Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

Legendary investor Charlie Munger often points to the benefits of reading broadly; history and processes in other fields can add greatly to effective investment approaches and decisions.

The odds change as our position in the cycles 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 our 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.

some of the most important lessons concern the need to (a) study and remember the events of the past and (b) be conscious of the cyclical nature of things.

It’s particularly important in this vein to note the extent to which economic expectations can be self-fulfilling. If people (and companies) believe the future will be good, they’ll spend more and invest more . . . and the future will be good, and vice versa. It’s my belief that most companies concluded that the Crisis of 2008 wouldn’t be followed by a V-shaped recovery, as had been the rule in the last few recessions. Thus they declined to expand factories or workforces, and the resulting recovery was modest and gradual in the U.S. (and even more anemic elsewhere).

when economies are strong, Keynes said governments should run surpluses, spending less than they take in. This removes funds from the economy, discouraging spending and investment. Surpluses are contractionary and thus an appropriate response to booms. However, the use of surpluses to cool a thriving economy is little seen these days. No one wants to be a wet blanket when the party is going strong. And spending less than you bring in attracts fewer votes than do generous spending programs. Thus surpluses have become as rare as buggy whips.

When I was a rookie analyst, we heard all the time that “the stock market is driven by greed and fear.” When the market environment is in healthy balance, a tug-of-war takes place between optimists intent on making money and pessimists seeking to avoid losses. The former want to buy stocks, even if they have to pay a price a bit above yesterday’s close, and the latter want to sell them, even if it’s on a downtick.

The vast majority of the highly superior investors I know are unemotional by nature.

Here’s how investors react to events when they’re feeling good about life (which usually means the market has been rising): Strong data: economy strengthening—stocks rally Weak data: Fed likely to ease—stocks rally Data as expected: low volatility—stocks rally

For me, the bottom line of all this is that the greatest source of investment risk is the belief that there is no risk. Widespread risk tolerance—or a high degree of investor comfort with risk—is the greatest harbinger of subsequent market declines.

If I could ask only one question regarding each investment I had under consideration, it would be simple: How much optimism is factored into the price? A high level of optimism is likely to mean the favorable possible developments have been priced in; the price is high relative to intrinsic value; and there’s little margin for error in case of disappointment. But if optimism is low or absent, it’s likely that the price is low; expectations are modest; negative surprises are unlikely; and the slightest turn for the better would result in appreciation.

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.

market participants demonstrated that when negative psychology is universal and “things can’t get any worse,” they won’t. When all optimism has been driven out, and panicked risk aversion is everywhere, it becomes possible to reach a point where prices can’t go any lower.

Because borrowing is difficult and capital is generally unavailable, those who possess it and are willing to part with it can apply rigorous standards, insist on strong loan structures and protective covenants, and demand high prospective returns. It’s things like these that provide the margin of safety required for superior investing. When these boxes can be ticked, investors should swing into an aggressive mode.

Initiating projects in boom times can be a source of risk. Buying them in weak times can be very profitable. It all depends on what you do and when you do it. Or as they say in golf, “Every putt makes someone happy.”

“What the wise man does in the beginning, the fool does in the end.”

“There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich”

Fomo

Because this new bubble arose in mortgage-land—a part of the financial markets completely separate from that which had been visited by the tech and Internet bubble—the fixed income investors and financial institutions it appealed to were ones who hadn’t been affected firsthand by the other, and hadn’t learned from it.

The sub-prime mortgage bubble arose from broad acceptance that phenomena would work that had never before been seen in action. The analysis of investment vehicles should entail (a) the application of skepticism and conservative assumptions and (b) examination over a long history that includes some trying times.

At Oaktree, we strongly reject the idea of waiting for the bottom to start buying.