Many intelligent investors spend most of their time on:
- “Security analysis” – assessing the fundamentals of industries, companies and securities.
- “Value investing” – determining the intrinsic value of securities and being disciplined as to the appropriate price to pay for them.
Howard Marks adds an important third element – deciding what balance to strike between aggressiveness and defensiveness – “Mastering the market cycle“.
- The intrinsic value of securities tends to slowly move up over time.
- Market prices are cyclical and often move away from intrinsic value.
- A cycle is a pattern of up-and-down oscillations around a midpoint. Cycles are inevitable and self-correcting (because economies are made up of people and people have feelings which vary over time).
- Risk means more things can happen than will happen, hence the dotted lines illustrating possible future outcomes.
- By studying how the economy, the markets and the psychology of investors move, one can improve portfolio positioning.
Marks devotes separate chapters to the different cycles – the economic cycle, the profit cycle, the cycle in attitudes toward risk, the credit cycle, the distressed debt cycle, the real estate cycle – and puts it all together in a chapter on the market cycle.
The book draws heavily on Marks’ great memos, which are available here. Like in these memos, Marks superbly describes how sentiment evolves, time and time again.
For instance, below is the expand-and contract process that drives the credit cycle (from the November 2001 memo “You Can’t Predict. You Can Prepare.“):
- The economy moves into a period of prosperity.
- Providers of capital thrive, increasing their capital base.
- Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
- Risk averseness disappears.
- Financial institutions move to expand their businesses – that is, to provide more
- They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.
What are the implications for investors? I suggest they have a couple of choices:
- Just “stay the course”, as advocated by the late Jack Bogle.
- Try to get the odds on your side by adjusting portfolio risk based on a sense for where the market stands in the cycle.
For the latter, Howard Marks is the best guide one can think of.
For further info on mastering the market cycle, check out: