What is the securities market? Why can you exploit the securities market so easily?
In Mastering the Market Cycle, Howard Marks outlines how cycles jointly drive the overall securities market. In particular, he shows how the predictable nature of foundational and psychological cycles makes for an exploitable securities market cycle.
Take a look at the factors driving the securities market cycle so you can reap large rewards from it.
What Drives the Securities Market Cycle?
What is the securities market and how does it work? According to Marks, the securities market cycle fluctuates in accordance with shifts in investor psychology that 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.
(Shortform note: In addition to average price-earnings ratios, financial experts consult an array of metrics to assess market position. For example, stock price breadth records the percentage of stocks whose prices are increasing; a higher number indicates a bullish market, whereas a lower number indicates a bearish market. Further, market volatility indices allow investors to see how volatile the market will be month-to-month, with higher volatility normally associated with a fearful market.)
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.
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.
