What’s Howard Marks’s Mastering the Market Cycle about? How unpredictable is the securities market?
One of the world’s leading investors, Howard Marks, claims that the securities market is a lot more predictable than people realize. In Mastering the Marketing Cycle, he discusses three cycles that shape the investing landscape and impact the securities market.
Read more in our brief overview of Mastering the Marketing Cycle.
Overview of Howard Marks’s Mastering the Market Cycle
Investing experts and laypeople alike often lament the unpredictability of the securities market—financial markets on which investments like stocks and bonds are sold. However, according to one of the world’s leading investors, this belief in the market’s unpredictability is unfounded. In Mastering the Market Cycle, Howard Marks argues that the securities market undergoes predictable fluctuations that depend on foundational business cycles and cycles in investor psychology that arise from those foundational cycles.
As the cofounder and cochairman of Oaktree Capital Management, an investment firm that manages $179 billion in assets, Marks brings years of investing experience to Mastering the Market Cycle. Key insights from Marks’s widely renowned investing memos—which Warren Buffett has praised—often form the foundation of his arguments throughout the book.
Foundational Cycles
Marks writes that three foundational cycles impact business prosperity (and consequently the value of securities): the economic cycle, the profit cycle, and the credit cycle. In this section, we’ll examine these three cycles to illustrate their underlying causes and their impact on securities.
The Economic Cycle
According to Marks, the economy experiences cyclical swings as it expands and contracts. These swings lead to long-term economic fluctuations due to shifts in productivity and net hours worked, as well as short-term fluctuations due to changes in spending patterns.
Regarding long-term change, Marks points out that the gross domestic product (GDP)—the value of all goods and services produced per year—varies depending on the total hours worked and the productivity of those hours. He explains that consequently, the GDP undergoes long-term swings due to changes in birth rate, as a higher birth rate at one point in time will cause a spike in total hours worked several decades later. In the US, for example, although GDP increases on average 2-3% per year, it’s subject to long-term cycles that mirror cycles in birth rates.
Regarding short-term change, Marks notes that the economy can fluctuate sharply on a yearly basis even though it trends upward over time. He writes that these fluctuations occur because consumers’ spending habits are fickle—for example, if the government were to issue stimulus checks, that would temporarily cause a spike in spending that jolts the economy. By contrast, if political unrest in a region were to cause consumers to worry, they might be less likely to spend, causing a short-term economic slowdown.
The Profit Cycle (profit cycle)
Marks relates that the economic cycle is closely related to another foundational cycle: the profit cycle. However, he explains that while the economic cycle’s fluctuations are rather small—GDP rarely increases more than 5% or decreases by more than 2% over a year—the profit cycle undergoes sharp swings as profits regularly increase far more than 5% or decrease far more than 2%.
Marks points out that these sharp swings happen for two reasons. First, many industries’ sales (which correlate with their profits) are extremely sensitive to shifts in the economic cycle. For example, the tourism industry sees exponential sales increases in years of economic prosperity and exponential decreases whenever there’s a recession. For this reason, their profits are much more volatile than the economy at large—if the GDP dropped 1%, for example, profits in the tourism industry might drop 10%.
Second, Marks explains that highly leveraged companies—that is, financed heavily with debt—have profits that are much more sensitive to changing sales revenue because they have to make interest payments that cut into their profits. For example, imagine a start-up company that’s financed with $50,000 of debt, requiring $5,000 annual interest payments, and $50,000 of equity. If this company’s operating profits (that is, its profits from sales before deducting interest payments) dropped from $15,000 to $7,500, then its true profits would drop from $10,000 to $2,500 after deducting interest payments. In other words, a 50% drop in operating profits from sales would correspond to a 75% drop in true profits.
The Credit Cycle
Much like the profit cycle depends on the economic cycle, the credit cycle is highly contingent on the economy. According to Marks, the credit cycle swings wildly in response to economic changes, causing credit to fluctuate from easily available to heavily restricted.
He explains that in times of economic prosperity, credit lenders often mistakenly believe that loans carry little risk, leading them to offer credit liberally to applicants. For example, start-up companies have little trouble securing loans when the economy is booming since lenders are overconfident that these companies can repay the loans. Consequently, creditors provide imprudent loans to unqualified applicants that carry a high risk of default.
As Marks relates, when borrowers eventually default on these unwise loans, it causes the capital market to overcorrect and become too restrictive. In other words, creditors become reluctant to issue further loans—even to qualified borrowers—causing the previously open stream of credit to dry up. The reduced availability of loans then feeds back into the economic cycle by slowing economic growth.
Psychological Cycles
Having seen the foundational cycles that impact business prosperity, we’ll now discuss how oscillations in these cycles impact investors’ psychology. In particular, we’ll see how shifts in foundational cycles lead to a psychological cycle between fear and greed that in turn causes a cycle between risk tolerance and risk aversion.
The Cycle Between Greed and Fear
According to Marks, the psychological cycle that influences the securities market most is the cycle between greed and fear. He argues that the most promising parts of foundational cycles—such as economic growth, high profits, and easy access to credit—fuel investors’ greed, causing them to act imprudently, which in turn contributes to downswings in foundational cycles that increase fear.
For example, when the economy is thriving and profits are high, investors are more likely to be flush with cash. Because of readily available credit, some may even borrow money to invest, convinced that borrowing money represents a path to outsized returns. In this environment, greed runs rampant as investors mistakenly think they’re guaranteed to earn money through aggressive investing strategies.
But, according to Marks, this greed can’t last forever. On the contrary, he suggests that some investors will eventually be deterred from investing upon realizing how greed has led to risky, speculative investments. As this contrarian view becomes more common, fear eventually infiltrates the securities market. In turn, this fear can influence the foundational cycles—lenders might become reluctant to issue credit, for example, leading to slowed economic growth.
The Cycle Between Risk Tolerance and Risk Aversion
Marks contends that as a result of the fluctuations between greed and fear, most investors alternate between being overly risk tolerant and overly risk averse. He explains that risk tolerance leads to inflated securities prices, eventually leading investors to become risk averse because of these excessive prices.
First, Marks writes that when investors become greedy—which, as we’ve seen, occurs whenever the economy prospers, profits rise, and credit is accessible—they’re more willing to purchase stocks and other securities at a premium. For example, even if Apple’s share price is exceedingly high, greedy investors might reason that it’ll keep increasing, meaning they think the currently inflated share price is moot because they’ll earn a significant profit regardless.
The upshot is that when investors believe the securities market poses the least risk (that is, when they bid up prices), it actually carries the most risk because securities are overpriced. According to Marks, savvy investors will realize that the market is overpriced, leading them to begin selling securities and dropping their prices. As other fearful investors see these initial price drops, they’ll likewise sell securities, causing a cascading series of price drops.
Marks contends that over time, these decreases in price will cause investors to become risk averse—they’ll become convinced that prices can only drop further, making them reluctant to purchase securities that are actually a good bargain. Thus, when the securities market is least risky because it’s underpriced, investors tend to be most risk averse.
The Securities Market Cycle and How to Exploit It
Now that we’ve examined the foundational and psychological cycles that underlie the securities market cycle, we’ll outline how these cycles jointly drive the overall securities market. In particular, we’ll discover how the predictable nature of foundational and psychological cycles makes for a predictable securities market cycle that you can exploit to reap large returns.
What Drives the Securities Market Cycle?
According to Marks, the securities market cycle fluctuates in accordance with shifts in investor psychology that, as we’ve seen, depend upon underlying foundational cycles. He argues that positive investor psychology drives bubbles in which securities become wildly overpriced, leading to crashes in which they become underpriced.
As Marks has shown, initial upticks in foundational cycles—for example, a steady rebound in GDP or profits that slightly exceed projections—tend to cause a handful of investors to begin purchasing securities. Over time, as more people become aware of these upticks, more investors purchase securities. At this point, greed and risk tolerance begin to infiltrate the market as investors expect prices to rise indefinitely.
According to Marks, these greedy, risk-tolerant investors drive prices further until they form a bubble—that is, a situation in which securities’ prices far outstrip their true value. The defining aspect of a bubble, he argues, is the emotionally driven belief that the market will only ever go up, regardless of its current pricing. In other words, bubbles represent the victory of speculative, emotional investing over collected, rational investing.
However, this bubble will eventually burst when a few rational investors begin to realize that securities are overpriced and sell them en masse, causing a crash—that is, a situation in which securities prices drop rapidly, making them dip below their true value. The defining feature of a crash, Marks relates, is the inverse of a bubble: In a crash, the emotionally charged belief that the market will only ever fall reigns supreme. Thus crashes and bubbles alike both require investors to stop acting rationally.
Why Can You Exploit the Securities Market Cycle?
Because the market cycle isn’t deterministic, you can’t reap guaranteed profits by simply waiting until the market is rife with fearful, risk-averse investors and then purchasing securities before their price skyrockets. However, Marks clarifies that you can tilt the deck in your favor by taking the market’s tendencies into account when positioning your portfolio.
To illustrate, imagine that you’re betting on whether a coin flip will land heads or tails. If you know that the coin is rigged so that it lands on tails 70% of the time, you should bet that it will land on tails—not because it’s guaranteed to do so, but because that’s the most likely outcome. Analogously, if the market is filled with speculative trading driven by greed and riskiness, you should bet that it will drop and security prices will fall—not because it’s guaranteed to drop, but because that outcome is more probable.
How Can You Exploit the Securities Market Cycle?
Having seen why it’s possible to exploit the securities market, Marks illustrates how to do so via two steps: Correctly assess the market’s position in the cycle, and adjust your portfolio accordingly.
Step #1: Correctly Assess the Cycle’s Position
The first step toward exploiting the market cycle involves correctly determining the market’s position in that cycle. To do so, he first recommends that you evaluate quantitative metrics that can signify whether the market is bullish or bearish. For example, you can look at the S&P 500’s average price-earnings ratio—that is, the ratio of a company’s share price to its earnings-per-share—to see whether investors seem to be overpaying or underpaying relative to earnings.
Marks also recommends performing a qualitative assessment by taking stock of the way investors are talking about the market. For instance, are prominent investing gurus lamenting the state of the stock market, or are they instead singing its praises and constantly issuing “buy” recommendations? By listening carefully, investors can determine the current location of the market in the various cycles described above.
Step #2: Adjust Your Portfolio Accordingly
Having determined the market’s position in the cycle, the next step involves correctly positioning your portfolio. According to Marks, this is a matter of choosing where your portfolio should lie on a spectrum between aggressiveness and defensiveness.
He relates that aggressive investing involves allocating a higher proportion of your portfolio to more volatile investments (like stocks) rather than safer investments (like bonds). Aggressive investing often includes riskier stocks from more volatile industries, rather than blue-chip stocks with steadier concerns. Aggressive investing is called for when the market is likely to rise—for example, if investors are mostly risk-averse, assets are underpriced, and foundational cycles point to an improvement in the market—then you should have an aggressive portfolio to capitalize on the rising market.
On the other hand, defensive investing involves allocating a higher proportion of your portfolio to less risky investments, such as bonds, instead of more volatile investments like stocks. Further, defensive investing involves focusing on assets that are more resilient to the market cycle’s fluctuations, such as stock in companies that sell commodities. Defensive investing is called for whenever the market is likely to drop—for instance, when investors are extremely risk-tolerant, assets are overpriced, and foundational cycles suggest the market may drop. In such cases, you should adopt a defensive portfolio that minimizes the risk of losing money.
