Investors will never be able to accurately predict what the future holds for financial markets and the economy. But, according to Howard Marks (Trades, Portfolio), we can get the odds on our side by trying to estimate where we are in the market cycle.
Unfortunately, because crystal balls don't exist, it is impossible to predict what the future holds for the market. We can, however, make an educated guess based on past trends, current economic fundamentals and other data.
This is what Marks meant when he said at the CFA Society Portland's Annual Investment Strategy Dinner earlier this year, "We never know what's going to happen in the markets... We never can be sure of an outcome, but I think we can get the odds on our side by understanding where we are in the cycle."Â
Risk management
As Marks went on to explain, one of the most important jobs of the professional investor is risk management. It can be effortless to make money with stocks in a roaring bull market. After all, a rising tide lifts all boats. Making money over the full market cycle, though, is much more challenging. Making money while keeping risk under control isn't easy. As Marks said:
"It's easy to make money in the market. It's especially easy to make money when the market does well, and the market does well most of the time...Making more money than average is not necessarily a distinguishing characteristic because some people do it merely by taking on more risk than average. The measure of a great professional is making money with the risk under control."
Risk can take many different forms, and Marks believes the form risk takes depends on what stage of the market cycle we are in. In his speech, he noted that at the top of the market cycle, risks are high and prospective returns are low. Meanwhile, at the bottom of the cycle, prospective returns are high and risks are low. As a result of this trend, he believes investors need to know and understand where we are in the market cycle if they are to approach risk correctly.
It is impossible to predict the macroeconomic environment. While some well-known media commentators and investors might have been successful in predicting the downturn last time around, consistently predicting economic growth, interest rates and the direction of the markets is impossible.
Marks' solution to this problem is to "get the odds on our side" by trying to estimate where we are in the market cycle, and adjusting for risk accordingly:
"I don't think anybody can consistently know the economy, interest rates, currencies and the direction of the markets better than anybody else. So I swear off forecasting, and one of the elements in Oaktree's investment philosophy is that we do not base our investments on macro forecasts. That doesn't mean we're indifferent to the macro, and our approach is, rather than depend on forecasts of the future, we depend on reading the present. I believe one of the greatest predictors of what the market's going to do, or influences on what the market's going to do, is where it stands in the various cycles, and if we can have an idea when the market is at an extreme position, I believe that can help us increase or decrease our aggressiveness or defensiveness in a timely fashion."
This is not a recommendation to try to time markets. The key phrase in the quote above is: "I believe that can help us increase or decrease our aggressiveness or defensiveness in a timely fashion." This suggests that when Oaktree's research shows we are at the top of the market cycle, the firm and its analysts take a more cautious approach to investing, sticking with low uncertainty, low-risk companies, rather than chasing high uncertainty, high-risk opportunities.
Marks and his team are not trying to time the market, but just investing according to the market environment. It all comes down to risk and reward.
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