Mastering the Market Cycle by Howard Marks
Getting the Odds on Your Side
Howard Marks is one of my favorite writers on investing and I enjoy reading his memos throughout the year. Mastering the Market Cycle has insights for learning to see the big picture in the economy and investing.
For other summaries on investing, see my Money and Finance Book Summaries Page.
- Memos from Howard Marks
- Howard Marks Bio
- Commemorating 25 Years of Mastering the Market Cycle
A timeline of Oaktree Capital and Howard Marks’ career from the 1970s to 2020
- The Most Important Thing Summary
My Favorite Quotes
- It is from the extremes of the cycle of fear and greed that arise the greatest investment profits.
- The rational investor is diligent, skeptical, and appropriately risk-averse at all times. But also on the lookout for opportunities for potential return that more than compensates for risk.
- The greatest source of investment risk is the belief that there is no risk.
- Cycles will happen to you, what you do in response is key.
- Being too far ahead of your time is indistinguishable from being wrong.
- You need a strong stomach for being wrong because we are all going to be wrong more often than we expect. Bring wrong is inevitable and normal.
- Success is not good for most people. Success can change people, and usually not for the better.
- In investing there is a complex relationship between humility and confidence.
- Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.
- What is the origin of risk?
- If I could ask only one question regarding each investment I had under consideration, it would be this: how much optimism is factored into the price?
- How are things priced?
- How are investors around us behaving?
Investors who disregard where they are in cycles are bound to suffer serious consequences. In order to get the most out of this book, an investor has to learn to recognize cycles, assess them, look for the instructions they imply, and do what they tell him to do.
Chapter 1: Why Study Cycles?
When we apply some insight regarding cycles, we can increase our bets and place them in more aggressive investments when the odds are in our favor. We can take money off the table, and increase our defensiveness, when the odds are against us.
It is very easy to achieve average investment performance and it is quite hard to perform above average.
We can most gainfully spend our time studying three areas:
- Trying to know more than others about the “knowable,” the fundamentals of industries, companies, and securities.
- Being disciplined as to the appropriate price to pay for participation in those fundamentals.
- Understanding the investment environment we are in, and deciding how to strategically position our portfolios for it.
Investors need to calibrate between aggressive and defensiveness. When we are getting value cheap, we should be aggressive. When value is expensive, we should pull back.
Two primary types of risk:
- The likelihood of permanent capital loss
- Opportunity risk, the likelihood of missing out on potential gains
The ideas below are from the memo Risk Revisited Again from June 8, 2015, they might help you understand and cope with risk.
Risk is all about uncertainty. Even though many things can happen, only one will happen.
Chapter 2: The Nature of Cycles
Cycles present profit opportunities for those who understand, recognize, and take advantage of of cyclical phenomena.
Phases of a cycle:
- A: Recovery from an excessively depressed lower extreme, toward the midpoint.
- B: The continued swing past the midpoint, toward an upper extreme or high.
- C: The attainment of a high.
- D: The downward correction from the high back toward the midpoint.
- E: A continuation of the downward movement past the midpoint, toward the new low.
- F: The reaching of a low.
- G: Recovery from the low back toward the midpoint.
There cannot be said to be a single starting point or ending point for a cycle. Many of the phases above can be represented as the beginning or the end of the cycle.
The swing back from a high or low almost never halts at the midpoint.
Themes that provide warning signals in every boom/bust:
- Excessive optimism is dangerous
- Risk aversion is an essential ingredient for the market to be safe
- Overly generous capital markets ultimately lead to unwise financing and thus to danger for participants
Cycles have to be understood both analytically and intuitively. Those who possess both abilities will go the furthest.
We usually see only one major cycle per decade.
Chapter 3: The Regularity of Cycles
When something rises, people have a tendency to think it will never fall, and vise versa. Betting against those tendencies can be very profitable.
Chapter 4: The Economic of Cycle
The output of an economy is the product of hours worked and output per hour. Thus the long term growth of the economy is determined by fundamental factors like birth rate and the rate of gain in productivity.
The average rate of growth of the economy is rather steady over long periods of time.
Long term trends (WWII – 2007) that have given the economy and stock market a strong uptrend over several decades.
- Macro Environment
- Corporate Growth
- The Borrowing Mentality
- Popularization of Investing
- Investor Psychology
Three main protagonists of this book are:
- Decision Making Processes
Most forecasts do not add value or lead to investment success. See chapter 14 of The Most Important Thing for discussion on “what we don’t know.”
It is easy to be an average investor, investment success consists in outperforming other investors and the averages. Investment success is a relative measurement.
Possibilities with regard to economic forecasts:
- Most economic forecasts are just extrapolations
- Extrapolations are usually correct, but not valuable
- Unconventional forecasts of significant deviation from trend would be very valuable if they are correct, but usually they aren’t.
- Thus most forecasts of deviation from trend are incorrect and also not valuable.
- A few forecasts of significant deviation turn out to be correct and valuable, leading their authors to be lionized for their acumen.
Chapter 5: Government Involvement with the Economic Cycle
It is part of the job of central bankers and treasury officials to manage cycles.
One of the primary concerns of the central bank is to manage and control inflation.
Central bankers have dual-responsibilities that are in opposition to each other:
- Limit Inflation: which requires restraining the growth of the economy.
- Support Employment: which calls for stimulating economic growth.
When governments want to stimulate their country’s economy, they can:
- Cut Taxes
- Increase Government Spending
- Distribute Stimulus Checks
When governments want to slow their country’s economy, they can:
- Increase Taxes
- Decrease Government Spending
Chapter 6: The Cycle in Profits
The normal growth rate for US GDP is 2-3% per year.
Chapter 7: The Pendulum of Investor Psychology
Swings in emotional psychology strongly influence the economic and corporate profit cycles. They also play a very prominent part in causing ups and downs in the investment world, especially in the short run.
These notes are from the following memos:
The mood swings of the securities markets resemble the swing of a pendulum. They swing between the following:
- Between euphoria and depression
- Between celebrating positive developments and obsessing over negatives
- Between overpriced and under-priced
- Between greed and fear
- Between optimism and pessimism
- Between risk tolerance and risk aversion
- Between urgency to buy and panic to sell
It is from the extremes of the cycle of fear and greed that arise the greatest investment profits.
Few people are always even keeled and unemotional. For this reason, few investors are capable of staking out a midpoint position that balances greed and fear, and staying there.
The market spends very little time at the happy medium, it spends the majority of time above or below the averages.
Chapter 8: The Cycle in Attitudes Toward Risk
The rational investor is diligent, skeptical, and appropriately risk-averse at all times. But also on the lookout for opportunities for potential return that more than compensates for risk.
What is investing? One way to think of it is as “bearing risk in pursuit of profit.”
The ability to understand, assess, and deal with risk is the mark of the superior investor and an essential requirement for investment success.
The way investors are collectively viewing risk, and behaving in regard to it, is of overwhelming importance in shaping the investment environment in which we find ourselves. The state of the environment is key in determining how we should behave with regard to risk at that point.
Assessing where attitudes toward risk stand in their cycle is what this chapter is about.
Risk aversion is the main element that keeps markets safe and sane.
Attitudes toward risk change, and in doing so they alter the investment environment.
The next section of this chapter comes from the memo Risk and Return Today, October 27, 2004 which includes several graphs you may want to view.
Fluctuations in attitude towards risk can cause exceptions to the principles of risk and investing described here. Sometimes investors can become too risk-averse, other times they can become too risk-tolerant.
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.
Risk tolerance is unlimited at the top of the market and nonexistent at the bottom.
When other investors are panicked and depressed, and can’t imagine conditions under which risk would be worth taking, we should turn aggressive.
The next section is from the following memos:
- The Happy Medium, July 21, 2004
- The Race to the Bottom, February 14, 2007
- The Limits to Negativism, October 15, 2008
If I could ask only one question regarding each investment I had under consideration, it would be this: how much optimism is factored into the price?
Skepticism calls for pessimism when optimism is excessive, and it also calls for optimism when pessimism is excessive.
Chapter 9: The Credit Cycle
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. These conditions are much more the case when the credit markets are in the less euphoric, more stringent part of their cycle.
The credit cycle is sometimes referred to as the capital market cycle, but the author does not find the distinction important.
Capital = all the money used to finance a business.
Credit = the portion of a company’s capital that is made up of debt rather than equity.
The next section is from the following memos:
- Open and Shut, December 01, 2010
- You Can’t Predict. You Can Prepare, November 20, 2001
- The Race to the Bottom, February 14, 2007
- The Happy Medium, July 21, 2004
Psychology has a profound impact on the availability of credit.
The credit cycle is like a window, sometimes it is open, sometimes it is closed.
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.
Everything else being equal, the bigger the boom – the greater the excesses of the capital markets in the upward direction – the greater the bust. Timing and extent are never predictable, but the occurrence of cycles is the closest thing I know to inevitable.
Chapter 10: The Distressed Debt Cycle
The opportunities for top returns in distressed debt come and go.What causes the fluctuations in distressed debt cycles?
- Risk averse investors limit quantities issued and demand high-quality.
- High-quality issuance leads to low default rates.
- Low default rates cause investors to become complacent and risk tolerant.
- Risk tolerance opens investors to increased issuance and lower quality.
- Lower quality issuance eventually is tested by economic difficulty and gives rise to increased defaults.
- Increased defaults have a chilling effect, making investors risk averse once more.
- The cycle restarts.
Each event in a cycle causes the one that follows.
Chapter 11: The Real Estate Cycle
It is difficult to protect an investment that is made at too high of a price.
The real estate cycle is similar to other cycles:
- Positive events and increased profitability lead to greater enthusiasm and optimism.
- Improved psychology encourages increased activity, that includes doing more of “something” on the basis of rosy assumptions and paying higher prices and/or lowering standards. Taking on greater risk.
- The combination of positive psychology and the increase in activity causes asset prices to rise, which encourages more activity, further price increases and greater risk bearing.
- News turns less positive, the resulting price correction causes psychology to become less positive, which causes disinvestment, which puts further downward pressure on prices.
The real estate cycle can have a longer lead time due to the time it takes for construction.
Howard has posted a 14 point list explaining the real estate cycle in the memo Ditto, January 07, 2013.
Initiating projects in boom times can be a source of risk, buying them in weak times can be very profitable.
People’s decisions often fail to take into account what others are doing.
A lost of people make the mistake of believing in extrapolation instead of cyclicality. Meaning if prices are going up, they will continue going up for ever, instead of coming back through the cycle.
The author urges readers to have a conscientious belief in the inevitability of cycles.
The reasons behind successful decisions invariably are obvious in hindsight.
When people use terms such as “ever increasing” it should be a red flag for the investor.
Chapter 12: Putting it All Together – The Market Cycle
The positives compound in a bull market or bubble.
Prices are affected primarily by the fundamentals and by psychology.
If the market were a disciplined calculator of value based exclusively on company fundamentals, the price of a security wouldn’t fluctuate much more than the issuer’s current earnings and the outlook for earnings in the future.
Three stages of a bull market:
- A few forward-looking people begin to believe things will get better.
- Most investors realize improvement is taking place.
- Everyone concludes things will get better forever.
Three stages of a bear market:
- A few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy.
- Most investors realize things are deteriorating.
- Everyone is convinced things can only get worse.
In the darkest times, it takes analytical ability, objectivity, resolve, and imagination to think things will ever get better. The few people who possess those qualities can make unusual profits with low risk.
What the wise man does in the beginning, the fool does in the end. This statement tells you 80% of what you have to know about market cycles and their impact.
- First the innovator
- Then the imitator
- Last the idiot (that jumps in or out at the end of a cycle when prices are at extremes)
Howard tells the story of Sir Isaac Newton and how he lost a lot of money during “the South Sea Bubble” from his memo bubble.com, January 2, 2000.
Chapter 13: How to Cope with Market Cycles
What is the key in all of this?
- To know where the pendulum of psychology and the cycle in valuation stand in their swings.
- To refuse to buy when too positive psychology and the willingness to assign too high valuations causes prices to soar to peak levels.
- To buy when downcast psychology and the desertion of valuation standards cause panicky investors to create bargains by selling despite the low prices that result.
The investor’s goal is to position capital so as to benefit from future development. The first step is to decide how you will deal with the future.
To respond to market cycles, and to understand their message one realization is more important than all others. The risk in investing doesn’t come primarily from the economy, the companies, the securities, the stock certificates, or the exchange buildings; it comes from the behavior of the market participants. So do most of the opportunities for exceptional returns.
The key to behaving in a way that is appropriate given the market climate lies significantly in accessing the psychology and behavior of others.
Howard has included a guide to market assessment on page five of his memo It Is What It Is, March 27, 2006.
If valuations aren’t out of line with history, the market cycle is unlikely to be highly extended in either direction.
Two key questions in assessing the market:
- How are things priced?
- How are investors around us behaving?
The answers will give us a sense for where we stand in the market cycle, but they will not tell us what will happen next, just the tendencies.
In an extreme bubble, all the rational investor has to do is be able to identify nutty behavior when you see it. Try to behave as an observer viewing with detachment from the sidelines.
Waiting for the market bottom is folly. You should buy when price is below intrinsic value. If the price goes lower, buy more.
Exiting the market after a decline, and thus failing to participate in a cyclical rebound, is truly the cardinal sin in investing.
When the market is high in its cycle, investors should emphasize limiting the potential for losing money. When the market is low in its cycle, they should emphasize reducing the risk of missing opportunity.
How? Try to travel into the future and look back. Five years from now, do you think you are more likely to say “Five years earlier, I wish I had been more aggressive” or “I wish I had been more defensive.”
Cycles will happen to you, what you do in response is key.
Chapter 14: Cycle Positioning
There are three ingredients for success:
If you have enough aggressiveness at the right time, you don’t need that much skill.
Good timing in investing can come from diligently assessing where we are in a cycle, and then doing the right thing as a result.
Six main components (or three pairings) to the formula for investment success:
- Pair 1: Cycle Positioning and Asset Selection
- Pair 2: Aggressiveness and Defensiveness
- Pair 3: Skill and Luck
An investor needs to question whether they have the skill required to improve on the market’s performance through active decision making, or should give up on doing so and invest passively in index funds, settling for market performance.
Superior investors have favorably skewed distributions of outcomes, but not batting averages of 1,000.
Chapter 15: Limits on Coping
Being too far ahead of your time is indistinguishable from being wrong.
Positioning for cycles isn’t easy. Be careful about betting too heavily on your opinions.
It is difficult to make frequent and correct distinctions about the market when it is in the middle ground between rich and cheap. Detecting and exploiting the extremes is really the best we can hope for.
By making decisions only at the greatest cyclical extremes, you maximize your chances of being right.
You shouldn’t expect to reach profitable conclusions daily, monthly, or even yearly.
When there is nothing clever to do, the mistake lies in trying to be clever.
No one should fear that he is not up to the task just because he is unsure of his conclusions. These are not things about which certainty is attainable.
You need a strong stomach for being wrong because we are all going to be wrong more often than we expect. Bring wrong is inevitable and normal.
Chapter 16: The Cycle in Success
Success carries within itself the seeds of failure, and failure the seeds of success.
Success is not good for most people. Success can change people, and usually not for the better. Success makes people think they are smart.
In investing there is a complex relationship between humility and confidence.
Pronounced bargain prices are most likely to be found among things that conventional wisdom dismisses, that make most investors uncomfortable, and whose merits are hard to comprehend.
Don’t confuse brains with a bull market.
Company’s gains can lead to losses and losses can lay the groundwork for gains. There is a cycle in business success.
Chapter 17: The Future of Cycles
The tendency of people to go to excess will never end, and neither will cycles.
Emotions magnify the forces that lead to extremes that will eventually require correction. They cause market participants to overlook the cyclicality of cyclical things at just those moments when recognition of excesses is most essential.
Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.
Investors with the ability to understand cycles will find opportunities for profit.
Chapter 18: The Essence of Cycles
This chapter contains some of the book’s paragraphs that Howard thinks hold the keys to understanding cycles. This chapter is a recap of the book’s key observations.
When we are getting value cheap, we should be aggressive.
Understanding and being alert to excessive swings is an entry-level requirement for avoiding harm from cyclical extremes, and hopefully for profiting from them.
Maximum psychology, maximum availability of credit, maximum price, minimum potential return, and maximum risk all are reached at the same time at the top of the market cycle.
In reverse of what happens at the top of the market cycle, the nadir of psychology, total inability to access credit, minimum price, maximum potential return, and minimum risk all coincide at the bottom.
Related Book Summaries
- Money and Finance Book Summaries Page
- The Education of a Value Investor Summary
- What I Learned Losing a Million Dollars Summary
- Warren Buffett’s Top 8 Activities (Post)
- The Richest Man in Babylon Summary
- The Most Important Thing by Howard Marks
- The Intelligent Investor