This weekend I finished reading “Mastering the Market Cycle” by Howard Marks of Oaktree Capital Management. The book describes an investment philosophy that I believe we all can learn and benefit from.
At its core, Marks describes the market cycle and explains how it will always exist, because ultimately, a market is nothing more than a collection of human decision-making, and humans are prone to irrational behavior, contributing to extremes of over- and under-valuation over time.
Taking the S&P 500 index as an example, we can assume its market value will always fluctuate around its “intrinsic value” -its midpoint or secular trend- but will rarely actually stay there, but rather surge past it to a peak or trough. During upswings, people see asset values rise and can’t help but get in on the action, so they buy in, pushing prices up even further. As this behavior continues, this phenomenon gathers momentum. After a while, the S&P can become overvalued, and one way to tell this is by comparing past and present valuation multiples, such as P/E ratios. If they’re higher than they have been historically, then this probably means assets have become expensive and are likely to generate lower returns for you relative to the risk you’re taking on because they’re running out of room to increase in price.
Conversely, if you’re in a downswing, the general mood is pessimistic, and asset values continue to fall, you eventually reach a point where asset values are cheap and present excellent buying opportunities. Said another way- when investors are euphoric and willing to tolerate more risk, and asset values have become untethered from their fundamentals, this is when one should exercise caution and skepticism. And as fear comes into the ascendancy, depression has set in, and investors are keen to sell off so as to avoid further losses, this is exactly when one should be aggressive and buy as assets are suddenly becoming “cheap” and are essentially “on sale.”
Essentially Marks advocates a contrarian approach that gives you greater odds of being more right than most. He describes future outcomes as a probability distribution, and how understanding where we are in the market cycle gives you the ability to prepare for future events- whether it is becoming more defensive or aggressive with regards to your portfolio positioning. If you know you’re in an overheated market, being underweight in equities is probably a good idea as history has shown a tendency for corrections to occur. Doing this in an environment where most investors are extrapolating further and further gains in equities gives you a better chance at avoiding future losses, or at least, do better than the market in a downturn.
The above, in a nutshell, is what this entire book is all about- understanding where we are in a market cycle and calibrating your portfolio accordingly to stack the odds in your favor. It does get a bit repetitive but if you skim through it and take note of its key ideas, you will be better served in your investment journey.