Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

One of the most important foundational elements of my investment philosophy is my conviction that we can’t know what the “macro future” has in store for us in terms of things like economies, markets or geopolitics. Or, to put it more precisely, few people are able on balance to know more about the macro future than others. And it’s only if we know more than others (whether that consists of having better data; doing a superior job of interpreting the data we have; knowing what actions to take on the basis of our interpretation; or having the emotional fortitude required to take those actions) that our forecasts will lead to outperformance.

Thus I dismiss macro prediction as something that will bring investment success for the vast majority of investors, and I certainly include myself in that group. If that’s so, what’s left? While there are lots of details and nuances, I think we can most gainfully spend our time in three general areas: 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.

In my view, the greatest way to optimize the positioning of a portfolio at a given point in time is through deciding what balance it should strike between aggressiveness and defensiveness. And I believe the aggressiveness/defensiveness balance should be adjusted over time in response to changes in the state of the investment environment and where a number of elements stand in their cycles.

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.

“History doesn’t repeat itself, but it does rhyme.”

But it’s equally significant to note that while cycles occur in a variety of areas due to these serial events, cyclical developments in one area also influence cycles in others. Thus the economic cycle influences the profit cycle. Corporate announcements determined by the profit cycle influence investor attitudes. Investor attitudes influence markets. And developments in markets influence the cycle in the availability of credit . . . which influences economies, companies and markets.

Rather, the themes that provide warning signals in every boom/bust are the general ones: that excessive optimism is a dangerous thing; that risk aversion is an essential ingredient for the market to be safe; and that overly generous capital markets ultimately lead to unwise financing, and thus to danger for participants.

The greatest lessons regarding cycles are learned through experience . . . as in the adage “experience is what you got when you didn’t get what you wanted.”

The main measure of an economy’s output is GDP, or gross domestic product, the total value of all goods and services produced for final sale in an economy. It can roughly be viewed as the result of multiplying the number of hours people spend working by the value of the output produced in each hour. (Earlier in my career it was called gross national product, but that term has gone out of style. The distinction between the two lies in the treatment of foreign manufacturers operating in a given country: GDP includes them in that country’s output, while GNP does not.)

The Standard & Poor’s 500 had a few down years in the period from 1975 to 1999, but none in which it lost more than 7.5%. On the upside, however, 16 of those 25 years showed returns above 15%, and seven times the annual gain exceeded 30%.

Changes in population growth and productivity growth can require decades to take effect, but clearly they can affect countries’ economic growth rates. In the 20th century, the U.S. surpassed Europe as an economic power. Then Japan seemed to sprint forward in the 1970s and 1980s, threatening to take over the world, until the late ’80s, when it fell back into negligible growth. The emerging markets—and especially China—were the site of rapid growth over the last few decades, and while their growth is slower at the moment, they may well outgrow the developed world in the next few decades. India has human resources that can make it a rapid-growth economy if it can increase its efficiency and reduce corruption. And frontier nations like Nigeria and Bangladesh stand behind the emerging nations, waiting for their turn as rapid growers.

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).

In investing, it’s easy to achieve performance that is equal to that of the average investor or a market benchmark. Since it’s easy to be average, real investment success must consist of outperforming other investors and the averages. Investment success is largely a relative concept, measured on the basis of relative performance. Simply being right about a coming event isn’t enough to ensure superior relative 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. Similarly, one doesn’t have to be right in order to be successful: just less wrong than others. Success doesn’t come from having a correct forecast, but from having a superior forecast. Can such forecasts be obtained?

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. But those extrapolation forecasts are likely to be commonly shared, already reflected in the market prices for assets, and thus not generators of superior performance—even when they come true. Here’s how Nobel Prize–winning economist Milton Friedman put it:

All these people see the same data, read the same material, and spend their time trying to guess what each other is going to say. [Their forecasts] will always be m...

The forecasts that are potentially valuable are those that correctly foresee deviation from long-term trends and recent levels. If a forecaster makes a non-conforming, non-extrapolation prediction that turns out to be correct, the outcome is likely to come as a surprise to the other market participants. When they scramble to adjust their holdings to reflect it, the result is likely to be gains for the few who correctly foresaw it. There’s only one catch: since major deviations from trend (a) occur infrequently and (b) are hard to correctly predict, most u...

So these are the possibilities I see with regard to economic forecasts: Most economic forecasts are just extrapolations. Extrapolations are usually correct but not valuable. Unconventional forecasts of significant deviation from trend would be very valuable if they were correct, but usually they aren’t. Thus most forecasts of deviation from trend are incorrect and also not valuable. A few forecasts of significant deviation turn out to be correct and valuable—leading their authors to be lionized for their acumen—but it’s hard to know in advance which will be the few right ones. Since the overall batting average with regard to them is low, unconventional forec...

Here is what I believe to be the bottom line on economic cycles: 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 by other changes in society and environment). These factors usually change relatively little from year to year, and only gradually from decade to decade. Thus the average rate of growth is rather steady over long periods of time. Only in the longest of time frames does the secular growth rate of an economy significantly speed up or slow down. But it does. Given the relative stability of underlying secular growth, one might be tempted to expect that the performance of economies would be consistent from year to year. However, a number of factors are subject to variability, causing economic growth—even as it follows the underlying trendline on average—to also exhibit annual variability. These factors can perhaps be viewed as follows: Endogenous—Annual economic performance can be influenced by variation in decisions made by economic units: for consumers to spend or save, for example, or for businesses to expand or contract, to add to inventories (calling for increased production) or sell from inventories (reducing production relative to what it might otherwise have been). Often these decisions are influenced by the state of mind of economic actors, such as consumers or the managers of busin...

Extreme economic cyclicality is considered undesirable. Too much strength can kindle inflation and take the economy so high that a recession becomes inevitable. Too much weakness, on the other hand, can cause companies’ profits to fall and can cost people their jobs. Thus it is part of the job of central bankers and Treasury officials to manage cycles. Since cycles produce ups and downs that can be excessive, the tools for dealing with them are counter-cyclical and applied with a cycle of their own—ideally inverse to the economic cycle itself. However, like everything else involving cycles, managing them is far from easy. If it weren’t, we wouldn’t see the extremes we do.

When the demand for goods increases relative to the supply, there can be “demand-pull” inflation. When inputs to production such as labor and raw materials increase in price, there can be “cost-push” inflation. Finally, when the value of an importing country’s currency declines relative to that of an exporting country, the cost of the exporter’s goods can rise in the importing country.

And sometimes inflation can increase without these things being present. There is a large psychological component that influences all of this.

Since inflation results from economic strength, the efforts of central bankers to control it amount to trying to take some of the steam out of the economy. They can include reducing the money supply, raising interest rates and selling securities. When the private sector purchases securities from the central bank, money is taken out of circulation; this tends to reduce the demand for goods and thus discourages inflation. Central bankers who are strongly dedicated to keeping inflation under control are called “hawks.” They tend to do the things listed above sooner and to a greater extent. The problem, of course, is that actions of this kind are anti-stimulative. They can accomplish the goal of keeping inflation under control, but they also restrain the growth of the economy, with effects that can be less than beneficial. The issue is complicated by the fact that in the last few decades, many central banks have been given a second responsibility. In addition to controlling inflation, they are expected to support employment, and, of course, employment does better when the economy is stronger. So central banks encourage this through stimulative actions such as increasing the money supply, decreasing interest rates, and injecting liquidity into the economy by buying securities—as in the recent program of “quantitative easing.” Central bankers who focus strongly on encouraging employment and lean toward these actions are called “doves.”

The bottom line is that most central bankers have two jobs: to limit inflation, which requires restraining the growth of the economy, and to support employment, which calls for stimulating economic growth. In other words, their dual responsibilities are in oppositi...

The economic theory propounded by John Maynard Keynes in the 1930s dwelled heavily on the role of governments vis-à-vis cycles. Keynesian economics focuses on the role of aggregate demand in determining the level of GDP, in contrast with earlier approaches that emphasized the role of the supply of goods. Keynes said governments should manage the economic cycle by influencing demand. This, in turn, could be accomplished through the use of fiscal tools, including deficits. Keynes urged governments to aid a weak economy by stimulating demand by running deficits. When a government’s outgo—its spending—exceeds its income—primarily from taxes—on balance it puts funds into the economy. This encourages buying and investing. Deficits are stimulative, and thus Keynes considered them helpful in dealing with a weak economy. On the other hand, 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.