Mastering The Market Cycle: Getting the odds on your side

by Howard Marks

Most people understand that busts follow booms. Somewhat fewer grasp the fact that the busts are caused by the booms. From the latter, it makes sense that (a) booms usually won’t be followed by modest, gradual and painless adjustments and (b) on the other hand, we’re unlikely to have a bust if we haven’t had a boom. It must be noted, however, that this symmetry only applies dependably to direction, not necessarily to the extent, timing or pace of movement.

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

I’m firmly convinced that markets will continue to rise and fall, and I think I know (a) why and (b) what makes these movements more or less imminent. But I’m sure I’ll never know when they’re going to turn up or down, how far they’ll go after they do, how fast they’ll move, when they’ll turn back toward the midpoint, or how far they’ll continue on the opposite side.

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.

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 unconventional, non-extrapolation forecasts turn out to be incorrect, and anyone who invests on their basis is usually likely to do below average.

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.

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.

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.

The vast majority of the highly superior investors I know are unemotional by nature.

in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.”

I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.

the way investors collectively are viewing risk and behaving with regard to it is of overwhelming importance in shaping the investment environment

“Investments that seem riskier have to appear to promise higher returns, or else no one will make them.”

It follows from the above that risk is high when investors feel risk is low. And risk compensation is at a minimum just when risk is at a maximum (meaning risk compensation is most needed). So much for the rational investor!

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.

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

It’s not what you buy that determines your results, it’s what you pay for it.

exiting the market after a decline — and thus failing to participate in a cyclical rebound — is truly the cardinal sin in investing.

when the market is high in its cycle, they should emphasize limiting the potential for losing money, and when the market is low in its cycle, they should emphasize reducing the risk of missing opportunity.

Among the many factors that make investing interesting is the fact that there’s no tactic or approach that always works.

“Imagine how much harder physics would be if electrons had feelings!”

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

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.