Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

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

lean heavily toward the first definition: in my view, risk is primarily the likelihood of permanent capital loss. But there’s also such a thing as opportunity risk: the likelihood of missing out on potential gains. Put the two together and we see that risk is the possibility of things not going the way we want.

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.

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. Yet it’s important to remember what I said earlier: even if you know the probabilities—that is, even if you do have superior insight regarding the tendencies—you still don’t know what’s going to happen.

Are we close to the beginning of an upswing, or in the late stages? If a particular cycle has been rising for a while, has it gone so far that we’re now in dangerous territory? Does investors’ behavior suggest they’re being driven by greed or by fear? Do they seem appropriately risk-averse or foolishly risk-tolerant? Is the market overheated (and overpriced), or is it frigid (and thus cheap) because of what’s been going on cyclically? Taken together, does our current position in the cycle imply that we should emphasize defensiveness or aggressiveness?

the economy and company profits are more likely to swing upward than down, investor psychology is sober rather than buoyant, investors are conscious of risk or—even better—overly concerned about risk, and market prices haven’t moved too high.

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.

In other words, the potential for havoc increases as the movement away from the midpoint increases: as economies and companies do “too well” and stock prices go “too high.” Advances are followed by mere corrections, and bull markets by bear markets. But booms and bubbles are followed by much more harmful busts, crashes and panics.

Cycles are inevitable. Every once in a while, an up- or down-leg goes on for a long time and/or to a great extreme, and people start to say “this time it’s different.” They cite the changes in geopolitics, institutions, technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend. But then it usually turns out that the old rules do still apply, and the cycle resumes. In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical.

perhaps most importantly, it can take years for a boom to grow to its full extent. But the bust that follows may seem like a fast-moving freight train; as my long-time partner Sheldon Stone says, “The air goes out of the balloon much faster than it went in.”

“experience is what you got when you didn’t get what you wanted.”

To swim against the current of human intuition is a difficult task. . . . The human mind is built to identify for each event a definite cause and can therefore have a hard time accepting the influence of unrelated or random factors. And so the first step is to realize that success or failure sometimes arises neither from great skill nor from great incompetence but from, as the economist Armen Alchian wrote, “fortuitous circumstances.” Random processes are fundamental in nature and are ubiquitous in our everyday lives, yet most people do not understand them or think much about them.

in the 1970s, economic stagnation set in, inflation reached 16%, the average stock lost almost half its value in two years, and Business Week magazine ran a cover story trumpeting “The Death of Equities” (August 13, 1979).

so-called “wealth effect”—is particularly noteworthy. Asset owners (a) are probably unlikely to fund consumption by selling their stocks or homes and (b) should recognize that asset price gains can prove ephemeral and thus aren’t a good reason to alter spending patterns. Yet asset appreciation does tend to lead them to spend more. This phenomenon demonstrates the contribution of psychology to behavior, and behavior to short-term economic variation.

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 moderately right—and almost never of much use.

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 cost people their jobs.

about stock market performance is that the average certainly isn’t the norm. Market fluctuations of this magnitude aren’t nearly fully explained by the changing fortunes of companies, industries or economies. They’re largely attributable to the mood swings of investors. Lastly, the times when return is at the extremes aren’t randomly distributed over the years. Rather they’re clustered, due to the fact that investors’ psychological swings tend to persist for a while—to paraphrase Herb Stein, they tend to continue until they stop. Most of those 13 extreme up or down years were within a year or two of another year of similarly extreme performance in