Howard Marks: Mastering the Market Cycle
Even among the classics of investing literature readers must be prepared to stomach a modicum of folksy wisdom, dusted with the odd strained aphorism or mildly exaggerated anecdote. Or else the reader is inducted into the cabala of Elliott Waves and similar charting techniques, most of which sounds like it was lifted from a Dan Brown novel.
While Marks’s latest book on market cycles is not without its share of Marksisms, this is surely some of the most self-aware writing of any professional investment manager. It offers something even the most experienced investors can appreciate and learn from, while remaining accessible to a general audience.
As humans we struggle to extricate our rational brain from our emotions-and not just when the markets head south. When things are going well, we tend to believe that they’ll carry on that way forever. We make more generous assumptions, reduce our margin of safety, and start underpricing risk. Likewise, when the market enters freefall, suddenly nothing is safe, any kind of risk appears monstrously overpriced, and the nightmare feels like it will never end.
If there’s a key insight from Marks it’s that cycles are fundamentally psychological. There may be some exogenous causes-new technologies, geopolitical events, or crises like the current coronavirus outbreak-but the reaction will always be psychological. Markets follow a long-term trend that is upward sloping: economies tend to grow, people tend to get wealthier, and companies tend to be more profitable over time. But while the trend might appear linear, the actual course that markets take is far from it. These fluctuations are, according to Marks, the manifestations of our very human reactions to events and information, as well as our lack of an historical memory that can save us from repeat errors.
Could there be a more fitting time to read this than in the middle of a market correction? Everything Marks says about the psychology of markets is playing out right now. If understanding cycles requires an understanding of investor psychology, taking advantage of the cycle in order to generate alpha requires us to overcome our own psychologies (and those of our clients). This is the real challenge of managing cycles, and it goes beyond our education and technical training.
Reading through this book there were four things that struck me:
1. Timing is in fact everything
Timing is everything, despite all the protests to the contrary. When we think about the market value of a security, generally we’re thinking in two dimensions: price and time. You can’t focus on one without the other. There might be a myriad of other factors we also want to consider, but time will always be a necessary factor for our analysis to make any kind of sense. This is true of any cycle we’re examining, whether it’s the credit cycle, the cycle for distressed assets, or the earnings cycle of a specific industry or company.
If you decide to become more aggressive when others are becoming more defensive, you’re timing the market. If you decide to become more aggressive when everyone else is also becoming more aggressive, you’re timing the market. If you decide to become more defensive after everyone else has already decided to become more defensive, you’re timing the market. When active managers claim they aren’t trying to time the market, I can’t help but wonder who they’re trying to fool.
2. Cycles are conceptually simple but incredibly difficult to manage in practice
It’s one thing to theorise about cycles, it’s another to put the theory into practice. The stylised cycles we see in textbooks and investment brochures don’t look like the ones we experience in the real world. Detecting the extremes of a cycle is relatively easy, but cycles have an unfortunate habit of disobeying classic investing heuristics for prolonged periods of time.
The current cycle is the perfect case in point. Most agree markets have been running hot and that a correction is inevitable, but how long will the reckoning last, and how low will it take us? In other words, when does a correction become a crash? These aren’t easy questions to answer, and Marks doesn’t give us a definitive template to use because one simply doesn’t exist.
It must also be said that efforts to interpret the current cycle are confounded by the low-growth, low-interest rate environment we’ve been stuck in more or less since the GFC. Depending on who you ask, this environment is the result of changes in secular trends or part of a broader cycle. Secular or not, this is the new reality investors are operating in.
3. If taking a view feels comfortable, it’s likely not a contrarian view
Holding a contrarian position takes courage. Being contrarian means most people will think you’re a fool (including possibly many of your clients and investors). There are times when following the market for the sake of expediency is very tempting, even if it goes against your philosophy. Resisting this temptation is not easy. Marks recounts his fund’s activity during the GFC:
Thinking strategically, we decided that if the financial world ended-which no one could rule out-it wouldn’t matter whether we’d bought or not. But if the world didn’t end and we hadn’t bought, we would have failed to do our job.
So we bought debt aggressively. Oaktree invested more than a half a billion dollars a week over the fifteen weeks from September 15 through the end of the year. Some days we thought we were going too fast, and some days too slow; that probably meant we had it about right. The world didn’t end; the vicious cycle of financial institution implosion stopped with Lehman Brothers; the capital markets reopened; the financial institutions came back to life; debt was again able to be refinanced; bankruptcies turned out to be very few relative to history; and the assets we bought appreciated substantially. In short, paying heed to the cycle was rewarded.
Beating the market requires you take a contrarian view. If making a trade doesn’t make you feel uncomfortable, it’s probably because your view is consensual. Standing aside from the crowd requires conviction and considerable faith in your investing process.
4. Successful investors should publish more
Reading this and similar books, I find it curious that successful investors don’t publish more or provide a public record of their thoughts and decisions over time. Such a record would be of immense value and help to investors. Beyond a handful of classic books, there are few contemporary examples of investment managers publishing for the sake of sharing their knowledge and relating their experience of markets warts and all, from the lucky breaks and strokes of genius to the lost opportunities and unmitigated disasters.
Marks’s books have always offered a genuine account of his philosophy and approach to investing, and I think that’s highly admirable. More should be doing the same.