the fifth most important takeaway from
Howard Marks mastering the market cycle
is to understand tendencies Brian has
been investing in the stock market for a
few years now ultimately he wants to be
able to live on his investment income so
that he can spend more time with family
and friends and less on his tedious
nine-to-five lately it seems like he
will have to work forever though as his
timing in the stock market has been well
let's say less than optimal his
portfolio took a serious hit in late
2018 apparently due to some trade war
between the US and China which made him
sell most of his stocks he just couldn't
stand looking at those red figures every
morning watching his hard-earned money
to slip away but apparently he should
have stayed with his stocks or even
invested more money because just a few
months later the market was hitting new
highs brian is now investing again but
he feels confused about whether to put
more of a savings into the market or to
take some of it out what if his
portfolio loses 20% again but worse what
if something like the financial crisis
is knocking on the door but he doesn't
know about it
Brian wants to be able to tell with
certainty if we are heading for a bull
or bear market and act accordingly in
other words he wants to master the
market cycle luckily for Brian there is
a way when market swings can become
friend rod than foe but first and
foremost some of his wording must be
examined in investing no one can ever
tell with certainty what will happen but
it is possible to talk about what is
more likely to happen and that makes all
the difference
let me show an example Brian gets the
opportunity to participate in one of
three different lotteries the three
lotteries follow the same rules at the
cost of a thousand dollars he gets to
draw one marble from a bag filled with
ten marbles if he draws a green one he
gets $3,000
if he draws a yellow one he gets his
money back or a thousand dollars and if
he draws a red one he gets nothing
which lottery should he participate in
laundry a has an expected payoff of $500
per marble drawn lottery B is a zero-sum
game and laundry C has a - $500 payoff
so picking lottery a would be the
correct answer however notice that even
if Brian identifies that laundry a is
the superior one is in no way guaranteed
to win money but there is a tendency for
it it could draw a red marble but it's
not very likely it's the same in
investing the superior investor is able
to tell which stock that has a higher
probability of returning a profit or in
other words he is able to tell which
marbles the bags hold the Mary ocher
investor on the other hand just picks a
bag at random there are times when
choosing a bag becomes quite simple
though we need the stocks of many ocher
companies can be expected to yield high
returns and then there are times when
pretty much all bags should be avoided
when even stocks of superior companies
are expected to yield negative returns
Brian
must now learn when the tendencies are
in his favor and when they are turned
against him number 4 introducing cycles
when Brian saw his portfolio crushed by
20% in late 2018 only for it to regain
more than that in the coming months well
hadn't he sold that is he witnessed a
stock market cycle in action but
thinking back he has seen this behavior
before he has a vague memory about how a
friend of his father made millions of
dollars in dot-com companies only to
lose it all in a later market crash and
he remembers the boom of new homeowners
that was later followed by newspaper
headlines about how the financial system
might implode the stock market is in the
only system that shows this type of
cyclical behavior seasonality and the
weather works like this many phenomena
in physics behave this way and even
success in one's life can be argued to
follow this pattern a cycle oscillates
around a so-called secular trend
midpoint or something which can be
viewed as reasonable in the stock market
the secular trend is rising and it's
made up of the underlying growth in
profits of businesses plus their
dividends most cycles show the following
behavior a a reversion to the mean from
an excessive low B the continuation past
midpoint towards an extreme high C
reaching high D a reversion to the mean
again this time from an excessive high e
the continuation past the midpoint
towards an extreme low F reaching a low
G and then once again a reversion to the
mean an important remark here is that
these events aren't just following each
other they are causing each other the
stock market is like a pendulum it
swings from optimism greed and high
prices to pessimism fear and low prices
and then back again greed and optimism
cannot continue ad infinitum it cannot
deviate forever from the secular trend
stocks become too expensive relative to
their earnings and when investors turn
more risk-averse the next crash or
correction comes knocking Warren Buffett
probably the greatest investor of all
time concludes that what the wise do in
the beginning fools do in the end it
won't always look as neat as in the
illustration are made here but to keep
stealing from others who know how to
express themselves better than me
Mark Twain said history doesn't repeat
itself but it does rhyme at the extreme
highs most stocks are
by bags of marbles like these while at
the extreme lows most are represented by
bags like these Brian wants to learn how
to identify these excessive highs and
excessive lows in the market cycle but
first he must learn that the stock
market does not function in isolation
number three what influences the market
cycle the pattern of ups and downs in
the stock market is a very dependable
one much like another cyclical
phenomenon but it does not work in
isolation rather it's influenced by four
other major cycles the economic cycle
the main measurement here is the GDP or
gross domestic product of a country it's
can be determined by multiplying two
variables number of hours worked and
productivity per hour the GDP of the USA
has been growing by about 2% per year
during the last decade and as an
investor Brian should be particularly
aware of deviations from this swings in
the economic cycle are caused by
demographic movements the unemployment
rates and globalization among other
things the cycle in profits the profits
of businesses are one of the main
components determining prices in the
stock market Brian knows about the most
commonly used indicator to determine if
prices are high or low the price to
earnings ratio the total sales of all
companies in a country is per definition
equal to the GDP of that same country
but profits fluctuate more than sales -
the reason for this is because of
leverage both in operations and in the
financing of a company the credit cycle
why is credit so important to companies
in the stock market a because it could
be used to speed up growth and B because
it is necessary to roll over old credit
not having access to new debt can cause
some companies to default when they are
required to fulfill their old
obligations I think it is both a bit
funny and bit frightening that most
people and companies don't plan to repay
their debts I was at a lecture with one
of Sweden's greatest real estate
investors he Eric saloon when he said 28
years ago I borrowed two million dollars
from the bank to pay for my first real
estate property little did they know
that 28 years later not only would the
loan not have been repaid but increased
to about a billion dollars instead at
times it's easy for companies to get
financing but at other times the credit
doors are slammed shut
Howard Marks explains prosperity brings
expanded lending which leads to unwise
lending which produces large losses
which makes lenders stop lending which
ends prosperity and on and on the cycle
in psychology / attitude towards risk or
before you miss out is replaced by so
before it goes to zero and vice versa
psychology is the main reason for swings
in the stock market when the financial
community is euphoric it becomes risk
tolerant and overlooks bad news when it
is depressed it becomes risk-averse and
expects that the world could end
assessing where attitudes towards risk
currently are is probably the most
important part for Brian to recognize
where we currently stand in the market
cycle
okay sir prices in the market cycle are
determined by two first fundamentals
such as the swings in the economic
profit and credit cycles and psychology
through the cycle in attitude towards
risk but how does this help mean
identifying the excessive highs and lows
of the market let's check it out number
two
taking the temperature of the market the
key steps in determining where in the
market cycle we stand can be divided
into two first Brian should look at
evaluations of the stock market and see
if they are out of line compared to what
they've been historically this is a
pre-requisite if there are no deviations
the market is probably not excessively
high or low and in that case there's no
need for the second step second Brian
must establish an awareness of what goes
on around him in the investing community
how do other investors feel about risk
the first step is quite simple the most
commonly used metric for evaluation in
the stock market is the price to
earnings ratio or how much investors
currently are willing to pay for $1.00
in yearly earnings Brian finds this
information at multiple comm and
recognizes that the p/e of today is at
twenty two point nine which could be
argued to be in excessive territory next
he examines this table for each pair he
checks the one which he thinks best
describes the current market if most of
his checks are in the left-hand column
we are probably at an excessive high and
vice-versa
these points are non quantifiable and
non-scientific
which is a good thing because otherwise
the skill to identify highs and lows
wouldn't be as profitable as it is a key
insight here is that Bryan needs no
forecasting to do this no guesses about
the future only observations of the here
and now sweets
now that Bryan knows how to identify
highs and lows it's time for him to
learn how to respond properly to that
information and finally number one
aggressiveness versus defensiveness
this graph shows quite well what the
stock market is typically expected to
return if Ryan has a good reason to
believe that we are currently in an
excessively low market he could tilt his
portfolio to be more aggressive he could
risk more of his capital hold lower
quality companies make investments that
are highly dependable on a good
macroeconomic outcome or use financial
leverage with an aggressive portfolio
like this he has made both very
profitable swings and very costly swings
more likely luckily as he now knows how
to take the temperature of the market
he's assured that there's a tendency for
positive outcome the difference between
the two curves is how much extra Bryan
can make by favoring this aggressive
play rather than a passive one should he
turn out to be right but what if Bryan
believes that we are currently in an
excessively high market then he could
tilt this portfolio to be more defensive
instead he could hold cash instead of
stocks invest in safer assets such as
high-quality corporate bonds and
Treasury bills by strong companies that
are in cyclical and stay away from
financial leverage with the defensive
portfolio he has made both very
profitable swings and very costly swings
less likely as he knows that there's a
tendency for a negative development
this is how much he can earn or perhaps
save is the better word should he turn
out to be proven right Brian now knows
how to master the market cycle and going
forward he will be able to profit from
market swings for other than crashing
and quitting from them but mastering the
market cycle is only one of the most
important things when fishing for stocks
according to Howard Marks check out my
summary of marks other book the most
important thing to learn about other
ones that are just as important
like contrarian ism for instance cheers
guys