Mastering the Market Cycle - Howard Marks

Mastering the market cycle with Howard Marks

We can tilt the investment odds in our favour by understanding the tendencies of markets and the reasons they wax and wane. Otherwise, we risk being too optimistic or pessimistic at precisely the wrong time. Investor Howard Marks outlines his thoughts on the matter in his book Mastering the Market Cycle. In describing how market forces interact with one another, he highlights the value of thinking in tendencies and probability distributions.

I found Marks’ work a nice complement his earlier Oaktree Capital Memos and book The Most Important Thing, and other seminal works such as Robert Shiller’s Irrational Exuberance. In this post, we’ll review the main lessons I took from his book. (And if you haven’t yet already, I highly recommend you read every Howard Marks memo. He’s shared a lifetime of investment insights generously and publicly on Oaktree’s website (linked above). It’s thoughtful and humbling reading for all value investors, old and new).

Predictions and positioning

Howard Marks believes that macroeconomic predictions, in areas such as economies, financial markets and geopolitics, are unlikely to help us to achieve outperformance in investing. Instead, Marks recommends we spend more of our time on security analysis and value investing. This involves analysing the knowables, such as industry, companies, and security fundamentals. It also requires a disciplined process to purchase assets at discounts to estimated intrinsic value. Furthermore, Marks suggests that it is important to understand our investment environment and position our portfolios accordingly. This involves balancing the aggressiveness (or defensiveness) in our positions based on the future tendencies and cycles of markets. (Notice that Marks’ language focuses on tendencies and cycles as opposed to predicting a knowable future)

Understanding risk

While many finance academics define risk as the volatility in asset prices or returns, risk, in practice, refers to the likelihood of permanent capital loss and the likelihood of missing out on potential gains. The latter is known also as opportunity risk. Risk implies that we are unsure about what’s about to unfold next and that there is a range of potential outcomes. We must always keep risk in mind when making decisions. This requires us to focus on both the tendencies and ranges of potential outcomes.

Thinking in cycles

Warren Buffett has previously noted that desirable information must be both important and knowable. Likewise, Howard Marks suggests then that the superior investor requires a knowledge advantage in knowable and important tendencies to outperform the market consistently. Most investors do not have a proper appreciation for the features and significance of market cycles, and what it implies about future tendencies. Similarly, most investors have not lived through many cycles or read sufficient financial history to develop such knowledge advantages. Too often, they see the investment environment as a series of isolated events.

Thinking in bets

Thinking in probability distributions can help us to think about the potential range and tendencies of outcomes. However, we also need an opinion about the reliability of our distributions when doing so. Marks believes people too often forget this point. They incorrectly treat all predictions as equally reliable. Similarly, World Series poker champion Annie Duke has talked about the value of thinking in bets. That is, probabilistic thinking can help us to distinguish between the role of process and luck. This can help us to learn from outcomes more effectively, and to avoid common decision-making traps such as resulting, hindsight biases and path-dependency biases.

The nature of market cycles

Market cycles are like pendulums or tides that move back and forth. While their reasons, timing and degree of change may vary, Marks believes they are an inherent feature of the investing environment. Like a pendulum in motion, markets are unlikely to remain at fair-value indefinitely. Rather, it swings from under-priced to over-priced and vice versa. These rationales become clearer as we layer and consider different cycles in aggregation.

Financial amnesia

Our inability to remember the past can enhance the strength of cycles. We are also quick to assume that this time is different. Furthermore, our asymmetric attitudes to market gyrations can make it difficult to observe cycles. For example, the media often contributes to downturns with record-breaking news, but tend to treat market upsurges with more moderate descriptions.

Human nature and randomness

Randomness and human behaviour contribute to the irregularity of cycles. Sometimes we develop simple explanations to make these events comprehensible, failing to recognise the complexity and randomness that characterise these events. Seeking such explanations may lead us to over extrapolate without evidence.

Complex reflexive systems

More generally, we should remember that financial markets are complex, reflexive systems. This is due in part to the nature of human participants in markets. Good ideas are unlikely to be infinitely or indefinitely scalable. Hence, ideas that generate abnormal profits tend to attract new capital that creates downward pressures on incumbent returns.

The economic cycle

The economic cycle underpins many other cycles of interest. Stock markets, for example, tend to rise with growing companies and profits. It’s important to take note of the long-term underlying trend and short-term oscillations that concern economic cycles.

There are several ideas here to keep in mind. Firstly, even long-term trends may exhibit their own cycles, subject to changes in underlying factors such as demography, productivity and public policy.

Secondly, responses from governments and institution have important implications for cycles. For example, central banks will tend to act counter-cyclically to trends in inflation and unemployment. It’s also rare to find advanced economies that run large surpluses today. Perhaps it’s difficult for governments to dampen growth through fiscal policy without losing voters.

Thirdly, Marks suggest that it’s difficult for the average investor to achieve out-performance on macroeconomic forecasts. Simple extrapolations are likely to be embedded into prevailing market prices, while non-conforming and non-extrapolating predictions of complex systems are difficult to make. This brings us to one Marks’ favourite quotes:

“We have two classes of forecasters: those who don’t know and those who don’t know they don’t know”.
John Kenneth Galbraith

The profit cycle

The economic cycle affect the sales and profits of some companies more greatly than others. For example, businesses in raw material commodities are more exposed to changes in aggregate demand than companies in everyday foods and medicines. Likewise, companies with higher operating leverage and/or financial leverage will experience relatively greater shifts in profits in response to changes in sales and the economic cycle. (Also, notice Marks’ focus on both operating leverage and financial leverage. Investors often neglect the former!)

The technology cycle

It is helpful to think about technologies and innovation in cycles as well. Technologies are developed, diffused and later displaced by future iterations and alternatives. While technology can boost productivity and generate new demand, new technology can also create new competitors and disrupt the profit margins of incumbents.

The psychology cycle

Emotions and psychology influence and are influenced by economic and profit cycles. Marks notes that company, industry, and macroeconomic fundamentals cannot fully explain the short-run gyrations that we observe in markets. Marks emphasises that investor psychology tends to swing between greed and fear, optimism and pessimism, risk tolerance and risk aversion, credence and scepticism, and our urgency to buy and sell.

Mania and risk

Marks notes how positive events can lead to optimism and credulousness in investors, and encourage greed and risk tolerance. Robert Shiller described this as the combination of feedback loops and irrational exuberance, where newfound expectations and enthusiasm, encourages investors to bid up and rationalise extraordinary growth in asset prices. By contrast, during periods of fear and pessimism, many struggle to see future value beyond near term losses.

An understanding of risk attitudes within the current investor psychology cycle can be a source of advantage. Markets may misprice assets on a risk-adjusted basis as society swings along the pendulum of psychology. Marks believes that the biggest source of investment risk is when investors believe that there are no risks at all.

Contrarianism

It’s helpful to consider the extent to which optimism or pessimism is incorporated into current asset prices. Scepticism is needed when optimism or pessimism is in excess. Contrarianism at the right moments is an important ingredient for successful investing. Marks believes that the rational, analytical and unemotional investor that finds balance between defensiveness and aggressiveness, particularly during periods of mania, is more likely to find success.

Warren Buffett rightly warns investors to “be fearful when others are greedy and greedy when others are fearful”. It takes a lot of self-awareness and self-restraint, and some contrarianism, to minimise the risk of selective perception and skewed interpretation on effective investment decision-making.

The credit cycle

The credit cycle both influences and is influenced by cycles in economic development and investor psychology. For example, access to credit (or capital) is important for financing growth and rolling-over existing obligations. Financial institutions in particular are reliant on the supply and velocity of credit flows. The credit cycle is also volatile, where small changes in economic progress can generate large changes in the supply of credit. This in turn affects asset prices, investor psyches and economic progress itself. This ‘vicious circle’ is a common feature of many financial crises.

Credit in action

Marks provides a simplified depiction of the credit cycle: Good economic times tend to expand riskier lending and investing. This is driven in part by increased optimism and risk-tolerance amongst investors and financiers. Over time, unwise lending leads to large losses and contribute to bad economic times. It is during these periods that investors and institutions become risk-averse. Prudent lending and investing during these periods help good economic times to re-emerge once again.

This tendency for riskier lending during good times is attributed to several structural and behavioural factors. In particular, financiers are more likely to accept deals of lower yields and riskier structures to protect market share during booms. This is aided by the confidence, optimism and risk-tolerance that good economic times bring. Capital markets can be a good indicator of investor psychology for these reasons.

The real estate cycle

Like other cycles, the real estate cycle both influences and is influenced by economic cycles, investor psychology and credit supply. High levels of leverage and the inflexibility in supply can amplify the real estate cycles observed.

These cycles also exhibit two additional features that we should keep in mind when thinking about cycles more generally. Firstly, unlike other cycles, the physical nature of real estate impose significant lags in timing. While optimism may inspire new projects, the economic cycle may have shifted by the time development has completed. Commencing new projects during the heights of a boom can increase risk.

Secondly, real estate cycles are driven in part by people’s failure to anticipate the decision and like mindedness of others. For example, suburbs with an under-supply of real estate may turn quickly to oversupply if every builder rushes into the perceived opportunity without consideration to the impact of other like-minded entrants. This can be exacerbated by simple generalisations to help rationalise the investment (e.g., ‘supply is limited’ and ‘prices can only go up’). These features provide a useful mental model for thinking about other capital intensive industries as well.

Fundamentals and psychology

Rarely do markets evaluate fundamentals or set prices without emotion. If they did, prices would fluctuate less than we observe today. That said, the markets cycle may reveal itself in various valuation metrics. These include price to earnings ratios, capitalisation ratios, cash flow multiples and so on. The vernacular and imagery adopted by the news media may be another important indicator. This may help inform our decision-making and positioning.

Falling knives

Many contrarians face the challenge of catching ‘falling knives’ during depressive episodes. Marks reminds readers that there is no reliable method to knowing when prices have bottomed. Bargains will disappear when the ratio between panic sellers and opportunistic buyers begin to shift. Marks also believes that “failing to participate in a cyclical rebound is the cardinal sin in investing”.

Value investing

Finally, it’s not obvious how long cycles can persist for. Realised outcomes may or may not match our probabilistic expectations. Historical cycles would have transpired differently if the initial conditions and dynamics were slightly different.

While getting things wrong is an inevitable feature of investing, skilful asset selection and cycle positioning may help us to tilt the odds in our favour over time. Marks reminds readers to invest with a margin of safety, and to understand what the current cycles may imply about future tendencies. Ultimately, we can only rely on our estimate of intrinsic value, our capacity to persevere during periods of manic, and time for mispricing to correct itself.

Mastering the Market Cycle — Howard Marks on Investing Odds and Tendencies