Mastering The Market Cycle: Getting the odds on your side

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When something rises, people have a tendency to think it will never fall, and vise versa. Betting against those tendencies can be very profitable. Chapter 4: The Economic of Cycle Marks said billionaire investor Warren Buffetttold him that for a piece of information to be desirable, it has to satisfy two criteria: It has to be important, and it has to be knowable. Howard: Well, I think that I have a bias, and we all have biases, and I think my bias is towards conservatism. It's not the worst thing in the world. It keeps you alive when others get carried out, but it causes you to underperform for long periods of time, especially, for example, the last 10 years, in a couple of months we'll be at the 10th anniversary of the low point of the equity market, March of '09. This has been a challenging time for a cautious investor. Now, most of our clients hire us because we're cautious and retain us, despite the fact that we may trail the indices a little bit. To refuse to buy when too positive psychology and the willingness to assign too high valuations causes prices to soar to peak levels. Just because you have improved odds doesn’t guarantee any particular outcome. But it does make it more likely, which is the best we can do while investing in an unknowable future.

The way investors are collectively viewing risk, and behaving in regard to it, is of overwhelming importance in shaping the investment environment in which we find ourselves. The state of the environment is key in determining how we should behave with regard to risk at that point. Patience and the ability to live through tough periods, until you are eventually proved right, is extremely important. Now, I think that what it allows me to do it, number one, I was wise enough to early condition my clients to expect me to be wrong in this regard. Client education, client preparation, the inculcation of reasonable expectations is one of the most important things we can do in our business. I always say the three most important words to me are "I don't know". If a client asks me a question I don't know the answer I tell them I don't know the answer. During this stage, investors are more likely to take on greater risk and engage in speculative behavior, as they believe that the market will continue to rise.So you know, I describe what we do, to finally answer your question, as fixed income investing, where, how the company does matters. It matters a lot, and you know, if you invest in a direct debt or in high yield bonds, or especially in distress debt, you better have the outlook right. So that's what we do. During this stage, investors are more likely to adopt a wait-and-see approach, as they believe that the market will continue to fall. The boom stage of the market is characterized by a period of rapid growth and increased investor optimism. Exiting the market after a decline, and thus failing to participate in a cyclical rebound, is truly the cardinal sin in investing. In the long run GDP tends to go up because it is a function of two variables that both themselves tend to go up over time: number of hours worked, and value of output produced per hour. The total number of hours worked increases as the population increases, and productivity per hour increases as technology advances. Of course, other factors like culture and government policy also make a big difference.

This chapter contains some of the book’s paragraphs that Howard thinks hold the keys to understanding cycles. This chapter is a recap of the book’s key observations. I was wise enough to early on condition my clients to expect me to be wrong . . . Client education, client preparation, the inculcation of reasonable expectations is one of the most important things we can do,” Marks said. “I always say the three most important words to me are ‘I don’t know.’ If a client asks me a question I don’t know the answer to, I tell them I don’t know the answer . . . We should prepare our clients for our own imperfection. If we do, we can get through tough periods.” You look at the yield spread, which measures people's risk aversion or their demand for compensation for bearing risk and the yield spread on the high-yield bond market broadened considerably over the last three months. Again, there is still risk in all these markets. The correction, if you will, of the fourth quarter did not eliminate the risk, but I think it went a fair way to adjusting the situation and providing increased risk compensation. Extreme economic cyclicality is considered undesirable. Too much strength can kindle inflation and take the economy high that a recession becomes inevitable. Too much weakness on the other hand can cause companies’ profits to fall and can cost jobs. Thus it is part of the central bankers and treasury to manage cycles. Since cycles produce ups and downs that can be excessive, the tools for dealing with them are counter cyclical and applied with a cycle of their own. Ideally inverse to the economic cycle itself. However, like everything else involving cycles managing them is far from easy. This obviously informs my agenda in reading this book, and will therefore shape the information I choose to highlight and what I choose to exclude. Specifically, I want to see if this book can help answer the following questions:

10. The Distressed Debt Cycle

Most forecasts do not add value or lead to investment success. See chapter 14 of The Most Important Thing for discussion on “what we don’t know.” But on the other hand, when the market goes down and fundamentals are negative and prices are retreating and people feel worse and worse and worse, that's when they should be buying, but that's when they're getting more and more depressed. So you have to be a contrarian, and one of the ... Contrarianism takes many forms, but I think the most important form of contrarianism is refusing to succumb to the same emotions that are driving the market. We are all, including me, we are all subjected to the same influences. We all read the same news. Well, some of us only read from the left, and some only from the right, but there aren't an infinite number of media outlets. We all hear the same facts, or alternative facts. We all see the market going up or down the same. We all make money or lose money at a given point in time. The output of an economy is the product of hours worked and output per hour. Thus the long term growth of the economy is determined by fundamental factors like birth rate and the rate of gain in productivity. And if you resist — and recognize and deal with risk and understand where we are in the cycle — chances are you’ll get the odds on your side. Patterns are a natural part of nature. Some are easy to predict, like seasons and tides. Market cycles are harder to predict because they depend on human psychology. But if you pay close attention you can use them to your advantage, rather than suffer from the chaos they can cause.