In an earlier piece, we looked at Howard Marks' (Trades, Portfolio) advice on market cycles. In the same talk at the China Europe International Business School he discussed how to use his understanding of cycles to get favorable investment odds. Marks views the market as a lottery, with low-priced securities representing potentially winning tickets, and overpriced ones representing losers. No one can know exactly which tickets will be winners, but one can increase the probability of picking a winner by understanding what part of the cycle one in currently in. Here’s how to do so.
When are the odds against you?
Marks listed a number of indicators that a given period or market may be a poor one to invest in. Recall from our previous discussion that there are three drivers of cycles: optimism, risk aversion and capital availability. These are the hallmarks of cycle peaks:
“A high level of investor optimism, as I discussed. Investors who are spurred on by greed. Recent successes, because what makes people more optimistic and greedy than having made money recently? Investors who are happy with their gains, or jealous of the gains of others -- and jealousy is one of the strongest forces all around the world. Unwise risk tolerance, and eagerness to supply capital. Things like this denote a market which is elevated and a market which is against you. And when are these things seen? At market highs. When the cycle reaches its high, the probability is that these things have occured and that the odds are against you.”
When are the odds in your favor?
These are the signs of cycle lows:
“A shortage of optimism, a high level of fear, poor recent market performance, widespread losses, excess risk aversion and a reluctance to supply capital. When are these things seen? At market lows. So if we can focus on cycles, if we can understand where we are in the cycle, we can get the odds on our side.”
Crucially, none of this requires any forecasting or forward-looking guidance. Marks strongly believes that no one in the market has a significant edge when it comes to predicting the future, at least when it comes to macro-variables. He does, however, believe in closely studying the "micro" -- companies, industries and securities.
“We never know where we’re going, but hopefully we can figure out where we are, and understand what that implies for the odds.”
So where are we?
Marks has been on record saying that we are in the eighth inning of this cycle for several years. Given that the stock market has not yet broken, does this mean that he is wrong? Not necessarily. As he himself said, investing is not baseball, so it can have many more innings. Understanding whether something is currently over- or underpriced tells you nothing about whether it will rise or fall in price tomorrow. All it does is give you the odds that your bet will pay off. But that is really all that you need to know.
Disclosure: The author owns no stocks mentioned.
Read more here:
Morgan Stanley Downgrades Global Stock Market Outlook
Stanphyl Capital’s Tesla Short Thesis
Howard Marks: The Most Valuable Lessons Are Learned in Hard Times
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