I recently picked up a copy of Mastering the Market Cycle by Howard Marks from my local library after receiving multiple recommendations on reading. I’ll admit I was skeptical and delayed reading it for a while due to the title – I’m a buy and hold investor and thought I would be reading something promoting market timing. The book turned out to be far more than market timing, but instead a great lesson on the history of the markets, how different markets interact with one another, and how investor psychology causes the market to overshoot on both the upside and downside.
Who is Howard Marks? He is the co-founder of Oaktree Capital Management, an asset management firm with $120 Billion under management. Mr. Marks is a billionaire in his own right and has become known for posting his regular memos to investors for both Oaktree’s investors and the rest of the world to read. There are many investment books written, but its not often one is written by a billionaire investor with a 50+ year track record. This alone should put it on the must read list.
What is it about? Psychology
Marks does not claim to have a foolproof technique about timing the market, but challenges you to think about psychological reactions. The markets are human and humans are impacted by psychology. Investors must constantly balance two risks, the risk of losing money and the risk of missing opportunity. The typical investor will get too greedy at the end of the cycle based on the fear of missing out while getting too conservative at the bottom once they’ve experienced enough pain.
This cycle repeats itself through the economic cycle, profit cycle, credit cycle, and real estate cycle. I was pleased at how Marks brilliantly explains the credit cycle, which I lived in for fifteen years. The pressure inside a bank goes from safety and profitability depending on what the market demands. The book makes the same statement over and over again that I came to learn inside the banking industry: The worst loans are made in the best of times!
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The book contains history about the stock market’s meteoric rise in the late 1990s and looks back at Marks’ memos to investors at the time. He constantly referenced investors taking part in IPOs if companies that have no earnings and the same rings eerily true of today. Its been nearly twenty years since since the dot.com explosion and once again companies with no earnings are receiving valuations based only on the prospects of future growth! (As a sidebar, I recently dabbled just a little bit of money into four technology companies with great businesses, earnings and cash flow, but high valuations. No surprise that at this writing I’m currently negative on this dabbling)
“Sometime the biggest motivator is the fear of missing out”. Could this be true of parts of today’s market? Real estate crowdfunding is all the rage – but is this partially due to a 9+ year run of everyone’s friends and coworkers talking about how well they’ve done in real estate? What about the high valuation in technology stocks today? Everyone today points to Amazon and Google when bringing up technology investing and not the 100s of other IPOs that blew up. The fear of missing out is driving good companies into astronomical valuations out of the fear of missing on the next Amazon.
One of the most insightful lines in the book was “At the end of a cycle, often the traditionally disciplined investor throws in the towel and jumps in.” Right now this may be buying a technology stock at a 100x P/E ratio or caving in and finally buying that primary residence you want even though it’s trading at 250x monthly rent. Often being right also involves being right too early then patience becomes a virtue.
Marks referenced a memo written in early 1991 about the psychology of buying at depressed prices: “The environment is dreary, as much of what one buys is soon quoted lower, and there is no ebullience”. Remember this from The Big Short? The largest investor got pretty antsy for being right too early.
Marks openly talks about the benefits of indexing (which I argue is appropriate for most investors on their path to financial independence) and the book gets more challenging to read in the late chapters. Marks reminds us that we are all “positioning capital” for based on future expectations. The index fund is a bet on the growth of the world & the human mind. I agree its a good bet.
Understanding Risk Relative to Return
“Everything that produces unusual profitability will attract incremental capital until it becomes overcrowded….until which time its risk adjusted return will move towards the mean (or worse)”. Marks eloquently explains risk adjusted return and points to numerous examples of superior returns becoming crowded and unpopular assets becoming so oversold that they then become the source of better than average returns. Equities are only one of many asset classes to consider when looking for risk adjusted return.
Ultimately cycles are inevitable. Human nature leads to overcapacity and an over extension if credit, which ultimately drives good times into bad (often around the same time people have proclaimed “the market cylce has been tamed”). Understanding risk adjusted return can help someone tweak their asset allocation at different times in the cycle to minimize participating in assets with poor risk adjusted returns.
After reading this I thought back to two experiences I’ve had in my life, one recent trip to look at housing and thinking through my mindset back in 2008-2010.
Real Estate: Earlier in the year I visited Raleigh, NC to check out the area for a potential move. I met with a nice real estate agent who was recommended to me. The idea was to buy something serviceable as both a residence and a rental if we were to move.
In the discussion, red flags started showing up. I asked about prices relative to rent and the response was “This is more of an appreciation market than a cash flow market”. I asked about due diligence periods and it was “Well, you have to put up 1-2% of the house in option money which you forego if there’s anything you find in the inspection”. Marketing periods for a home were three days. Houses would receive multiple offers on opening weekend and sellers would even get their own home inspection and force the buyer to accept it. We thanked the agent for her time but opted against participating in a market full of warning signals.
This quote from the books rings true when I think of that house viewing experience: “When investors are flying high and making money, they find it easy to come up with convenient reasons why assets should be untethered from the constraints of valuation norms”. “This is an appreciation market” on rental properties sent off alarms in my head. I have a similar opinion when I see crowdfunded real estate opportunities offering high single digit returns. To me that’s not a high enough return. These are often five year, private placement, non-liquid investment carrying leverage on an underlying asset. My hurdle would require 15% or more for such an investment.
Conservative vs. Aggressive
Missed opportunity is one of my biggest investing regrets in 2008-2011. I fell prey to the psychology of “this may never get better” and many of my investment choices I made were overly conservative at the exact time they should have been more aggressive.
We both had good jobs that were relatively safe. Instead of taking on debt and buying as much real estate and equity as we could, I prepaid the mortgage and bought balanced mutual funds to protect against further losses. I worked in banking knew intuitively that Chase and Bank of America weren’t going under and should have bought their stock. Class A single family rentals near me were trading for better than the 1% rule and I remained cautious. This quote rings true to my thought at the time: “Emotions operate on cycles in two ways: they magnify the forces that lead to extremes and require correction”
I wish I could say that I was now this master robot without human emotions with investing, but alas I am not. I’ve been playing around with financial sector stocks for nearly a year. Different things continue to panic the prices and I buy. It’s done decently well for me, but twice in the last year after buying a large position I’ve watched it go down. Inevitably I have said “I have enough, it is probably going lower” at the precise time I should have bought more. My psychology actually signaled the last two bottoms.
Understanding Risk Adjusted Returns: Marks regularly comes back to two graphs demonstrating the risk/return chart. In great times, investors tend to be rewarded less for incremental risk as everyone things good times will continue. The highest risk assets get crowded after many good years and asset prices keep getting bid up far beyond historical valuation standards. Investors bid up these assets and flatten the risk/return line. In these environments, the best risk adjusted returns can often be found from the lowest risk assets (ie: the case for assets such as US Treasuries and Utility Stocks).
In times of despair, the lowest risk assets are bid higher, driving down their return, while the highest risk assets are unloaded by investors “to stop the pain”. The best return at this point in time comes from the people willing to buy the riskiest assets (remember these two teachers who retired at 29?). Understanding the signs the one to two times they appear in a decade and adjusting asset allocation will improve the return for the astute investor.
Look at Asset Allocation: Even if you’re a full believer of passive investing, don’t overlook asset allocation. Equity is only one of many asset classes. If you see flashing warning signs, its okay to move around your allocation some. If the market is trading at near record CAPE ratios, then consider moving some of your funds over to lower risk assets. If stocks are declared dead on the front page of Business Week, maybe so much money has run away that stocks are a solid value and its time to buy.
Real Estate is more challenging with how quickly the pendulum of supply, demand, and sentiment can move. Ultimately all residential properties are worth their future potential cash flows, either for an investor holding a rental property or an an alternate for a family to buy a home instead of renting. A market may be undervalued for three years and overvalued for the next seven, but that is the nature of a real estate cycle. It will revert to the mean and likely go lower.
Don’t Miss The Rare Opportunity: Warren Buffett is often quoted as saying “Be greedy when others are fearful” and “Dark clouds tend to rain gold”. Marks generously shares why these rare opportunities show up and Warren Buffett is known to be an avid reader of Howard Marks’ memos. There were rare opportunities last decade and there will be rare opportunities in future decades that may allow thoughtful investors to earn a superior return. Pay attention to the world around you and don’t overlook the next opportunity you see.
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