Book Synopsis: "Mastering the Market Cycle" by Howard Marks

Last updated March 9, 2019, 6:58 p.m. by Author

Tags: book synopsis markets investing money


The book covered here is, as the title say, a layman's guide to the market cycles. I find the book a good introduction to market cycles for somebody who starts his adventure with investing and want to move the odds a little in his favour. For a seasoned investor, there is not much new knowledge to be gained as he has already experienced what is described here, or has read about it as a student of the market history. Let you remind of the most famous market cycles of the last century:
- roaring 20's and the Great Crash of 1929,
- the bull market of 1980's and the Black Monday of 1987,
- the Great Moderation of 1990's and the ensuing dotcom bubble which resulted in a big bear market of 2000 - 2002, - the housing bubble and the Global Financial Crisis of 2008

There are many more examples of market cycles but those are the most important and they are the best illustration of what cycles are and that they are inevitable.

And what makes them inevitable in the first place? The key factor is the human psychology. People tend to extrapolate the recent and current environment ad infinitum which causes either an irrational exuberance, or a complete investor capitulation. The first phenomenon causes the prospective investment return to diminish, the second one gives rise to the best possible investing opportunities one can hope to encounter.

As John Kenneth Galbraith has said:
"There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present."

To add to the reasons for the market cycles, one must remember that there is a direct causal relationship between a bull market and a bear market. Prosperity carries within itself the seeds of a recession and recession carries seeds of prosperity. Peter Kaufman, Charlie Munger’s biographer and the CEO of Glenair, describes the workings of dialectical materialism as follows: “As any system grows toward its maximum or peak efficiency, it will develop the very internal contradictions and weaknesses that bring about its eventual decay and demise” (his essay #49: “The Perpetual See-Saw,” 2010).

Market Cycle Illustrations

All of that can be best illustrated with a following charts. The first one present a "normal" market:


Source: "Mastering the Market Cycle" by Howard Marks

Here you can see that you are somewhat in the middle of the cycle and your potential long term return is positively biased (because we assume that there is a positive slope of the market direction caused by the growing productivity and overall economy), so one can expect earn money when investing in this environment.

Next, you can see a situation, when we are at the top of the cycle and the potential return distribution that has moved to the left relatively to the one before.


Source: "Mastering the Market Cycle" by Howard Marks

Now, your expected return are negatively biased, so you should expect to lose money on average when investing.

Lastly, we have the best situation an investor can hope for - we are at the bottom of the cycle, prices are very low and your prospective return distribution has moved to the right. The highest rates of return are achievable here.


Source: "Mastering the Market Cycle" by Howard Marks

Market Cycle Checklist

All of the above seems very nice and easy in theory, but the hard part is to identify the the exact moment of the cycle we are currently in. Luckily Howard Marks offer us a simple but useful rule book in a form of a table that can come to the rescue:

Feature: Top-like characteristic: Bottom-like characteristic:
Economy: Vibrant Sluggish
Outlook: Positive Negative
Lenders: Eager Reticent
Capital markets: Loose Tight
Capital: Plentiful Scarce
Terms: Easy Restrictive
Interest rates: Low High
Yield Spreads: Narrow Wide
Investors: Optimistic Pessimistic
Sanguine Distressed
Eager to buy Uninterested in buying
Asset owners: Happy to hold Rushing for the exits
Sellers: Few Many
Markets: Crowded Starved for attention
Funds: Hard to gain entry Open to anyone
New ones daily Only the best can raise money
General Partners hold the cards on terms Limited Partners have bargaining power
Recent performance: Strong Weak
Asset prices: High Low
Prospective returns: Low High
Risk: High Low
Popular qualities: Aggressiveness Caution and discipline
Broad reach Selectivity
The right qualities: Caution and discipline Aggressiveness
Selectivity Broad reach
Available mistakes: Buying too much Buying too little
Paying up Walking away
Taking too much risk Taking too little risk

For each pair, check off the one you think is most descriptive of the current market. And if you find that most of your checkmarks are in the left-hand column, hold on to your wallet.

Investor's Psychology

If identifying the exact market cycle moment we are in is hard, than overcoming ourselves and "doing the right thing" is the hardest part. In investing we are our own worst enemies and it is the inner self that must be conquered first, before we are able to conquer the markets. There are many traps waiting for an unprepared investor that await him within himself. To list all of them here would be pointless, but just to flag the seriousness of the issue look at this short list of the most common ones:
- gambler's fallacy
- overconfidence
- availability heuristic
- illusion of knowledge
- illusion of control
- disposition effect
- endowment effect
- status quo effect
- cognitive dissonance
- mental accounting
- sunk cost fallacy
- ... and many more

As you can see the list of mental traps is very long and the traps themselves are very serious and can end your promising career as an investor. By the way, when you get on the market with your money, the key is not to get killed, but to survive. As Peter Bernstein said:
"After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winningest forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive! Performing that trick requires a strong stomach for being wrong because we are all going to be wrong more often then we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future." (Jeff Saut, “Being Wrong and Still Making Money,” Seeking Alpha, March 13, 2017)

To sum up the psychological element of market cycles, the most dangerous word you can hear are: "This time is different." When you start hearing people say them, just sell everything and keep cash.

Hype Cycle

Another type of cycle that is not covered in the book is the so called "hype cycle", which in reality is not a cycle at all. It looks like his:

It describes the life cycle of a product or technology with the corresponding expectations of the general public/investors. One has to be very careful in order to avoid getting involved during the peak of inflated expectations, and try to invest only afterwards or just at the beginning of the 'cycle' - this is much harder because only a handful of people know about the upcoming technology at this point of time.

Bull and Bear Market timelines

When looking for a descriptive portrait of both bull and bear market we can use Howard Marks' timeline of developments.

Bull Market:

  • The economy is growing, and the economic reports are positive.
  • Corporate earnings are rising and beating expectations.
  • The media carry only good news.
  • Securities markets strengthen.
  • Investors grow increasingly confident and optimistic.
  • Risk is perceived as being scarce and benign.
  • Investors think of risk-bearing as a sure route to profit.
  • Greed motivates behavior.
  • Demand for investment opportunities exceeds supply.
  • Asset prices rise beyond intrinsic value.
  • Capital markets are wide open, making it easy to raise money or roll over debt.
  • Defaults are few.
  • Skepticism is low and faith is high, meaning risky deals can be done.
  • No one can imagine things going wrong. No favorable development seems improbable.
  • Everyone assumes things will get better forever.
  • Investors ignore the possibility of loss and worry only about missing opportunities,
  • No one can think of a reason to sell, and no one is forced to sell.
  • Buyers outnumber sellers.
  • Investors would be happy to buy if the market dips.
  • Prices reach new highs.
  • Media celebrate this exciting event.
  • Investors become euphoric and carefree.
  • Security holders marvel at their own intelligence; perhaps they buy more.
  • Those who’ve remained on the sidelines feel remorse; thus they capitulate and buy.
  • Prospective returns are low (or negative).
  • Risk is high.
  • Investors should forget about missing opportunity and worry only about losing money.
  • This is the time for caution!

Bear Market:

  • The economy is slowing; reports are negative.
  • Corporate earnings are flat or declining, and falling short of projections.
  • Media report only bad news.
  • Securities markets weaken.
  • Investors become worried and depressed.
  • Risk is seen as being everywhere.
  • Investors see risk-bearing as nothing but a way to lose money.
  • Fear dominates investor psychology.
  • Demand for securities falls short of supply.
  • Asset prices fall below intrinsic value.
  • Capital markets slam shut, making it hard to issue securities or refinance debt.
  • Defaults soar.
  • Skepticism is high and faith is low, meaning only safe deals can be done, or maybe none at all.
  • No one considers improvement possible. No outcome seems too negative to happen.
  • Everyone assumes things will get worse forever.
  • Investors ignore the possibility of missing opportunity and worry only about losing money.
  • No one can think of a reason to buy.
  • Sellers outnumber buyers.
  • “Don’t try to catch a falling knife” takes the place of “buy the dips.”
  • Prices reach new lows.
  • The media fixate on this depressing trend.
  • Investors become depressed and panicked.
  • Security holders feel dumb and disillusioned. They realize they didn’t really understand the reasons behind the investments they made.
  • Those who abstained from buying (or who sold) feel validated and are celebrated for their brilliance.
  • Those who held give up and sell at depressed prices, adding further to the downward spiral.
  • Implied prospective returns are sky-high.
  • Risk is low.
  • Investors should forget about the risk of losing money and worry only about missing opportunity.
  • This is the time to be aggressive!

Summary

To sum up, one can expect that market cycles will not go away and we will still have to live with them. That is both positive and negative, because it results in an emotional and financial pendulum but also serves us opportunities to invest successfully and earn an above average rate of return.

You must not trust any market pundits that claim that this time is different and thanks to financial innovation we have got rid of market cycles and now we only have a bright future ahead of us.

Forecasting future is futile, nobody know it and cannot know it because the economy and the world as a whole is too complicated, it is a chaotic system. Often you can hear people comparing the economy to a well oiled machine (or a rusty machine that needs some repairs when said during a crisis) with its gears working tirelessly towards a better future. That comparison is very biased and untrue. In reality the economy is not a machine but a living organism without any gears but with cells - people are those cells. And the same people are not completely rational beings (so called homo economicus but emotional creatures with whims and wishes, whim imperfect minds, with biases, with very often irrational behaviours that do not lead them to the desired results.

As long as people are those imperfect beings, we will witness market cycles with overreactions in both directions. That is important to be able to recognize them and make use of them as often as possible. Quoting Howard Marks once again: "You can't predict, but you can prepare." and the so called rule of 7 Ps: "Proper Planning and Preparation Prevents Piss Poor Performance." - this is the correct attitude towards the market cycles and investing in general.


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