PDF Summary:Mastering The Market Cycle, by Howard Marks

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, Howard Marks, this belief in the market’s unpredictability is unfounded. In Mastering the Market Cycle, he argues that the securities market fluctuates predictably based on recurring business cycles and patterns in investor psychology.

In this guide, we’ll begin by discussing the foundational cycles—the economic cycle, the profit cycle, and the credit cycle—that shape the investing landscape and impact the securities market. Then, we’ll turn to the psychological cycles that arise from these business cycles, examining how investors swing between greed and fear and between risk tolerance and risk aversion. Finally, we’ll discuss how these cycles influence the overall securities market cycle and how understanding the securities market is crucial to earning above-market returns.

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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.

(Shortform note: At the height of investing greed, some even commit financial crimes to earn more money, as Stratton Oakmont cofounder Jordan Belfort did. In his memoir, The Wolf of Wall Street, Belfort explains how he committed fraud via stock price manipulation. He writes that, through many proxies, he and his fellow stockbrokers illegally bought up controlling interest in companies during their initial public offering (IPO) so that he could bid the price up and artificially inflate it. Then, they sold the stocks to wealthy investors, pocketing the profits before the stock price inevitably cooled.)

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.

(Shortform note: Investing experts point out that one way to mitigate fear involves starting with smaller investments before working your way up to larger sums. Because fear is proportional to how much money you could lose—and therefore how much money you have invested—slowly increasing your portfolio can help you handle incrementally more fear.)

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.

(Shortform note: In The Warren Buffett Way, Robert G. Hagstrom explains that you can resist the temptation to buy overpriced stocks by calculating stocks’ intrinsic value and only buying stocks that are currently below this threshold. Intrinsic value, he clarifies, is roughly a company’s projected lifetime net income divided by its number of shares—this allows you to calculate the intrinsic value of each share. By calculating intrinsic value, you can determine whether greed has caused a stock to become overpriced by seeing whether its current share price exceeds its intrinsic value per share.)

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.

(Shortform note: Marks’s contention that the market is riskiest when investors believe it’s the least risky, and vice versa, jibes well with the approach known as contrarian investing. Contrarian investors seek out investing positions that run counter to current investing trends, reasoning that these trends often reveal opportunities. For example, a contrarian might reason that bearish markets are likely to feature underpriced securities, making a bear market ideal for purchasing more securities.)

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.

(Shortform note: In The Most Important Thing, Marks clarifies that in addition to greed and risk tolerance, conformity can cause investors to unwittingly participate in bull markets (those whose prices are rising considerably). He writes that many investors mindlessly do whatever their fellow investors do, causing them to make irrational decisions whenever the consensus view is mistaken.)

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.

(Shortform note: In Irrational Exuberance, Robert Shiller explains that the strength of moral anchors—that is, the narratives that convince investors to keep their money invested rather than selling their stocks and cashing it—determines how long a bubble will last. For example, investors in 2024 might accept the narrative that the explosion of AI products like ChatGPT will cause tech stocks to grow unchecked until 2030, at which point they’ll begin to sell. So, unlike Marks, Shiller doesn’t think bubbles require investors to believe the market will always go up, but rather that it’ll go up for a certain amount of time.)

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.

(Shortform note: In the most severe crashes, it can take decades for investors to regain faith in the markets and bring them back to pre-crash heights. For example, following the stock market crash of 1929, the Dow Jones Industrial Average didn’t return to its pre-1929 peak until 1954, 25 years later.)

The Probabilistic Market

Although Marks’s portrayal of the market cycle sounds straightforward, he clarifies that in reality the situation is more complex. Rather than psychological cycles guaranteeing bubbles and crashes, Marks contends that psychological cycles make these bubbles and crashes much more likely. In other words, the securities market follows probabilistic rules rather than deterministic rules.

In practice, this means that greedy, risky investing doesn’t ensure that a bubble will form that eventually causes prices to plummet; it merely makes it more likely. Conversely, it also means that fearful, risk-averse investing after a crash doesn’t always precede a rise in security’ prices; it merely makes it more likely that securities will increase in price.

(Shortform note: Against Marks’s claim that the market is probabilistic—such that greedy markets are more likely to fall and fearful markets are more likely to rise—some economists embrace the random walk hypothesis. According to this hypothesis, securities’ prices change with no discernible pattern, much like an individual going on a random walk. Consequently, economists who accept this thesis deny that it’s possible to gain an edge on the stock market, since nobody can know which direction the market is likely to move toward.)

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.

The Efficient Market Hypothesis: Is It Possible to Beat the Market?

Although Marks contends that it’s possible to consistently earn above-market returns by assessing market position, other economists argue otherwise. These economists typically embrace the efficient market hypothesis (EMH), according to which current stock prices perfectly reflect all publicly available information. In other words, the EMH dictates that stocks’ prices are always identical to their intrinsic value, as all relevant information is already baked into their price because investors convey the information they know via the prices that they’re willing to buy or sell stocks at.

The consequence of the EMH is that it’s impossible to consistently beat the market because doing so would require finding underpriced stocks—those whose share price is less than their intrinsic value. But according to the EMH, no such disparity between share price and intrinsic value exists, even when the securities market is rife with fear as Marks claims.

Nonetheless, the success of some money managers—such as Peter Lynch, whose average annual returns of 29% between 1977 and 1990 far exceeded the S&P 500’s returns—calls the EMH into question. After all, such individuals did beat the market consistently over long periods of time, and if the EMH were true, they must have done so by luck alone.

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 described above.

(Shortform note: Experts list several other strategies for qualitatively assessing the stock market. For example, they point out that you can follow financial gurus on social media to receive real-time updates on the stock market, in addition to news aggregator sites like Google News, to ensure you’re hearing about the market from a diverse set of sources.)

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.

Additional Thoughts on Aggressive vs. Defensive Investing

While Marks focuses on the market’s position when deciding how aggressively to invest, John C. Bogle, founder of the Vanguard Group and author of The Little Book of Common Sense Investing, instead focuses on your individual financial situation and innate risk aversion.

According to Bogle, your personal financial situation—especially your liabilities (such as the cost of raising a child, buying a house, or retiring)—should inform your investment portfolio. For example, if you’re young and single with no looming liabilities, you can afford to have a more aggressive portfolio, whereas an older retiree might prefer a more defensive approach. Further, Bogle notes that some individuals have naturally high risk aversion and can’t handle the increased volatility of an aggressive portfolio; for these people, he recommends a defensive portfolio.

In practice, Bogle suggests that younger, more risk-tolerant investors could have a portfolio that’s split 80-20 between stocks and bonds—they may also invest in more volatile stocks, rather than stocks with consistent growth. By contrast, he clarifies that older, more risk-averse investors with many liabilities could instead adopt a 25-75 split between stocks and bonds, focusing especially on more established stocks that are less risky.