source of risk. Buying them in weak times can be very profitable.
People often don’t take into account what others are doing in their decision making process
How to cope with market cycles
The investor’s goal is to position their capital so as to benefit from future developments.
They want to have more invested when the market rises than when it falls and to own more of the things that rise more or fall less and less of the others.
First step is to decide how you will deal with the future.
Some people believe in economic and market forecasting and in taking the actions that such forecasts demand. Meaning they invest more aggressively when forecasters demand and vice Vera’s.
This is generally difficult to do consistently and deliver above average results. People generally became famous for periods of time but then get it wrong over future periods.
The next best alternative is to look at where the market is in it’s cycle and what it implies for future movements.
“We may never know where we’re going, but we’d better have a good idea where we are”
To do that we need to have a good understanding of:
What causes their movements
What causes them to progress towards peaks and troughs
What causes them to retreat from those extremes
Key elements to pay attention to - generalities that affect cycles of all kinds:
The tendency of basic themes to repeat and history to rhyme;
The tendency of things to rise and fall, especially those determined by human nature;
The way each development in a cycle has implications for the next;
The way the various cycles interact and influence each other;
The role of psychology in pushing cyclical phenomena beyond rational levels
Thus the tendency of cycles to go to extremes
Their tendency to move from extremes back toward a midpoint and,
The regularity with which that movement continues past the mid-point, toward the opposite extreme.
Specific elements that influence the market cycle:
The economic and profit cycles that shape the investment environment
The tendency of psychology to overreact to developments in the environment
The way risk is considered non-existent and benign at some times, and then enormous, inescapable and lethal at others; and
The way market prices reflect only positives and overstate them at one point, and then reflect only negatives and ignore all the positives at another.
The upward movement of of prices from fair value to excess usually is related to the presence of some combination of important elements:
Generally good news
Complacency regarding events
Uniformly upbeat treatment by the media
The unquestioning acceptance of optimistic accounts
A decline in skepticism
A dearth of risk aversion
A wide-open credit market
A positive general mood
The collapse of prices from fair value to bargain levels is usually seen through:
Generally bad news
Rising alarm regarding events
Highly negative media accounts
The wholesale acceptance of scare stories
A strong rise in skepticism
A significant increase in risk aversion
A credit market that has slammed shut; and
A mood of general depression
The key thing is to know where you are in a cycle:
One way is to use measurable things like:
P/E ratios on stocks
Yields on bonds
Capitalisation ratios on real estate
Cash flow multiples on buyouts
If they are all elevated on historical norms, then they’re usually a precursor to low prospective returns.
Another thing to consider is how investors are behaving
FILL THIS OUT from page 211 on wards.