Mastering The Market Cycle: Getting the odds on your side

by Howard Marks

Here is what I believe to be the bottom line on economic cycles: The output of an economy is the product of hours worked and output per hour; thus the long-term growth of an economy is determined primarily by fundamental factors like birth rate and the rate of gain in productivity (but also by other changes in society and environment). These factors usually change relatively little from year to year, and only gradually from decade to decade. Thus the average rate of growth is rather steady over long periods of time. Only in the longest of time frames does the secular growth rate of an economy significantly speed up or slow down. But it does. Given the relative stability of underlying secular growth, one might be tempted to expect that the performance of economies would be consistent from year to year. However, a number of factors are subject to variability, causing economic growth — even as it follows the underlying trendline on average — to also exhibit annual variability. These factors can perhaps be viewed as follows: ˚ Endogenous — Annual economic performance can be influenced by variation in decisions made by economic units: for consumers to spend or save, for example, or for businesses to expand or contract, to add to inventories (calling for increased production) or sell from inventories (reducing production relative to what it might otherwise have been). Often these decisions are influenced by the state of mind of economic actors, such as consumers or the manager...

Central Banks

today central banks are concerned primarily with managing economic cycles.

their primary concern usually has been with inflation.

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

the efforts of central bankers to control it amount to trying to take some of the steam out of the economy. They can include reducing the money supply, raising interest rates and selling securities.

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.

Governments

Governments’ main tools for managing the economic cycle are fiscal, defined as being concerned primarily with taxing and spending. Thus when governments want to stimulate their countries’ economies, they can cut taxes, increase government spending and even distribute stimulus checks, making more money available for spending and investment. On the other hand, when they think economies are growing so fast as to be at risk of overheating — setting the scene for a resulting slowdown — governments can increase taxes or cut spending, reducing demand in their economies and thereby slowing economic activity.

So profits are more volatile than GDP.

By definition, the collective sales of all businesses are one and the same as GDP, and they reflect the same rate of change.

sales of some products respond to cycles other than economic. Because

Durables like cars will be affected by credit cycle (availability of funds)

For the most part, however, economic growth dominates the process through which sales are determined. Sales generally rise strongly when GDP growth is strong and less so (or they decline) when it isn’t.

This will cause its profit margin to rise, meaning the increase in operating profits will be considerably greater than the increase in sales: that’s operating leverage. In general, it’s higher for companies for whom a larger percentage of costs are fixed and lower for the ones whose costs are more variable.

Taxi company example and thev3 types of cost : fixed (office) semi fixed (cars) variable (gasoline)

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

And, of course, idiosyncratic developments can have a very significant impact on profits.

Newspapers provide an excellent example of the ability of an idiosyncratic factor to influence a company’s sales and profits, completely apart from of the economic and traditional profit cycle.

“Greed/fear” is the most obvious psychological or emotional continuum along which investors swing, and in many ways the most illustrative.

In other words, it’s not the data or events; it’s the interpretation. And that fluctuates with swings in psychology.

risk is the mark of the superior investor and an essential — I’m tempted to say the essential — requirement for investment success.

Assessing where attitudes toward risk stand in their cycle is what this chapter is about — perhaps the most important one in this book.

Well, that’s the point: most people would prefer a sure 7% over a possible 7%. In other words, most people are risk-averse.

“If I can get 10% from stocks, I need 15% to accept the illiquidity and uncertainty associated with real estate. And 25% if I’m going to invest in buyouts … and 30% to induce me to go for venture capital, with its low success ratio.”

When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-averse, prices can offer more return than risk.

Understanding how investors are thinking about and dealing with risk is perhaps the most important thing to strive for. In short, excessive risk tolerance contributes to the creation of danger, and the swing to excessive risk aversion depresses markets, creating some of the greatest buying opportunities.

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.

Second, capital must be available in order for maturing debt to be refinanced.

Third, financial institutions represent a special, exaggerated case of reliance on the credit markets.

Fourth and finally, the credit market gives off signals that have great psychological impact.

In making investments, it has become my habit to worry less about the economic future — which I’m sure I can’t know much about — than I do about the supply/demand picture relating to capital. Being positioned to make investments in an uncrowded arena conveys vast advantages. Participating in a field that everyone’s throwing money at is a formula for disaster. (“You Can’t Predict. You Can Prepare.”)

The main forces that created this cycle were the easy availability of capital; a lack of experience and prudence sufficient to temper the unbridled enthusiasm that pervaded the process; imaginative financial engineering; the separation of lending decisions from loan retention; and irresponsibility and downright greed.

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.

As you can see, the rise and fall of opportunities in the market for distressed debt stems from the interaction of other cycles: in the economy, investor psychology, risk attitudes and the credit market. The economic cycle influences investor psychology, company profitability and the incidence of default. The cycle in psychology contributes to fluctuations in credit market conditions and the desire of investors to lend, buy and sell. The cycle in attitudes toward risk facilitates the issuance of weak bonds at the top and denies capital for refinancing at the bottom. The credit cycle has a profound effect on the availability of refinancing and the degree to which would-be debt issuers are subjected to stringent credit standards. Hopefully it’s clear that multiple underlying cycles have effects on the distressed debt market that are far from discrete and isolated. As I wrote earlier, each of these cycles rises and falls; each causes the others to rise and fall; and each is affected by the rise and fall of others. But the result of all of this is a dramatic cycle in distressed debt opportunities, and one that is subject to explanation.

But the real estate cycle incorporates another ingredient that the others generally don’t share: the long lead times required for real estate development to take place.

Bulls and Bears

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

“First the innovator, then the imitator, then the idiot.”

In other words, after failing to do the right thing in stage one, they compound the error by taking that action in stage three, when it has become the wrong thing to do. That’s capitulation. It’s a highly destructive aspect of investor behavior during cycles, and a great example of psychology-induced error at its worst.

Bubbles and Crashes

So much for “no price too high.” No asset or company is so good that it can’t become overpriced.

I think “price doesn’t matter” is a necessary component — and a hallmark — of a bubble.

It should be noted, however, that “overpriced” is far from synonymous with “going down tomorrow.”

The most important thing to note is that maximum psychology, maximum availability of credit, maximum price, minimum potential return and maximum risk all are reached at the same time, and usually these extremes coincide with the last paroxysm of buying.

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

the risk in investing doesn’t come primarily from the economy, the companies, the securities, the stock certificates or the exchange buildings. It comes from the behavior of the market participants. So do most of the opportunities for exceptional returns.

It’s not what you buy that determines your results, it’s what you pay for it. And what you pay — the security’s price and its relationship to intrinsic value — is determined by investor psychology and the resulting behavior.

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.

Assessing our cycle position doesn’t tell us what will happen next, just what’s more and less likely. But that’s a lot.

So what was at the root of the formation of this bubble? According to “Now It’s All Bad?” (September 2007): … a standard combination that proved perfectly incendiary: underlying greed, good returns in the up-leg of the cycle, euphoria and complacency, a free-and-easy credit market, Wall Street’s inventiveness and salesmanship, and investors’ naiveté.

The resulting developments that fed the upswing are clear: a huge decrease in risk aversion, and thus the disappearance of skepticism, the acceptance of sweeping positive generalizations regarding homes and mortgages, excessive faith in new tools like financial engineering and risk management, and widespread blindness to the impact of improper incentives on participants in the process.