Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

About 45 years ago—in the early 1970s—I received one of the greatest gifts I was ever given, when an older and wiser investor introduced me to “the three stages of a bull market”: the first stage, when only a few unusually perceptive people believe things will get better, the second stage, when most investors realize that improvement is actually taking place, and the third stage, when everyone concludes things will get better forever.

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

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)

The idea of “growth stocks” began to be popularized in the early 1960s, based on the goal of participating in the rapidly growing profits of companies benefitting from advances in technology, marketing and management techniques. It gathered steam, and by 1968, when I had a summer job in the investment research department of First National City Bank (the predecessor of Citibank), the Nifty Fifty stocks—the fastest growing and best—had appreciated so much that the bank trust departments that did most of the investing in those days generally lost interest in all other stocks. Everyone wanted a piece of Xerox, IBM, Kodak, Polaroid, Merck, Lilly, Hewlett-Packard, Texas Instruments, Coca-Cola and Avon. These companies were considered to be so great that nothing bad could ever happen to them. And it was accepted dictum that it absolutely didn’t matter what price you paid. If it was a little too high, no matter: the companies’ fast-rising earnings would soon grow into it. The result was predictable. Whenever people are willing to invest regardless of price, they’re obviously doing so based on emotion and popularity rather than cold-blooded analysis. So Nifty Fifty stocks that had been selling at 80–90 times earnings in 1968, in the vanguard of a powerful bull market, came down to earth when ardor cooled. Thus many sold at 8–9 times earnings in the much weaker stock market of 1973, meaning investors in “America’s best companies” had lost 80–90% of their money. And note that several...

What’s the key in all of this? To know where the pendulum of psychology and the cycle in valuation stand in their swings. To refuse to buy—and perhaps to sell—when too-positive psychology and the willingness to assign too-high valuations cause prices to soar to peak levels. And to buy when downcast psychology and the desertion of valuation standards on the downside cause panicky investors to create bargains by selling, despite the low prices that result.

So the key to understanding where we stand in the cycle depends on two forms of assessment: The first is totally quantitative: gauging valuations. This is an appropriate starting point, for if valuations aren’t out of line with history, the market cycle is unlikely to be highly extended in either direction. And the second is essentially qualitative: awareness of what’s going on around us, and in particular of investor behavior. Importantly, it’s possible to be disciplined even in observing these largely non-quantitative phenomena. The key questions can be boiled down to two: how are things priced, and how are investors around us behaving?

First, let’s review the meteoric rise of stocks in the late 1990s and early 2000, and especially the formation of the Internet bubble. What should the alert investor have noted during that time? In the decade of the 1990s, the U.S. economy enjoyed the longest peacetime expansion in its history. In December 1996, when the S&P 500 index of equities stood at 721, Fed Chairman Alan Greenspan asked, “How do we know when irrational exuberance has unduly escalated asset values?” But he was never heard from again on this subject, even as the S&P more than doubled to a high of 1527 in 2000. In 1994, Prof. Jeremy Siegel of the Wharton School published his book Stocks for the Long Run, in which he pointed out that there had never been a long period of time in which stocks had failed to outperform bonds, cash and inflation. Whereas researchers at the University of Chicago had earlier concluded that the normal return on U.S. equities was in the vicinity of 9% per year, in the 1990s the average return on the S&P was nearly 20%. The better stocks performed, the more capital investors allocated to them. This was especially true of technology stocks, which were the clear market leaders. More tech stocks were added to equity indices like the S&P 500—meaning index and quasi-index investors had to buy more of them—which made them go up—which attracted still more capital to them. This was a classic “virtuous circle,” and no one could imagine it ending. The absence of earnings at most “new-econ...

All it takes for the perpetual motion machine to grind to a halt is the failure of one or two assumptions and the operation of some general rules: Interest rates can go up as well as down. Platitudes can fail to hold. Improper incentives can lead to destructive behavior. Attempts to quantify risk in advance—particularly as to novel financial products for which there is no history—will often be unavailing. The “worst case” can indeed be exceeded on the downside.

What was the basis on which we did this? In retrospect it was easy . . . although it never seems as easy in real time. All you really had to do in 2005–07 was make the following general observations: the Fed had reduced the base rate of interest to very low levels in order to ward off the depressing effects of the tech bubble’s bursting, as well as concern over Y2K; because of the low yields available on Treasurys and high grade bonds, as well as the disenchantment with equities that had resulted from their three-year decline in 2000–02, investors were eager to put money into alternative instruments; investors had shrugged off the pain of the collapse of the tech bubble in 2000 and the telecom meltdown and corporate scandals of 2001–02; thus little risk aversion was present (especially in areas other than equities, which remained out of favor), rendering investors generally eager for investments in exotic, structured and synthetic instruments; and as a result of all the above, the markets were wide open for the issuance of low-quality debt, poorly structured instruments and untested alternatives.

There are three ingredients for success—aggressiveness, timing and skill—and if you have enough aggressiveness at the right time, you don’t need that much skill.

Positioning and selection are the two main tools in portfolio management. It may be an over-simplification, but I think everything investors do falls under one or the other of these headings. Aggressiveness—the assumption of increased risk: risking more of your capital; holding lower-quality assets; making investments that are more reliant on favorable macro outcomes; and/or employing financial leverage or high-beta (market-sensitive) assets and strategies Defensiveness—the reduction of risk: investing less capital and holding cash instead; emphasizing safer assets; buying things than can do relatively well even in the absence of prosperity; and/or shunning leverage and beta The choice between aggressiveness and defensiveness is the principal dimension in which investors position portfolios in response to where they think they stand in the cycles and what that implies for future market developments.

Skill and luck are the prime elements that determine the success of portfolio management decisions. Without skill on an investor’s part, decisions shouldn’t be expected to produce success. In fact, there’s something called negative skill, and for people who are saddled with it, flipping a coin or abstaining from decisions would lead to better results. And luck is the wildcard; it can make good decisions fail and bad ones succeed, but mostly in the short run. In the long run, it’s reasonable to expect skill to win out.

I loved the part where it quoted him as saying it was his job “to prepare to be lucky.”

“Being too far ahead of your time is indistinguishable from being wrong.”

The important lesson is that—especially in an interconnected, informed world—everything that produces unusual profitability will attract incremental capital until it becomes overcrowded and fully institutionalized, at which point its prospective risk-adjusted return will move toward the mean (or worse). And, correspondingly, things that perform poorly for a while eventually will become so cheap—due to their relative depreciation and the lack of investor interest—that they’ll be primed to outperform. Cycles like these hold the key to success in investing, not trees that everyone is assuming will grow to the sky.

“As any system grows toward its maximum or peak efficiency, it will develop the very internal contradictions and weaknesses that bring about its eventual decay and demise” (his essay #49: “The Perpetual See-Saw,” 2010).

This is the reason for one of the oldest and most important investment adages: “don’t confuse brains with a bull market.”

Let’s think about investment strategies. It’s essential to grasp that nothing will work forever: no approach, rule or process can outperform all the time. First, most securities and approaches are right for certain environments and parts of the cycle, and wrong for others. And second, past success will in itself render future success less likely. In the 1960s, when the idea of investing in stocks was first gaining popularity among Americans, the emphasis was on industry leaders and so-called “blue-chip” securities. Small-capitalization stocks were largely overlooked at first, but eventually they were noticed and bought. This caused them to do better than large-caps. When people noticed small-cap stocks’ superior returns in this “catch-up” phase, their buying produced further gains for them . . . until it caused them to be fully priced relative to large-caps. At that point, interest rotated to large-caps, which then regained the lead.

In other words, “outperformance” is just another word for one thing appreciating relative to another. And, clearly, that can’t go on forever. Regardless of how great its merits may be, “a” is unlikely to be infinitely more valuable than “b.” That means if “a” keeps appreciating relative to “b,” there has to be a point at which it will become overvalued relative to “b.” And just when the last person gives up on “b” because it’s been performing so poorly and jumps to “a,” it will be time for “b” (now compellingly cheap relative to “a”) to outperform.

The lesson is simple: investors should be leery of popular assets. Rather, it’s unpopularity that is the buyer’s friend.

In his autobiography, Stress Test, former Treasury secretary Tim Geithner describes the climate when he arrived at the Fed in 2003: Economists were starting to debate whether America’s long stretch of stability constituted a new normal, a Great Moderation, a quasi-permanent era of resilience to shocks. There was growing confidence that derivatives and other financial innovations designed to hedge and distribute risk—along with better monetary policy to respond to downturns and better technology to smooth out inventory cycles—had made devastating crises a thing of the past.

Of course, what these observations signaled wasn’t that cycles wouldn’t repeat, but rather that the onlookers had grown too confident. Cycles in economies, companies and markets will continue to occur at least as long as people are involved in making the key decisions—which I believe means forever.

Richard Feynman, the noted physicist, wrote, “Imagine how much harder physics would be if electrons had feelings!” That is, if electrons had feelings, they couldn’t be counted on to always do what science expects of them, so the rules of physics would work only some of the time.