No one, I’m sure, would argue with the proposition that much of the market is materially affected by economic cycles, those ups and downs that are inevitable, influence our investing performance and remain largely unpredictable.
So it would help to know where we are in a cycle, and that’s the subject of chapter 15 of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor.” Author Howard Marks (Trades, Portfolio) wrote:
“So we have to cope with a force that will have great impact but is largely unknowable. What, then, are we to do about cycles? The question is of vital importance, but the obvious answers—as so often—are not the right ones.”
The first potential response is to ignore the idea cycles are unpredictable and apply even more time and money toward predicting the future. Given the huge number of variables, however, we could only conclude they are inevitable and that few people know more than the consensus.
Second, we might surrender all attempts to make sense of cycles and just ignore them. That can be done by buying good stocks or other investments and holding them for long periods, the buy-and-hold strategy.
Third, and this is the approach Marks favors, is to try to understand where we are within each cycle, and what the implications are. Ideally, that would allow us to move in sync with the cycle or pendulum and make the right moves at the right time. But that’s more aspirational than achievable. What Marks suggests instead is to:
- Be ready when the market might reach an extreme.
- Adjust our behavior accordingly.
- Refuse to follow the herd at the tops and bottoms of cycles.
Knowing the present may be difficult, but is not impossible (unlike the future). In Marks’ words, we need to “take the market’s temperature.” More specifically, “If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do.”
What can we infer from the daily flow of news and trivia about the psychology of other investors and the investment climate? From our inferences, what actions should we take? These are some of the issues we might follow:
- The pessimism or optimism of investors.
- The broad consensus of experts in the media.
- How the market responds to “novel investment schemes.”
- Are there lots of get-rich-quick ideas?
- The level of capital available at this stage of the market cycle.
- The level of price-earnings ratios “in the context of history” and the state yield spreads.
Marks pointed out these issues are all important, and none of them involves forecasting. With these six questions, an investor can make “excellent” decisions without guessing at the future. They are particularly important at the tops and bottoms of cycles.
To illustrate these points, he turned to the financial crisis of 2007-08, and the years leading up to it:
- Lots of “unconscious” risk taking.
- Money shifted from stocks and bonds to “alternative investments” such as private equity “in amounts sufficient to doom them to failure.”
- The notion that homes and real estate were bound to be profitable and a hedge against inflation.
- Easy access to capital, including loose terms and low interest rates.
When all those factors are considered, and it’s certainly easier with hindsight, the inference could be made that sources of capital were competing to place their funds instead of being disciplined about proper protection and commensurate rewards.
From another perspective, greed was getting ahead of fear. In part, that was due to the belief risk had been eliminated thanks to “securitization, tranching, selling onward, disintermediation and decoupling.” The belief originated with the idea risk could be divided into very small pieces and then those pieces would be sold to the investors who were best suited to hold them.
But again, the silver bullets turned to lead. Marks wrote, “It turned out that risk hadn’t been banished and, in fact, had been elevated by investors’ excessive trust and insufficient skepticism.” Still, the 2004 to 2008 period was an excellent opportunity for value investors who took the temperature of the market and were well positioned for the many bargains that appeared in late 2008.
As a practical guide to taking the temperature, Marks created a checklist comprised of these questions:
- Is the economy vibrant or sluggish?
- Is the economic outlook positive or negative?
- Are lenders eager or reticent?
- Is capital loose or tight?
- Are terms easy or restrictive?
- Are interest rates low or high?
- Are the spreads narrow or wide?
- Are investors optimistic or pessimistic, sanguine or distressed, eager to buy or disinterested?
- Do asset owners want to hold or to buy?
- Are there few or many sellers?
- Are markets crowded or starved for attention?
- Are funds (or hedge funds) hard to get in to or open to anyone?
- Has recent performance been strong or weak?
- Are asset prices high or low?
- Are prospective returns low or high?
- Is risk high or low?
- Are “popular qualities” aggressiveness or caution and discipline, broad or selective?
With those questions, Marks enables ordinary investors to take the temperature of the market, or to know where in the cycle we are. As one of the book’s annotations suggests, if this practice was done twice a year, through at least a full market cycle, investors could build up a dynamic portrait. A portrait that would make decisions easier and profits more probable.
(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.)
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