Mastering The Market Cycle: Getting the odds on your side

by Howard Marks

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 of the investment environment and where a number of elements stand in their cycles.

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.

As a consequence of the above, the future should be viewed not as a single fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and — hopefully on the basis of insight into their respective likelihoods — as a probability distribution. Probability distributions reflect one’s view of tendencies.

Superior investors are people who have a better sense for what tickets are in the bowl, and thus for whether it’s worth participating in the lottery. 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.

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 odds change as our position in the cycles changes. If we don’t change our investment stance as these things change, we’re being passive regarding cycles; in other words, we’re ignoring the chance to tilt the odds in our favor. But if we apply some insight regarding cycles, we can increase our bets and place them on more aggressive investments when the odds are in our favor, and we can take money off the table and increase our defensiveness when the odds are against us.

Or as Mark Twain is reputed to have said (although there’s no evidence he actually said it), “History doesn’t repeat itself, but it does rhyme.”

Owing to this view of cycles as progressions of causative events, this book contains several step-by-step accounts of progressions that took place in the past. The goal with each progression will be to illustrate what caused each event in the progression, what it meant in the progression, and how it contributed to the events that followed.

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.

as my long-time partner Sheldon Stone says, “The air goes out of the balloon much faster than it went in.”

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

Investment markets make the same pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between being overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”

Mastering the market Cycle

But the truth is that sometimes euphoria and optimism cause most investors to view things more positively than is warranted, and sometimes depression and pessimism make them see only bad and interpret events with a negative cast. Refusing to do so is one of the keys to successful investing.

they approach investing with caution, they perform careful analysis when considering investments, and especially risky ones, they incorporate conservative assumptions and appropriate skepticism into their analysis, they demand greater margins of safety on risky investments to protect against analytical errors and unpleasant surprises, they insist on healthy risk premiums — the expectation of incremental returns — if they’re going to undertake risky investments, and they refuse to invest in deals that make no sense.

Good times cause people to become more optimistic, jettison their caution, and settle for skimpy risk premiums on risky investments. Further, since they are less pessimistic and less alarmed, they tend to lose interest in the safer end of the risk/return continuum. This combination of elements makes the prices of risky assets rise relative to safer assets.

Widespread risk tolerance — or a high degree of investor comfort with risk — is the greatest harbinger of subsequent market declines.

Their ardor and excitement cause them to bid prices to levels that are so high — and to accept tales that clearly are so unrealistic — that after the fact it would be laughable if the damage done weren’t so great.

No, those risk-tolerant attitudes will not persist forever. Eventually, something will intrude, exposing securities’ imperfections and too-high prices. Prices will decline. Investors will like them less at $60 than they did at $100. Fear of losing the remaining $60 will overtake the urge to make back the lost $40. Risk aversion eventually will reassert itself (and usually go to excess).

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.

Warren Buffett puts it well in the above quote; it’s one I use all the time. I think it aptly sums up this phenomenon, as well as the contrarian response that is required as a result. When others fail to worry about risk and fail to apply caution, as Buffett says, we must turn more cautious. But it must also be said that when other investors are panicked and depressed and can’t imagine conditions under which risk would be worth taking, we should turn aggressive.

But that triggered an epiphany: Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

The fluctuation — or inconstancy — in attitudes toward risk is both the result of some cycles and the cause or exacerbator of others. And it will always go on, since it seems to be hard-wired into most people’s psyches to become more optimistic and risk-tolerant when things are going well, and then more worried and risk-averse when things turn downward. That means they’re most willing to buy when they should be most cautious, and most reluctant to buy when they should be most aggressive. Superior investors recognize this and strive to behave as contrarians.

Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.

The key to dealing with the credit cycle lies in recognizing that it reaches its apex when things have been going well for a while, news has been good, risk aversion is low, and investors are eager. That makes it easy for borrowers to raise money and causes buyers and investors to compete for the opportunity to provide it. The result is cheap financing, low credit standards, weak deals, and the unwise extension of credit. Borrowers hold the cards when the credit window is wide open — not lenders or investors. The implications of all of this should be obvious: proceed with caution. The exact opposite becomes true at the other extreme of the credit cycle. Its nadir is reached when developments are unpleasant, risk aversion is heightened, and investors are depressed. Under such circumstances, no one wants to provide capital, the credit market freezes up, and proposed offerings go begging. This puts the cards into the hands of providers of capital rather than the borrowers. Because borrowing is difficult and capital is generally unavailable, those who possess it and are willing to part with it can apply rigorous standards, insist on strong loan structures and protective covenants, and demand high prospective returns. It’s things like these that provide the margin of safety required for superior investing. When these boxes can be ticked, investors should swing into an aggressive mode. Superior investing doesn’t come from buying high-quality assets, but from buying when the deal...

credit cycles

Risk-averse investors limit quantities issued and demand high quality. High-quality issuance leads to low default rates. Low default rates cause investors to become complacent and risk-tolerant. Risk tolerance opens investors to increased issuance and lower quality. Lower-quality issuance eventually is tested by economic difficulty and gives rise to increased defaults. Increased defaults have a chilling effect, making investors risk-averse once more. And so it resumes.

are we winessing a market cycle

The first time an inexperienced investor lives through an upward market cycle, the beginnings of the progression may seem logical, as the positives compound in a bull market or bubble. The fact that so much good news and good feeling can end in losses can come as a surprise. It is inescapable that it will seem so to the uninitiated, of course, because if the progressions weren’t permitted to go on to extremes on the basis of errors in judgment, markets wouldn’t reach bull market tops to collapse from (or bear market bottoms to recover from).

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. The arrival of this simple truth opened my eyes to the notion of investors’ psychological extremes and the impact of those extremes on market cycles. Like many of the great quotations and adages, it captures disproportionate wisdom in a few simple words. It’s all about the changeability of attitudes, the pattern they follow over the course of a cycle, and how they contribute to error.

But not long after learning about the three stages, I came across something even better and briefer — essentially the same message in just 14 words: “What the wise man does in the beginning, the fool does in the end.”

“What the wise man does in the beginning, the fool does in the end” tells you 80% of what you have to know about market cycles and their impact. Warren Buffett has said much the same thing even more concisely: “First the innovator, then the imitator, then the idiot.”

Of course, cycles work in both directions, and the depths of the Global Financial Crisis gave me an opportunity to invert the old saying and describe the three stages of a bear market in “The Tide Goes Out” (March 2008): the first stage, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy, the second stage, when most investors recognize that things are deteriorating, and the third stage, when everyone’s convinced things can only get worse.

My favorite quote on this subject is from Charles Kindleberger: “There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich” (Manias, Panics, and Crashes: A History of Financial Crises, 1989).

The following progression serves to sum up regarding the upswing of the market cycle. It shows how cycles in economics, profits, psychology, risk aversion and media behavior combine to move market prices well beyond intrinsic value, and how one development contributes to the next. The economy is growing, and the economic reports are positive. Corporate earnings are rising and beating expectations. The media carry only good news. Securities markets strengthen. Investors grow increasingly confident and optimistic. Risk is perceived as being scarce and benign. Investors think of risk-bearing as a sure route to profit. Greed motivates behavior. Demand for investment opportunities exceeds supply. Asset prices rise beyond intrinsic value. Capital markets are wide open, making it easy to raise money or roll over debt. Defaults are few. Skepticism is low and faith is high, meaning risky deals can be done. No one can imagine things going wrong. No favorable development seems improbable. Everyone assumes things will get better forever. Investors ignore the possibility of loss and worry only about missing opportunities, No one can think of a reason to sell, and no one is forced to sell. Buyers outnumber sellers. Investors would be happy to buy if the market dips. Prices reach new highs. Media celebrate this exciting event. Investors become euphoric and carefree. Security holders marvel at their own intelligence; perhaps they buy more. Those who’ve remained on the sidelines feel remor...

Likewise, the following progression outlines what happens in a market downswing. The economy is slowing; reports are negative. Corporate earnings are flat or declining, and falling short of projections. Media report only bad news. Securities markets weaken. Investors become worried and depressed. Risk is seen as being everywhere. Investors see risk-bearing as nothing but a way to lose money. Fear dominates investor psychology. Demand for securities falls short of supply. Asset prices fall below intrinsic value. Capital markets slam shut, making it hard to issue securities or refinance debt. Defaults soar. Skepticism is high and faith is low, meaning only safe deals can be done, or maybe none at all. No one considers improvement possible. No outcome seems too negative to happen. Everyone assumes things will get worse forever. Investors ignore the possibility of missing opportunity and worry only about losing money. No one can think of a reason to buy. Sellers outnumber buyers. “Don’t try to catch a falling knife” takes the place of “buy the dips.” Prices reach new lows. The media fixate on this depressing trend. Investors become depressed and panicked. Security holders feel dumb and disillusioned. They realize they didn’t really understand the reasons behind the investments they made. Those who abstained from buying (or who sold) feel validated and are celebrated for their brilliance. Those who held give up and sell at depressed prices, adding further to the downward spiral...

As I wrote in The Most Important Thing, “we may never know where we’re going, but we’d better have a good idea where we are.”

Warren Buffett tells us, “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” When others are euphoric, we should be terrified. And when others are terrified, we should turn aggressive.

The key questions can be boiled down to two: how are things priced, and how are investors around us behaving? Assessing these two elements — consistently and in a disciplined manner — can be very helpful. The answers will give us a sense for where we stand in the cycle. In closing on this subject, I want to repeat something I’ve been harping on: even the best of temperature-taking can’t tell us will happen next … just the tendencies.

Like so many other things in the investment world that might be tried on the basis of certitude and precision, waiting for the bottom to start buying is a great example of folly. So if targeting the bottom is wrong, when should you buy? The answer’s simple: when price is below intrinsic value. What if the price continues downward? Buy more, as now it’s probably an even greater bargain. All you need for ultimate success in this regard is (a) an estimate of intrinsic value, (b) the emotional fortitude to persevere, and (c) eventually to have your estimate of value proved correct.

But they must bear in mind what John Maynard Keynes is reputed to have said: “The market can remain irrational longer than you can remain solvent.”

I’d like to return to that simple sentence and apply a little more thought regarding the formula for investment success. I conclude that it should be considered in terms of six main components, or rather three pairings: Cycle positioning — the process of deciding on the risk posture of your portfolio in response to your judgments regarding the principal cycles Asset selection — the process of deciding which markets, market niches and specific securities or assets to overweight and underweight

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 — the ability to make these decisions correctly on balance (although certainly not in every case) through a repeatable intellectual process and on the basis of reasonable assumptions regarding the future. Nowadays this has come to be known by its academic name: “alpha” Luck — what happens on the many occasions when skill and reasonable assumptions prove to be of no avail — that is, when randomness has more effect on events than do rational processes, whether resulting in “lucky breaks” or “tough luck”

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...

In 1977, New York City experienced a wave of lovers’ lane murders perpetrated by a serial killer labeled “the Son of Sam.” In 2014, I read the obituary of Timothy Dowd, the detective who caught him. I loved the part where it quoted him as saying it was his job “to prepare to be lucky.” Given my view of the future as indeterminate and subject to considerable randomness, I think that’s a great way to think about it. While it may sound like I’m advocating being passive and leaving things to chance, the truth is that superior investors have favorably skewed distributions of outcomes, but not batting averages of 1.000. They still need favorable outcomes: they need the right tickets to be drawn from the bowl.

One of the best ways to enjoy the skewed distribution of outcomes that marks superior investors is to get the market’s tendency on your side. The outcome will never be under your control, but if you invest when the market’s tendency is biased toward favorable, you’ll have the wind at your back, and if the tendency is biased toward unfavorable, the reverse will be true. Skillful analysis of cycles can give you a better-than-average understanding of the market’s likely tendency and thus enable you to improve your chances of properly positioning your portfolio for what lies ahead.

Investing, as I’ve said, consists of positioning capital so as to benefit from future events. I also said we never know what the future holds, and thus where we’re going. But we should do all we can to know where we stand, since the current position of the cycle has powerful implications for how we should cope with its possible future.

most important investment adages says, “Being too far ahead of your time is indistinguishable from being wrong.”

Remember, when there’s nothing clever to do, the mistake lies in trying to be clever.

After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winningest forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive! Performing that trick requires a strong stomach for being wrong because we are all going to be wrong more often then we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future … (Jeff Saut, “Being Wrong and Still Making Money,” Seeking Alpha, March 13, 2017, emphasis added)

“success carries within itself the seeds of failure, and failure the seeds of success.”

Another way I put it is that “success isn’t good for most people.” In short, success can change people, and usually not for the better. Success makes people think they’re smart. That’s fine as far as it goes, but there can also be negative ramifications. Success also tends to make people richer, and that can lead to a reduction in their level of motivation.

In investing there’s a complex relationship between humility and confidence. Since the greatest bargains are usually found among things that are undiscovered or disrespected, to be successful an investor has to have enough confidence in his judgment to adopt what David Swensen, the hugely successful head of Yale’s high-performing endowment, describes as “uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom” (Pioneering Portfolio Management, 2000). By definition, pronounced bargain prices are most likely to be found among things that conventional wisdom dismisses, that make most investors uncomfortable, and whose merits are hard to comprehend. Investing in them requires considerable inner strength. When one of those positions initially fails to rise as the investor expects — or perhaps goes in the opposite direction — the investor has to have enough confidence to hold on to his position or even add to it. He can’t take a price decline as a sure “sell” signal; in other words, it can’t be his default position that the market knows more than he does. But, on the other hand, the investor also has to know his limitations and not assume he’s infallible. He has to understand that no one knows for sure what the macro future holds. While he’s likely to have opinions regarding the future course of economies, markets and interest rates, he should acknowledge that they’re not necessarily correct. And, counter to the abov...