Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

Because human psychology and behavior play such a big part in creating them, these cycles aren’t as regular as the cycles of clock and calendar, but they still give rise to better and worse times for certain actions.

A winning investment philosophy can be created only through the combination of a number of essential elements: A technical education in accounting, finance and economics provides the foundation: necessary but far from sufficient. A view on how markets work is important—you should have one before you set out to invest, but it must be added to, questioned, refined and reshaped as you proceed. Some of your initial views will come from what you’ve read, so reading is an essential building block. Continuing to read will enable you to increase the efficacy of your approach—both embracing those ideas you find appealing and discarding those you don’t. Importantly, it’s great to read outside the strict boundaries of investing. 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. Exchanging ideas with fellow investors can be an invaluable source of growth. Given the non-scientific nature of investing, there’s no such thing as being finished with your learning, and no individual has a monopoly on insight. Investing can be solitary, but I think those who practice it in solitude are missing a lot, both intellectually and interpersonally. Finally, there really is no substitute for experience. Every year I have come to view investing differently, and every cycle I’ve lived through has taught me something about how to cope with the next one. I recommend a l...

In short, if we have the same information as others, analyze it the same way, reach the same conclusions and implement them the same way, we shouldn’t expect that process to result in outperformance. And it’s very difficult to be consistently superior in those regards as relates to the macro.

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.

What do value investors do? They strive to take advantage of discrepancies between “price” and “value.” In order to do that successfully, they have to (a) quantify an asset’s intrinsic value and how it’s likely to change over time and (b) assess how the current market price compares with the asset’s intrinsic value, past prices for the asset, the prices of other assets, and “theoretically fair” prices for assets in general.

The key word is “calibrate.” The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive. . . . When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back. (“Yet Again?,” September 2017)

I 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.

“Risk means more things can happen than will happen.”

When our position in the various cycles is neutral, the outlook for returns is “normal.” When the cycles are positioned propitiously, the probability distribution shifts to the right, such that the outlook for returns is now tilted in our favor. Our favorable position in the cycles makes gains more likely and losses less so. But when the cycles are at dangerous extremes, the odds are against us, meaning the likelihoods are less good. There’s less chance of gain and more chance of loss.

Henry Kissinger was a member of TCW’s board when I worked there, and a few times each year I was privileged to hear him hold forth on world affairs. Someone would ask, “Henry, can you explain yesterday’s events in Bosnia?” and he’d say, “Well, in 1722 . . .” The point is that chain reaction-type events can only be understood in the context of that which went before.

Cycles have more potential to wreak havoc the further they progress from the midpoint—i.e., the greater the aberrations or excesses. If the swing toward one extreme goes further, the swing back is likely to be more violent, and more damage is likely to be done, as actions encouraged by the cycle’s operation at an extreme prove unsuitable for life elsewhere in the cycle.

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 are self-correcting, and their reversal is not necessarily dependent on exogenous events. The reason they reverse (rather than going on forever) is that trends create the reasons for their own reversal. Thus I like to say success carries within itself the seeds of failure, and failure the seeds of success.

“The air goes out of the balloon much faster than it went in.”

This is true of cycles in finance, and absolutely true of financial crises. As you’ll see later, the Global Financial Crisis of 2007–08 occurred largely because of the issuance of a huge number of unsound sub-prime mortgages, and that took place in turn because of an excess of optimism, a shortage of risk aversion, and an overly generous capital market, which led to unsafe behavior surrounding sub-prime mortgages. Thus the narrow-minded literalist would say, “I’ll definitely turn cautious the next time mortgage financing is made readily available to unqualified home buyers.” But that aspect of the Crisis need never recur for the lessons of the Global Financial Crisis to be valuable. 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. In short, the details are unimportant and can be irrelevant. But the themes are essential, and they absolutely do tend to recur. Understanding that tendency—and being able to spot the recurrences—is one of the most important elements in dealing with cycles.

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

I think it would be better to recognize that bonds default in response to a wide variety of influences—like those that contribute to the success or failure of a hitter in baseball—and that most defaults have absolutely nothing to do with the number of years that have elapsed since the bonds were issued. To invert Mark Twain’s purported remark, history may rhyme, but it rarely repeats exactly.

The main questions most people (and certainly most investors) care about with regard to the economy are whether we’ll have growth or recession in a given year, and what the rate of change will be. Both of these are components of what I call the short-term economic cycle. (I’ll introduce other considerations shortly.)

Changes in productivity, like changes in birth rate, take place in modest degrees and gradually, and they require long periods to take effect. They stem primarily from advances in the productive process.

More recently, economic growth appears to have slowed in the U.S. (as well as elsewhere). Is this a short-term cyclical change relative to the underlying long-term trend, or a change in the long-term trend itself? It will take many years before we know definitively. But there has arisen a school of thought blaming it on “secular stagnation”—that is, a fundamental slowing of the long-term trend.

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 forecasts can’t be valuable on balance. There are forecasters who became famous for a single dramatic correct call, but the majority of their forecasts weren’t worth following.

Thus it’s not for nothing that John Kenneth Galbraith said, “We have two classes of forecasters: those who don’t know—and those who don’t know they don’t know.”

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.

Wtf

Despite the widespread acceptance of the free-market system, markets are rarely left entirely free. Government involvement takes many forms, ranging from the enactment and enforcement of laws and regulations to direct participation in the economy through entities like the U.S.’s mortgage agencies. Perhaps the most important form of government involvement, however, comes in the attempts of central banks and national treasuries to control and affect the ups and downs of economic cycles.

But in general, inflation is viewed as a result of a strong upward movement of the economic cycle. 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.

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 opposition to each other, and thus their job requires a delicate balancing act.

The ultimate topic under this heading concerns national deficits. In the distant past, most governments ran balanced budgets. In short, they weren’t able to spend more money than they brought in through taxes (or conquests). But then the concept of national debt arose, and the ability to incur debt introduced the potential for deficits: that is, for governments to spend more than they take in.

First, businesses are subject to operating leverage. Profits equal revenues minus costs (or expenses). Revenues are the result of sales, and we know that sales fluctuate for a large number of reasons. So do costs, and different kinds of costs fluctuate in different ways, particularly in response to changes in sales.

The second form of leverage affecting most companies is financial leverage.

The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back. Investment markets make the same pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between being overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”

But remember, a swinging pendulum may be at its midpoint “on average,” but it actually spends very little time there. The same is true of financial market performance. Here’s a fun question (and a good illustration): for how many of the 47 years from 1970 through 2016 was the annual return on the S&P 500 within 2% of “normal”—that is, between 8% and 12%? I expected the answer to be “not that often,” but I was surprised to learn that it had happened only three times! It also surprised me to learn that the return had been more than 20 percentage points away from “normal”—either up more than 30% or down more than 10%—more than one-quarter of the time: 13 out of the last 47 years. So one thing that can be said with total conviction 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.

Clearly that’s what happened to tech stocks in 1999. Greed was the dominant characteristic of that market. Those who weren’t participating were forced to watch everyone else get rich. “Prudent investors” were rewarded with a feeling of stupidity. The buyers moving that market felt no fear. “There’s a new paradigm,” was the battle cry, “get on board before you miss the boat. And by the way, the price I’m buying at can’t be excessive, because the market’s always efficient.” Everyone perceived a virtuous cycle in favor of tech stocks to which there could be no end.

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)

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 Banks make $4 billion: business conditions favorable—stocks rally Banks lose $4 billion: bad news out of the way—stocks rally Oil spikes: growing global economy contributing to demand—stocks rally Oil drops: more purchasing power for the consumer—stocks rally Dollar plunges: great for exporters—stocks rally Dollar strengthens: great for companies that buy from abroad—stocks rally Inflation spikes: will cause assets to appreciate—stocks rally Inflation drops: improves quality of earnings—stocks rally

The prevalence of risk-tolerance (or risk-obliviousness) in the late 1990s was clear. I personally heard a prominent brokerage house strategist say, “Stocks are overpriced, but not enough to keep them from being a buy.” And we all heard the man on the street say, “I’m up so much in my 401(k), it wouldn’t bother me if it fell by a third.” (Where was that guy two or three years later?) No, those risk-tolerant attitudes will not persist forever. Eventually, something will intrude, exposing securities’ imperfections and too-high prices. Prices will decline. Investors will like them less at $60 than they did at $100. Fear of losing the remaining $60 will overtake the urge to make back the lost $40. Risk aversion eventually will reassert itself (and usually go to excess). How about some quantification of this cycle? In mid-1998, just before the collapse of Long-Term Capital Management brought investors other than techies to their senses, only $12.5 billion of non-defaulted bonds yielded more than 20% (one possible threshold for the label “distressed debt”). Because investors weren’t very worried about risk, they demanded ultra-high returns from relatively few non-defaulted bonds; the word “blithe” might best describe their attitude. But Long-Term’s demise awakened investors to the existence of risk, and a year later, the amount of bonds yielding more than 20% had more than tripled to $38.7 billion. By mid-2002, when the corporate scandals held the debt market in a grip of terror...

The scene was set for its occurrence by a number of developments. Here’s a partial list: Government policies supported an expansion of home ownership—which by definition meant the inclusion of people who historically couldn’t afford to buy homes—at a time when home prices were soaring; The Fed pushed interest rates down, causing the demand for higher-yielding instruments such as structured/levered mortgage securities to increase; There was a rising trend among banks to make mortgage loans, package them and sell them onward (as opposed to retaining them); Decisions to lend, structure, assign credit ratings and invest were made on the basis of unquestioning extrapolation of low historic mortgage default rates; The above four points resulted in an increased eagerness to extend mortgage loans, with an accompanying decline in lending standards; Novel and untested mortgage backed securities were developed that promised high returns with low risk, something that has great appeal in non-skeptical times; Protective laws and regulations were relaxed, such as the Glass-Steagall Act (which prohibited the creation of financial conglomerates), the uptick rule (which prevented traders who had bet against stocks from forcing them down through non-stop short selling), and the rules that limited banks’ leverage, permitting it to nearly triple;

While the last few years have given me many opportunities to marvel at excesses in the capital markets, in this case the one that elicited my battle cry—“that calls for a memo”—hit the newspapers in England during my last stay. As the Financial Times reported on November 1, 2006: Abbey, the UK’s second-largest home loans provider, has raised the standard amount it will lend homebuyers to five times either their single or joint salaries, eclipsing the traditional borrowing levels of around three and a half times salary. It followed last week’s decision by Bank of Ireland Mortgages and Bristol and West to increase standard salary multiples from four to 4.5 times.

What did we see in the U.S. mortgage market as home prices rose and interest rates declined? First, low teaser rates. Then higher loan-to-value ratios. Then 100% financing. Then low-amortization loans. Then no-amortization loans. Then loans requiring no documentation of employment or credit history. All these things made it possible for more buyers to stretch for more expensive homes, but at the same time they made mortgages riskier for lenders.

Pension fund: What about the potential that defaults will render the investment unsuccessful? HM: Well, our average default rate over the last 26 years in high yield bonds—which are junior in the capital structure to loans like the fund holds—has been about 1% a year (and bear in mind that there are recoveries in the case of default, meaning our credit losses have been less than a percent per year). Thus defaults at our historic rate would do little to diminish the fund’s promised return in the 20s. Pension fund: But what if it’s worse than that? HM: The worst five-year period we’ve ever had showed defaults averaging 3% per year; obviously not a problem relative to the yields we’re talking about. Pension fund: But what if it’s worse than that? HM: The average default rate in the high yield bond universe—without assuming any ability to avoid defaults through skillful credit selection—has been 4.2% per year. Resulting credit losses of 2–3% clearly wouldn’t do much to jeopardize the results on this investment. Pension fund: But what if it’s worse than that? HM: The worst five years in history for the universe averaged 7.3%—still not a problem. Pension fund: But what if it’s worse than that? HM: The worst one-year default rate in high yield bond history was 12.8%. That still leaves plenty of return here. Pension fund: But what if it’s worse than that? HM: One and a half times the worst year in history would be 19%, and we would still make a little money given the portfolio yie...

But that triggered an epiphany: Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive. I’ll write some more on the subject, but it’s really as simple as that.

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.

In short, whereas economies fluctuate a little and profits a fair bit, the credit window opens wide and then slams shut . . . thus the title of this memo. I believe the credit cycle is the most volatile of the cycles and has the greatest impact. Thus it deserves a great deal of attention.

Why does this cycle have the importance I ascribe to it? First, capital or credit is an essential ingredient in the productive process. Thus the ability of companies (and economies) to grow usually depends on the availability of incremental capital. If the capital markets are closed, it can be hard to finance growth. Second, capital must be available in order for maturing debt to be refinanced. Companies (as well as most other economic units, such as governments and consumers) generally don’t pay off their debts. Most of the time they merely roll them over. But if a company is unable to issue new debt at the time that its existing debt comes due, it may default and be forced into bankruptcy. Where we stand in the credit cycle—whether credit is readily available or difficult to obtain—is the greatest determinant of whether debt can be refinanced at a given time.

(The importance of the market being open—and of the ability to roll over maturing paper—underlines the essential difference between positive net worth and liquidity. Even a wealthy company can get into trouble if it doesn’t have cash on hand and can’t obtain enough to meet its debt maturities, bills and other calls on cash as they arise.)

The process is simple: The economy moves into a period of prosperity. Providers of capital thrive, increasing their capital base. Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk. Risk averseness disappears. Financial institutions move to expand their businesses—that is, to provide more capital. They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants. At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.” This leads to capital destruction—that is, to the investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital. When this point is reached, the up-leg is reversed. Losses cause lenders to become discouraged and shy away. Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements. Less capital is made available—and at the trough of the cycle, only to the most qualified of borrowers. Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies. This process contributes to and reinforces the economic contraction. Of course, at the extreme the process is ready to be reversed...

The existential cause was the too-liberal attitudes toward financial risk described on pages 119–120. Those carefree attitudes were inflamed by strong demand for high-yielding investments that resulted from the Fed’s lowering of general interest rates. Those two factors led to, among other things, an excessive willingness on the part of investors to accept innovative financial products, and to swallow whole the favorable extrapolation of history and the other optimistic assumptions on which those products were based.

It must be noted, however, that this chain reaction was abetted by elected officials who were eager to expand the American dream of home ownership and naively thought it would be great if everyone was enabled to buy a home. In a speech in October 2002, President George W. Bush repeated what he’d been told by one of his friends: “You don’t have to have a lousy home for the first-time home buyers. If you put your mind to it, the first-time home buyer, the low-income home buyer can have just as nice a house as anybody else.” I wonder if the people who heard that statement at the time found it as illogical as it seems today. After the GFC hit, Congressman Barney Frank, formerly one of the strongest proponents of broadened home ownership, said: “Home ownership is a good thing. But we have made a great mistake in this society. There are people in the society who should not be allowed to borrow money to buy a home. And we have pushed people into home ownership who shouldn’t be there.” (As you can see, political rhetoric is cyclical, too.)

“good company, bad balance sheet.”

The answer is that debtholders who aren’t paid as scheduled have a “creditor claim” against the debtor. In short—and to over-simplify—when a company goes through bankruptcy, the old owners are wiped out and the old creditors become the new owners. Each creditor receives his share of the value of the company—depending on the amount and seniority of the debt he holds—in some combination of cash, new debt and ownership of the company going forward. A distressed debt investor tries to figure out (a) what the bankrupt company is worth (or will be worth at the time it emerges from bankruptcy), (b) how that value will be divided among the company’s creditors and other claimants, and (c) how long this process will take. With correct answers to those questions, he can determine what the annual return will be on a piece of the company’s debt if purchased at a given price.

Much of investing is subject to gross generalizations and sweeping statements—usually stressing the positives, because of humans’ tendency toward greed and wishful thinking—and for some reason this seems particularly true in real estate. Over the course of my career I’ve heard investment in real estate rationalized by easily digested statements like “they’re not making any more” (in connection with land), “you can always live in it” (in connection with houses), and “it’s a hedge against inflation” (in connection with properties of all types). What people eventually learn is that regardless of the merit behind these statements, they won’t protect an investment that was made at too high a price.