MASTERING THE MARKET CYCLE (BY HOWARD MARKS) - YouTube

The fifth most important takeaway from Howard Marks Mastering the Market Cycle is to understand "Tendencies"

Brian has been investing in the stock market for a few years now

Ultimately, he wants to be able to live on his investment income, so that he can spend more time with family and friends and

less on his tedious nine-to-five

Lately, it seems like he will have to work forever though, as his timing in the stock market has been well ...

let's say less than optimal

His portfolio took a serious hit in late 2018,

apparently due to some trade war between the US and China, which made him sell most of his stocks

He just couldn't stand looking at those red figures every morning - watching his hard-earned money just slip away

But apparently, he should have stayed with his stocks, or even invested more money because just a few months later,

the market was hitting new highs

Brian is now investing again

but he feels confused about whether to put more of a savings into the market or to take some of it out

What if his portfolio loses 20% again? Or worse, what if something like the financial crisis is knocking on the door,

but he doesn't know about it?

Brian wants to be able to tell with certainty if we are heading for a bull or bear market and act accordingly

In other words, he wants to "Master the Market Cycle

Luckily for Brian, there is a way

When market swings can become friend rather than foe

But first and foremost, some of his wording must be examined

In investing, no one can ever tell with certainty "what will happen"

But it is possible to talk about what is "more likely to happen". And that makes all the difference

Let me show an example

Brian gets the opportunity to participate in one of three different lotteries

The three lotteries follow the same rules - at the cost of $1,000,

he gets to draw one marble from a bag filled with ten marbles. If he draws a green one, he gets

$3,000. If he draws a yellow one, he gets his money back (or $1,000) and

if he draws a red one he gets nothing

Which lottery should he participate in?

Lottery A has an expected payoff of

$500 per marble drawn

Lottery B is a zero-sum game and lottery C has a -$500 payoff

So picking lottery a would be the correct answer

However

Notice that even if Brian identifies that lottery A is the superior one is in no way guaranteed to win money,

but there is a "tendency" for it

He could draw a red marble, but it's not very likely

It's the same in investing

The superior investor is able to tell which stock that has a higher probability of returning a profit, or in other words,

he is able to tell which marbles the bags hold

The mediocre investor, on the other hand, just picks a bag at random

There are times when choosing a bag becomes quite simple though,

when even stocks of mediocre companies can be expected to yield high returns

And then there are times when pretty much all bags should be avoided - when even stocks of superior companies are expected to yield negative returns

Brian must now learn when the tendencies are in his favor, and when they are turned against him

Number 4: Introducing: Cycles

When Brian saw his portfolio crash by 20% in late 2018,

only for it to regain more than that in the coming months

(well, hadn't he sold that is) he witnessed a stock market cycle in action

But thinking back, he has seen this behavior before

He has a vague memory about how a friend of his father made millions of dollars in dot-com companies,

only to lose it all in a later market crash

And he remembers the boom of new homeowners that was later followed by newspaper headlines about how the financial system

might implode

The stock market isn't the only system that shows this type of cyclical behavior

Seasonality and the weather works like this, many phenomena in physics behave this way, and

even success in one's life can be argued to follow this pattern

A cycle oscillates around a so-called "secular trend",

a "midpoint" or something which can be viewed as "reasonable"

In the stock market, the secular trend is rising, and it's made up of the underlying growth in profits of businesses

plus their dividends

Most cycles show the following behavior:

A: a reversion to the mean from an excessive low

B: the continuation past midpoint towards an extreme high

C: reaching a high

D: a reversion to the mean again, this time from an excessive high

E: The continuation past the midpoint towards an extreme low

F: reaching a low

G: and then, once again, a reversion to the mean

An Important remark here is that these events aren't just following each other. They are causing each other.

The stock market is like a pendulum

It swings from optimism, greed and high prices,

to pessimism, fear and low prices - and then back again

Greed and optimism cannot continue ad infinitum. It cannot deviate forever from the secular trend.

Stocks become too expensive relative to their earnings and when investors turn more risk-averse, the next crash or correction comes knocking

Warren Buffett, probably the greatest investor of all time, concludes that: "What the wise do in the beginning, fools do in the end"

It won't always look as neat as in the illustration I've made here, but,

to keep stealing from others who know how to express themselves better than me, Mark Twain said:

"History doesn't repeat itself, but it does rhyme"

At the extreme highs, most stocks are represented by bags of marbles like these.

While, at the extreme lows, most are represented by bags like these.

Brian wants to learn how to identify these excessive highs and excessive lows in the market cycle,

but first, he must learn that the stock market does not function in isolation

Number 3: What influences the market cycle?

The pattern of ups and downs in the stock market is a very dependable one, much like another cyclical phenomenon

But it does not work in isolation

Rather, it's influenced by four other major cycles

The economic cycle

The main measurement here is the GDP, or gross domestic product of a country

It can be determined by multiplying two variables: number of hours worked and productivity per hour

The GDP of the USA has been growing by about 2% per year during the last decade, and, as an investor

Brian should be particularly aware of

deviations from this

Swings in the economic cycle are caused by:

demographic movements, the unemployment rate, and globalization, among other things

The cycle in profits

The profits of businesses are one of the main components determining prices in the stock market

Brian knows about the most commonly used indicator to determine if prices are high or low - the price-earnings ratio

The total sales of all companies in a country is per definition equal to the GDP of that same country, but

profits fluctuate more than sales

The reason for this is because of leverage - both in operations and in the financing of a company

The credit cycle

Why is credit so important to companies in the stock market?

A: because it could be used to speed up growth, and

B: because it is necessary to roll over old credit

Not having access to new debt can cause some companies to default, when they are required to fulfill their old obligations

I think it is both a bit funny and bit frightening that most people and companies don't plan to repay their debts.

I was at a lecture with one of Sweden's greatest real estate investors, Erik Selin, when he said:

"28 years ago, I borrowed two million dollars from the bank to pay for my first real estate property. Little did they know that,

28 years later, not only would the loan not have been repaid - but increased - to about a billion dollars instead.

At times, it's easy for companies to get financing. But at other times, the credit doors are slammed shut

Howard Marks explains:

"Prosperity brings expanded lending, which leads to unwise lending,

which produces large losses, which makes lenders stop lending, which ends prosperity and on and on"

The cycle in psychology/attitude towards risk

"Buy before you miss out!" is replaced by "Sell before it goes to zero!" and vice versa

Psychology is the main reason for swings in the stock market. When the financial community is euphoric,

it becomes risk tolerant and overlooks bad news

When it is depressed, it becomes risk-averse and expects that the world could end

Assessing where attitudes towards risk currently are is probably the most important part for Brian to recognize where we currently stand in the market cycle

Okay, so prices in the market cycle are determined by two:

First - fundamentals - such as the swings in the economic profit and credit cycles

Second - psychology - through the cycle in attitude towards risk

[Brian:] "But how does this help me in identifying the excessive highs and lows of the market?" Let's check it out

Number 2: Taking the temperature of the market

The key steps in determining where in the market cycle we stand can be divided into two:

First, Brian should look at the valuations of the stock market and see if they are out of line compared to what they've been historically

This is a pre-requisite - if there are no deviations,

the market is probably not excessively high or low. And in that case, there's no need for the second step

Second, Brian must establish an awareness of what goes on around him in the investing community

How do other investors feel about risk?

The first step is quite simple

The most commonly used metric for valuations in the stock market is the price-earnings ratio, or,

how much investors currently are willing to pay for $1 in yearly earnings

Brian finds this information at multpl.com and

recognizes that the p/e of today is at 22.9, which could be argued to be in excessive territory

Next, he examines this table:

For each pair, he checks the one which he thinks best describes the current market

If most of his checks are in the left-hand column, we are probably at an excessive high and vice-versa

These points are non quantifiable and

non-scientific, which is a good thing, because otherwise the skill to identify highs and lows wouldn't be as profitable as it is

A key insight here is that Bryan needs no forecasting to do this. No guesses about the future, only observations of the here and now

Sweet.

Now that Bryan knows how to identify highs and lows, it's time for him to learn how to respond properly to that information and

Finally - number 1: Aggressiveness vs defensiveness

This graph shows quite well what the stock market is typically expected to return

If Brain has a good reason to believe that we are currently in an excessively low market, he could tilt his portfolio to be more aggressive

He could:

- Risk more of his capital

- Hold lower quality companies

- Make investments that are highly dependable on a good macroeconomic outcome; or

- Use financial leverage

With an aggressive portfolio like this, he has made both very profitable swings and very costly swings more likely

Luckily, as he now knows how to take the temperature of the market, he's assured that there's a tendency for positive outcome

The difference between the two curves is how much extra Bryan can make by favoring this aggressive play, rather than a passive one,

should he turn out to be right

But what if Bryan believes that we are currently in an excessively high market?

Then he could tilt this portfolio to be more defensive instead. He could:

- Hold cash instead of stocks

- Invest in safer assets, such as high-quality corporate bonds and Treasury bills

- Buy strong companies that aren't cyclical; and

- Stay away from financial leverage

With this defensive portfolio, he has made both very profitable swings and very costly swings less likely

As he knows that there's a tendency for a negative development,

this is how much he can earn (or perhaps save is the better word?) should he turn out to be proven right

Brian now knows how to master the market cycle, and,

going forward, he will be able to profit from market swings, rather than crashing and quitting from them

But mastering the market cycle is only one of the most important things when fishing for stocks, according to Howard Marks

Check out my summary of Marks' other book, The Most Important Thing, to learn about other ones, that are just as important

Like ... contrarianism, for instance

Cheers guys!