We Study Billionaires - The Investor’s Podcast Network - TIP562: How to Cope With Market Cycles

Starting point is 00:00:00 You're listening to TIP. Hey, everybody, welcome to the Investors Podcast. I'm your host today, Clay Fink, and today I will be continuing my discussion on Howard Marks' wonderful book called Mastering the Market Cycle. On episode 559, I covered the first half of the book, and this episode covers the second half, as well as bringing in a few of my favorite clips from Howard's recent appearance on our show with Trey Lockerbie. During this episode, we cover the real estate cycle and how it differs from other cycles,

Starting point is 00:00:29 the three stages of a bull in bear market, what we can learn from previous bubbles and crashes such as the South Sea bubble, the one telltale sign to recognize when you're in a bubble, how Howard thinks about gauging the temperature of the market, how he approaches buying during a panic, and why he doesn't try to time the bottom, why cycles are likely to persist as far as the I can see and much more. Without further ado, here is part two of our review 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.

Starting point is 00:01:09 We keep you informed and prepared for the unexpected. All right, so jumping right in, I wanted to start with Chapter 11 covering the real estate cycle. If there is any asset class where people make broad generalizations to justify their purchased, real estate may be the most prominent example. All the time, you hear people say things like, they're not making any more of it. You can always live in it, and it's a hedge against inflation. People use these maxims as justification for making their purchase, even if they don't do proper due diligence on the price they're paying.

Starting point is 00:01:49 Marx explains that real estate has many common themes that relate to other cycles. One big reason is so cyclical is the importance of credit in the real estate market. The cycle goes something like this. First, positive events and increased profitability lead to great. enthusiasm and optimism. Second, improved psychology encourages increased activity as buyers use rosier assumptions, and they're willing to pay higher prices and or lower their quality threshold. And third, this leads to asset prices rising, which encourages more activity, further price increases, and a greater risk-bearing upon market participants. And then fourth, eventually the upward

Starting point is 00:02:27 reinforcement is unsustainable before the cycle reverses back the other way. Now, one important difference between real estate and other asset classes is the level of liquidity and then the long lead time for real estate development to take place. Before a building can come to the market and therefore increase the supply of real estate, economic analysis has to be performed by investors, a site has to be found and purchased, the building has to be designed, you have to work through these regulatory hurdles and get permission to build, financing has to be obtained, and construction has to be completed, just to name a few. So as you probably know, there are many, many steps before new real estate can be put on the market for sale.

Starting point is 00:03:06 Sometimes this whole process can take years, while the market conditions can change significantly from start to finish. Another consideration with cycles in real estate is that the players need to be well aware of what others in the space are doing. For example, when the real estate market is booming, it may appear that there's a housing shortage and there's a need for new houses. So say a real estate developer decides that there's unmet demand for 100 houses, and they say, all right, we're going to go out and build 20 new homes to bring in some sort of margin of

Starting point is 00:03:36 safety so they're not flooding the market with new homes. But if nine other home builders make the same assessment, then you may have 200 homes fill what was 100 homes of demand. And by the time the homes get built, the economy may have cooled down. People might not feel as prosperous and willing to buy. And the demand for homes in turn may be lower. And he shows this chart to help illustrate the cyclicality here. The chart shows the number of new housing developments. developments relative to the overall population, because naturally, population growth is a key driver in the demand for housing. The chart showed that the ratio of new housing developments per million people after the Great Financial Crisis, it was at its lowest level in recorded history dating

Starting point is 00:04:18 all the way back to the 1940s. Most people after the Great Financial Crisis were totally convinced that the American dream of home ownership was really over. The demands for houses would remain depressed forever, and thus the overhang of unsold homes would be absorbed very slowly. So in short, the market naturally extrapolated this negative sentiment into the future, rather than understanding and believing in the cyclicality of markets. Marks understood that any material increase in demand for housing would lead this strong recovery for housing prices, and since he's a believer in cycles, and with the support of data and analysis, Howard went ahead and invested heavily into non-performing home mortgages, and he purchased

Starting point is 00:04:59 North America's largest private home building company, which were both investments that turned out very well for him and Oak Tree. Then Howard turns to talk about the gross generalizations and sweeping statements that people make, like I mentioned at the beginning, you know, they aren't making any more real estate. You can always live in it. These sweeping statements usually highlight the positive because humans have a natural tendency towards greed and wishful thinking.

Starting point is 00:05:22 Howard writes, what people eventually learn is that regardless of the merit behind these statements, they won't protect an investment that was made at a price too high, end quote. These sort of general beliefs are what lead asset prices to be lifted to levels that are extreme and unsustainable. To help avoid these dangerous generalizations, Marx recommends removing a number of words and phrases from an intelligent investor's vocabulary, words like never, always, forever, can't, won't, will, and has to. Marks goes back to the great financial crisis to talk about the bullish behavior in the real estate market and how many came to believe that real estate could be dependent on to steadily appreciate and prove to not be cyclical and prone to

Starting point is 00:06:06 corrections like all other markets. He then references a Times article that highlights a study by Pete Eicholts. Icultz found that from 1628 through 1973, real property values increased by just 0.2% per year, and that's adjusted for inflation over that period. Now, many people would probably argue that real estate has generally performed really well since the great financial crisis due to things like currency debasement and the use of policies like QE by the Federal Reserve. And this is a really valid point because QE has fueled the growth in prices of scarce assets like real estate, stocks, etc. The bottom line is that real estate is subject to the cyclical ups and downs, just like all other markets.

Starting point is 00:06:49 And the real estate cycles can be amplified by high financial leverage like it was during the great financial crisis, and it can be amplified by the fact that the supply is inflexible, and it takes a lot of time to adjust to the market dynamics. In Chapter 12, Howard ties everything together here that we've learned thus far. He says our job as investors is simple. It's to deal with the prices of assets, assess where they stand today, and make judgments regarding how they will change in the future. Prices are primarily affected by two things.

Starting point is 00:07:19 Fundamentals and psychology. Fundamentals can relate to many things depending on the asset you're talking about. For stocks, it might be earnings, cash flow, and the outlook for the two. And these are all influenced by the trends in the economy, profitability levels, and the availability of capital. And then the other side is psychology. This relates to how investors feel about the fundamentals and how they're valuing these assets. If the market valued, say, a stock based primarily on the company's current earnings and the outlook for future earnings, then the stock really wouldn't fluctuate that much more than the company's earnings. But since the market is also highly influenced by the market psychology, the reality is that generally stock prices

Starting point is 00:08:00 move much more than earnings and they move much more than the general fundamentals of the business. Like I explained in the previous episode, a company doing well and the stock price increasing, it really feeds on itself. So a rising stock price feeds into that investor psychology, and they want to get in on that action. Positive and negative events really feed on themselves either way. And humans, whether it's going up or going down, humans tend to take it too far. We're all familiar with examples where bubbles forms, such as the tech bubble in 99, where these profitless.com companies just soar it through the roof, regardless of the underlying fundamentals.

Starting point is 00:08:38 A more recent example of the market taking things too far down is meta. Given that meta is now today worth over $270 per share, when meta was trading for under $90, like six months ago, it seems like the market became way too pessimistic on that company's future. You know, it started out as bad news, and then the falling stock really just fed on itself as investor psychology just fed on it, they sold out, they capitulated, and they just lost all belief in the company. To summarize the way a cycle works here briefly again, events in the economy turn positive, and higher corporate profits lead to higher asset prices. Higher asset prices feed investor psychology,

Starting point is 00:09:17 and they trigger the animal spirits, and they trigger this increased tolerance for risk. Because more people are optimistic, they're less demanding in terms of risk protection and prospective returns, and this causes asset prices to rise further. Eventually, things fail to meet expectations, and the market hops out, and it moves in the other direction, reversing its trend. Asset prices start going down and this causes investors to be less positive down to the point where the market sets a new stage for recovery. Now, this process sounds basic and it seems to make a lot of sense, but in reality it's really quite messy. The speed and duration of one cycle versus another can really vary by quite a lot. As Mark Twain said, history doesn't repeat itself, but it does rhyme.

Starting point is 00:10:01 There are a number of reasons that Howard lists here that cycles come into play time and time again. A few that I'll mention here is that first, investors' natural instinct is to want to profit, and they don't want to miss out on the bull markets, and they're skeptical, and they don't want to lose anything during the bear markets. The second reason that cycles occur is that herd behavior results from pressure to fall in line with what other people are doing, rather than people really thinking for themselves and thinking independently. Third is the extreme discomfort that comes from watching others make money doing something

Starting point is 00:10:33 you've previously rejected. Fourth is the tendency to give up on investments that are unpopular or unsuccessful, no matter how intellectually sound they are. And then Howard has a couple sections here that cover bull markets, bear markets, as well as stock market bubbles and crashes. Starting with bull markets, Howard early in his career was taught about the three stages of a bull market, which I'll list here. The first stage is only when a few unusually prospective people believe things will get better.

Starting point is 00:11:01 The second stage is when investors realize that improvement is actually taking place, and then the third stage is when everyone concludes that things will get better forever. In the first stage, the possibility of improvement is really invisible to most investors, and thus the asset is underappreciated and it reflects little to no optimism. In the third stage, events have gone well for so long, and they've been reflected powerfully in asset prices, so instead of little to no optimism, there's excessive optimism. optimism. Trees generally don't grow to the sky, but in the third stage of a bull market, investors act as if they will and they're willing to bet money on it. Howard states, few things are as costly as paying for potential that turns out to be overrated." This description of a bull market also brings in the brilliant quote by Warren Buffett. What a wise man does in the beginning, the fool does in the end. Howard says that this quote

Starting point is 00:11:58 alone tells 80% of what you need to know about market cycles and their impacts. Buffett also has a similar quote that points out the three stages of a bull market. First, the innovator, then the imitator, then the idiot. And another one of Howard's favorite quotes on FOMO is from Charles Kendelberger. There is nothing as disturbing to one's well-being in judgment as to see a friend get rich. Howard writes, market participants are pained by the money that others have made and they've missed out on. and they're afraid the trend and the pain will continue forever. They conclude that joining the herd will stop the pain, so they surrender. Eventually, they buy the asset well into its rise or sell after it's fallen a great deal, end quote.

Starting point is 00:12:44 Now, the three stages of a bare market are essentially the inverse of the bull market. The first stage is when a few thoughtful investors recognize that despite the prevailing bullishness, things won't always be rosy. The second stage is when investors recognize that things are deteriorating, and then the third stage is when everyone's convinced that things can only get worse. Then Howard tells the story of the South Sea bubble to illustrate how even the most brilliant people can fall prey to capitulation. Isaac Newton, along with many other wealthy Englishmen, joined in on the South Sea investment

Starting point is 00:13:18 as it started at 128 pounds per share in January and rose to 1,050 pounds in June. And this was in the year 1720, by the way. Newton was smart, though, and he realized the speculative nature of the rise of this bubble. And before he got to the euphoric heights, he sold out and gained his 7,000 pounds, early on in the bubble. When asked about the South Sea market, he said, I can calculate the motions of heavenly bodies, but not the madness of people. But even Newton couldn't keep himself from watching all of his friends get incredibly

Starting point is 00:13:51 rich off the price of the shares continuously rising day by day. Newton bought back in near the top at around 1,000 pounds a share, and by September of that year, the bubble had popped, and the price of shares already fell to 200 pounds, which was down 80% from the highs. Newton had then exited his position at prices he had originally bought in at earlier on that year, and he lost 20,000 pounds, which equates to over $5 million today. Even with the chance to learn from history, and learn from things like the South Sea bubble, people are still prone to create bubbles. They buy into them through FOMO and they suffer from the crash that follows. People are naturally hardwired to have a very hard time overcoming FOMO

Starting point is 00:14:35 and watching all of their friends get rich on paper in a bubble. Because bubbles are all too common when looking at the bigger picture, as people seem to create a bubble every decade, Marx has often asked if today's market resembles a bubble since we've seen the massive rise in the stock market, since the great financial crisis, and he cautions that any big market rise doesn't necessarily mean it's a bubble. The first big market bubble that Howard Marks lived through was the Nifty 50 in the late 1960s. Investors believed that these high-flying companies had no price too high that investors could pay for them

Starting point is 00:15:09 because of the prosperous growth that was certain to lie ahead. And this led to shares in the Nifty 50 to rise to 80 to 90 times earnings in 1968. Marks writes, the result was predictable. Whenever people are willing to invest regardless of the price, they're obviously doing so based on emotion and popularity rather than cold-blooded analysis, end quote. What came next was a massive correction as many of these stocks saw their PE multiples go to eight to nine times. So that's an 80 to 90% drop, which is a good reminder that many of the greatest companies today may cease to exist over time, as many of those companies did. and no asset or company is so good that it can't become overpriced.

Starting point is 00:15:49 The hallmark of a bubble is when investors stop believing that price does not matter. Since investors believed that the underlying bubble will only continue to go up, they oftentimes double down using leverage because they're so certain that the prices will continue to rise. Marks writes, No price too high is the ultimate ingredient in a bubble, and thus a full-proof sign that a market has gone too far. There is no safe way to participate in a bubble, only danger.

Starting point is 00:16:19 It should be noted, however, that overpriced is far from synonymous with going down tomorrow. Many fads roll on well past the time they've reached bubble territory, end quote. Then he has a long list of events and inputs that can form a bubble, which is all items I've been discussing during this episode and in the previous episode. When you have people getting really greedy, they're getting overconfident, the credit window of easy money is wide open. the media is celebrating new highs, and risk is at its highest, perspective returns are at their lowest, and it's time for investors to act with caution. And then you see the opposite when it swings back the other way as bad things start to happen. The economy slows, the media emphasizes price drops, and it causes panic and prices to drop further. Defaults occur, credit dries up,

Starting point is 00:17:06 prices fall well below the intrinsic value, which leads to minimal risk, higher prospective returns, as even the optimists start to throw in the towel. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year,

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Starting point is 00:21:35 of cycles, we need to better understand how to deal with them so we know when to be more aggressive and when to be more defensive. Some investors believe in economic and market forecasting, but Howard Marks certainly isn't one of them. He rightly mentions that very few people can consistently rely on economic and market forecasts in order to achieve superior investment results. So we may not know where we're going, but we can try and get an idea of where we're at today. So far, Marx has covered the basic nature of cycles and the elements that influence market cycles. Things like the tendency of themes within cycles to repeat throughout history, the role of psychology and human behavior within cycles causing markets to continually rise and fall,

Starting point is 00:22:18 the tendency of cycles to reach extremes, and their tendency to eventually head back to the midpoint and overcorrect the other way. Using these insights, Marx wants to try and get an accurate picture of where we're at today in the cycle in acting counter to the crowd. Surgeon Templeton stated, to buy when others are despondently selling and sell when others are greedily buying, requires the greatest fortitude and it pays the greatest reward. One way to get a sense of how optimistic or pessimistic the market is is to simply look at various valuation metrics, such as a PE ratio on stocks, the yields on bonds, and the cap rates in real estate. The good things about these metrics is that they're an actual number, and they're based on something

Starting point is 00:22:59 that's quantified rather than just going off your gut feeling. The qualitative aspect of figuring out where you're at in the cycle is being aware of what's going on around you and taking note of how other investors are behaving. Here's an excerpt from Howard in his book The Most Important Thing, I quote. If we are alert in perspective, we can gauge the behavior of those around us, and from that judge what we should do. The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day as reported in the media.

Starting point is 00:23:29 But how many people make an effort to understand what those everyday events say about the psyches of the market participants, the investment climate, and thus what should be done in response? Simply put, we must strive to understand the implications of what's going on around us. When others are recklessly confident in buying aggressively, we should be highly cautious. When others are frightened into inaction and panicked selling, we should become more aggressive. So look around and ask yourself, are investors optimistic or pessimistic? Do the media talking heads say markets should be piled into or avoided? Are novel investment schemes readily

Starting point is 00:24:07 accepted or dismissed out of hand? Are security offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Are PE ratios high or low in the context of history and our yield spreads tight or generous? All of these factors are important and yet, None of them entails forecasting. We can make excellent investment decisions on the basis of present observations with no need to make guesses about the future. The key is to take note of things like these and let them tell you what to do. While the markets don't cry out for action along these lines every day, they do at

Starting point is 00:24:42 the extremes when their pronouncements are highly important, end quote. So like I mentioned before, to gauge the temperature of the market, Howard looks at both the quantitative and the qualitative. The quantitative being the valuation metrics of whatever asset class he's looking at, and the qualitative is being aware of his environment and how other investors are behaving. And again, he isn't forecasting. No matter where you're at in the cycle, the market is fully capable of moving in any direction, whether that be up, down, or sideways.

Starting point is 00:25:12 But that doesn't mean that all three are equally likely. Assessing the position in the cycle accurately doesn't tell you what will happen next, but it does tell you what's more and less likely, which can really be powerful as investors. Then Howard outlines how cool-headed investors were easily able to recognize the euphoria and the extremes that were happening during the tech bubble in the 2006-2007 housing bubble. For example, during the tech bubble, Webb Van Group was a business that started in 1999. They had $3.8 million in sales, $350,000 in profit in the September quarter, and the stock was valued at $7.3 billion.

Starting point is 00:25:51 Another company called VA Linux went public on December 9th at $30 a share, and it soared by 698% on the first day of trading to $239 a share, which is really just laughable considering that in 1999, the company had $17 million in sales, and its earnings were negative $14 million. Another company named Red Hat traded at 1,000 times annualized revenues. The list really goes on of these obvious excesses in the greed and the euphoria that was present in the market. Howard writes, the bottom line is that in an extreme bubble like this one, the rational investor doesn't have to make fine distinctions.

Starting point is 00:26:31 All you have to be able to do is identify nutty behavior when you see it. To me, as an observer viewing it in detached fashion from the sidelines, rather than someone with skin in the tech investing game, the events of the tech slash internet craze had the appearance of a Hans-critical. Anderson Tale. Those who participated in it wanted it to roll on forever so no one would step forward to say the emperor had no clothes. Developments like those just described were signs of mass hysteria that is present in every bubble, end quote. As I mentioned in part one of these episodes, the stock market declined by three straight years after the tech bubble in 2000, 2001, and 2002 the stock market went down. And that was the first three-year decline of the overall

Starting point is 00:27:15 market since 1929 through 1931. One would think that after the market experienced such a dramatic rise and fall of the market, that market participants would be hesitant to allow it to happen for quite some time. But a new one emerged just a few years later. Kenneth Galbraith wrote about how a new one could emerge so quickly. Contributing to Euphoria are two further factors, little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances

Starting point is 00:27:54 occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world, end quote. So a different segment of the economy, especially a different segment within Wall Street, led to the bubble in subprime mortgages through financial engineering and the packaging of these bad loans. And this together was all falsely deemed as safe because it was believed that there could never be a nationwide default on mortgages. And when I've read this piece, the key word that stands out is the word never. In a very uncertain and fragile world, you have to be very, very careful with using words like never and always.

Starting point is 00:28:40 There's another lesson that Marks drew out of the financial crisis as well. Because many investors were shying away from equities and bonds, they were easily drawn into buying mortgage-backed securities. They shied away from equities because of terrible recent performance and shying away from bonds because of historically low interest rates. So they were drawn in a mortgage-backed securities because they offered higher returns with what was sold as a similar or maybe even a lower, or even a lower, or a lower, or they were drawn to be amount of risk. Mark says that he has never seen what he calls a silver bullet play out well,

Starting point is 00:29:12 which is something that is pitched as something that offers a superior return with no additional risk. If it was true that there wasn't additional risk, then the market should, in theory, drive the price up to the point that the mispricing no longer exists. He says no investment strategy or tactic will ever deliver a high return without risk, especially to buyers lacking a high level of investing skill. Outstanding investment results can only come from exceptional skill, and then in parentheses, or perhaps in isolated moments from good luck, end quote. So Oak Tree took risk off the table before it was too late, and the prices of essentially all assets collapse in 2008. Shortly after the collapse of Lehman in 2008, Howard and co-chairman of Oak Tree Bruce Karsh

Starting point is 00:29:58 came to the conclusion that, one, no one knew how far the financial meltdown would go, and two, Negativity was certainly rampant and very possibly excessive. And then three, assets looked very, very cheap. So they came to the conclusion that if the financial world did collapse to the ground, then it really didn't matter if they bought into the fear or not because they'd have much bigger issues to worry about. And if the financial world did not end, then they would profit tremendously just like they did.

Starting point is 00:30:28 So they bought debt aggressively as they invested over half a billion dollars each week for 15 weeks straight from mid-September 2008 through the end of the year. Taking note of investors' attitudes ended up working out perfectly for them. They didn't know how bad it would get, but judging investor psychology at that time, they knew that market pessimism was about as worse as they can imagine. Now, when markets are crashing and pessimism is high, it can be really easy to say to yourself, the market keeps going down, why would I jump in now and catch a falling knife? And this is a totally normal reaction to have. If you expected that the market was going to go down by a few percentage points tomorrow,

Starting point is 00:31:08 then why would you want to buy today? Even the greatest investors like Howard Marks can't reliably time every bottom. So it's easy for investors to say they're going to wait it out and wait until the market environment looks clearer and more optimistic. But by that time, the market will be way up and it will have rebounded from where you could have originally bought it at. When things get really bad, sometimes the window of opportunity in hindsight is really, really small. If the coast is clear and markets don't look as risky, you can be pretty

Starting point is 00:31:38 certain that most of the biggest bargains have come to pass. Oak Tree strongly rejects the idea of thinking that they can try and time the bottom. The first reason is because you never know what the bottom is until you have the benefit of hindsight. There's no big flashing sign that tells you what day the bottom is going to be. By definition, a bottom can only be declared after the passage of time. The second reason they don't try to time the bottom is because during a sharp drawdown, you have massive selling pressure due to things like margin calls, and those waiting on the sidelines don't want to catch a falling knife, so you have big sell pressure relative to the amount of buyers,

Starting point is 00:32:16 which leads to falling prices. Once a bottom is found, selling pressure has found relief, so by definition, there aren't as many sellers as there were prior. So Oak Tree would rather be buying when there is overwhelming sell pressure, rather than jumping in when buyers have come back to dominate the market and push prices back up. Oak Tree's guideline for investing isn't speculating on where prices will move from day to day or week to week. Rather, they purchase when the price is trading well below its intrinsic value, and if the price keeps dropping, then they prefer to keep buying because it's an even bigger bargain.

Starting point is 00:32:51 Howard writes that all you need for investment success in this regard is an estimate of intrinsic value, the emotional fortitude to persevere, and eventually to have your estimate of value be proven correct. To round out this lengthy chapter, Howard gives some final thoughts in regards to positioning yourself during various points in the cycle. Investors generally take on two kinds of risks that he outlines here. The first risk being the risk of losing money. And the second risk is more subtle, the risk of missing opportunity. You can eliminate either risk, but doing so exposes you to the other. So an investor should decide some sort of normal stance to balance out the two, which depends on your goals, your circumstances, your personality, and your ability to withstand risk. And then the stance or normal posture, it can be adjusted based on where you're at in the cycle if you feel like you've gained an insight and you can bear the possibility of being wrong by acting on that insight.

Starting point is 00:33:48 Ideally, when the market is high, you want to limit your potential to lose money and when the market is low, you want to limit your risk of misconduct. opportunity. One thought experiment he proposes here is to put yourself, say, five years into the future. So today I'm recording this in June 2023. Think five years ahead to June 2028 and ask yourself, is it more likely you wished you had been more aggressive or more defensive during this time period? So think about what you might say a few years down the road whenever you're in extreme points of a market cycle and that'll help you determine what you think is the best action. I think this is a good reminder to think about the big picture and think long term rather than getting caught up on what's happening in the day to day that may cause some people to act based on their emotions and act based on how they're feeling in that moment. In Chapter 15, Howard touches more on how we can position ourselves during cycles.

Starting point is 00:34:44 Since making superior investment decisions can be really difficult, we want to be careful to try and make decisions that tilt the odds heavily in our favor. When you consider this in the context of cycles, a lot of the time we're in a fairly normal part of the cycle, which I would say is somewhere close to the trend line or generally close. When you get to the extreme points like where we were for some asset classes in 1999, 2007, 2021, these were the high points in an extreme cycle. And then 2002, 2008-2009, and then 2020, these were on the opposite side, and they were sort of the compitulation in the bottoms in the markets. And this is when Marks is looking to make some major or larger changes in his portfolio

Starting point is 00:35:29 because he's oftentimes able to recognize when we're somewhere close to or we're around an extreme point in the cycle. This is when he's able to tilt the odds heavily in his favor. The reason it's important to take action at the extremes is because that is when he's most able to heavily tilt the odds in his favor. When you're somewhere around the trend line, the odds really aren't. aren't heavily tilted either way, and there may be a higher likelihood of you being wrong in your assessment based on where you're at in the cycle if you're close to the trend line.

Starting point is 00:35:59 It reminds me of Charlie Munger talking about how truly great opportunities are rare, and you need to be able to recognize these opportunities when they come along and act in size when they do. The market extremes might come maybe only once in a decade, but when they do, they are highly profitable for superior investors who recognize the cycle, they're able to accurately assess the intrinsic value of an asset, and they buy it when it's trading at a large discount to that intrinsic value. Howard mentions that positioning Oak Tree's portfolio based on the major cycles has been a big contributor to the firm's success. They became aggressive in the early 90s in 2002 and in 2008, and they became defensive in 94, 95, 2005, 2006, and they've been

Starting point is 00:36:42 largely right in recognizing the extremes. But he rightly points out that it's by no means easy, and he doesn't want to give that impression that it is easy. Interestingly, Howard has a chapter here on the cycle of success as well, Chapter 16. I love this because he links the concept of market cycles to other walks of life, because really, cycles are really everywhere. Even with the best investors, they see their success come and go, as they won't be successful all the time. As Howard mentioned earlier in the book, success carries within itself the seeds of failure,

Starting point is 00:37:16 and failure carries with it the seeds of success. Another way you put it is that success isn't good for most people. Success can actually change people and usually change them in a way that isn't good for them or not for the better. You can think about how someone reaches some level of success in their life. They start a business and then the business makes them financially independent. Well, now that person may have a really difficult time coming up with the motivation to take that success to new heights and new levels.

Starting point is 00:37:44 where you think about a business like Blockbuster, this business took off and it sees tremendous success, but they fail to adapt to the changing times with the rise of the internet. Jeff Booth has this line that instead of adapting to the rise of Netflix, Blockbuster decided to add candy to their aisles to try and increase their sales. It's human nature to not want to make drastic changes, but that's what's required in the fiercely competitive and fiercely capitalistic world that we live in. When Howard says that success carries within itself the seeds of failure, it's because when people become successful, they can be tricked into thinking that it's easy, and they take

Starting point is 00:38:22 it for granted. For example, people tend to confuse brains with the bull market, and don't consider the way luck played into that success. And they might even think that they no longer need to do proper risk management. And it's a good reminder to be humble. You never know when your success or when your luck may turn against you, whether that be because of poor decision-making or things just simply totally outside of your control. Always remain humble.

Starting point is 00:38:47 We can also think about how different segments or areas of the market become really popular, and they get a lot of people's attention. No sector or asset class can outperform the market into perpetuity, and no investment strategy is likely to continue to work well all the time. During the late 90s, people were enthusiastic about tech stocks. In the mid-2000s, it was real estate. In the 2010s, we saw the rise of the fang stocks, and in 2021, we saw the rise of things like cryptocurrencies and other up-and-coming tech companies.

Starting point is 00:39:18 Howard writes that one essential truth about investing is that, generally speaking, good results will bring more money to hot money managers and strategies, and if allowed to grow unchecked, more money will bring actually bad performance. Once a certain segment produces unusual profitability, it's going to attract incremental capital until it becomes overcrowded and fully institutionalized, and this will push down prospective returns towards the mean to correct that mispricing. On the flip side, assets that perform poorly for a while, they'll become so cheap, and due to their depressed prices and lack of investor enthusiasm, they will be primed to outperform on a relative basis. The bottom line, Howard states,

Starting point is 00:40:00 is that nothing works forever. When people start truly believing that a strategy will keep working forever, very time that it'll become certain not to. He has this wonderful quote that, in investing, everything that's important is counterintuitive, and everything that's obvious to everyone is wrong. One famous example was the Business Week magazine publishing the story titled The Death of Equities in 1979 after a decade of poor performance. The symbol logic was that stocks weren't popular and interest was low. Thus, they will remain low because institutions and pension funds were much more interested in

Starting point is 00:40:37 interested in hard assets like gold. First level thinking says that stocks haven't done well, and they aren't popular, so they'll continue to not do well. Second level thinking says that stocks haven't done well, and no one cares to touch them. Thus, there must be some good bargains available somewhere in the equity markets. At the time the article was published, the S&P 500 traded at $107, and it rose to 1527 by March of 2000, which is an average annual return of 13.7% over that 21-year period. The lesson is to be leery of popular assets, because unpopularity is a buyer's friend. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:44:26 risks, charges, and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. He has a section here talking about the tendency of companies rising and falling and he talks about Xerox, which I won't go directly into here, the story.

Starting point is 00:44:46 When a company rises to unprecedented heights, the natural tendency is to become complacent, bureaucratic, and slow-moving, innovation is lost, and thus, they aren't able to release new breakthrough products to push for continued growth, and these giants tend to also assume that they can venture into any industry because they think they're special. But just like how success carries a seeds of failure, failure can also carry the seeds of success. Once a company realizes that they're under attack from competition, then that can stem motivation and a sense of purpose can be regained. They can make changes, they can shut out the bureaucratic excess, and they can cut

Starting point is 00:45:24 unprofitable business units and get serious about regaining that market share. When reading about a company like Xerox and looking at their stock chart, it's another good reminder to remain humble. One of your biggest stock winners today may eventually see its downfall because for every great company seeing their profits increase year after year, there are many other companies out there working really, really hard to try and get their piece of the pie and create a product or service that's better. And you can think about as investors, once we realize one or two big investment successes in choosing the right stock or the right investment, it's really easy to think we've got the game figured out. And we can be willy-nilly in choosing our next investments or becoming

Starting point is 00:46:04 overconfident and doubling down on something that has gotten really popular. Nothing has made me personally more humble than experiencing a giant boom and bust for myself and watching what felt like easy gains turn into fast losses. And it makes you realize that you probably aren't as smart as you maybe think you are. Good times counterintuitively can produce bad times. And with anything in life, don't ignore the cyclical nature of things, whether you're currently at the upswing or currently in the midst of a down swing. Nature tends to bring things back the other way, and you want the general direction, of course, to be up, at least when you're talking about your investments. The final two chapters here cover the future of cycles and the essence of cycles before we

Starting point is 00:46:47 wrap up the book. Mark speaks of past times in history when leaders believe that, that we've entered a new era, and cycles of the past weren't expected to be repeated. But it's the belief that cycles don't matter or cycles won't ever happen again that helps create the bubble in the crash to follow. In Howard's piece titled, Will It Be Different This Time? He writes, of course, what these observations signaled wasn't that cycles wouldn't repeat, but rather that the onlookers had grown too overconfident. Cycles in economies, companies, and markets will continue to occur, at least as long as

Starting point is 00:47:21 people are involved in making the decisions, which I believe means forever. 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, end quote. The main reason that cycles will continue as they have is because humans, as we've mentioned many times here, humans are a key component of markets. Scientists can predict the movement of atoms, but they can't precisely predict the actions of human beings that are highly influenced by their own personal emotions. Human emotion

Starting point is 00:48:04 in human psychology is what drives bull and bare markets, and that aspect really cannot be removed from the equation, no matter how much we'd like it to. Humans are emotional and they're inconsistent, and they're not steady and they're not clinical. In Howard's last chapter brings everything together and he summarizes the most important points from the book, I loved the connection he made here related to the stock market being like a lottery or a parlay betting system. I quote, investment success is like the choosing of a lottery winner. Both are determined by one ticket, which is the outcome. And it's being pulled from a bowl full of tickets which represent the range of possible outcomes. In each case, one outcome is chosen from among the

Starting point is 00:48:47 many possibilities. Superior investors are people who have a better sense for what tickets are in the bowl and thus for whether it's worth participating in that lottery. In other words, while superior investors like everyone else don't know exactly what the future holds, they do have an above-average understanding of future tendencies, end quote. I just find this to be such an interesting way to view the world and a good reminder that not every investment is going to turn out how you'd like and you need to try and diversify across a number of different bets to prevent that risk of ruin. And as it relates to cycles, your odds are changing as your position in the cycle changes. As valuations march higher, then your odds aren't as good.

Starting point is 00:49:26 And as valuation multiples drop, then your odds tend to improve as people become too pessimistic. This last chapter hits on a lot of what I've already covered during this two-part series, so I thought I'd transition to a clip of Howard's most recent interview on our channel with Trey Long. That was released in mid-April of 2023 this year, episode number 545. Really great episode. And I just wanted to play a few clips here from that chat with Howard. Having read this book, I find it really interesting to think about where we're at in today's market.

Starting point is 00:49:59 And that's what everyone wants to know. Since our economy is largely driven by credit and lending, one might generally expect, like I did, that interest rates moving from near zero to 5% would cause massive reports. effects throughout the economy. But as I record today, surprisingly, the S&P 500 is only 7% off its all-time high. I can't even believe I'm really saying that, and I can't believe the chart, but it's only 7% off its all-time high. So I wanted to play a clip here with Howard's assessment of what he's seeing in the market cycle today from that interview. I know that you're not one to make market forecasts. And in your 54 years of investing, you've only made five real market

Starting point is 00:50:40 calls, which have all come to pass. And in your latest memo, C-change, you list two major C-changes that you've experienced along the way and make a prediction that a third is currently underway. You are a master of market cycles. And Ray Dalio has recently been out there saying we're in the 12th major market cycle. I'd love it if you could outline for us how a C-Change differs from normal market cyclicality, which two prior events qualified in the past as a C-Change. and what you're seeing today that's giving this level of conviction. Sure. You know, back in 2017, I was writing a book called The Mastering the Market Cycle, which I'm

Starting point is 00:51:21 happy to see on your shelf. And, you know, I've been a student of cycles, observer and user of cycles, you know, for a long time as you cite. And yet, when I got two-thirds of the way through writing that book, I said to me, myself, I wonder why we have cycles. Why don't things just go in a straight line? If the economy grows 2% every year on average, why does it just grow 2% every year? Why sometimes 3 and sometimes 1 and sometimes 4 and sometimes negative?

Starting point is 00:51:51 The stock market, the S&P 500, has risen at about 10% a year on average for the last 100 years. Why does it just go up 10% every year? And in fact, Trey, why does it almost never return between 8 and 12? If the average is 10, why don't we see some 8s, 9s, and 11? and 12s. And the answer is that cycles, in my opinion, occur because people take things too far. When things are going well, they turn optimistic. And then they become too optimistic. And then they do things which are unsustainable. And so then eventually the events become less optimistic. The people become less optimistic. And they kind of reverse their prior actions, whether it be

Starting point is 00:52:35 the decision to build a factory or a decision to buy a stock, whatever it might be. And when the overly optimistic or actions are reversed, very often the actions are too pessimistic. And so I concluded that we have a trend line, let's say it's the 2% of the economy, but then optimism takes over and we do above trend. But then people say, no, that's unsustainable and it corrects back toward the trend, but through the trend, because psychology goes too far, to an excess on the negative side, and that corrects back toward the trend, but goes through it toward an excess on the positive side. So I think that cycles are very useful in thinking about excesses and correction.

Starting point is 00:53:15 They are, for the most part, the operation of the traditional machine, be it the economy of the market, with some novel events thrown in from exogenous territory, but just going too far and then correcting in both directions, normal operation with normal excesses and normal corrections. A C-change in my way of thinking is a change in the machine, in the fundamentals of the machine. People are going to do things differently post the C-change than how they did it before. So in the memo, I talk about the two important C-change that I feel I've lived through and worked through. The first occurred in the late 70s. I started this business in the late 60s, and at that time, a fiduciary was somebody who would buy high quality assets for the beneficiaries,

Starting point is 00:54:12 trust, whatever it is. And you could not be criticized for buying quality that was too high. You could be criticized for buying quality that was too low. And in fact, under the right circumstances, if a fiduciary bought 10 risky assets, if 10, if nine of them were up 10x and the 10th one lost 5%, the fiduciary could be surcharge for having bought a risky asset and made to pay. So the job of the fiduciary was to avoid low quality. Then around 7778, Michael Milken and others had the idea that the prohibition on issuing below investment grade debt was excessive. And rather than consist of a blanket prohibition,

Starting point is 00:54:59 there should be an understanding that they're risky. Because they're risky, they have to appear to offer a higher return as an indebt. inducement, but if the promised return seems adequate for the risk, then that's a reasonable thing for a fiduciary to do. So this was a big change. This was a sea change, you know. You go from, there are good assets and bad assets, and you can't buy bad assets, to you can buy any asset, no matter how risky it is, as long as a prudent professional would say that the prospective return compensates for the risk. Big change. Risk return thinking. And I dare say that it's risk return thinking that governs everything we do today. And nobody declines to buy anything just because it's

Starting point is 00:55:40 low quality, but because it's too risky for the return that seems to be offered. Big change, big change. And we wouldn't have hedge funds, venture capital, private equity, and all the derivatives at the institutional level if the old fiduciary rules were still in force. So shifting to thinking about risk and return together really has made the investment universe of today unrecognizable from 50 years ago. The other C change I lived through came right around the same time, not connected, I don't think, by anything underlying. But in 1980, I had a loan outstanding from a bank in Chicago, and they sent me a slip of paper, as they did when rates changed. And they said the rate on your loan is now 22 and a quarter percent, 1980, December. 40 years later,

Starting point is 00:56:29 I was able to borrow at 2.5% fixed for 15 years. Well, this is a major change. And first of all, declining interest rates have a number of very strong impacts. They stimulate the economy. They make it easier for companies to make money. They make assets worth more. And, of course, they reduce the cost of borrowing. So these events of those 40 years made it very, very, very,

Starting point is 00:56:59 very attractive for asset owners and for borrowers. And people who borrowed money to buy assets got a double bonus. And this was the overwhelming condition over this period. And it's not a coincidence that this is when private equity in particular had its great success because that's what it does. You borrow money to buy assets. The assets, as it happened, turned out to be worth more than you thought they would, and the cost of borrowing to buy them turned out to be less than you thought it would be. What a great combination. And so that, and I believe, there's a couple of things worth noting. Number one, I think that this decline in interest rates was the biggest single event of the last 45 years in the financial world. Most people wouldn't say that. Why?

Starting point is 00:57:48 Because it was very gradual over a long period of time. Kind of like the frog in the pot of water. You know, you put a frog in a pot of boiling water, he'll jump right out. But if you put them in a cool water and you turn on the heat, he'll just sit there while it gets hot and eventually he'll succumb. Because he doesn't notice that it's taking place so gradually. And I think that's what happened with rates. They change so gradually that people, I mean, if you sent out a questionnaire, what was the most important event the last 45 years in the world if it has? I don't think anybody would say they would say derivatives, high yield bonds, private equity. very few, I think, would say the decline in interest rates.

Starting point is 00:58:25 So a couple of other things worth noting. Number one, that means that in order to have seen a more normal period, you had to be working in the 70s or maybe in the 60s. In the 70s, of course, we had the battle against inflation. So that wasn't a typical period. The 60s may have been something we would call normal. But that was obviously the 60s ended 53 years ago. So not too many people who worked in the 60s are still working today.

Starting point is 00:58:52 And I believe that the declining interest rates were responsible for the majority of all the money that's been made in the last 45 years. So that's pretty important. Those are my candidates for seed changes. Obviously, not just a normal cyclical up and down, not just an access and a garage. But a replumbing of the whole environment. So a couple of things stick out here. As someone myself that wants to find high-quality businesses to invest in at a reasonable, price, his remarks are a good reminder that prudent investors should still be very mindful of the

Starting point is 00:59:27 prices that you're paying. If the prospective return doesn't compensate for the level of risk, then the odds are not in your favor, and it's not a bet worth making. Also, Howard's piece on the sea change relates to the change in the level of interest rates, meaning that we may have a tougher time receiving similar returns to what we've seen in the past decade, because companies generally will have a harder time growing without having that. tailwind of ultra-low interest rates, which is almost like having free money at your disposal. Apple is one example of a company that just became this massive business. They were able to take on a bunch of debt at low interest rates and just buy back shares in their own company.

Starting point is 01:00:08 Economically, it just made so much sense for them to do that, given how robust their business is and how attractive the interest rates were at the time to take on that debt. And since we as investors naturally have some recency bias, Howard also talks about how since we, we have some recency bias, how the era of ultra-low interest rates is over, what worked so well during that era likely isn't going to be what works in the era that we're entering. This is why we need to use some level of caution and account for a margin of error or margin of safety in our investing approach because the world today, as much as ever, is fundamentally uncertain. And the future may not come to play out as we expect. And this is the type of things I talked about in my interview with Scott

Starting point is 01:00:47 Patterson on episode 558. Next, I wanted to play a clip here of how, how we're going to play a clip here of Howard's view on the level of caution investors should have today in light of where we're at in the current cycle. I'm curious how your opinion on investing with caution has changed in recent months. Is it the new definition of caution to a degree or a different type of caution that you're now investing with? Well, there are lots of kinds of caution. And for me, caution means insisting on a margin of safety. You know, not many of us are so dumb. that we will make investments that would suffer if things stay the way they are. But if a cautious investor insists on margin of safety or margin of error or whatever you want to call it, what he's saying

Starting point is 01:01:34 is, I want to make sure that if things get worse, then I think they will, I'll still be okay. And so I think that that's a very important part of being a cautious investor because, you know, from time to time, things will be worse than you had thought, how will you do? That's a key question. Now, when the market's flying high and valuations are stretched and all opinions are loaded down with optimism, clearly you need a lot of caution because there's so much potential for things to come in worse than expected. When the market's really low in its cycle, there's not much risk of that. There's no optimism in prices. Nobody thinks anything good is going to happen. So you're not at risk of overestimating the situation and being disappointed to the same extent.

Starting point is 01:02:23 So the thesis of mastering the market cycle is that your actions should be determined by where the market stands in its cycle, to the extent you can figure that out. And when it's high, you should be cautious. And when it's low, you should be aggressive. And, you know, I still feel the same about that. At Oakry, we have, I would say, a cautious bias. every investor and every investment portfolio embodies a mix of aggressiveness and defensiveness. Well, you say, I want to be defensive so that if things go badly, I wouldn't suffer too much. But on the other hand, I don't want to miss all the opportunities, so I'm going to have some

Starting point is 01:03:01 aggressiveness. And the question of how you strike the balance between aggressiveness and defensiveness for me is question number one in the short or intermediate term. And when the market is, I think the market's in moderate territory. So I'd like to keep the same in their normal balance, which for Oak Tree means a cautious balance. And, you know, we charted our course many years ago as saying that what we're going to deliver is lots of good years, maybe an occasional great year, but hopefully never a terrible one. And if you can just do that combination, which I think we've done, and you can do it for 40 or 50 years, then I think you've really accomplished something. And then to round out this episode, I wanted to play one more clip from Howard that I think is a really good one to leave our audience with. Here it goes.

Starting point is 01:03:49 What is the least important thing when it comes to investing? I'm glad you asked that. Very few people ask that. And I happen to have written a memo in November, I believe, entitled, What Really Matter? And first, I talk about a bunch of things that, in my opinion, don't matter. Short-term events, short-term trading, short-term performance, volatility, hyperactivity. These are things that don't matter, that don't add to your long-term success and that you shouldn't emphasize. But, of course, these are the things that most people spend all their time on. You go into a committee, you know, I've been on a lot of investment committees for nonprofits. And you go into the meeting and they spend the first 45 minutes discussing the performance in the last quarter.

Starting point is 01:04:37 Why? It's over. Nothing you do about it. Well, you might say there's stuff you can figure out to do in the future. Yeah, but you almost never see anybody taking any strong action based on what happened last quarter, changing their portfolio. Most people never changed their portfolio wholesale. And, you know, they spend 45 minutes because they think it's their job. Well, why is it your job? Well, I'm a fiduciary. You got to care. Well, yeah, but it's over. you know and there was a great quote from a guy named Ian Wilson who was head of GE one of my favorites nowadays he said something like there is no degree of sophistication that you will get around the fact that all your knowledge is with regards to the past and all your decisions are with regards to the future so studying the past as a way of figuring out what you could do in the future

Starting point is 01:05:23 has severe limitations and I would rather go with fundamentals I'd rather say which companies can I buy a piece of that will become most value, more valuable over the years and decades, and which companies can I lend money to that have the highest probability of paying me back? And those things have nothing to do with GDP forecasts, interest rates, recession, inflation. So, you know, I wrote that memo. Almost nobody said a word about it. I think it's one of the most important things, ones I've written. And I hope the readers will take a look.

Starting point is 01:05:56 By the way, all the memos are available on the Oak Tree website, Oak Tree Capital website, on the heading of something called Insights. Hopefully they have Insight. But the great thing is that the price is right, because they're all free. And I hope people will take a look. All right. Well, that wraps up today's episode covering Howard Marks's book, mastering the market cycle. I hope you enjoyed this two-part series as much as I enjoyed putting it together for you.

Starting point is 01:06:22 If you happen to miss part one, you can check that out in our podcast feed here. that is episode number 559. And by the way, if you've been enjoying the show, if you'd leave us a rating or review on the podcast app you're on, that will really help us continue to deliver this great content to you for free. Thanks again for tuning in, and I really hope to see you again next week. Thank you for listening to TIP.

Starting point is 01:06:45 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.

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We Study Billionaires - The Investor’s Podcast Network - TIP562: How to Cope With Market Cycles

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