Summary of Mastering the Market Cycle by Howard Marks

Review

I’ve read this book in November 2018 and at the same time a market correction occurred in the equity markets world wide. I think the book really gives some great insights in how the markets work and how important investor’s psychology is for the market. This drives the excesses in overpriced as underpriced assets the most which is the basic statement of this book.

Some parts are directly taken from the book as excerpts below.

Nature of cycles

Phases:

  • recovery from an excessively depressed lower extreme or “low” toward the midpoint
  • the continued swing past the midpoint toward an upper extreme or “high”
  • the attainment of a high
  • the downward correction from the high back toward the midpoint or mean
  • the continuation of the downward movement past the midpoint, toward a new low
  • the reaching of a low
  • once again, recovery from the low back toward the midpoint
  • and then, again, the continuation of the upward swing past the midpoint, toward another high

  • like a pendulum around a midpoint trajectory swinging up and down, gravity forcing it back to the mid

Quotes:

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

The regularity of cycles

Cycles can’t be compared to mathematics. The next high is rarely equal to the previous high. They can’t be compared to sin/cos curves. There are cycles on cycles with a secular trend. If one knows what causes them and why, it gives them an edge. When, how long and the extent of cycles are not predictable. There is a lot of randomness involved.

The economic cycle

economics = the dismal science

Many investors predicate their actions on forecasts that they make themselves or obtain from economists, banks or the media. And yet many such forecasts contain information that’s likely to not add value and lead to investment success.

  • In investing, it’s easy to achieve performance that is equal to that of the average investor or a market benchmark.
  • Since it’s easy to be average, real investment success must consist of outperforming other investors and the averages. Investment success is largely a relative concept, measured on the basis of relative performance.
  • Simply being right about a coming event isn’t enough to ensure superior relative performance if everyone holds the same view and as a result everyone is equally right. Thus success doesn’t lie in being right, but rather in being more right than others.
  • Similarly, one doesn’t have to be right in order to be successful: just less wrong than others.
  • Success doesn’t come from having a correct forecast, but from having a superior forecast. Can such forecasts be obtained?

The cycle in profits

  • profits can be lower because of fixed, semi-fixed and variable costs
  • profits are also influenced by leverage which effect the bottom line considerably the higher the leverage

The pendulum of investor psychology

  • markets swing between greed and fear
  • rarely market average of 2%. more common extremes which tend to cluster together for 1-2years
  • news is interpreted more positive in a positive environment and vice versa. important to view news from a natural stand point.

A few years ago my friend Jon Brooks supplied this great illustration of skewed interpretation at work. Here’s how > investors react to events when they’re feeling good about life (which usually means the market has been rising):

  • Strong data: economy strengthening—stocks rally
  • Weak data: Fed likely to ease—stocks rally
  • Data as expected: low volatility—stocks rally
  • Banks make $4 billion: business conditions favorable—stocks rally
  • Banks lose $4 billion: bad news out of the way—stocks rally
  • Oil spikes: growing global economy contributing to demand—stocks rally
  • Oil drops: more purchasing power for the consumer—stocks rally
  • Dollar plunges: great for exporters—stocks rally
  • Dollar strengthens: great for companies that buy from abroad—stocks rally
  • Inflation spikes: will cause assets to appreciate—stocks rally
  • Inflation drops: improves quality of earnings—stocks rally

The cycle in attitudes towards risk

  • Investors try to predict the future but only the smart know that’s not possible
  • Higher return doesn’t equal higher risk. Return doesn’t increase proportional to the risk taken.
  • People are naturally more risk-averse than risk-taking
  • People fluctuate between being to risk-averse and being to risk-seeking
  • “When the music stops, in terms of liquidity, things will be complicated. But as long as the music’s playing, you’ve got to get up and dance. We’re still dancing.” Charles Prince 2007
  • Related article: The Limits to Negativism

The credit cycle

  • Good deals when the deal is good, the price is low, return is substantial, risk is limited and not from buying high quality assets.
  • Credit works like a windows, sometimes it’s wide open and in a blink of an eye it closes shut immediately.
  • Short term debt preferred by companies for long term investments (machines etc.) because they are cheaper and can usually be rolled over every 270 days. If credit freezes up and no cash on hand, big trouble could arise.

The distressed debt cycle

  • invest in debt that is likely to default on the future but where it’s a good company with just a bad balance sheet
  • more demand for bonds because of its high yield results in more bonds being issued by Wallstreet even though they may be of lesser creditworthiness
  • with higher demand prices rise and yields fall
  • cycle originates from the economy, investor psychology, risk attitudes and the credit market

The real estate cycle

  • slower than other cycle because of its physicality
  • some projects started during the boom will only be completed after demand has fallen and bad times have arrived
  • cycles are self perpetuating
  • one forgotten reason for the housing boom was the increase in the US population from 1945 to 2010 which is rarely discussed
  • Taboo words in investing: never, always, forever, can’t, won’t, will, has to, “ever-increasing”

Putting it all together - The market cycle

  • investor’s job: deal with prices, assess where they stand and where they will go in the future
  • price are affected by fundamentals and psychology
  • investors generally over exaggerate changes in fundamental changes like earnings
  • History doesn’t repeat itself, but it does rhyme
  • Most cycles interact with other cycles making it one big market cycle
  • Investor rationality is the exception, not the rule. Ben Graham’s opinion that the market is a weighing machine as a disciplined assessor of the value of assets is wrong.
  • “What the wise man does in the beginning, the fool does in the end.”
  • Even Sir Isaac Newton fell pray to the lures of the “South Sea Bubble”. First investing and selling appropriately only to reinvest and loose his money.
  • Bubble: “There’s no such thing as a price too high” and the believe that no matter what price you pay, you’ll make money.

How to cope with market cycles

  • Knowing where the pendulum of psychology and the cycle in valuation stands in their swings
  • “We may never know where we’re going, but we’d better have a good idea where we are.”
  • Knowing when to refuse to buy and perhaps to sell
  • Sir John Tempelton: “To buy when others are despondently selling and sell when others are greedily buying requires the greates fortitude and pays the greatest rewards.”
  • Warren Buffet: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
  • “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.”
  • Failing to participate in a cyclical rebound after a selloff is a cardinal sin.
  • John Maynard Keynes: “The markert can remain irrational longer than you can remain solvent.”

Cycle positioning

  • Investment success consists of 2 parts: cycle positioning and asset selection
  • Skill/luck is a big part too
  • Being too aggressive or too defensive makes you either an under performer or over performer

Limits on coping

  • The longer the cycle continues to move upward, the more likely the expected correction becomes
  • “Being too far ahead of your time is indistinguishable from being wrong.”
  • Positioning for cycles isn’t easy.

The cycle in success

  • Peter Bernstein: “Even the best investors won’t be successful all the time.”
  • Peter Kaufman: “As any system grows toward its maximum or peak efficiency, it will develop the very internal contradictions and weaknesses that bring about its eventual decay and demise.”
  • David Swensen: “Uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional widsom” - to achieve trading success
  • Having the guts to hold even if a trade against one or even consider to add to the trade. But, nobody is infallible.
  • Adage: “Don’t confuse brains with a bull market.”
  • Henry Kaufman: “There are two kinds of people who lose a lot of money: those who know nothing and those who know everything.”
  • Nothing will work forever and one has to constantly adapt to stay successful. But, as soon as people say something works forever, that’s the very time when it’ll become certain not to.
  • “It takes a highly simplistic first-level thinker to conclude that poor past performance has led to unpopularity today, which implies poor performance tomorrow. Rather, the insightful second-level thinker says poor past performance has led to unpopularity today, which implies low prices today, which in turn implies good performance tomorrow.”
  • Companies have potential to fail as well while being successful:
    • They can become “fat and happy”
    • They can become bureaucratic and slow-moving
    • They fail to take action to defend their positions
    • They cease to be innovative and non-conforming, join the crowd of mediocrity
    • They think they can do pretty much anything and venture into areas beyond their competence
  • Success carries the seeds of failure. Failure carries the seeds of success.
  • Demosthenes: “For that which a man wishes, that he will believe” - wishful thinking

The future of cycles

  • Most dangerous words: “It’s different this time.”
  • Even the most unemotional and stoic “economic men” are subject to human influences and the loss of objectivity.
  • Most people underestimate the importance of greed on the upswing and and fear on the downswing.
  • Never extrapolate past returns into the future.
  • People who have experienced a downturn once are at a clear advantage.

The essence of cycles

  • Being aware of cycles is key to investment success. Superior investors know this fact.
  • Correctly calibrating the aggressiveness of capital allocation goes hand in hand with the current position of the cycle.
  • Excessive optimism is core part of cycles
  • One cycle is causing the next cycle. They are not a mere sequence of occurrences.
  • Humans create the cycle.
  • Most excesses on the upside and downside are side-effects of human psychology.
  • Risk is high when investors feel risk is low and risk is low when investors feels risk is at a maximum.
  • Greatest investment risk is the belief that there is no risk.
  • Same people who bought risky assets at the top they become the people who worry about everything on the bottom and sell there.
  • Safest time to buy when everyone is convinced there’s no hope.
  • Swing to excessive risk aversion depresses markets and creates some of the greatest buying opportunities.
  • 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. This is usually the case when the credit market is less open.

The mind agrees.