Howard Marks on Investing Cycles
Previously, we reviewed chapters on risk, and on an investors attitude to risk. The next two chapters (8 and 9) focus on the cyclical nature of markets, and how we can take advantage of the pendulum of markets.
Here goes:
- It is essential to remember that just about everything is cyclical.
- there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.
- we never know what lies ahead, but we can prepare for the possibilities and reduce their sting.
- there are two rules we can hold to with confidence:
- Rule number one: most things will prove to be cyclical. • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
- the underlying principle is that things will wax and wane, grow and decline. The same is true for economies, markets and companies: they rise and fall.
- basic reason for the cyclicality in our world is the involvement of humans. people are emotional and inconsistent, not steady and clinical.
- objective factors do play a large part in cycles, of course—factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.
- The extremes of cycles result largely from people’s emotions and foibles, nonobjectivity and inconsistency.
- Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal. Success carries within itself the seeds of failure, and failure the seeds of success.
- Look around the next time there’s a crisis; you’ll probably find a lender. Overpermissive providers of capital frequently aid and abet financial bubbles. In the financial world, if you offer cheap money, they will borrow, buy and build—often without discipline, and with very negative consequences.
- Understanding that cycles are eventually self-correcting is one way to maintain some optimism when bargain hunting after large market drops.
- Cycles will never stop occurring. If there were such a thing as a completely efficient market, and if people really made decisions in a calculating and unemotional manner, perhaps cycles (or at least their extremes) would be banished. But that’ll never be the case. And yet, every decade or so, people decide cyclicality is over. They think either the good times will roll on without end or the negative trends can’t be arrested. At such times they talk about “virtuous cycles” or “vicious cycles”—self-feeding developments that will go on forever in one direction or the other.
- This belief that cyclicality has been ended exemplifies a way of thinking based on the dangerous premise that “this time it’s different.” These four words should strike fear—and perhaps suggest an opportunity for profit—for anyone who understands the past and knows it repeats. Every once in a while, an up- or down-leg goes on for a long time and/or to a great extreme and people start to say “this time it’s different.” They cite the changes in geopolitics, institutions.technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend.
- It’s essential that you be able to recognize this form of error when it arises. It turns out that the old rules do still apply, and the cycle resumes.
- There is a right time to argue that things will be better, and that’s when the market is on its backside and everyone else is selling things at giveaway prices. It’s dangerous when the market’s at record levels to reach for a positive rationalization that has never held true in the past. But it’s been done before, and it’ll be done again. Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.
- The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc.
- Investment markets follow a pendulum-like swing: • between euphoria and depression, • between celebrating positive developments and obsessing over negatives, and thus • between overpriced and underpriced.
- This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”
- The pendulum also swings with regard to greed versus fear; willingness to view things through an optimistic or a pessimistic lens; faith in developments that are on-the-come; credulousness versus skepticism; and risk tolerance versus risk aversion.
- The swing in the last of these—attitudes toward risk—is a common thread that runs through many of the market’s fluctuations. The greed/fear cycle is caused by changing attitudes toward risk.
- Risk aversion is the essential ingredient in a rational market, as I said before, and the position of the pendulum with regard to it is particularly important. Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash.
- Reaping dependably high returns from risky investments is an oxymoron. The main risks in investing are two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns. But from time to time, at the extremes of the pendulum’s swing, one or the other predominates. When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.
- The ultimate danger zone is reached when investors are in agreement that things can only get better forever. That makes no sense, but most people fall for it. It’s what creates bubbles—just as the opposite produces crashes.
- Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.
- The significance of all this is the opportunity it offers to those who recognize what is happening and see the implications. At one extreme of the pendulum—the darkest of times—it takes analytical ability, objectivity, resolve, even imagination, to think things will ever get better. The few people who possess those qualities can make unusual profits with low risk. But at the other extreme, when everyone assumes and prices in the impossible—improvement forever—the stage is set for painful losses.
- In theory with regard to polarities such as fear and greed, the pendulum should reside mostly at a midpoint between the extremes. But it doesn’t for long. Primarily because of the workings of investor psychology, it’s usually swinging toward or back from one extreme or the other
- The pendulum cannot continue to swing toward an extreme, or reside at an extreme, forever. Like a pendulum, the swing of investor psychology toward an extreme causes energy to build up that eventually will contribute to the swing back in the other direction. Sometimes, the pent-up energy is itself the cause of the swing back—that is, the pendulum’s swing toward an extreme corrects of its very weight.
- The swing back from the extreme is usually more rapid—and thus takes much less time—than the swing to the extreme.
- The occurrence of this pendulum-like pattern in most market phenomena is extremely dependable. But just like the oscillation of cycles, we never know: • how far the pendulum will swing in its arc, • what might cause the swing to stop and turn back, • when this reversal will occur, or • how far it will then swing in the opposite direction.