We Study Billionaires - The Investor’s Podcast Network - TIP559: Mastering the Market Cycle by Howard Marks

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to the Investors Podcast. I'm your host today, Clay Fink. And boy, I am just so excited to bring you today's episode covering Howard Marks' book, Mastering the Market Cycle. Now, I've been wanting to get to this book for quite some time, and honestly, it's really blown me away with how good it is and thinking about market cycles and how that ties into being a better investor.

Starting point is 00:00:25 I decided to break this book up into two episodes, with today's episode being part one, and the second episode should be coming out in about two weeks. During this episode, we cover why it's important to understand market cycles to be a superior investor. What drives market cycles and why they exist? How to identify where we're at in a market cycle? Why cycles are really inevitable and will likely always be a key driver of markets in the future. How to think about the economic cycle and the government's role in managing economic cycles, what the greatest source of investment risk is, why the credit cycle is the most volatile of all cycles and has the greatest impact on markets and so much more. At the tail end of the episode,

Starting point is 00:01:05 I also share a story of Marx's experience going through the great financial crisis and what it taught him about identifying and profiting from the most extreme cycles. Without further ado, here is my episode covering the first half of mastering the market cycle by Howard Marks. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. All right, so like I mentioned at the top, the title of this book is mastering the market cycle by Howard Marks, and on the front it states is subheading, Getting the Odds on Your Side. On the inside cover of the book, it gets praise from Ray Dalio and Charlie Munger, which is very high praise.

Starting point is 00:02:00 So I'm super excited to cover this book in today's episode. Munger's quote here is, I always say there's no better teacher than history in determining the future. And Howard's book tells us how to learn from history and thus get a better idea of what the future holds, end quote. And then Warren Buffett has been on record saying that whenever he receives Howard Marx's memos in the mail, they're the first thing he opens and reads because he always learns something new from Howard's wisdom.

Starting point is 00:02:24 This book has 18 chapters, so I definitely can't cover everything during this one episode, but hopefully I can hit on a lot of the high points here and cover the first half of the book and then share some of my biggest takeaways from reading it. In case you missed my episode covering one of Howard's other books titled The Most Important Thing, you may want to cue that up in your podcast feed as well. That is episode number 497 on The We've SETI Billioners Show. In that episode, one of the most important things for investors to understand, according to Howard, is being attentive to cycles.

Starting point is 00:02:55 Mark states, quote, good cycle timing combined with an effective, investment approach and the involvement of exceptional people has accounted for the vast bulk of the success of my firm, Oak Tree Capital Management, end quote. Understanding cycles makes our lives much easier. I just think about my own life how my family plans on going to the lake during July because that's when it's going to be hot outside. And we plan our trips around when we anticipate there to be nice weather because the lake is really just much less fun when it's cold out. Just like how the weather moves in cycles or moves in this pattern, economies, companies, and markets move in cycles too. Marks explains how cycles in the markets are largely driven by human psychology and human behavior.

Starting point is 00:03:39 And because human behavior is the key driver in cycles, predicting exactly how the cycles play out really aren't as predictable as something like the weather or like predicting when the sun is going to rise and when the sun's going to set. Mark states here, quote, In order to do the best job of dealing with cycles, an investor has to learn to recognize cycles, assess them, look for the instructions they imply, and do what they tell them to do. If an investor listens in this sense, he will be able to convert cycles from a wild, uncontrollable force that wrecks havoc into a phenomenon that can be understood and taken advantage of, a vein that can be mined for significant outperformance, end quote. Chapter 1 in Marx's book is titled Why Studies Cycles? And the reason we want to study cycles is because the odds of success in investing changes as our position changes in the cycle. He argues that if you're being passive about where you're at in the cycle, then you're

Starting point is 00:04:33 ignoring the chance to tilt the odds in your favor. He also mentions that we should be cautious about making macro forecasts about the economy, markets, or geopolitics because very few investors are able to achieve outperformance over the benchmark based on macro forecasts. It's not that the macro environment doesn't matter because it does matter a great deal, but we shouldn't make macro forecasts because those who do really have unimpressive results overall and very few are able to outperform based on macro forecasts. So Marks focuses his time more generally on three areas.

Starting point is 00:05:08 First is trying to know more than others in areas that are knowable, such as the fundamentals of industries, fundamentals of companies, and securities. Second, is being disciplined as to the appropriate price to pay for a participation in those fundamentals. And third is understanding the investment environment we're in and deciding how to strategically position our portfolios for it. The first two points, which was fundamental analysis and understanding the value, is core to what value investing is all about.

Starting point is 00:05:37 And a ton has been written about it as we've covered on the show. And this is why Marks and his book has focused on the last point, which is understanding cycles. Marks believes that the greatest way to optimize the positioning of a portfolio is determining the right balance between aggressive and defensive. I interpret that as if you believe we're at the top of a cycle, then you want to be more defensive. And if you believe we're around the bottom of a cycle, then you want to be more aggressive. Part of investing is that we don't necessarily know what the future holds.

Starting point is 00:06:09 Even legendary investors like Howard Marks can't be 100% certain of what is in the future. But superior investors have a better sense of what the odds are, and what bets are and aren't worth making. So they understand the odds better than everyone else. Understanding cycles is important because the average investor doesn't fully understand the nature and importance of cycles, and they haven't been around long enough to have lived through many of these cycles. The average investor falls victim to their own natural human psychology rather than being

Starting point is 00:06:42 a level-headed student of history that doesn't fall victim to think. like greed and fear. The superior investor is attentive to cycles. They make judgments about whether they're at the beginning of an upswing or in the late stages of a bull market. They consider whether they're operating in dangerous territory or not, and they're mindful of how greedy and how fearful the current market is, and whether it's time to be aggressive or defensive in their portfolio approach. In Chapter 2 titled The Nature of Cycles, Marks highlights the Mark Twain quote, history doesn't repeat itself, but it does rhyme. Cycles will vary in terms of the details, how far they're going and the timing, but the ups and downs and the reasons for them will occur

Starting point is 00:07:25 forever. Cycles are going to oscillate around a central trend that tends to be up and to the right because company profits tend to increase, economies tend to grow, and then markets tend to rise. Markets oscillate above and below the trend line because of human psychology, and what Mark said recently on our show was that humans tend to take things too far. It's funny that people seem to say all the time that markets move in cycles, but people tend to get caught up in cycles, and when they really get caught up in them in the extreme levels of them, that's when they can really get themselves in trouble. Mark states, the oscillation bedevils people who don't understand it, are surprised by it, or even worse, partake in it, and contribute to it, end quote.

Starting point is 00:08:09 He breaks down this cyclical phenomenon into a number of different phases, which I'll read here. First is the recovery from an excessively depressed lower extreme or the transition from a low toward the midpoint. Next is the continued swing past the midpoint towards the upper extreme or the high. Then you have the high itself or the peak of the cycle. After the peak is the downward correction back towards the midpoint. Then you have it overcorrect and cross below the midpoint. and then you reach a new low, and once again you see a recovery again, and then the cycle repeats.

Starting point is 00:08:44 And he notes that there's no defined beginning or end of a cycle. Each part of the cycle is influenced by what happened before it. So when somebody asks you how we got to this point today, you'd have to decide how far back in history you'd want to go when explaining your thesis for how we got to where we are today. While cycles frequently rise above or fall below the trend line, a typical rule of cycles is that eventually they're going to move back towards that trend line, which reminds me of the value investing belief that over the long run, companies tend to gravitate towards their intrinsic value, and this idea also relates to the concept of the reversion to the mean.

Starting point is 00:09:22 The tricky thing with cycles is that the details when comparing one cycle to another can vary widely. This can refer to the timing, the duration, speed, and the power of the market swings, as well as the reasons for the swings. Remember the Mark Twain quote, history doesn't remember. repeat itself, but it does rhyme. Marks also makes a point, which he considers to be one of the most important points about the nature of cycles.

Starting point is 00:09:47 People tend to think of cycles in terms of the phases that I described earlier when the upswings are followed by the downswings and so on. But Marks makes the distinction that one event causes the next event. During a bull market, the market going up fuels the bull market itself as people become greedy and they pile in. Eventually, the weight of the bull market becomes too much. and it stops moving up and then it peaks out. All of the energy that fueled the bull market then fuels the bear market back toward the trend line, and that energy and continued momentum

Starting point is 00:10:19 downward is what carries it to a low below the trend line. I think understanding physical reality terms like gravity and momentum, I think is really important here, and I believe it's a good mental model for investing in the very best companies. There are times when they're going to trade well above and well below their general trend line, and patience is needed to enter these companies at the appropriate time. Related to the nature of cycles, he pulls in a few observations from his November 2001 memo titled You Can't Predict You Can't Prepar. The first observation is that cycles are inevitable.

Starting point is 00:10:53 Every once in a while, you'll see a new extreme where people start to say, this time's different for whatever reason, and they make the mistake of extrapolating a new trend that ignores the time-tested ways of investing, but it turns out that the old rules still apply in the cycle resumes. He states, in the end, trees do not grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical, end quote. The second observation is that cycles clout is heightened by the inability of investors to remember the past, or in other words, people forget or just simply don't know that

Starting point is 00:11:29 markets have a natural way of moving in cycles. The third observation is that cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. The reason they reverse rather than go on forever is that trends create the reasons for their own reversal. Thus, Howard likes to say that success carries within itself the seeds of failure, and failure the seeds of success. The final observation about the nature of cycles is that through the lens of human

Starting point is 00:11:58 perception, cycles are often viewed as less symmetrical than they are. Negative price fluctuations are referred to as volatility, while positive price fluctuations are called profit. Collapsing markets are referred to as selling panics, and surging markets receive more benign descriptions. Marks believes that cycles generally are largely symmetrical based on his own experience. However, he also clarifies that the symmetry only applies dependably to the direction of the market, and not necessarily applying to the extent, timing, or the pace of the movement. As they say, the stock market takes the stairs up, climbing a wall of worry, and it takes the elevator down as it oftentimes falls more swiftly than it climbs.

Starting point is 00:12:43 Marks argues that the details of each boom and each busts are really not that important and they're really irrelevant, but the themes behind those booms and bust are essential to understand. For example, during the great financial crisis, the boom occurred largely because of the issuance of a number of unsound subprime mortgages, and that took place in turn because of excess optimism, a shortage of risk aversion, and an overly generous capital market, which led to unsafe behavior surrounding these subprime mortgages. Then he says the themes or warning signs that should be drawn from this is that excessive optimism is a very dangerous thing, that risk aversion is an essential ingredient for the market to be safe, and that overly

Starting point is 00:13:24 generous capital markets ultimately lead to unwise financing and thus danger for participants. Again, you want to understand the overall common themes of a boom and bust and the specific details to a particular event really aren't as important. At the end of this chapter, Marks has one of my very favorite quotes that, experience is what you got when you didn't get what you wanted. And he states that the greatest lessons regarding cycles are learned through experience. And I'm sure a number of listeners are like me and they've gotten caught up in the euphoria of a bull market or the despair of a bear market. Chapter 3 is titled The Regularity of Cycles. One of the definitions of cycles that Marx likes is one which reflects how he thinks about

Starting point is 00:14:08 cycles and oscillations. It's a definition from the Cambridge Dictionary, which defines it as a group of events that happen in a particular order, one following the other, and it's often repeated. Since cycles are driven by human psychology, and as many of us know, human psychology is not entirely predictable. How people react in one situation may not be exactly how they react in another situation. Cycles and things like mathematics and physics are very predictable, and they're regularly occurring, but in markets, it just isn't the case. In markets, cycles play out in a somewhat random fashion, and they aren't entirely predictable. To help explain the unpredictability of markets, he pulls in an analogy of baseball and how the result of any particular at-bat depends primarily on the player's ability, but it also depends on the interplay of many other factors, such as the player's health, the wind, the sun, the quality of the pitches he receives, the game situation, and countless other factors.

Starting point is 00:15:12 If it wasn't for all of those unpredictable factors, then a player would be able to hit a home run at every single. at-bat or fail to do so at every at-bat. The same unpredictability applies to the markets. A company may release positive earnings for the quarter, but whether the stock rises or falls may be a result of its competitors' results, what the central banks are doing at that time, or what the overall market is doing at that time, too. So when someone proposes a very simple rule to doing well in the markets, they're probably oversimplifying how the world truly works.

Starting point is 00:15:45 people will always have a thirst for simple rules rather than recognize that markets are driven by a variety of different forces. Towards the end of this chapter, he states, I'm firmly convinced that markets will continue to rise and fall. And I think I know why and what makes these movements more or less imminent. I'm sure I'll never know when they're going to turn up or turn down, how far they'll go when they do, how fast they'll move, when they'll turn back towards the midpoint, or how far they'll continue on the opposite side. So there's a great deal to admit uncertainty about.

Starting point is 00:16:21 I have found, however, that the little I do know about cycle timing gives me a great advantage relative to the majority of investors who understand even less about cycles and pay less heat to them and their implications for appropriate action. The advantage I'm talking about is probably all anyone can achieve, but it's enough for me, end quote. I love the humility that Marks shows here of just how much about cycles are unknown, but he does know enough to gain some sort of advantage in his investment approach. So while many get caught up in the excessive bull market, for example, Marks recognizes that he's seen this story play out before and knows to be more defensive when people have become too euphoric. Turning to Chapter 4, which is titled

Starting point is 00:17:05 The Economic Cycle, Marks opens it up by stating, quote, the economic cycle, also known as the business cycle provides much of the foundation for cyclical events in the business world and the markets. The more the economy rises, the more likely it is that companies will expand their profits and stock markets will rise, end quote. Now, the main measure of an economy's output is GDP, and GDP is the total value of all goods and services produced and sold in an economy. On average, people typically assume 2 to 3% in growth in GDP in the U.S., while many emerging markets are growing at a rate faster than 3% for many years. When thinking about economic growth, we mainly want to consider what are the long-term

Starting point is 00:17:49 secular trends rather than the oscillations around those trends. The oscillations around the trend tend to cancel out in the long run, and the long-term secular trend is what's really going to lift the economy. In January of 2009, Howard wrote a memo titled The Longview, where he outlined that security markets have risen over the previous decades due to a number of factors, including the macro environment, corporate growth, the barring mentality of consumers, the popularization of investing, as well as investor psychology. With these factors driving the secular uptrend, markets, of course, did not go up in a straight line. Another factor he mentions later in the chapter, which drives

Starting point is 00:18:31 the economy, is population growth. Population growth can take a long time to change, and of course, If population growth were to turn negative and the population were shrinking, then of course, GDP growth would be facing a headwind. In addition to population growth, the other important element of GDP is productivity. Higher productivity in an economy simply means that more can be produced in the same number of hours worked by a worker. Like population growth, the change in productivity growth is very slow and it's very gradual, which AI is certainly trying to accelerate in the future.

Starting point is 00:19:06 years to come. He states that economic growth appears to have slowed in the U.S. And I'll note here that this book was originally published back in 2018. From 2010 through 2018, U.S. GDP growth trended around 2 to 3%. 2019, it was 2.3%, 2020 was minus 2.8%. 2020 was nearly 6%. And then when I look back at the 1990s period, for example, I see many years where we had growth of over 4%. So it does seem that in general, economic growth has slowed. And Mark states that it's yet to be seen that if this is a short-term cyclical change or if it's a change in the long-term trend itself. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:23:58 Back to the show. Then Marks touches on short-term economic cycles and how all the Although many factors in the economy might not change too much, there are periods where consumer and investor behavior can change drastically. For example, during the great financial crisis, consumers were spending less, even if they still had their jobs. The credit market just totally dried up, which meant less investment was happening, and companies generally were hesitant to expand their operations, and that led to a recessionary

Starting point is 00:24:27 period from December 2007 through June 2009. To help paint a picture of how psychology plays into the economy and the short-term cycle, you can think about the wealth effect. When people feel wealthy and they feel that times are good, then they're much more likely to spend more money. I know I'm personally much more likely to do things like go out for a nice dinner or buy something I don't really need if my portfolio is doing really well. The housing market also ties into this because people generally keep an eye on how much their

Starting point is 00:24:58 house is worth relative to what they bought it for. and how much equity they have after you consider the mortgage. This makes the economy somewhat self-fulfilling. If consumers and businesses expects times to be good in the future, then they spend more and they invest more, and this creates economic activity. Mark says that it's his belief that the crisis of 2008 was not a V-shaped recovery as it had been in last recessions

Starting point is 00:25:23 because most companies were hesitant to do things like expand their operations, so their expectations in a way led to the reality of a more modest and gradual recovery. He then touches on how most economic forecasts are simply extrapolations of the past. And any derivations from the general trend really are hard to predict. So he doesn't really spend time trying to make economic forecasts. And he references this quote from John Galbraith. We have two classes of forecasters. Those who don't know and those who don't know, they don't know.

Starting point is 00:25:58 So the big takeaways from this chapter on economic cycles is, I have five points here. The output of an economy is the product of the hours worked and the output per hour. And that's determined primarily by factors like the birth rate and the rate of gain and productivity. And those factors change relatively little from year to year. Second is, although the long-term secular growth is relatively steady, the year-to-year changes can drastically change due to things like wars, pandemic, economic crises, and other factors that really. aren't foreseeable. Third is the long-term economic growth is steady over long periods of time, but is subject to change in the long-term cycle. Fourth, the short-term cycle oscillates around the trend line from year to year, and over a long enough time period, it tends to

Starting point is 00:26:43 follow the trend line. And then fifth and finally, people try really hard to predict economic growth, but very few are able to do it right consistently, and few do it much better than everyone else and few correctly predict the major deviations from the trend. So in order to understand market cycles, it's also really important to understand the government's role in cycles, which is what's covered in Chapter 5. Free markets today are accepted as being the best system for allocating economic resources and encouraging economic output, but markets today are rarely left to their own devices. Central banks in particular play a big role in markets today. Today's central banks are primarily concerned with actually managing the economic

Starting point is 00:27:26 cycle. One thing central bankers want to do is try and control inflation. Because when inflation becomes high, then it's interpreted by central banks as the economy running too hot and having too strong of an upward movement and central banks want to prevent high inflation from spiraling out of control before it's too late. So when inflation is high and the economy is too hot, then central banks will try to slow things down in the economy, and when the economy is too slow, they'll try and stimulate it by doing things like QE and lowering interest rates. Central banks also want to support high employment because it helps stimulate the economy and then have continued economic growth.

Starting point is 00:28:04 This is often referred to as the Federal Reserve's dual mandate, which is low inflation and low unemployment. And the central bank also wants to help tamper the swings in the market cycles, but just like how it's really difficult for us as investors to spot where we're at in the cycle. It's also very difficult for central bankers to figure out where exactly we're at in the cycle. Along with the central bankers, governments themselves also play a critical role through things like deficit spending and the level of taxation. To stimulate their own country's economy, they can increase spending, lower taxes, and

Starting point is 00:28:37 then vice versa if they feel they need to slow the economy down. Left to their own devices, the free market can produce extreme levels. of economic cyclicality, which is considered undesirable by governments. So the government, along with the central bank, wants to make an attempt to tamper down that cyclical. So in a way, the job of these groups is to be countercyclical. When things get too hot, they try and cool things down. When things get too cold, they try and heat it up a little bit. Jumping to Chapter 7, this is one of the longer chapters in the book titled The Pendulum of Investor Psychology.

Starting point is 00:29:12 At the start of this chapter, he references a piece he wrote all. all the way back in 1991 that I'll read here, I quote, 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. But whenever the pendulum is near either extreme, it is inevitable that it will move back towards the midpoint sooner or later.

Starting point is 00:29:45 In fact, it is the movement towards an extreme itself that supplies the energy for the swing back. Investment markets make the same pendulum-like swing, between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced markets and underpriced markets. 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 the, quote, happy medium, end quote. I find the pendulum analogy really useful here

Starting point is 00:30:21 as the market continually fluctuates between greed and fear, optimism and pessimism, risk tolerance and risk averse, and between urgency to buy and panic to sell. The swings in the pendulum represent the psychological excesses. For example, Marx explains how it seems logical that the overall stock market should provide returns in line with the sum of their dividends plus the trendline growth in corporate profits, and that really equates to a ballpark figure of around 6 to 10%. Now, when stocks return much more than that for a while,

Starting point is 00:30:55 Howard says that it's likely to be excessive and people are getting too optimistic and returns are essentially being borrowed from the future, which makes stocks risky and a downward correction certain. Howard has talked about on our show recently that stocks, on average, tend to return around 10% a year, but the majority of years are really not in the 8 to 12% range. People have a natural tendency to get carried away. From 1995 through 1999, for example, we had five straight years where stocks returned 19% or more. The S&P 500 entered 1995 at a price of $541, and it closed the year 1999 at 1469, and this is an average annual return of over 22% not in close. Then we all know what happened next. As the S&P 500 had three straight years of negative

Starting point is 00:31:48 returns, it had negative 10% in 2000, negative 13% in 2001, and then negative 23% in 2002. So from peak to trough, the index nearly got cut in half as it dropped by 49%. Now, in hindsight, it seems that the market got way too optimistic and greedy in 98 and 99, and then it became way too pessimistic and fearful around 2002 because the market rebounded by 26% in 2003. Howard points out that from 1970 through 2016, which is a period of 47 years, there were only three years where the market returned between 8 and 12%. So the market very rarely delivers the average returns that investors generally expect from it. So in this chapter, Marx is really hitting home on this idea of the pendulum and how the overall market swings,

Starting point is 00:32:39 between greed and optimism to fear and pessimism, and he says that the superior investor strikes an appropriate balance between greed and fear. Everyone feels these emotions, but the superior investor keeps these conflicting elements in balance. He writes, quote, The superior investor is mature, rational, analytical, objective, and unemotional. Thus, he performs a thorough analysis of investment fundamentals and the investment environment. He calculates the intrinsic value of each potential investment asset, and he buys with a discount to the price from the intrinsic value, plus any potential increases in the intrinsic value in the future, together suggests that buying at the current price is a good idea, end quote.

Starting point is 00:33:26 Harder the reason why investors are so emotional is because we tend to view things through a skewed lens rather than viewing things the way they truly are. Mark says that few people are always even keeled and unemotional. and thus few investors are capable of staking out a midpoint position between the balance of greed and fear. Most swing between greedy when they're optimistic and being fearful when they're pessimistic, and they're doing so at the exact wrong times, which is just so ironic. This reminds me of the classic bubble chart that oftentimes circulates on the internet or on Twitter. The smart money buys early before the trend becomes apparent to everyone else.

Starting point is 00:34:06 Then there's the awareness phase where the assets start to appreciate in price, starts to gain some momentum. Then it receives media attention and investors start to really become enthusiastic as the price starts to go parabolic. And then greed and delusion set in as many people fomo in near the top before you see the bubble crash and then we fall well below the trend line. So it's a great example of taking things too far both to the upside and too far to the downside. When I think about these swings as a stock investor, it also reminds us. me that you need to look at your investments as objective as possible. If a stock I'm holding has declined by, say, 20%, I have to ask myself questions like, has the business's intrinsic value been increasing or decreasing as of late? What is my assessment of the intrinsic value? Has the

Starting point is 00:34:54 moat been impaired? Is the company gaining or losing market share? Is management deploying capital effectively? These are all questions that get to the core of where the business is trending and trying to ignore the stock price movements. If I can get a good sense of some of the answers to these questions, and if the business is well positioned to continue to grow, then drawdowns shouldn't really phase investors who purchased at a reasonable price, and they're willing to hold it for the long term. And since earlier, I checked out the stock returns during the tech bubble and the crash to follow. I figured I'd also pull in what things look like as of the time of this recording. In 2019, we saw stocks return 28% for the S&P 500.

Starting point is 00:35:35 2020 was 16%, 2021, 26%, and three really, really good years overall. And then 2022 was minus 19%. And then year to date, 2023, we have positive 11%. So again, really volatile returns, typically straying pretty far away from the midpoint of around 10%. We'll see where 20203 turns out in another six months to see whether greed or fear prevails in the markets. This brings us to Chapter 8 titled The Cycle and Attitudes Towards Risk.

Starting point is 00:36:08 Investing at its core is the art of bearing some level of risk in pursuit of a profit. Investors generally try to position themselves to profit from future developments rather than being penalized by them, and the superior investor is someone who's able to do that better than others. Mark says that, since risk and the uncertainty with regard to future developments is the primary source of the challenge in investing, the ability to understand, assess, and deal with risk is the mark of the superior investor and an essential requirement for investment success. Then a bit later, my view that risk is the main moving piece in investment makes me conclude

Starting point is 00:36:48 that at any given point in time, the way investors collectively are viewing risk and behaving with regard to it is as of overwhelming importance in shaping the investment environment in which we find ourselves. And 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, and perhaps the most important one in this book, end quote. Howard outlines the trade-off between risk and return and how generally investors believe

Starting point is 00:37:20 that in order to receive a higher return, then they must take on more risk. But he says this assumption can't be correct because if riskier assets, could be counted on to produce higher returns, then by definition, they wouldn't be riskier. Instead, investments that seem riskier appear to offer the promise of higher returns. Again, investments that seem riskier appear to offer the promise of higher returns. Otherwise, no one would make that investment. To better understand risk and return, you can think about your opportunity costs. Today, the yield on, say, a 10-year treasury is around 3.8%, and this is perceived to be

Starting point is 00:37:59 one of the safest investments one can make because the U.S. government is the one footing the bill on the yield associated with that asset. If a stock gives an investor an expected return of 3.8% as well, then the theory in finance is that no one would be interested in making that bet, so they would need a return well above 3.8% to even consider taking that position because there's a higher risk associated with investing in stocks. No rational investor wants to take on any extra risk than they need to, and people are naturally risk-averse. If we assume that investors are rational and risk-averse, then once there are mispricings in the market, we would assume that investors would correct those mispricings by purchasing

Starting point is 00:38:41 assets that offer high returns relative to their risk and selling assets that offer lower returns relative to their risk. And this pretty much all aligns with the efficient market hypothesis, and we all know that markets are not always efficient, and they're more so driven by human psychology, as Mark's outlines in this book. In this chapter, Howard talks about how investor attitude towards risk changes over time, and this leads to changes in market prices. Sometimes investors become too risk averse, and sometimes they relax their risk aversion and become too risk-tolerant. This ties directly into the investor emotions of greed and fear that we've been talking about, when investors become too greedy, they become too risk-tolerant

Starting point is 00:39:22 and too optimistic, and they reduce their level of caution they use in their investing process. Since greedy and optimistic investors have more risk-tolerance, they tend to chase returns and get pushed into riskier and riskier assets. This reminds me exactly of 2021. We saw crypto prices going through the roof, hyper-growth tech that had little or no profits, we're trading at 100-time sales, countless IPOs and SPAC offerings and so on. Overall, investors were very optimistic about the future while things were going really, really well. Ironically, risk is the highest when investors generally feel that risk is low, and risk is the

Starting point is 00:40:01 lowest when investors feel that risk is high. This is because when investors feel risk is low, they overestimate future expectations and they're too optimistic. So future returns are low and the potential downside is high. Conversely, when stocks fall, investors are too cautious. This leads to higher than average future expected returns and lower than average potential downside risk. Howard writes, quote, For me, the bottom line of all this is that 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

Starting point is 00:40:37 risk is the greatest harbinger of subsequent market declines. But because most investors are following the progression described just above, this is rarely perceived at the time when perceiving it, and turning cautious is most important, end quote. Then a bit later, he writes, what's the greatest source of investment risk? Does it come from negative economic developments, corporate events that fall short of forecasts? No, it comes when asset prices attain excessively high levels as a result of some new, intoxicating investment rationale that can't be justified on the basis of fundamentals, and that causes unreasonably high valuations to be assigned. And when are these prices reached?

Starting point is 00:41:18 When risk aversion and caution evaporate and risk tolerance and optimism takeover, this condition is the investor's greatest enemy, end quote. He points to the example of the great financial crisis as the greatest financial down swing of his lifetime. And I just love how he points out in this book that one of the most difficult periods of his career, he sees it as an opportunity, an opportunity to observe, to reflect, and learn, rather than a burden he has to endure. To sum it up, investors overall became complacent, and they lacked their standards on risk assessment and quality. Banks started to lend to those

Starting point is 00:41:55 who previously weren't able to get loans. Wall Street packaged together new types of assets that were riskier than they were perceived more generally. And it reminded Howard of Warren Buffett's wise words that we need to adjust our financial action. based on the investor behavior playing out around us. The Buffett quote he's referring to here is, the less prudence with which others conduct their affairs, the greater prudence we should conduct our own affairs, end quote. So Howard says when others fail to worry about risk and fail to apply caution,

Starting point is 00:42:26 we must in turn be more cautious. And when investors become panicked or depressed and can't imagine condition under which risk would be worth taking, we should be more aggressive. When times were good from 2005 to 2007, there was a high degree of confidence. But when fear struck in the markets, it quickly eroded all confidence, and excessive risk aversion took the place of unrealistic risk tolerance. Once Lehman Brothers had collapsed in 2008, people were very quick to sell everything they

Starting point is 00:42:58 could with a high degree of urgency. There were many more sellers than buyers, leading to a total collapse of all asset prices, and liquidity just totally dried up. I love that Howard shared this story of his own troubles he personally had to endure through the financial crisis, which inspired him to write a memo called The Limits of Negatism. Proceeding the great financial crisis, Oak Tree started to participate in the use of leverage in some of their funds, but they used less leverage than most other companies. For example, they used leverage of four times equity in their European senior loan fund

Starting point is 00:43:32 versus the more conventional 7 or 8 times leverage. And they tried to be more conservative about the assets they bought as well. But the crisis still managed to almost bring down their fund. Prior to the Great Financial Crisis, Senior Leveraged loans rarely sold below 96 cents on the dollar. And Oatree believed that they were well positioned to never have to worry about a margin call as long as these prices didn't fall to 88 cents on the dollar. But after the bankruptcy of Lehman Brothers, loan prices fell to $0.1.5 million. unprecedented levels, and margin calls were off the hook, which further exacerbated the issue of falling

Starting point is 00:44:09 loan prices. Oak Tree acted swiftly to raise more equity from their investors to lower their leverage in their fund. They wanted to lower it from 4 to 1 down to 2 to 1. They were able to raise more money from their investors, and now they were protected to if the loans were to fall to 65 cents on the dollar. And then not too long after, Oak Tree's book then fell to 70 cents on the dollar, as there was a total absence of buyers, and margin calls continued, and it lets them more and more selling pressure. Now, Otrey saw the need to go out and raise even more equity from investors. But getting a call from your investment manager twice isn't exactly a good sign. And many people don't always have a ton of cash laying around, and especially when there's a market panic, and they've already been called

Starting point is 00:44:54 once, and they see prices collapsing. Some investors just didn't have the cash on hand, and some didn't have the willingness to defend additional investment. Marks writes, at bottoms, it can be extremely hard to take actions that require conviction and staunchness, and that led to the event I'm going to describe, end quote. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why Vanta is a game changer. Vanta automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC 2 or running an enterprise GRC program, VANTA

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Starting point is 00:48:32 slash income. This is a paid advertisement. All right. Back to the show. So Howard had approached a pension fund that was one of his investors to make the case to put up more capital. But they were worried about the possibility of a loan defaults on their positions.

Starting point is 00:48:49 They pushed Howard to explain how the fund would do if the loan started to default. And even if they saw the worst default rate in the history of high yield bonds, which was a 12.8% default rate, that was 12 times the average default rate in their portfolio, if they saw the worst default rate ever, Oak Tree would still make money. Howard told them that since they're so fearful and so doomsday about their outlook on the economy, they should be selling every single equity they own that instant. And that pension fund, of course, did own a lot of equities. Howard writes,

Starting point is 00:49:24 My point is that in the negative environment, excessive risk aversion can cause people to subject investments to unreasonable scrutiny and endlessly negative assumptions, just as they may have performed little or no scrutiny and applied rosy assumptions when they made investments in the preceding heady times. During panics, people spend a hundred. 100% of their time making sure there can be no losses, at just the time that they should be worrying instead about missing out on great opportunities. In times of extreme negatism, exaggerated risk aversion is likely to cause prices to already

Starting point is 00:50:01 be as low as they can go, and further losses to be highly unlikely, and thus the risk of loss is minimal. As I've indicated earlier, the riskiest thing in the world is the belief that there's no risk. By the same token, the safest is the safest is. and most rewarding time to buy usually comes when everyone is convinced there's no hope. If I could only ask one question regarding each investment I had under consideration, it would be simple. How much optimism is factored into the price? A high level of optimism

Starting point is 00:50:33 is likely to mean the favorable possible developments have been priced in. The price is high relative to the intrinsic value and there's no margin for error in case of disappointment. But if optimism is low or absent, it's likely that the price is low. Expectations are modest, negative surprises are unlikely, and the slightest turn for the better would result in appreciation. The pension fund meeting described above was important for the simple reason that it indicated that all optimism had been wrung out of investors' thinking, end quote. This event with the pension fund then led Howard to run back to his office to write this

Starting point is 00:51:09 piece titled The Limits of Negatism. And this is all a good reminder that we should always include a higher level margin of safety than what our initial gut instinct might be, especially in the really good times. If your gut says that an emergency fund of, say, three months expenses is appropriate, then maybe it should really be five or six months. Maybe you should have a little bit less debt than your gut instinct tells you. Marks originally believed that the loans hitting 65 cents on the dollar was unimaginable. And they still managed to almost hit that and they actually have.

Starting point is 00:51:41 hit 70 cents on the dollar. So whatever you think isn't likely is still potentially in the cards and it's probably a good general rule of thumb to have in your life and in your investments. In that piece, the limits to negatism, Howard writes, skepticism and pessimism aren't synonymous. Skepticism calls for pessimism when optimism is excessive, but it also calls for optimism when pessimism is excessive. Contrarianism, or doing the opposite of what others do, or, quote, leaning against the wind is essential for investment success. But as the credit crisis reached a peak last week, people succumbed to the wind rather than

Starting point is 00:52:24 resisting it. I found very few who were optimistic. Most were pessimistic to some degree. Some became genuinely depressed, even a few great investors I know. Increasingly negative tales of the coming meltdown were exchanged via email. No one applied skepticism or said, That horror story is unlikely to be true, end quote. I found this story just so valuable since I myself was not an investor during the great financial crisis,

Starting point is 00:52:53 and the story also gives a sense of what the market environment can look like in the extremes of far too much optimism and far too much pessimism. A few of Howard's funds investors didn't put up additional capital, including the one he visited that day in the story he told. And in order to keep his fund afloat, Howard put up the money himself to keep things going. This one investment into a levered portfolio of depressed senior loans at a time of Max pessimism ended up being one of the best investments he has ever made because there was a massive unwillingness for anyone to participate in that market, which gave him absurdly cheap prices. This

Starting point is 00:53:35 It brings us to chapter 9, which is the last chapter we'll touch on here in today's episode, which is titled The Credit Cycle. All the cycles discussed in the book vary to some degree. The stock market cycles can have big swings, whereas cycles and things like food or everyday needs really don't change all that much. And then there's GDP, which really doesn't fluctuate much either, and then corporate profits fluctuate a little bit more than GDP. Now, when thinking about credit cycles, these are really subject to massive swings. Howard actually believes that the credit cycle is the most volatile of the cycles, and it has the greatest impact on the economy.

Starting point is 00:54:16 Sometimes the credit window is wide open, and then suddenly it can just slam shut. This is why it deserves a great deal of attention. Now, in order for the overall economy to continue to grow, it's essential that businesses have access to credit, because without credit, most businesses wouldn't be able to finance future growth, at least to the same extent. And without credit, then debt that is maturing on a company's and government's balance sheets, that debt couldn't be refinanced and rolled over. Generally, companies aren't repaying their debts. Usually, these debts are rolled over and refinanced. Other considerations with regards to credit is that financial institutions rely on credit in order to maintain their daily

Starting point is 00:54:57 operations. For example, if a bank has an influx of depositors wanting their money, then that bank is in trouble if they don't have access to the credit markets to make good on those depositors. And then finally, there's a psychological impact. When the credit market seizes up, it can quickly cause fear to spread leading to things like forced selling and margin calls, which further exacerbates the issue and creates a vicious cycle downward until relief is provided. Now, why does the credit window open and close the way it does? Howard explains in his November 2001 memo, you can't predict you can prepare. When the economy enters a period of prosperity and bad news is relatively scarce, lenders

Starting point is 00:55:38 are more willing to lend out more capital. Financial institutions then compete to expand their businesses, and then you have a growing economy and more capital is just flush in the economy. This leads to some lenders lowering their returns by offering lower interest rates, they're lowering their credit standards, and they're providing more capital in a transaction, and they're easing their covenants. At the extreme end of this credit cycle, many borrowers end up getting loans they shouldn't have been getting, and this, of course, leads to capital destruction. The credit cycle reaches a tipping point when lenders have over-extended

Starting point is 00:56:14 themselves and the cycle reverses the other way. Lenders start to see losses from their bad loans, and they start to rein in on their lending standards. Interest rates are go up, and requirements to get a loan are now our higher bar for the borrowers to reach, and then at the trove of the cycle on the downside, only the most creditworthy borrowers are able to get a loan if anyone at all is able to. Then companies begin to starve for capital as some borrowers aren't able to roll over their debts, you have defaults and bankruptcies, and then the cycle turns back the other way. To sum this process all up, Mark summarizes this as, quote, prosperity brings expanded lending, which leads to unwise lending standards, which produces

Starting point is 00:56:58 large losses, which makes lenders stop lending, which ends prosperity, and so on, end quote. Howard believes that the credit market can be a great indicator for seeing where the market stands psychologically, and it's a great contributor to investment bargains. You can see we're around the trope of a credit cycle when you know that credit is tight in the economy, and if there's a liquidity event like what happened in March 2020, then you can almost be certain that there are bargains out there to be found, as many people have become forsellers of assets. The Great Financial Crisis is another prime example of an extreme credit cycle.

Starting point is 00:57:36 Marx writes, the developments that constituted the foundation for the crisis weren't caused by a general economic boom or a widespread surge in corporate profits. The key events didn't take place in the general business environment or the greater world beyond that. Rather, the GFC was largely a financial phenomenon that resulted entirely from the behavior of financial players. The main forces that created the cycle were the easy availability of capital, a lack of experience and prudence sufficient to temper the unbridled enthusiasm that pervaded the process,

Starting point is 00:58:10 unimaginative financial engineering, the separation of lending decisions from loan retention and irresponsibility and downright greed." When the credit window slammed shut in 2008, Howard believes that financial catastrophe similar to the Great Depression was absolutely possible and in the cards, but the U.S. government took the necessary steps to turn the tide. The final big shoe to drop was the collapse of Lehman Brothers before the government provided bailouts to the banks and they put guarantees behind commercial paper and money market funds. Howard writes, market participants demonstrated that when negative psychology is universal and things, quote,

Starting point is 00:58:50 can't get any worse, they won't. When all optimism has been driven out and panicked risk aversion is everywhere, it becomes possible to reach a point where prices can't go any lower. And when prices eventually stop going down, people tend to feel relief. And so the potential for price recovery begins to rise, end quote. At the end of the chapter, Marx talks about how the best time to work, invest is when there is an uptight and cautious credit market. When lenders generally are fearful of losing money, they have high risk aversion, there's an unwillingness to lend, a shortage of

Starting point is 00:59:26 capital everywhere, there's an economic contraction taking place, and there are defaults, bankruptcies, and restructurings occurring. These all create a market with low asset prices, high potential returns, low risk, and excessive risk premiums. Ironically, when the market is is very fearful in this way, it makes it very difficult for people to invest because it's just so hard to psychologically be optimistic when the whole overall market is pessimistic. On the flip side, a generous capital market shows characteristics like investors showing fear missing out on profitable opportunities, reduced risk aversion and skepticism, too much money chasing too few deals, the willingness to buy securities and decreased quality, the willingness to

Starting point is 01:00:12 buy securities in increased quantity, a willingness to buy securities of reduced quality, and these all lead to high asset prices, low prospective returns, high risk, and skimpy risk premiums. From Howard's perspective, when the credit window is wide open, it's best to proceed with caution as an investor and be more defensive. When the credit window is closed and sealed shut, it's the best time to be aggressive because that's when the bargain prices are likely available. Now, at the end of the chapter, he writes, quote, 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

Starting point is 01:00:59 when the credit markets are in the less euphoric, more stringent part of the cycle. The slammed shut phase of this credit cycle probably does more to make bargains available than any other single factor, end quote. I just loved the first half of this book, so hopefully you found value in this episode and learning how to think about cycles, how you can think about identifying, and trying to figure out where we're at in the cycle. This covered the first nine chapters of the book, which is roughly the first half of it. I hope to see you again next time to cover the second half of the book, which I believe will be going out in two weeks from today if you're listening to this episode as it comes out. Thank you so much for tuning in. I really hope you enjoyed it.

Starting point is 01:01:39 And I hope to see you again next time. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP559: Mastering the Market Cycle by Howard Marks

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