Building on his ideas about cycles, Howard Marks (Trades, Portfolio) next turned to the concept of the pendulum in his book, “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor.”
The pendulum refers to mood swings in the markets, up and down, as in cycles. The midpoint of the pendulum is the “on-average” point, although it spends little time at this point. That’s because it normally swings up or down, away from its extremes.
It relentlessly moves toward extremes, but once reaching an extreme the pendulum races off again in the other direction. Marks said, “In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.” As he noted in a 1991 memo to clients, most investors swing with the pendulum:
- From euphoria to depression.
- From cheering the positive to obsessing over the negatives.
- As a result, they operate in overpriced and underpriced markets.
He called this “one of the most dependable features of the investment world” and noted investor psychology is more frequently found at the extremes than at the “on-average” point.
When he revisited the subject 13 years later, he added several other perspectives:
- Greed versus fear.
- An optimistic versus a pessimistic lens.
- Credulousness versus skepticism.
- Risk tolerance versus risk aversion.
Note that the last three of these perspectives commonly appear in many of the market fluctuations. Marks tied risk aversion to rational markets and too much risk tolerance to the development of bubbles. Further, when bubbles burst and markets crash, too much risk aversion prevents many investors from buying bargains.
In a 2004 memo, he wrote:
“In my opinion, the greed/fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk.”
And, again he takes on finance theory, which he argued depends too much on the assumption that investors are risk-averse and thus demand higher returns for greater risk. Marks’ objection is that investors also ignore the need for higher returns in bullish markets. They become comfortable with risk and pay a premium, which is to say they overpay when buying assets such as stocks.
He also reported he had “boiled down” the main risks of investing into two elements:
- Risk of losing money.
- Risk of missing opportunities.
Investors may eliminate either one or the other, but not both. In an ideal world, he added, investors would be able to balance those concerns; usually, though, they are at one extreme or the other. For example, between 2005 and early 2007, they were ebullient, with many believing “risk had been banished.” At that time, they worried they might miss an opportunity. In late 2007 and 2008 they believed exactly the opposite, that the markets would melt down and they would lose their capital.
So, how do we know whether we should worry about missing opportunities — or about losing money? Marks offered what he had learned from a veteran investor early in his career. It was about the three stages of a bull market (and an implied entry/exit strategy):
- A small number of forward-looking investors believe there is cause for optimism.
- Most investors recognize that improvement really is occurring.
- Everyone knows that things will keep on getting better, forever.
Building on that, Marks argued that changes in investor psychology — and not in the fundamentals — are responsible for most short-term price fluctuations. At the bottom of a downward trend, investor psychology keeps would-be investors out of the market because things look bad to them.
Gradually, though, the market and economy look less threatened, and they come back into the market, paying fair prices. Once comfortable, they want more and bid up prices, regardless of valuations. Good times are extrapolated far into the future. And, as we know, the good times do roll on—until they stop without warning.
Thirty-five years after learning about the stages of a bull market, Marks came up with his own three stages of a bear market:
- A few forward-looking investors realize the good times cannot continue a lot longer.
- Most investors realize markets are deteriorating.
- Everyone believes that conditions can only get worse.
When Marks first wrote out the three stages of a bear market, it was March 2008. He believed at that time that the financial system was in stage 2 (most investors realize markets are deteriorating). Just six months later, the system went into stage 3, a real meltdown in this case. This swing of the pendulum produced price declines that he described as the worst he had ever seen. At such times, it does seem that conditions can only get worse, but as we know in hindsight, a recovery (the first stage of a bull market) was on its way.
Marks didn't touch on this explicitly, but the pendulum is one of two time-based creators of bargain prices; the other is short-term pricing aberrations. The pendulum does this is in a more deliberate way, while short-term pricing does it in a more opportunistic way. Thus, patient value investors can wait for the markets to do their work for them: creating discounted stocks and then pushing their value up over time. It is a slow-but-steady strategy to generate above-average returns.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
