Mastering the Market Cycle by Howard Marks Book Summary
Mastering the Market Cycle, Getting the Odds on Your Side by Howard Marks
Looking to improve your investment returns? Investing legend Howard Marks shows you how to recognize market cycles: the ups and downs of economic markets that repeat and reverberate throughout history. Deciphering market cycles provides a knowledge advantage. Calibrating your investment strategy to cycle movement enables you to be aggressive when the chance for success is high and defensive when it is not – which often puts you at odds with the rest of the investment community. Lean in to the human-driven phenomenon of market excess and correction to capitalize on opportunities for exceptional returns.
- Calibrating your investment portfolio in response to changes in the market environment brings superior results.
- Learn to identify market cycle themes and patterns.
- Short-term economic activity fluctuates along the long-term trend without changing its trajectory.
- The free-market system enables the distribution of economic resources and promotes productivity.
- People’s emotional swings and resulting behaviors cause the highs and lows of market cycles.
- Assessing and managing risk are the greatest challenges to building a high-performing portfolio.
- Excessive risk aversion carries penalties: missed opportunities and depressed markets.
- The reactive, changeable credit cycle affects financial activity in many areas.
- The long development process differentiates the real estate cycle from others.
- Investor behavior causes market fluctuations beyond what company fundamentals might indicate.
Mastering the Market Cycle Book Summary
Calibrating your investment portfolio in response to changes in the market environment brings superior results.
Professional investors analyze industries, companies and securities to assess their intrinsic value and potential to grow or change in the short term. They compare the current market price with intrinsic value to establish worth. These investors often seek to build portfolios of assets with the highest cost-to-value relationship. Such portfolios perform equal to the average, but seldom above it. When every investor makes decisions from the same information, analyzed in the same way, no one can outperform the average. Calibrating an asset portfolio in response to changes in the investment environment brings superior results.
“Although it’s very easy to generate average investment performance, it’s quite hard to perform above average.”
Investors try to foresee tendencies and calculate the risk level inherent in different outcomes. Their predictions take the form of probability distributions informed by insights regarding the strength and likelihood of various tendencies. Learning to read market cycles provides investors with a knowledge advantage that allows them to be aggressive when the odds are in their favor and defensive when the odds are not.
Learn to identify market cycle themes and patterns.
Markets rise and fall or swing back and forth. Many factors – including human behavior – spur them into movement. The pattern of up and down remains consistent over time even though the length and causes of cycles vary. Fluctuations oscillate around a midpoint, known as the “secular trend, norm, mean or average.” Up or down movement in the cycle gains energy and momentum as one event gives rise to the next. The extremes of high – bubbles – and low – crashes – are deviations from the mean and forecast a correction or regression toward the mean.
“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.”
Circumstances rarely hover at normal on the way to the other high or low point. The market doesn’t move from overpriced, for example, to linger indefinitely at a fair price point.
Short-term economic activity fluctuates along the long-term trend without changing its trajectory.
An economy’s output is a measure of its overall productivity, determined, primarily, by the numbers of hours worked and population size. Birth rates, productivity speeds, and societal and environmental changes affect long-term economic growth; these take years or decades to play out. Economists concern themselves with gross domestic product (GDP): the market value of all the goods and services for sale that a nation produces within a given time frame.
“This underlying trend in growth clearly follows a long-term cycle, although the short-run ups and downs around it are more discernible and thus more readily discussed.”
The short-term economic cycle is the annual growth or constriction of an economy, and, generally, falls in the two to three percent range. Two negative quarters in a row signal the onset of a recession. Short-term cycles oscillate around a long-term upward or downward trend. Shorter movements in economic activity have little effect on the enduring trajectory.
The free-market system enables the distribution of economic resources and promotes productivity.
The term “free-market system” isn’t entirely accurate because government regulation and central bank activity temper the highs and lows of economic cycles. Central banks, such as the US Federal Reserve Bank, counteract inflation by restricting money supply, increasing interest rates and trading securities. They seek to boost employment with activities that support economic growth. These dual goals work against each other and require a counter-cyclical approach. Governments direct economic growth rates by increasing spending and cutting taxes during down times and doing the opposite when markets overheat.
“Since cycles produce ups and downs that can be excessive, the tools for dealing with them are counter-cyclical and applied with a cycle of their own – ideally inverse to the economic cycle itself.”
The economic cycle affects the sales and profits of some industries more than others. Corporate profit cycles echo the market cycle, but prove more variable than GDP because economics is not the only driver of sales. Price reductions, new product introductions and availability of financing, for example, all influence sales figures. An increase in revenues doesn’t always translate into larger profits due to differences in company operating costs and debt obligations.
People’s emotional swings and resulting behaviors cause the highs and lows of market cycles.
Human emotion drives the short-term ups and downs of the investment environment. People’s psychological reactions swing between the poles of “greed and fear,” “optimism and pessimism,” “risk tolerance and risk aversion,” “credulousness and skepticism,” and from “flawless to hopeless.” When times are good, and people feel positive, they become greedy and spend more on investments, inflating markets and increasing the value of assets. When their outlook is negative, they become fearful about losing money and sell, so asset values depreciate.
“Markets move upward when events are positive and psychology turns up, and they fall when events are negative, and psychology turns down.”
The tech stock market in 1999 serves as an apt example. When everyone bought, greed motivated investors to join the frenzy rather than stay on the sidelines while others became rich. When prices fell, fear replaced greed, and investors couldn’t dump their tech stocks fast enough. The lesson: remain objective and unemotional to protect yourself from making buying and selling decisions based on psychological excesses.
Assessing and managing risk are the greatest challenges to building a high-performing portfolio.
When investors become too risk averse or risk tolerant, their behavior causes swings and fluctuations that deviate from the capital market line – the risk/return continuum of rational markets. The shakiest investments often occur during the brightest and most robust economic times, due to unchecked optimism.
“Risk is high when investors feel risk is low. And risk compensation is at a minimum, just when risk is at a maximum.”
A positive mind-set regarding the economic outlook triggers greed and the following pattern results:
- Optimism reduces investors’ caution and hightens their risk tolerance.
- Investors forego careful analysis and make unwarranted assumptions about an upside.
- Investors relinquish demands for risk premiums and accept lower margins of safety.
- More people purchase the risky assets, driving up prices and reducing returns.
The Financial Crisis of 2007-2008 exemplifies what happens when investors exercise an unjustified tolerance for risk. The steps leading up to the crisis included government promotion of home ownership, low interest rates, the creation of levered mortgage-backed securities and financial derivatives, and declining lending standards and practices. Media coverage was uniformly rosy and optimistic; the government relaxed necessary protections, such as the Glass-Steagall Act. High risk tolerance allowed unsound, unsafe financial behavior and led to the inevitable crash.
Excessive risk aversion carries penalties: missed opportunities and depressed markets.
Burned investors become overly cautious. Those hyper-focused on loss avoidance make negative assumptions, expose investments to unnecessary scrutiny and reject even the lowest margins of safety. In this market, savvy investors realize greater gains by taking on reasonable risk.
“The riskiest thing in the world is the belief that there’s no risk. By the same token, the safest (and most rewarding) time to buy usually comes when everyone is convinced there’s no hope.”
It pays to be a contrarian – to buy when others are cautious and to be conservative when others are aggressive.
The reactive, changeable credit cycle affects financial activity in many areas.
Even small fluctuations in the economy cause the credit window to open wider or slam shut. When the credit window opens, financing becomes readily available. When the window closes, financing becomes difficult to obtain. The availability of credit strongly affects companies’ ability to grow and refinance maturing debt. A tight credit market causes consumers and investors to curtail activity and retreat to their corners.
“The slammed-shut phase of the credit cycle probably does more to make bargains available than any other factor.”
Upward movement in the credit cycle occurs during economic prosperity. The positive economic environment creates a wide-open capital market; businesses and financial entities easily obtain financing at lower interest rates, and with fewer conditions. Economic activity increases, and asset prices rise; but, eventually, relaxed credit diligence leads to losses – the credit window begins to close. When the credit crunch occurs at the bottom of the cycle, shrewd investors find opportunities for low-risk, high-yield assets at rock-bottom prices.
The long development process differentiates the real estate cycle from others.
The real estate cycle follows the pattern of other market cycles with one glaring difference: The real estate development process can take years. During this time, market conditions may change drastically.
At the start of the real estate cycle, a suppressed economy keeps building activity low. As the economy improves, housing demand rises. Limited inventory inflates rents and housing prices, attracting developers who obtain easy financing. The first available building projects benefit from pent-up demand. Their rosy returns attract more builders to capitalize on the still unmet need. Inventory eventually outpaces demand, the economy slides downward from its peak, rents and housing prices fall, and last-in real estate developers lose out.
The factors unique to real estate that intensify its cycle are the long duration between a project’s beginning and completion, the high level of financial leverage and the inability of supply to adjust nimbly to demand. These realities create opportunities for astute investors to pick up incomplete projects at reduced prices when the cycle hits bottom.
Investor behavior causes market fluctuations beyond what company fundamentals might indicate.
Security prices vary more than current earnings and outlook for future earnings indicate. Investors tend to believe what they want to believe, follow the herd, bounce between risk tolerance and risk aversion, surrender to the fear of missing out and let emotion rule. Investing brings out people’s deepest insecurities and stokes their subconscious fears.
“The key to being able to behave in a way that’s appropriate given the market climate lies significantly in assessing the psychology and the behavior of others.”
To invest intelligently, ascertain what an asset is worth and buy it for slightly less. When emotions interrupt the relationship between price and value, you will lose money. Quantitative assessment of gauging valuations coupled with qualitative measures of evaluating investor behavior indicate the cycle position. When everyone is buying euphorically, hold back; when they panic, scoop up deals.
Consider these components to build a high-performing investment portfolio:
- “Cycle positioning” – Take on or avoid risk in response to market cycles.
- “Asset selection” – Choose investments based on safe and proven metrics.
- “Aggressiveness and Defensiveness” – Determine if market conditions warrant either stance.
- “Skill” – Make investment decisions on a range of reasonable probabilities.
- “Luck” – Random events and circumstances may break to your benefit.
About the Author
Co-founder of Oaktree Capital Management Howard Marks also wrote the bestseller The Most Important Thing.