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Mastering the Market Cycle

Mastering the Market Cycle

Date read: 2021-05-10
How strongly I recommend it: 8.87/10
(See my list of books, for more.)

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Mastering the Market Cycle

investor psychology and event interpretation

When psychology is negative and markets have been falling for a while, everything is capable of being interpreted negatively. Strong economic data is seen as likely to make the Fed withdraw stimulus by raising interest rates, and weak data is taken to mean companies will have trouble meeting earnings forecasts. In other words, it’s not the data or events; it’s the interpretation. And that fluctuates with swings in psychology.”

Average is not normal

how many of the 47 years from 1970 through 2016 was the annual return on the S&P 500 within 2% of “normal”—that is, between 8% and 12%?

I expected the answer to be “not that often,” but I was surprised to learn that it had happened only three times! It also surprised me to learn that the return had been more than 20 percentage points away from “normal”—either up more than 30% or down more than 10%—more than one-quarter of the time: 13 out of the last 47 years.”

Value investors' actions

> “What do value investors do? They strive to take advantage of discrepancies between “price” and “value.” In order to do that successfully, they have to (a) quantify an asset’s intrinsic value and how it’s likely to change over time and (b) assess how the current market price compares with the asset’s intrinsic value, past prices for the asset, the prices of other assets, and “theoretically fair” prices for assets in general.”

Mindset of a contrarian

“Contrarianism—doing the opposite of what others do, or “leaning against the wind”—is essential for investment success”

“The key—as usual—was to become skeptical of what “everyone” was saying and doing. One might have said, “Sure, the negative story may turn out to be true, but certainly it’s priced into the market. So there’s little to be gained from betting on it. On the other hand, if it turns out not to be true, the appreciation from today’s depressed levels will be enormous. I buy!” The negative story may have looked compelling, but it’s the positive story—which few believed—that held, and still holds, the greater potential for profit.”

Formula for investment disaster

“Participating in a field that everyone’s throwing money at is a formula for disaster.”

Investment and the future

“Do we know what will happen in the future? Some investors think they do—or think they have to act as if they do, because if they don’t they’ll lose their jobs and their clients—or they have been pursuing profit through forecasts for so long that they’ve brainwashed themselves into believing it’s possible to be right about the future (and have become conditioned to ignore their low past success rates). Other investors—the smarter, more self-aware ones, I think—understand that the future isn’t knowable with certainty. They may form opinions regarding future events, but they don’t bet heavily that those opinions will prove correct.”

Market judgement

> “another element can profitably enter into the process: properly positioning a portfolio for what’s likely to happen in the market in the years immediately ahead.”

Cycles and inflation

“Early on, many central banks issued currency. As time passed and central banks took responsibility for cycles, their primary concern usually has been with inflation

The causation of market cycle events

“The events in the life of a cycle shouldn’t be viewed merely as each being followed by the next, but—much more importantly—as each causing the next.”

Cheap money and losses

“There have been numerous recent examples where loose capital markets contributed to booms that were followed by famous collapses: real estate in 1989–92; emerging markets in 1994–98; Long-Term Capital in 1998; the movie exhibition industry in 1999–2000; venture capital funds and telecommunications companies in 2000–01. In each case, lenders and investors provided too much cheap money and the result was over-expansion and dramatic losses.”

Investment areas to spend time on

>“I think we can most gainfully spend our time in three general areas:


> * trying to know more than others about what I call “the knowable”: the fundamentals of industries, companies and securities,

> * being disciplined as to the appropriate price to pay for a participation in those fundamentals, and

> * understanding the investment environment we’re in and deciding how to strategically position our portfolios for it.”

distressed debt investing

“our typical company isn’t challenged operationally, just overloaded with debt; thus our mantra is “good company, bad balance sheet.”

Where the pendulum spend most of its time

“The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc.”

Investor mindset in crisis

“Shortly after Lehman’s bankruptcy filing on September 15, 2008, Bruce Karsh and I reached the conclusion that (a) no one could know how far the financial institution meltdown would go, but (b) negativity was certainly rampant and very possibly excessive, and assets looked terribly cheap. 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.”

Economic activities and cycles

“some activities—like home buying—are highly responsive to movements in the economic cycle, and others—like purchasing food—are not

Traits and actions of a superior investor

“The superior investor is mature, rational, analytical, objective and unemotional. Thus he performs a thorough analysis of investment fundamentals and the investment environment. He calculates the intrinsic value of each potential investment asset. And he buys when any discount of the price from the current intrinsic value, plus any potential increases in intrinsic value in the future, together suggest that buying at the current price is a good idea.”

Uniform pessimism and cheap assets

At this market cycle extreme, all the news truly was negative . . . and certainly not imaginary. The only questions I received were “How far will it go?” and “What will be the effects?” Given that asset prices reflected nothing but abject pessimism regarding these things—I’d say near-suicidal thinking—the key to profiting lay in recognizing that even in the face of uniformly bad news and a very poor outlook, pessimism can be overdone, and thus assets can become too cheap.”

Real world vs world of investing

“That’s one of the crazy things: in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.” The pendulum careens from one extreme to the other, spending almost no time at “the happy medium” and rather little in the range of reasonableness. First there’s denial, and then there’s capitulation.”

Market cycle detail and theme

“the details are unimportant and can be irrelevant. But the themes are essential, and they absolutely do tend to recur.”

Iregular cycles

Little in the world—and certainly not in the investment world—is regular enough in time to profit from applying a mechanistic process. But that doesn’t mean you can’t take advantage of up-and-down cycles. . . .”

Slow boom and fast bust

“it can take years for a boom to grow to its full extent. But the bust that follows may seem like a fast-moving freight train; as my long-time partner Sheldon Stone says, “The air goes out of the balloon much faster than it went in.”

Superior investing

“Superior investing doesn’t come from buying high-quality assets, but from buying when the deal is good, the price is low, the potential return is substantial, and the risk is limited.”

Capital market and investment bargains

“There are times when anyone can get any amount of capital for any purpose, and times when even the most deserving borrowers can’t access reasonable amounts for worthwhile projects. The behavior of the capital markets is a great indicator of where we stand in terms of psychology and a great contributor to the supply of investment bargains.”

Hallmark of a bubble

price doesn’t matter” is a necessary component—and a hallmark—of a bubble. Likewise, in bubbles, investors often conclude that you can make money by borrowing money to buy into the mania

Clustered extreme returns

the times when return is at the extremes aren’t randomly distributed over the years. Rather they’re clustered, due to the fact that investors’ psychological swings tend to persist for a while—to paraphrase Herb Stein, they tend to continue until they stop. Most of those 13 extreme up or down years were within a year or two of another year of similarly extreme performance in the same direction.”

Financial memory and market cycle

“trees don’t grow to the sky, and few things go to zero”

"extreme brevity of the financial memory keeps market participants from recognizing the recurring nature of these patterns, and thus their inevitability”

The rhyme of market cycle

“Cycles vary in terms of reasons and details, and timing and extent, but the ups and downs (and the reasons for them) will occur forever, producing changes in the investment environment”

Cardinal sin in investing

exiting the market after a decline—and thus failing to participate in a cyclical rebound—is truly the cardinal sin in investing. Experiencing a mark-to-market loss in the downward phase of a cycle isn’t fatal in and of itself, as long as you hold through the beneficial upward part as well. It’s converting that downward fluctuation into a permanent loss by selling out at the bottom that’s really terrible.”

Investment risk

> “I lean heavily toward the first definition: in my view, risk is primarily the likelihood of permanent capital loss. But there’s also such a thing as opportunity risk: the likelihood of missing out on potential gains. Put the two together and we see that risk is the possibility of things not going the way we want.”

History's rhyme

“Let’s return to what Mark Twain is supposed to have said: “History doesn’t repeat itself, but it does rhyme.” Grasping this concept is absolutely critical to an understanding of cycles. What Twain must have meant by this statement—if he indeed was responsible for it—is that whereas the details vary from one event to another in a given category of history (say, the ascent of demagogues), the underlying themes and mechanisms are consistent.”

the themes that provide warning signals in every boom/bust are the general ones: that excessive optimism is a dangerous thing; that risk aversion is an essential ingredient for the market to be safe; and that overly generous capital markets ultimately lead to unwise financing, and thus to danger for participants”

risk and market

“the greatest source of investment risk is the belief that there is no risk. Widespread risk tolerance—or a high degree of investor comfort with risk—is the greatest harbinger of subsequent market declines

Howward Marks record in 48 years

“But my personal “all” consists of four or five times in 48 years. By making my calls only at the greatest cyclical extremes, I’ve maximized my chances of being right. No one—and certainly not I—can succeed regularly, other than perhaps at extremes.”

Cycle and the willingness to value the future

“This cycle in investors’ willingness to value the future is one of the most powerful cycles that exists.

A simple metaphor relating to real estate helped me to understand this phenomenon: What’s an empty building worth? An empty building (a) has a replacement value, of course, but it (b) throws off no revenues and (c) costs money to own, in the form of taxes, insurance, minimum maintenance, interest payments and opportunity costs. In other words, it’s a cash drain. When investors are in a pessimistic mood and can’t see more than a few years out, they can only think about the negative cash flows and are unable to imagine a time when the building will be rented and profitable. But when the mood turns upward and interest in future potential runs high, investors envision it full of tenants, throwing off vast amounts of cash, and thus salable at a fancy price.”

Market cycle symmetry

“It must be noted, however, that this symmetry only applies dependably to direction, not necessarily to the extent, timing or pace of movement. (This is the point that Nick Train makes—you’ll meet him in the next chapter.) Thus an upward movement may be followed by a downward movement of either greater or lesser magnitude.”

2 conditions of superior returns

“Getting our start in distressed debt investing in 1988 was extremely advantageous, as there were few competitors and the field was little known and little understood—two conditions that can help make for superior returns possible in any field”

How to deal with future

> “Most people think the way to deal with the future is by formulating an opinion as to what’s going to happen, perhaps via a probability distribution. I think there are actually two requirements, not one. In addition to an opinion regarding what’s going to happen, people should have a view on the likelihood that their opinion will prove correct.”

Portfolio and investment envirionment

> “In my view, the greatest way to optimize the positioning of a portfolio at a given point in time is through deciding what balance it should strike between aggressiveness and defensiveness. And I believe the aggressiveness/defensiveness balance should be adjusted over time in response to changes in the state of the investment environment and where a number of elements stand in their cycles.”