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Mastering the Market Cycle by Howard Marks

A good and interesting book on the different kinds of cycles in investing and how to navigate them.

Howard Marks discusses all kinds of cycles including the real estate cycle, credit cycle, distressed debt cycle, and the cycle in profits. He also discuses the psychology behind each cycle, why they occur, how one cycle leads to another cycle, and what to do about them.

Howard Marks has a great record as an investor through the company he founded called Oaktree Capital. He is known as one of the best writers in the investing industry due to his very popular memos, which Warren Buffett said were the first things he reads once he receives them in his email. He also wrote another popular book called the Most Important Thing, which was very good.

The best part about this book is the wisdom you gain learning about the psychology of the market. One of my favorite quotes from this book that originated from one of his memos and gives a good perspective on why investing isn't anything like a science is:

"Richard Feynman, the noted physicist, wrote, 'Imagine how much harder physics would be if electrons had feelings!' That is, if electrons had feelings, they couldn’t be counted on to always do what science expects of them, so the rules of physics would work only some of the time. The point is that people do have feelings, and as such they aren’t bound by inviolable laws. They’ll always bring emotions and foibles to their economic and investing decisions."


Cycles neither begin nor end.

There’s an old story about a group of blind men walking down the road in India who come upon an elephant. Each one touches a different part of the elephant – the trunk, the leg, the tail or the ear – and comes up with a different explanation of what he’d encountered based on the small part to which he was exposed. We are those blind men. Even if we have a good understanding of the events we witness we don’t easily gain the overall view needed to put them together. Up to the time we see the whole in action, our knowledge is limited to the parts we’ve touched…

It’s extremely important to note this causal relationship: that the cycles I’m talking about consist of series of events that cause the ones that follow. But it’s equally significant to note that while cycles occur in a variety of areas due to these serial events, cyclical developments in one area also influence cycles in others. Thus the economic cycle influences the profit cycle. Corporate announcements determined by the profit cycle influence investor attitudes. Investor attitudes influence markets. And developments in markets influence the cycle in the availability of credit... which influences economics, companies and markets.

But this effort to explain life through the recognition of patterns – and thus to come up with winning formulas – is complicated, in large part, because we live in a world that is beset by randomness and in which people don’t behave the same from one instance to the next, even when they intend to.

So these are the possibilities I see with regard to economic forecasts: Most economic forecasts are just extrapolations. Extrapolations are usually correct but not valuable. Unconventional forecast of significant deviation from trend would be very valuable if they were correct, but usually they aren’t. Thus most forecasts of deviation from trend are incorrect and also not valuable. A few forecasts of significant deviation turn out to be correct and valuable – leading their authors to be lionized for their acumen – but it’s hard to know in advance which will be the few right ones. Since the overall batting average with regard to them is low, unconventional forecasts can’t be valuable on balance. There are forecasters who became famous for a single dramatic correct call, but the majority of their forecasts weren’t worth following.

We have two classes of forecasters: those who don’t know – and those who don’t know they don’t know.

Pg 78 operating leverage

One of the most time-honored market adages says that “markets fluctuate between greed and fear.” There’s a fundamental reason for this: it’s because people fluctuate between greed and fear.

The superior investor is mature, rational, analytical, objective and unemotional. Thus he performs a thorough analysis of investment fundamentals and the investment environment. He calculates the intrinsic value of each potential investment asset. And he buys when any discount of the price from the current intrinsic value, plus any potential increases in intrinsic value in the future, together suggest that buying at the current price is a good idea.

One of the most significant factors keeping investors from reaching appropriate conclusions is their tendency to assess the world with emotionalism rather than objectivity. Their failings take two primary forms: selective perception and skewed interpretation. In other words, sometimes they take note of only positive events and ignore the negative ones, and sometimes the opposite is true. And sometimes they view events in a positive light, and sometimes it’s negative. But rarely are their perceptions and interpretations balanced and neutral.

Investors’ interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment.

That’s one of the crazy things: in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.”

The superior investor – who resists external influences, remains emotionally balanced and acts rationally – perceives both positive and negative events, weights events objectively and analyzes them dispassionately. But the truth is that sometimes euphoria and optimism cause most investors to view things more positively than is warranted, and sometimes depression and pessimism make them see only bad and interpret events with a negative cast. Refusing to do so is one of the keys to successful investing.

How is the investment environment formed? In short, it is the result of discussions that take place in the marketplace – either within each investor’s consciousness or among investors, spoken or signaled through their actions.

In recessions and recovers, economic growth usually deviates from its trendline rate by only a few percentage points. Why, then, do corporate profits increase and decrease so much more. The answer lies in things like financial leverage and operating leverage, which magnify the impact on profits of rising and falling revenues. And if profits fluctuate this way – more than GDP, but still relatively moderately – why is it that the securities markets soar and collapse so dramatically? I attribute this to fluctuations in psychology and, in particular, to the profound influence of psychology on the availability of capital. IN short, whereas economies fluctuation a little and profits a fair bit, the credit window opens wide and then slams shut… I believe the credit cycle is the most volatile of the cycles and has the greatest impact.

Many corporate assets are long-term in nature (like buildings, machinery, vehicles and goodwill). Yet corporations often raise the money with which to buy those things by issuing short-term debt. They do this because the cost of borrowing is generally lowest on short maturities. This arrangement – “borrowing short to invest long” – works out well most of the time, when the credit market is open and fully functioning, meaning debt can be rolled over with ease when it comes due. But the mismatch between long-term assets that can’t be easily liquidated and shorter-term liabilities can easily bring on a crisis if the credit cycle turns negative so that maturing debt can’t be refinanced.

It helps to think of money as a commodity. Everyone’s money is pretty much the same… So if you want to place more money – that is, get people to go to you instead of your competitors for their financing – you have to make your money cheaper. As with the other commodities, low price is the most dependable route to increased market share. One way to lower the price for your money is by reducing the interest rate you charge on loans. A slightly more subtle way is to agree to a higher price for the thing you’re buying, such as by paying a higher p/e ratio for a common stock or a higher total transaction price when you’re buying a company. Any way you slice it, you’re settling for a lower prospective return.

In making investments, it has become my habit to worry less about the economic future – which I’m sure I can’t know much about – than I do about the supply/demand picture relating to capital.

An uptight, cautious credit market usually stems from, leads to or connotes things like these: fear of losing money; heightened risk aversion and skepticism; unwillingness to lend and invest regardless of merit; shortages of capital everywhere; economic contraction and difficulty refinancing debt; defaults, bankruptcies and restructurings and low asset prices; high potential returns, low risk and excessive risk premiums.

On the other hand, a generous capital market is usually associated with the following: fear of missing out on profitable opportunities; reduced risk aversion and skepticism (and, accordingly, reduced due diligence); too much money chasing too few deals; willingness to buy securities in increased quantity; willingness to buy securities of reduced quality; high asset prices, low prospective returns, high risk and skimpy risk premiums.

Our job as investors is simple: to deal with the prices of assets, assessing where they stand today and making judgements regarding how they will change in the future. Prices are affected primarily by developments in two areas: fundamentals and psychology.

Regardless of the imprecision of the process, it’s clear that past events and expected future events combine with psychology to determine asset prices. Events and psychology also influence the availability of credit, and the availability of credit greatly affects asset prices, just as it feeds back to influence events and psychology.

Investor rationality is the exception, not the rule; and the market spends little of its time calmly weighing financial data and setting prices free of emotionality.

I can’t write a book telling you how to know more than others about future events. Doing a superior job of that requires elements of foresight, intuition and “second-level thinking” that I doubt can be reduced to paper or taught.

Here are the most important influences [on investment decision making]: the way investors fluctuate rather than hold firmly to rational thinking and the resulting ration decisions; the tendency of investors to hold distorted views of what’s going on, engaging in selective perception and skewed interpretation; quirks like confirmation bias, which makes people accept evidence that confirms their thesis and reject that which doesn’t, and the tendency toward non-linear utility, which causes most people to value a dollar lost more highly than a dollar made (or a dollar of potential profit forgone); the gullibility that makes investors swallow tall tales of profit potential in good times, and the excessive skepticism that makes them reject all possibility of gains in bad times; the fluctuating nature of investors’ risk tolerance and risk aversion, and thus of their demands for compensatory risk premiums; the herd behavior that results from pressure to fall into line with what others are doing, and as a result the difficulty of holding non-conformist positions; the extreme discomfort that comes from watching others make money doing something you’ve rejected; thus the tendency of investors who have resisted an asset bubble to ultimately succumb to the pressure, throw in the towel and buy; the corresponding tendency to give up on investments that are unpopular and unsuccessful, no matter how intellectually sound and finally, the fact that investing is all about money, which introduces powerful elements such as greed for more, envy of the money others are making, and fear of loss.

“What the wise man does in the beginning, the fool does in the end” tells you 80% of what you have to know about market cycles and their impact. Warren Buffett has said much the same thing even more concisely: “First the innovator, then the imitator, then the idiot.”

The three stages of a bear market: The first stage, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rose; the second stage, when most investors recognize that things are deteriorating, and the third stage, when everyone’s convinced things can only get worse.

“There is nothing as disturbing to one’s well-being and judgement as to see a friend get rich.” (Charles Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises)

Nifty Fifty stocks that had been selling at 80-90 times earnings in 1968, in the vanguard of a powerful bull market, came down to earth when ardor cooled. Thus many sold at 8-9 times earnings in the much weaker stock market of 1973, meaning investors in “America’s best companies” had lost 80-90% of their money. And note that several of the “flawless” companies mentioned have since gone bankrupt or experienced serious brushes with distress.

What’s the key in all of this? To know where the pendulum of psychology and the cycle in valuation stand in their swings. To refuse to buy – and perhaps to sell – when too-positive psychology and the willingness to assign too-high valuations cause prices to soar to peak levels. An to buy when downcast psychology and the desertion of valuation standards on the down side cause panicky investors to create bargains by selling, despite the low prices that result.

The investor’s goal is to position capital so as to benefit from future developments.

The question is how we can tell where the market stands in its cycle. Importantly, the elements that contribute to the market’s rise manifest themselves via valuation metrics – p/e ratios on stocks, yields on bonds, capitalization ratios on real estate, and cash flow multiples on buyouts – that are elevated relative to historic norms. All of these things are precursors of low prospective returns.

To responds to market cycles and understand their message, one realization is more important than all others: the risk in investing doesn’t come primarily from the economy, the companies, the securities, the stock certificates or the exchange buildings. It comes from the behavior of the market participants. So do most of the opportunities for exceptional returns.

Everyone see what happens each day, as reported in the media. But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what should be done in response? Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panicked selling, we should become aggressive.

The key question can be boiled down to two: how are things priced, and how are investors around us behaving.

Thinking strategically, we decided that if the financial world ended – which no one could rule out – it wouldn’t matter whether we’d bought or not. But if the world didn’t end and we hadn’t bought, we would have failed to do our job. So we bought debt aggressively. Oaktree invested more than a half a billion dollars a week over the fifteen weeks from September 15 through the end of the year.

When the market is high in its cycle, they should emphasize limiting the potential for losing money, and when the market is low in its cycle, they should emphasize reducing the risk of missing opportunity.

When the market is high in its cycle, the should emphasize limiting the potential for losing money, and when the market is low in its cycle, they should emphasize reducing the risk of missing opportunity. How? Try to travel into the future and look back. In 2023, do you think you’re more likely to say, “Back in 2018, I wish I’d been more aggressive” or “Back in 2018, I wish I’d been more defensive?”

After 28 years at this, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winningest forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive! Performing that trick requires a strong stomach for being wrong because we are all going to be wrong more often then we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances.

Success isn’t good for most people. In short success can change people, and usually not for the better. Success makes people think they’re smart. That’s fine as far as it goes, but there can also be negative ramifications. Success also tends to make people richer, and that can lead to a reduction in their level of motivation. In investing there’s a complex relationship between humility and confidence. Since the greatest bargains are usually found among things that are undiscovered or disrespected, to be successful an investor has to have enough confidence in his judgement to adopt what David Swensen describes as “uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.”

It is essential to grasp that nothing will work forever: no approach, rule or process can outperform all the time. First, most securities and approaches are right for certain environments and parts of the cycle, and wrong for others. And second, past success will in itself render future success less likely.

The most important lesson is that – especially in an interconnected, informed world – everything that produces unusual profitability will attract incremental capital until it becomes overcrowded and fully institutionalized, at which point its prospective risk-adjusted return will move toward the mean (or worse). And correspondingly, things that perform poorly for a while eventually will become so cheap – due to their relative depreciation and the lack of investor interest – that they’ll be primed to outperform.

The bottom line is clear: nothing works forever. But it’s essential to recognize that when everyone becomes convinced that something will keep working forever, that’s the very time when it’ll become certain not to. I say, “In investing, everything that’s important is counter-intuitive, and everything that’s obvious to everyone is wrong.”

Richard Feynman, the noted physicist, wrote, “Imagine how much harder physics would be if electrons had feelings!” That is, if electrons had feelings, they couldn’t be counted on to always do what science expects of them, so the rules of physics would work only some of the time. The point is that people do have feelings, and as such they aren’t bound by inviolable laws. They’ll always bring emotions and foibles to their economic and investing decisions.

The basic reason for the cyclicality in our world is the involvement of humans. Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical… When people feel good about the way things are going and optimistic about the future, their behavior is strongly impacted. They spend more and save less. They borrow to increase their enjoyment or their profit potential, even though doing so makes their financial position more precarious. And they become willing to pay more for current value or a piece of the future.

The effort to explain life through the recognition of patterns – and thus to come up with winning formulas – is complicated, in large part, because we live in a world that is beset by randomness and in which people don’t behave the same from one instance to the next, even when they intend to. The realization that past events were largely affected by these things – and thus that future events aren’t fully predictable – is unpleasant, as it makes life less subject to anticipation, rule-making and rendering safe. Thus people search for explanations that would make events understandable… often to an extend beyond that which is appropriate. This is as true in investing as it is in other aspects of life.

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