Mastering the Market Cycle, by Howard Marks will help you understand when is the optimal time to invest given a market’s conditions.

Between 2010 – 2020 there has been an unprecedented growth in the world’s stock market. But in March 2020 it  dropped suddenly and significantly.  The question is: when is the time to be defensive or aggressive, when buying shares in the market, start your new business or borrow money to buy property?  When things are going well and everyone is optimistic, or when things are poor and everyone is pessimistic?

Warren Buffet said “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs”  and “be fearful when everyone is greedy, and greedy when everyone is fearful.”

In this episode we look at:

• The economics of the cycle
• Governments and central banks
• Credit and debt in the world economy
• Real Estate
• Investor Psychology

Mastering the Market Cycle will help you understand when is the optimal time to invest given a market’s conditions.

In order to properly position your portfolio for what’s going on in the environment, and for what that implies regarding the future of the markets, the investor has to maintain a high level of attention to the market cycle.

What is a cycle?

The market cycle oscillates around the midpoint. The midpoint of a cycle is generally thought as a trend, norm, or mean.

The rational midpoint generally exerts a kind of magnetic pull. Bringing the thing that’s cycling back from an extreme in the direction of “normal”. But it usually doesn’t stay at normal for long, as the influences responsible for the swing towards the midpoint invariably continue in force and thus cause the swing back from an extreme to proceed through the midpoint and then carry further, towards the other extreme.

Markets rarely go from under-priced, to fairly priced and stop there. Usually the fundamental improvement and rising optimism that cause markets to recover from depressed levels remain in force, causing them to continue right through fairly priced and onto overpriced.

As the phenomenon swings toward the extreme, this movement gives it energy which it stores. Eventually its increased weight makes it harder for the swing to continue further from the midpoint and it reaches to a maximum it no longer can proceed. Eventually it stops moving in that direction and once it does, gravity pulls it back in the direction of the central midpoint, with the energy it has amassed powering the swing back.

Why read Mastering the Market Cycle?

The odds change as our position in the cycle changes. If we don’t change our investment stance as these things change, we’re being passive regarding cycles. In other words, we’re ignoring the chance to tilt the odds in our favour. Investing is a matter of preparing for the financial future. It’s simple to define the task. We assemble portfolios today that will benefit from certain events that unfold in the years ahead.

BUT – Investment success is like the choosing of a lottery winner. Both are determined by one ticket (the outcome) pulled from a bowlful of possibilities (the full range of possible outcomes). In each case, one outcome is chosen from among the many possibilities

Superior investors are people who have a better sense for what tickets are in the bowl, and thus for whether it’s worth participating in the lottery. In other words, while superior investors – like everyone else – don’t know what the future holds, they do have an above-average understanding of future tendencies.

Mastering The Market Cycle quotes Mark Twain: “history doesn’t repeat itself, but it does rhyme”. The details from one event to another in a given category vary, but the underlying themes and mechanisms are consistent.

If the details vary from one event to another in a given category of history, the underlying themes and mechanisms are consistent.

This is true for the financial crisis. Mastering The Market Cycle provides the case study of the GFC in 2007-2008 occurred largely because of the issuance of a huge number of unsound subprime mortgages and that took place in turn because of excessive optimism. A shortage of risk aversion and an overly generous capital market. Which led to unsafe behaviour surrounding subprime mortgages.

The exact details of the subprime mortgage won’t repeat for a future financial crisis. But the rhyme of optimism, risk aversion and general capital markets can be expected to reoccur.

 Governments & Central Banks on the economic cycle

Mastering The Market Cycle explains the role of governments, who have a wide variety of responsibilities, only a small portion are related to economic matters. They are charged with stimulating the economy when appropriate, albeit not directly. In their work they are also concerned with regulating the cycle, not too fast or slow.

Governments tools for managing the cycle are fiscal, which means taxing and spending. Thus when governments want to stimulate their countries’ economies, they can cut taxes, increase government spending and even distribute stimulus checks, making more money available for spending and investment. On the other hand, when they are growing too fast. They increase taxes, cut spending, reduce demand in their economies.

The ultimate topic under this heading is national deficits. In the distant past they ran balanced budgets. In short they weren’t able to spend more money than they brought in through taxes. But the concept of national debt arose, and the ability to incur debt introduces the potential for deficits. That is for governments to spend more than they take in. There was a time when there was an active debate regarding countries having national debt but there is no longer that much resistance (in Australia different).

It is now generally accepted that countries can owe money, although questions arise from time to time about how much debt is prudent. But the answer is always “not too much more than we have now”. The use of government surpluses to cool a thriving economy is little seen these days. No one wants to be a wet blanket when the party is going strong and spending less than you bring in attracts fewer votes than generous spending.

Central Banks Effects on the Cycle (RBA, BOJ, The Fed, BOE, The ECB)

Extreme economic cyclicality is considered undesirable. Too much strength can kindle inflation and take the economy high that a recession becomes inevitable. Too much weakness on the other hand can cause companies’ profits to fall and can cost jobs. Thus it is part of the central bankers and treasury to manage cycles. Since cycles produce ups and downs that can be excessive, the tools for dealing with them are counter cyclical and applied with a cycle of their own. Ideally inverse to the economic cycle itself. However, like everything else involving cycles managing them is far from easy.

Since inflation results from economic strength, the efforts of central banks to control it amount to trying to take steam out of the economy. They can reduce money supply by raising interest rates and selling securities. When the private sector purchases securities from the central bank, money is out of circulation. This tends to reduce inflation

Mastering the Market Cycle explains how the issue is complicated by the fact in the last few decades many central banks have been given another responsibility. In addition to controlling inflation, they are expected to support employment, and employment does better when the economy is stronger. So they increase money supply, decreasing interest rates and injecting liquidity into the economy by buying securities  as in the recent program of Quantitative Easing central banks who focus on these kind of actions are called Doves. If cycles are challenging for investors to understand and predict, they are no easier for central bankers to manage

Quantitative Easing

QE is where the central bank buys government bonds, essentially an IOU for the government to repay at some time in the future. Buying bonds are the last resort to pump money into the financial system. It raises the price of asset prices.  Now that bonds are overpriced, people are pushed out to buy shares, people with shares might sell and have cash for the economy: or in economist language “push liquidity out into the market”

The Credit Cycle

Mastering The Market Cycle uses the metaphor of a window. In short, sometimes it is open and sometimes it is closed and in fact, people in the financial world make frequent reference to just that: “the credit window” ..  As in the place you go to borrow money. When the window is open financing is plentiful and easily obtained. When it is closed, financing is scarce and hard to get. Finally it’s essential to always bear in mind that the window can go from wide open to slammed shut in just an instant. There’s a lot more to fully understand this cycle. Including reasons for these cyclical movements and their impact – but that’s the bottom line.

Changes in the availability of capital or credit constitute one of the most fundamental influences on economies companies and markets. Even though credit cycle is less well known to the man on the street, it is one of the most important and profound influence, according to Mastering the Market Cycle.

Why is this cycle important?

• First capital or credit, is an essential ingredient in the productive process. Thus the ability of companies (and economies) to grow usually depends on the availability of incremental capital. If the capital markets are closed, it can be hard to finance growth

• Second capital must be available in order for maturing debt to be refinanced. Companies, governments and consumers generally don’t pay off their debts. Most of the time they just roll them over. Most companies “borrow short to invest long”  (the kick the can strategy). Meaning they use short term debt which is cheaper then roll them over. This works well most of the time when credit market is open and fully functioning so the debt can roll over when it is due. But the mismatch between long term assets that can’t be easily liquidated and shorter term liabilities can easily bring on a crisis if the credit cycle turns negative so that maturing debt can’t be refinanced. This classic mismatch is often the cause of the most spectacular financial melt downs.

• Third financial institutions represent a special exaggerated case of reliance on the credit markets. Financial institutions are in the business of trading in money and they need access to finance to keep that going. Consider for example the bank that takes deposits that can be withdrawn any day and use them to make mortgage loans that won’t be repaid for 30 years. What happens if all the depositors want their money back on the same day “a run on the bank”. If there’s no access to the credit market that bank may fail.

• Fourth and finally, the credit market gives signals that have great psychological impact. A closed credit market causes fear to spread.

The Real Estate Cycle

Much of investing is subject to gross generalizations and sweeping statements. Usually stressing positives due to greed and this seems particularly true in real estate. Everyone is heard things like “they’re not making any more land’, “you can always live in it”, and “its a hedge against inflation”. Mastering The Market Cycle explains that people eventually learn is that regardless of the merit behind these statements they won’t protect an investment that was made at too high a price.

Robert Shiller did a study on how much property prices really increase, over the longest period ever studied. Even though your uncle or broker who preaches the gospel of real estate that it is one of the best long term investments, on the contrary the data says it stinks. Between 1628 to 1973 real property prices adjusted for inflation went up 0.2% per year. Real home prices do actually double every 350 years or so.

The cycle in real estate has a lot in common with the other cycles. Positive events and increased profitability lead to greater enthusiasm and optimism. Improved psychology increases activity. The combination of positive psychology and the increase in activity causes asset prices to rise, which encourages still more activity, further price increases and greater risk bearing. Inevitably, this cycle takes on the appearance of being unstoppable and this appearance causes asset prices and the level of activity to go far to be sustained.

The better times and improved economics also make providers of capital more optimised. Finance is easier to get . Cheap money means a better return on potential projects, adding the attractiveness to developers. The first projects sell fast and cranes go up everywhere. The period between start and planning is long enough for the economy to go from boom to bust. Projects started in good times go up in the bad times.

As in so many of the examples in Mastering The Market Cycle, for most people, psychology-driven extrapolation took the place of an understanding of and belief in cyclicality. When things go well, people tend to think the good times will roll on forever.

Psychological Cycle

In business, financial and market cycles most excesses on the upside, and inevitable reactions to the downside, are  a result of the pendulum of psychology. The basic point is that psychology does swing and most people’s behavior swings with it. The fluctuation between greed and fear is typical of the swing of the psychological pendulum.

In fact it explains the behaviour of individual investors and entire market. Markets move upwards when events are positive and psychology turns up and they fall when events are negative and psychology turns down.

E.g  “On wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realisation that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to a re-imposition of higher interest rates”

The superior investor. Who resists external influences remains emotionally balanced and acts rationally. Perceives both positive and negative events, weights events objectively and analyses them dispassionately.

Mastering The Market Cycle Case Study: The GFC

The GFC represented the greatest financial downswing for a long time, and consequently it presents the best opportunity to observe, reflect and learn. The scene was set by a number of developments. Government policies supported an expansion of home ownership, which by definition meant the inclusion of people who historically couldn’t afford homes – at a time when home prices were soaring.

The Fed pushed interest rates down, causing the demand for higher yielding instruments such as structured/leveraged mortgage securities to increase. There was a rising trend among banks to make mortgage loans, package them and sell them onward. Decisions to lend, structure and assign credit ratings and invest were made on the basis of unquestioning extrapolation of low historic mortgage default rates. This led to increased eagerness to extend mortgage loans, with a decline in lending standards. Novel untested mortgaged backed securities were developed that promised high returns with low risk, something that has great appeal in the good times.

Finally the media ran articles saying the risk has been eliminated by the FED who can inject stimulus when the economy is sluggish. That the Wall Street innovations sliced and riced risk so finely, spread it widely and placed it with those who could best bear it.

Perhaps most importantly was marked by the risky behavior of financial institutions. When there is a lot of financial innovation there can be a race to the bottom. The Citigroup CEO Charles Prince in June 2007, virtually on the eve of the GFC virtually said  “when the music stops in terms of liquidity, things will be complicated. But as long as the music is playing you’ve got to get up to dance. We’re still dancing” .

No banker could decline to participate in fear of losing market share. The instruments were untested and potentially defective, but no one was willing to pass up his share. In theory the bank CEO could have declined to join in. But under the realities of the times, anyone who sat out of the dance, lost market share and failed to make “easy money” that his competitors were reaping.

In 2006, Abbey, the Second largest home loan provider in the UK raised the standard amount it will lend homebuyers to five times their single salaries (previously 3-3.5X).  In other words, there had been a traditional rule of thumb saying that borrowers can safely handle mortgages with a face amount equal to 3 times their salaries. But now they can go 5 times, roughly 50% more.

Mastering the Market Cycle explains that the inference here is the old standard was too conservative and the new one is right. Conditions have changed. There is so much competition to put out money in low interest rates. This competition is late stage and fits the usual belief “it is different this time”. Lenders and investors depart from time honoured principles

What did we see in the US mortgage market as home prices rose and interest rates declined? Eventually loans that require no documentation of employment or credit history. First lower teaser rates, higher loan to value ratios, then 100% financing. The so called winner in the auction of the people’s money between the banks, is the one who’ll put out the most money with the least safety. Whether that’s really winning or losing will become clear when the cycle turns. But certainly there’s a race to the bottom going on. A contest to become the institution that’ll make loans with the slightest margin for error.

Warren Buffet said all of this with even fewer words “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs”. When others fail to worry about risk and fail to apply caution, it is the time to be cautious. But when other investors are panicked or depressed, we should turn aggressive

How to cope with market cycles

The question that Mastering The Market Cycle answers is: When should one begin to buy? When should you try to catch the “falling knife”?

When the market is cascading downwards many investors will say “we’re not going to try to catch the falling knife”. In other words “the trend is downward and there’s no way to know when it will stop… So why not buy when it reaches the bottom?”. They are typically scared normally of looking bad so when it reaches the bottom and uncertainty has resolved. But the problem is, when the dust and investors nerves are settled, the bargains will be gone.

There are two risks that need to be considered. The first is obvious, the risk of losing money. The second is more subtle, the risk of missing opportunity.

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