Mastering The Market Cycle: Getting the odds on your side

by Howard Marks

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.

Some of your initial views will come from what you’ve read, so reading is an essential building block.

Importantly, it’s great to read outside the strict boundaries of investing.

Exchanging ideas with fellow investors can be an invaluable source of growth.

Finally, there really is no substitute for experience.

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.

Given that we cannot understand macro economics or predict them we can know the following

I think another element can profitably enter

into the process: properly positioning a portfolio for what’s likely to happen in the market in the years immediately ahead.

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 o...

Calibrating one’s portfolio position is what this book is mostly about.

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.

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.

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.

Remember, where we stand in the various cycles has a strong influence on the odds. For example, as we’ll see in later chapters, opportunities for investment gains improve when: 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 events in the life of a cycle shouldn’t be viewed merely as each being followed by the next, but — much more importantly — as each causing the next.

The events in the life of a cycle shouldn’t be viewed merely as each being followed by the next, but — much more importantly — as each causing the next. For example:

But as I mentioned above and we’ll see later on, the most important deviations from the general trend — and the variation in those deviations’ timing, speed and extent — are largely produced by fluctuations in psychology.

it’s equally significant to note that while cycles occur in a variety of areas due to these serial events, cyclical developments in one area also influence cycles in others. Thus the economic cycle influences the profit cycle. Corporate announcements determined by the profit cycle influence investor attitudes. Investor attitudes influence markets. And developments in markets influence the cycle in the availability of credit … which influences economies, companies and markets.

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.

I will attempt to discuss each type of cycle in isolation … although in truth they don’t operate in isolation.

I want to point out a few more things about the nature of cycles that are essential for a thorough understanding

Cycles are inevitable.

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

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.

cycles are often viewed as less symmetrical than they are.

“History doesn’t repeat itself, but it does rhyme.”

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.

Understanding that tendency — and being able to spot the recurrences — is one of the most important elements in dealing with cycles.

The main measure of an economy’s output is GDP, or gross domestic product, the total value of all goods and services produced for final sale in an economy.

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.

The official definition of a recession is two consecutive quarters of negative growth,

Long-Term Economic Trends

The oscillations around the trend will cancel out in the long run (admittedly after causing much elation or distress in individual years), but changes in the underlying trend will make the biggest difference in our long-term experience.

Thus births are one of the main reasons for the usual presumption that economic growth will be positive.

Changes in birth rates generally take place over long periods of time, and when they do, they require years to affect GDP growth.

The other principal element in the GDP equation — the value of the output produced in each hour of labor — is determined by “productivity.”

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. The first big gains occurred during the Industrial Revolution of

Machines vs humans

The second major gains occurred in the late 19th and early 20th centuries, when electricity and automobiles replaced older and less-efficient forms of power and transportation. The third major change occurred in the latter half of the 20th century, when computers and other forms of automated control began to take the place of humans in guiding production machinery. And, of course, the fourth wave is underway now, during the Information Age, as massive advances in information acquisition, storage and application — and such activities as metadata and artificial intelligence — are permitting tasks to be accomplished that weren’t dreamed of in the past.

It’s clear that trends in hours worked and in output per hour combine to determine long-term trends in national output. But what factors produce changes in those two? Here’s a partial, indicative list:

Demographic movements

Determinants of inputs

Short-Term Economic Cycles

In other words, although economies are made up of people, the level of economic growth isn’t thought to be highly reflective of those people’s ups and downs. But, in fact, it is. While the long-term trend sets the potential economic growth rate, the actual level of each year’s GDP will vary relative to that which the trend dictates … largely because of the involvement of people.

There may be times when conditions discourage people from seeking a place in the workforce, as previously mentioned, and also times when world events alter the level of consumption.

Spending fluctuates more than employment and earnings because of variation in something called “the marginal propensity to consume”: of every additional dollar earned, it determines the percentage that will go to consumption.

Earners may choose to spend a higher percentage of their earnings on consumption because: the daily headlines are favorable; they believe election results presage a stronger economy, higher incomes or lower taxes; consumer credit has become more readily available; asset appreciation has made them feel richer; or their team won the World Series.

Asset appreciation is not a reason to consume more. But it actually affect spending snd thats why we day psychological factors affect the short economic cycle

These are only a few examples of the factors that can cause the output of an economy to vary in a given quarter or year from the growth in potential output that birth rate and productivity gains might suggest. They are the result of factors that are not “mechanical” or reliable in nature. Many of them stem from human behavior, and thus they are uncertain and unpredictable.

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.