Notes: Mastering the Market Cycle
Warren Buffetts and Charlie Mungers value investment style disregards macro economics and encourage bottom up investing. In their opinion most macro investors failed and only a few did macro investing successfully. Yet Howard Marks publishes his new book "Mastering the Market Cycle" and proposes that investors need to take the market cycles into account to be able to deliver above average returns.
TLDR
I recommend Marks book highly. You will learn from a market veteran about cycles, cycle positioning and investment decision making.
Chapters about Cycles
Howard Marks starts the first half of his book speaking about cycles. He describes cycles in nature and physics, to economic cycles and cycles in profits, debt and real estate and defines the market cycle.
Cycles in nature and physics
Nature is full of cycles. The sun circles around the milky way galaxy. Our earth cycles around the sun. So does the seasons. The earth spins every day 1 time around her center. And it is intentional that the clocks on on our walls spin at the same speed.
A cycle and periodic behavior are related over time. Imagine walking in a circle and recording the position over time. The following video shows in red the "walking" on the vertical axis and the green on the horizontal axis. The result is an up and down swing and a left to right swinging motion, similar to a pendulum. The important message is that both axis are co-depend, like a dancing couple. The dance is only nice to watch when both are together. (sorry for the bad music tast in the video ;-)
All this sounds very theoretic. Lets bring the concept down to what we experience in our day to day life. Imagine a single tree on green meadow in spring. There is no wind and the tree is not moving. The wind picks up slowly and the branches are still not moving. A little bit more and the smaller branches and leafs start shaking from one side to another. The wind picks up even more speed and the branches start shaking faster and faster. Bigger branches start shaking from left to right slowly.
Wind flows from left to right causing a periodic air turbulence after passing the branch. This turbulence pulls the branch left and right. The turbulence is caused by the Reynolds number (Re), which describes the ration between inertia and viscosity of the air, speed and the size of the system.
The periodic turbulence on the "vertical axis" is very easy to see, but it is only one half of the dancing couple. The other half is very hard to see in the above video. It is the darker "eye" directly behind the branch. It is air moving within a bubble of calm air (white). As long as the air in the bubble is not moving too fast versus its size, the bubble is stable. Is a critical threshold passed (critical Reynolds number), then tiny imbalances cause the bubble to collapse on a regular basis and the periodic swinging turbulence occurs.
Analogically to financial market, it is relatively easy to see a bubble in a asset class but it is nearly impossible to time its implosion. First the bubble needs to be large enough to pass its critical Reynolds number and tiniest imbalances have huge impact on how the bubble collapse unfolds. What caused the financial crisis of 2008? Sub-prime credit, credit card debt, derivatives, leverage, economic slow down? Even in retrospective it is impossible to name a single factor.
Other Takeaways
In conclusion a cycle / periodic behavior depends on Reynolds number. The Reynolds number is depended on inertia of its agents to accept new information, the speed agents exchange information, speed new information comes into a system and the size of the system.
Cycles in human made systems
"Imagine how hard physics would be if electrons could think" (Feynman, Planck).
Contrary to periodic behavior in physics, we cannot apply the same math precision to human made cycles. The core problem is that humans change their behavior over time in a non-predictable way. Yet we can apply the same logic.
The average long-term growth of an economy is influenced by productivity and population growth. In short-term the economic growth is influenced by daily news, believes in future events and available credit. On top of that central banks and governments can change policies, increase liquidity and spending.
On company level profit is the result of sales minus costs. When the costs are only variable a company can scale its cost directly to the sales. But this is seldom the case. Often the costs are semi-variable, which can be scaled only medium-term (employees, leases) or are fixed and are independent of sales. The fluctuations of sales versus costs and the inability adjust them short-term causes profits to be periodically depressed and elevated.
On financial side companies, consumers and government can take on debt when their credit increases. When the economy is thriving, the credit increases. More debt can be taken on the balance sheet and more cash is available for spending and investment. The spending of one company is the sales of another company, the credit is self reinforcing. As the bad spending and investment increases and becomes obvious, financial institutions are more and more reluctant to extend debt levels the debt slows and even contracts, forcing organizations to cut down on spending.
In conclusion human made cycles are based system endogenous relations and exogenous events. The effects are inter-dependent and influence each other directly and indirectly whereas exogenous event are somewhat uncertain. Humans act within these systems. Their actions are based on their subjective perspective on the world and their expectation about the future.
Pendulum of Investor Psychology
According to Benjamin Graham the wild swings of stock prices is explained by an analogy: Mr. Market is a maniac-depressive. When he is maniac, he buys assets at elevated prices; when he is depressive, he sells assets as if they are on fire sale.
Marks uses the analogy of a pendulum. When asset prices are low future returns can be acquired cheaply. Some early investors buy those assets. As the prices increases slowly more investors become more optimistic about the future of these assets and start buying, the prices increase more until assets become overvalued. As the optimism needs to be higher and higher to justify the current market prices the optimism peeks out. The expected future return is the lowest. Some investors see this low return and start selling. As the prices plunge, the investors psychology becomes depressed and the outlook turns more and more negative for the asset. At undervalued prices some investors start acquiring cheap assets again and the cycle repeats.
The investors psychology is pulled away from an objective view by biases. A great talk was given by Charlie Munger, which can be found on fs.blog
Psychology and investors risk appetite
Investors have a different risk appetite. Starting with investments into money market funds, over treasuries into more risky bonds, equity, real estate and venture capital investments. The capital market line is shown below.
TLDR
I recommend Marks book highly. You will learn from a market veteran about cycles, cycle positioning and investment decision making.
Chapters about Cycles
Howard Marks starts the first half of his book speaking about cycles. He describes cycles in nature and physics, to economic cycles and cycles in profits, debt and real estate and defines the market cycle.
Cycles in nature and physics
Nature is full of cycles. The sun circles around the milky way galaxy. Our earth cycles around the sun. So does the seasons. The earth spins every day 1 time around her center. And it is intentional that the clocks on on our walls spin at the same speed.
A cycle and periodic behavior are related over time. Imagine walking in a circle and recording the position over time. The following video shows in red the "walking" on the vertical axis and the green on the horizontal axis. The result is an up and down swing and a left to right swinging motion, similar to a pendulum. The important message is that both axis are co-depend, like a dancing couple. The dance is only nice to watch when both are together. (sorry for the bad music tast in the video ;-)
Wind flows from left to right causing a periodic air turbulence after passing the branch. This turbulence pulls the branch left and right. The turbulence is caused by the Reynolds number (Re), which describes the ration between inertia and viscosity of the air, speed and the size of the system.
The periodic turbulence on the "vertical axis" is very easy to see, but it is only one half of the dancing couple. The other half is very hard to see in the above video. It is the darker "eye" directly behind the branch. It is air moving within a bubble of calm air (white). As long as the air in the bubble is not moving too fast versus its size, the bubble is stable. Is a critical threshold passed (critical Reynolds number), then tiny imbalances cause the bubble to collapse on a regular basis and the periodic swinging turbulence occurs.
Analogically to financial market, it is relatively easy to see a bubble in a asset class but it is nearly impossible to time its implosion. First the bubble needs to be large enough to pass its critical Reynolds number and tiniest imbalances have huge impact on how the bubble collapse unfolds. What caused the financial crisis of 2008? Sub-prime credit, credit card debt, derivatives, leverage, economic slow down? Even in retrospective it is impossible to name a single factor.
Other Takeaways
- Do not mix up population variance and time variance. Economic models expect population variance, but time variance is used!
- Re = 50: It can take some time for a turbulence to crawl back to the turbulence cause.
In conclusion a cycle / periodic behavior depends on Reynolds number. The Reynolds number is depended on inertia of its agents to accept new information, the speed agents exchange information, speed new information comes into a system and the size of the system.
Cycles in human made systems
"Imagine how hard physics would be if electrons could think" (Feynman, Planck).
Contrary to periodic behavior in physics, we cannot apply the same math precision to human made cycles. The core problem is that humans change their behavior over time in a non-predictable way. Yet we can apply the same logic.
The average long-term growth of an economy is influenced by productivity and population growth. In short-term the economic growth is influenced by daily news, believes in future events and available credit. On top of that central banks and governments can change policies, increase liquidity and spending.
On company level profit is the result of sales minus costs. When the costs are only variable a company can scale its cost directly to the sales. But this is seldom the case. Often the costs are semi-variable, which can be scaled only medium-term (employees, leases) or are fixed and are independent of sales. The fluctuations of sales versus costs and the inability adjust them short-term causes profits to be periodically depressed and elevated.
On financial side companies, consumers and government can take on debt when their credit increases. When the economy is thriving, the credit increases. More debt can be taken on the balance sheet and more cash is available for spending and investment. The spending of one company is the sales of another company, the credit is self reinforcing. As the bad spending and investment increases and becomes obvious, financial institutions are more and more reluctant to extend debt levels the debt slows and even contracts, forcing organizations to cut down on spending.
In conclusion human made cycles are based system endogenous relations and exogenous events. The effects are inter-dependent and influence each other directly and indirectly whereas exogenous event are somewhat uncertain. Humans act within these systems. Their actions are based on their subjective perspective on the world and their expectation about the future.
Pendulum of Investor Psychology
According to Benjamin Graham the wild swings of stock prices is explained by an analogy: Mr. Market is a maniac-depressive. When he is maniac, he buys assets at elevated prices; when he is depressive, he sells assets as if they are on fire sale.
Marks uses the analogy of a pendulum. When asset prices are low future returns can be acquired cheaply. Some early investors buy those assets. As the prices increases slowly more investors become more optimistic about the future of these assets and start buying, the prices increase more until assets become overvalued. As the optimism needs to be higher and higher to justify the current market prices the optimism peeks out. The expected future return is the lowest. Some investors see this low return and start selling. As the prices plunge, the investors psychology becomes depressed and the outlook turns more and more negative for the asset. At undervalued prices some investors start acquiring cheap assets again and the cycle repeats.
The investors psychology is pulled away from an objective view by biases. A great talk was given by Charlie Munger, which can be found on fs.blog
Psychology and investors risk appetite
Investors have a different risk appetite. Starting with investments into money market funds, over treasuries into more risky bonds, equity, real estate and venture capital investments. The capital market line is shown below.
One central point of Marks book is, that outcomes of investments cannot
be predicted with certainty. So, the outcomes of investments underlie an outcome distribution. The more risky an investment the broader the distribution and the higher the expected return.
At market cycle neutral state, the outlook distribution is not shifted. Assets can be in general acquired at intrinsic value.
At market highs the outlook distribution is shifted lower. Assets can be in general acquired at above intrinsic value.
At market lows the outlook distribution is shifted higher. Assets can be acquired at blow intrinsic value
Measure - do not predict
One central theme is, that you cannot predict markets, but you can measure the current situation. Mark uses market inherent factors to measure the current phase [TIP]. Blow is the Shiller PE [MUL]
As we see, the Shiller pe was at its 10 year high before it fell recently. Interesting, that Marks publishes a book close to its 10 year high and warns about cycle highs. Yet this does not mean he predicted the highs coming to an end, just that the odds for an end increasing.
Cycle positioning - do not wait for the market bottom
In retrospective its easy to see the market bottom or highs. But at the time it is impossible to know. For large funds like Oaktree, they use market slides to acquire large positions from sellers. These sellers outnumber buyers and therefor move market prices lower. At the market bottom, the sellers and buyers balance out again and Oaktree could not buy large enough positions.
At market highs, the danger origins from aggressive buyers of assets. As buyers outnumber sellers, they compete for assets and prices move up. At those time its wise to shift to more defensive assets. "The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs." (Buffett)
Self-Defeating Market System
If I need to describe market cycles, black swans and business disruption in one sentence, the following quote is the sentence:
"As any system grows towards it maximum or peak efficiencies, it will develop the very internal contradictions and weaknesses that bring about its eventual decay and demise." (Peter Kaufmann)
Conclusion
I recommend Marks book highly. You will learn from a market veteran about market cycles, cycle positioning and investment decision making.
Warren Buffett, Charlie Munger and Howard Marks are on the same page, with respect to the market cycle. All three do not invest at elevated market prices and buy aggressively at market lows. Buffett said “[be] fearful when others are greedy and greedy when others are fearful.”
TIP: https://www.theinvestorspodcast.com/episodes/howard-marks-credit-cycles/
Tim Ferris: https://tim.blog/2018/09/25/howard-marks/
25IQ: https://25iq.com/2018/10/06/lessons-from-howard-marks-new-book-mastering-the-market-cycle-getting-the-odds-on-your-side/
MUL: http://www.multpl.com/shiller-pe/
At market cycle neutral state, the outlook distribution is not shifted. Assets can be in general acquired at intrinsic value.
At market highs the outlook distribution is shifted lower. Assets can be in general acquired at above intrinsic value.
Measure - do not predict
One central theme is, that you cannot predict markets, but you can measure the current situation. Mark uses market inherent factors to measure the current phase [TIP]. Blow is the Shiller PE [MUL]
As we see, the Shiller pe was at its 10 year high before it fell recently. Interesting, that Marks publishes a book close to its 10 year high and warns about cycle highs. Yet this does not mean he predicted the highs coming to an end, just that the odds for an end increasing.
Cycle positioning - do not wait for the market bottom
In retrospective its easy to see the market bottom or highs. But at the time it is impossible to know. For large funds like Oaktree, they use market slides to acquire large positions from sellers. These sellers outnumber buyers and therefor move market prices lower. At the market bottom, the sellers and buyers balance out again and Oaktree could not buy large enough positions.
At market highs, the danger origins from aggressive buyers of assets. As buyers outnumber sellers, they compete for assets and prices move up. At those time its wise to shift to more defensive assets. "The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs." (Buffett)
Self-Defeating Market System
If I need to describe market cycles, black swans and business disruption in one sentence, the following quote is the sentence:
"As any system grows towards it maximum or peak efficiencies, it will develop the very internal contradictions and weaknesses that bring about its eventual decay and demise." (Peter Kaufmann)
Conclusion
I recommend Marks book highly. You will learn from a market veteran about market cycles, cycle positioning and investment decision making.
Warren Buffett, Charlie Munger and Howard Marks are on the same page, with respect to the market cycle. All three do not invest at elevated market prices and buy aggressively at market lows. Buffett said “[be] fearful when others are greedy and greedy when others are fearful.”
TIP: https://www.theinvestorspodcast.com/episodes/howard-marks-credit-cycles/
Tim Ferris: https://tim.blog/2018/09/25/howard-marks/
25IQ: https://25iq.com/2018/10/06/lessons-from-howard-marks-new-book-mastering-the-market-cycle-getting-the-odds-on-your-side/
MUL: http://www.multpl.com/shiller-pe/
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