Howard Marks (Trades, Portfolio) likes to discuss cycles. In this talk at the China Europe International Business School, he discussed what they are and where they come from.
A cycle can be defined as a progression of events that repeats, with event A being followed by event B, being followed by event C. But a better way of thinking about cycles is that A causes B, which in turn causes C. For Marks, this causal progression is the key to understanding cycles:
“There is a causal relationship, for example, between the issuance of high-yield bonds and the incidence of difficulty in the market ... Risk-averse investors limit the quantity of bonds that can be issued and demand high quality. High-quality issuance leads to low default rates. Low default rates cause investors to become complacent and lazy, and risk-tolerant. Risk-tolerance opens investors to increased issuance and lower quality. Lower quality issuance is eventually tested by economic difficulty and leads to increased defaults. Increased defaults have a chilling effect, resurrecting investors’ risk-aversion.
"This is a standard pattern. But [how many of you] have caught on that at each line of this description the last few words are the first few words of the next line? That is the process through which events cause the events that follow them.”
Why do we have them?
No two cycles are the same. Yet there are certainly trends and similarities between them. For Marks, it all comes down to a tug of war between optimism and risk aversion. Let’s first look at optimism.
“We call events in our business ‘fundamentals.’ Many people believe that stock prices fluctuate in response to fundamental developments. That’s true, but incomplete, because in addition to this, stock prices are influenced by optimism. The more optimism there is baked into the price of a security, the more likely it is that it’s price will be high relative to its intrinsic value. If instead, the prevalent feeling is one of pessimism, there’s a higher probability that the price will be below the intrinsic value.”
Now on risk aversion. Most people fear the loss of $100 more than they want to gain $100. Risk aversion is normal and healthy, and is the reason investors perform due diligence. But risk aversion can sometimes break down:
“People don’t always act as they should. They should always embody a reasonable degree of risk aversion, but sometimes they forget to be risk-averse, and sometimes they become excessively risk-averse. When people are excessively risk-averse, they won’t touch a risky security, regardless of how high the potential reward. That’s a form of error.”
As an investor who made his fortune by playing in the market for distressed debt, Marks knows all too well the opportunities that can be found when taking a chance on securities that no one else will touch.
There is also a third component to cycles, capital availability:
“The securities markets are an auction place. In an auction, the item up for sale goes to the highest bidder ... which is to say, the person who will accept the least for his money ... But sometimes, when the people in the crowd have too much money, and are too eager to get rid of their money, the bidding goes too high.”
Excessive capital availability causes the return on assets to go down, and the relative risk to go up. This is known as “too much money chasing too few deals.”
Taken together, these three components provide the fuel for cycles. In a later piece, we will look at how Marks uses his assessment of market cycles to get the odds in his favor.
Disclosure: The author owns no stocks mentioned.
Read more here:
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Howard Marks: The Most Valuable Lessons Are Learned in Hard Times
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