Mastering the Market Cycle

Author

Howard Marks

Genre

Investing

Last Read

June 30, 2020

Cover

Stars

★★★★☆

Howard Marks is one of my favourite investors:

I originally listened to this book via Audiobook, so did not have Kindle highlights. But I have gone through and added notes and analysis (highlights section uses quotes directly from the book).

“The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day, as reported in the media. But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what should be done in response?” - Howard Marks

“The tendency of people to go to excess will never end. And thus, since those excesses eventually have to correct, neither will the occurrence of cycles. Economies and markets have never moved in a straight line in the past, and neither will they do so in the future.” - Howard Marks

Highlights (And Summary of the Book):

1. Investment success is like the choosing of a lottery winner. Both are determined by one ticket (the outcome) being pulled from a bowlful of tickets (the full range of possible outcomes). In each case, one outcome is chosen from among the many possibilities. 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.
2. 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.
3. 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.
4. In the world investors inhabit, cycles rise and fall, and pendulums swing back and forth. Cycles and pendulum swings come in many forms and relate to a wide variety of phenomena, but the underlying reasons for them—and the patterns they produce—have a lot in common, and they tend to be somewhat consistent over time. 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.”
5. The cycle oscillates around the midpoint. The movement from either a high or a low extreme back toward the midpoint is often described as “regression toward the mean,” a powerful and very reasonable tendency in most walks of life. The rational midpoint generally exerts a kind of magnetic pull, bringing the thing that’s cycling back from an extreme in the direction of “normal.”
6. The themes that provide warning signals in every boom/bust are the general ones: that excessive optimism is a dangerous thing; that risk aversion is an essential ingredient for the market to be safe; and that overly generous capital markets ultimately lead to unwise financing, and thus to danger for participants.
7. Cycles have more potential to wreak havoc the further they progress from the midpoint—i.e., the greater the aberrations or excesses. If the swing toward one extreme goes further, the swing back is likely to be more violent, and more damage is likely to be done
8. Most people think of cycles as series of events that follow each other in a usual sequence: upswings are followed by downswings, and then eventually by new upswings. But to have a full understanding of cycles, that’s not enough. 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.
9. The things I call cycles do not stem completely—or sometimes at all—from the operation of mechanical, scientific or physical processes. The involvement of humans in this process enables their emotion-and psychology-induced tendencies to influence cyclical phenomena.
10. Why is the pendulum of psychology important? In essence, the too-strong upward and downward swings of the cycles I’m covering in this book largely result from—and represent—psychological excesses in action. In business, financial and market cycles, most excesses on the upside—and the inevitable reactions to the downside, which also tend to overshoot—are the result of exaggerated swings of the pendulum of psychology.
11. It all seems so obvious: investors rarely maintain objective, rational, neutral and stable positions. First they exhibit high levels of optimism, greed, risk tolerance and credulousness, and their resulting behavior causes asset prices to rise, potential returns to fall, and risk to increase. But then, for some reason—perhaps the arrival of a tipping point—they switch to pessimism, fear, risk aversion and skepticism, and this causes asset prices to fall, prospective returns to rise, and risk to decrease
1. That’s one of the crazy things: in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.”
12. The superior investor—who resists external influences, remains emotionally balanced and acts rationally—perceives both positive and negative events, weighs events objectively, and analyzes them dispassionately. But of course, the swing of the market pendulum to one extreme or the other occurs for the simple reason that the psyches of most market participants are moving in the same direction in a herd-like fashion.
13. My view that risk is the main moving piece in investing makes me conclude that at any given point in time, the way investors collectively are viewing risk and behaving with regard to it is of overwhelming importance in shaping the investment environment in which we find ourselves.
14. People are more inclined to make risky investments in good times even though the higher prices often mean the prospective risk premiums offered are skimpier than they were in more risk-conscious times. And when negative events occur, the lack of adequate risk premiums and margin for error shows the investments to have been unwise. It follows from the above that risk is high when investors feel risk is low.
15. Just as the inadequacy of investors’ risk aversion allows them to push prices up and buy at the top—egged on by the vision of easy money in a world in which they can’t discern any risk—in less positive times they push prices down and sell at the bottom.
16. During panics, people spend 100% of their time making sure there can be no losses . . . at just the time that they should be worrying instead about missing out on great opportunities.
17. 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.
18. Changes in the availability of capital or credit constitute one of the most fundamental influences on economies, companies and markets. Even though the credit cycle is less well known to the man on the street than most of the other cycles discussed in this book, I consider it to be of paramount importance and profound influence.
19. 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.
20. Looking for the cause of a market extreme usually requires rewinding the videotape of the credit cycle a few months or years. Most raging bull markets are abetted by an upsurge in the willingness to provide capital, usually imprudently.
21. 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.
22. The merits of the asset in question matter only so much, and certainly they can’t be strong enough to always carry the day. Human emotion inevitably causes the prices of assets—even worthwhile assets—to be transported to levels that are extreme and unsustainable: either vertiginous highs or overly pessimistic lows.
23. In short, conscientious belief in the inevitability of cycles like I’m urging means that a number of words and phrases must be excluded from the intelligent investor’s vocabulary. These include “never,” “always,” “forever,” “can’t,”, “won’t,” “will” and “has to.”
24. 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.
25. It’s usually during market slides that you can buy the largest quantities of the thing you want, from sellers who are throwing in the towel and while the nonknife-catchers are hugging the sidelines.
26. Exiting the market after a decline—and thus failing to participate in a cyclical rebound—is truly the cardinal sin in investing.
27. The truth is that financial facts and figures are only a starting point for market behavior; investor rationality is the exception, not the rule; and the market spends little of its time calmly weighing financial data and setting prices free of emotionality.
28. The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day, as reported in the media. But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what should be done in response?
29. “It’s different this time” are four of the most dangerous words in the business world—especially when applied, as is often the case, to something that has reached what in prior times would have been called an extreme.
30. Cycle positioning is the process of deciding on the risk posture of your portfolio in response to your judgments regarding the principal cycles, and asset selection is the process of deciding which markets, market niches and specific securities or assets to overweight and underweight.
31. Cycle positioning primarily consists of choosing between aggressiveness and defensiveness: increasing and decreasing exposure to market movements. The recipe for success here consists of (a) thoughtful analysis of where the market stands in its cycle, (b) a resulting increase in aggressiveness or defensiveness, and (c) being proved right. These things can be summed up as “skill” or “alpha” at cycle positioning.