Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

Invariably, investors who disregard where they stand in cycles are bound to suffer serious consequences.

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.

the future should be viewed not as a single fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and—hopefully on the basis of insight into their respective likelihoods—as a probability distribution. Probability distributions reflect one’s view of tendencies.

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.

I think there are actually two requirements, not one. In addition to an opinion regarding what’s going to happen, people should have a view on the likelihood that their opinion will prove correct. Some events can be predicted with substantial confidence

in order to win at this game more often than you lose, you have to have a knowledge advantage. That’s what the superior investor has: he knows more than others about the future tendencies.

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. Up close, the blind man may mistake the elephant’s leg for a tree—and the shortsighted investor may think an uptrend (or a downtrend) will go on forever. But if we step back and view the long sweep of history, we should be able to bear in mind that the long-term cycle also repeats and understand where we stand in it.

Cyclical events are influenced by both endogenous developments (including the cyclical events that precede them) as well exogenous developments (events occurring in other areas). Many of the latter—but far from all—are parts of other cycles. Understanding these causative interactions isn’t easy, but it holds much of the key to understanding and coping with the investment environment.

Cycles’ clout is heightened by the inability of investors to remember the past.

There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. (A Short History of Financial Euphoria, 1990)

The ancient Greek historian Thucydides stated in History of the Peloponnesian War that he would be satisfied “if these words of mine are judged useful by those who want to understand clearly the events which happened in the past and which (human nature being what it is) will, at some time or other and in much the same ways, be repeated in the future.” That’s a good description of my goal here as well.

the things I call cycles do not stem completely—or sometimes at all—from the operation of mechanical, scientific or physical processes. They would be much more dependable and predictable if they did—but much less potentially profitable. (This is because the greatest profits come from seeing things better than others do, and if cycles were totally dependable and predictable, there would be no such thing as superiority in seeing them.)

Since the factors that produce the long-term trend change little from quarter to quarter and year to year, why should short-term changes be of great concern? In fact, why should they even occur? Why isn’t there just growth at the average rate—say 2%—every year? These questions provide a good opportunity to introduce some of this book’s protagonists: psychology, emotion and decision-making processes.

A simple metaphor relating to real estate helped me to understand this phenomenon: What’s an empty building worth? An empty building (a) has a replacement value, of course, but it (b) throws off no revenues and (c) costs money to own, in the form of taxes, insurance, minimum maintenance, interest payments and opportunity costs. In other words, it’s a cash drain. When investors are in a pessimistic mood and can’t see more than a few years out, they can only think about the negative cash flows and are unable to imagine a time when the building will be rented and profitable. But when the mood turns upward and interest in future potential runs high, investors envision it full of tenants, throwing off vast amounts of cash, and thus salable at a fancy price. Fluctuation in investors’ willingness to ascribe value to possible future developments represents a variation on the full-or-empty cycle. Its swings are enormously powerful and mustn’t be underestimated. (“The Happy Medium,” July 2004)

In other words, it’s not the data or events; it’s the interpretation. And that fluctuates with swings in psychology.

Other investors—the smarter, more self-aware ones, I think—understand that the future isn’t knowable with certainty. They may form opinions regarding future events, but they don’t bet heavily that those opinions will prove correct. Since (a) investing consists of dealing with the future but (b) the future isn’t knowable, that’s where the risk in investing comes from. If future events were predictable, investing would be easy and profit would be sure. (The general level of returns might be low in that case because so little risk is involved; that’s a topic for another day.) But the fact that events aren’t predictable introduces risk. Because the events that actually occur may be different than those that were predicted, or the market’s reaction to events may differ from what was expected, a portfolio may be positioned incorrectly for the future that unfolds.

My view that risk is the main moving piece in investing makes me conclude that at any given point in time, the way investors collectively are viewing risk and behaving with regard to it is of overwhelming importance in shaping the investment environment in which we find ourselves. And the state of the environment is key in determining how we should behave with regard to risk at that point. Assessing where attitudes toward risk stand in their cycle is what this chapter is about—perhaps the most important one in this book.

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. The pension fund meeting described above was important for the simple reason that it indicated that all optimism had been wrung out of investors’ thinking.

Superior investing doesn’t come from buying high-quality assets, but from buying when the deal is good, the price is low, the potential return is substantial, and the risk is limited. These conditions are much more the case when the credit markets are in the less-euphoric, more-stringent part of their cycle. The slammed-shut phase of the credit cycle probably does more to make bargains available than any other single factor.

There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

Warren Buffett has said much the same thing even more concisely: “First the innovator, then the imitator, then the idiot.”

Charles Kindleberger: “There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich” (Manias, Panics, and Crashes: A History of Financial Crises, 1989). Market participants are pained by the money that others have made and they’ve missed out on, and they’re afraid the trend (and the pain) will continue further. They conclude that joining the herd will stop the pain, so they surrender. Eventually they buy the asset well into its rise or sell after it has fallen a great deal.

Sir Isaac Newton, who was the Master of the Mint at the time of the “South Sea Bubble,” joined many other wealthy Englishmen in investing in the stock [of the South Sea Company]. It rose from £128 in January of 1720 to £1,050 in June. Early in this rise, however, Newton realized the speculative nature of the boom and sold his £7,000 worth of stock. When asked about the direction of the market, he is reported to have replied “I can calculate the motions of the heavenly bodies, but not the madness of the people.” By September 1720, the bubble was punctured and the stock price fell below £200, off 80% from its high three months earlier. It turned out, however, that despite having seen through the bubble earlier, Sir Isaac, like so many investors over the years, couldn’t stand the pressure of seeing those around him make vast profits. He bought back the stock at its high and ended up losing £20,000. Not even one of the world’s smartest men was immune to this tangible lesson in gravity! (“bubble.com,” January 2000)

There’s only one form of intelligent investing, and that’s figuring out what something’s worth and buying it for that price or less. You can’t have intelligent investing in the absence of quantification of value and insistence on an attractive purchase price. Any investment movement that’s built around a concept other than the relationship between price and value is irrational.

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George Soros’s theory of reflexivity: In situations that have thinking participants, the participants’ . . . distorted views can influence the situation to which they relate because false views lead to inappropriate actions. (“Soros: General Theory of Reflexivity,” Financial Times, October 26, 2009) People trying to understand how things work in the economic and financial worlds should take this lesson very much to heart.

The key—as usual—was to become skeptical of what “everyone” was saying and doing. One might have said, “Sure, the negative story may turn out to be true, but certainly it’s priced into the market. So there’s little to be gained from betting on it. On the other hand, if it turns out not to be true, the appreciation from today’s depressed levels will be enormous. I buy!” The negative story may have looked compelling, but it’s the positive story—which few believed—that held, and still holds, the greater potential for profit.

Oaktree invested more than a half a billion dollars a week over the fifteen weeks from September 15 through the end of the year. Some

The reasonableness of the effort at cycle timing depends simply on what you expect of it. If you frequently try to discern where we are in the cycle in the sense of “what’s going to happen tomorrow?” or “what’s in store for us next month?” you’re unlikely to find success. I describe such an effort as “trying to be cute.” No one can make fine distinctions like those often enough or consistently right enough to add materially to investment results. And no one knows when the market developments that efforts at cycle positioning label “probable” will materialize.

Another way I put it is that “success isn’t good for most people.” In short, success can change people, and usually not for the better. Success makes people think they’re smart. That’s fine as far as it goes, but there can also be negative ramifications. Success also tends to make people richer, and that can lead to a reduction in their level of motivation. In investing there’s a complex relationship between humility and confidence. Since the greatest bargains are usually found among things that are undiscovered or disrespected, to be successful an investor has to have enough confidence in his judgment to adopt what David Swensen, the hugely successful head of Yale’s high-performing endowment, describes as “uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom” (Pioneering Portfolio Management, 2000). By definition, pronounced bargain prices are most likely to be found among things that conventional wisdom dismisses, that make most investors uncomfortable, and whose merits are hard to comprehend. Investing in them requires considerable inner strength.

When one of those positions initially fails to rise as the investor expects—or perhaps goes in the opposite direction—the investor has to have enough confidence to hold on to his position or even add to it. He can’t take a price decline as a sure “sell” signal; in other words, it can’t be his default position that the market knows more than he does.