Mastering The Market Cycle: Getting the odds on your side

by Howard Marks

The upward movement of prices from fair value to excess usually is related to the presence of some combination of important elements: generally good news, complacency regarding events, uniformly upbeat treatment by the media, the unquestioning acceptance of optimistic accounts, a decline in skepticism, a dearth of risk aversion, a wide-open credit market, and a positive general mood. Conversely, the collapse of prices from fair value to bargain levels is usually marked by some or all of the following: generally bad news, rising alarm regarding events, highly negative media accounts, the wholesale acceptance of scare stories, a strong rise in skepticism, a significant increase in risk aversion, a credit market that has slammed shut, and a mood of general depression. The question is how we can tell where the market stands in its cycle. Importantly, the elements that contribute to the market’s rise manifest themselves via valuation metrics — p/e ratios on stocks, yields on bonds, capitalization ratios on real estate, and cash flow multiples on buyouts — that are elevated relative to historic norms. All of these things are precursors of low prospective returns. The reverse is true when a market collapse takes asset prices to