Market Cycles

Published On: November 4, 2019

Written by: Ben Atwater and Matt Malick

Howard Marks, who founded Oaktree Capital Management and popularized “distressed debt investing” throughout his roughly fifty-year career, authored a book last year called Mastering the Market Cycle.

Mastering the Market Cycle offers the thesis that markets move in repeating cycles and that human psychology largely drives these patterns.  While timing the market is impossible, knowing where you stand in the cycle can help inform your investment decisions.  We wanted to pass along a few quotes that we found relevant to our investment approach.

“There’s only one form of intelligent investing, and that’s figuring out what something’s worth and buying it for that price or less.”

An investor can use any number of approaches to estimate the intrinsic value of a security.  We typically look at free cash flow yields, dividend yields, and price-to-earnings ratios compared to the overall market and historical averages.  But a stock’s current price often deviates from its intrinsic value.  As contrarian investors, we look to buy stocks trading below or near their intrinsic values and sell or reduce positions trading well above intrinsic value.

“…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.”

As investors, it’s crucial to remember that markets are made up of people and people don’t always act rationally.  People often succumb to a herd mentality and chase stocks based on greed or flee from stocks out of fear.  Regardless of the quality of companies or strength of the economy, the market can fall at any point in time, which is why it’s vital to focus on intrinsic value and long-term investing.

“it’s important to note that exiting the market after a decline—and thus failing to participate in a cyclical rebound—is truly the cardinal sin in investing.  Experiencing a mark-to-market loss in the downward phase of a cycle isn’t fatal in and of itself, as long as you hold through the beneficial upward part as well.  It’s converting that downward fluctuation into a permanent loss by selling out at the bottom that’s really terrible.”

Bear markets are undoubtedly difficult to endure.  But historically, they tend to be somewhat short-lived, averaging 14 months post-World War II.  In the last bear market, from October 2007 through March 2009, a period of 17 months, the S&P 500 fell almost 57%.  Roughly four years later, in April 2013, the S&P 500 had recovered its losses.  This was an extraordinarily deep and prolonged bear market but, even so, the whole cycle lasted only 5 ½ years.  A disciplined investor with a high-quality bond allocation who periodically rebalanced his portfolio would have survived the bear market.  Truly, the “cardinal sin” would have been locking in the losses by selling out of fear.

“We have to safeguard our portfolios (and our investment management businesses) against the danger stemming from the fact that the thing that’s most likely to happen—which our understanding of cycles can tell us—may not happen until long after it first becomes likely.  And we have to steer ourselves emotionally so as to be able to live through the potentially long time lag between reaching a well-reasoned conclusion and having it turn out to be correct.”

Financial market trends can seem to last forever and timing the market is impossible.  Therefore, it’s entirely possible to be correct in an assessment of the market or a specific security but not be proven right for months or even years.

For example, during the technology bubble of the late 1990s, the price-to-earnings ratio of the S&P 500 hit a level of 24 by the end of 1997.  A reasoned investor could have compared this to the historical average P/E of about 16 and sold their stocks because they were overvalued.  But the bull market continued its ascent for another two-plus years, with the P/E ratio eventually exceeding 33 before the market crashed.  Not only did this investor miss out on gains, but the temptation to get back in at higher levels would have been strong.

“Remember, when there’s nothing clever to do, the mistake lies in trying to be clever.”

When it comes to investing, inaction is often the best option.  Over the very long-term, stocks should deliver solid returns that are loosely tied to economic growth and inflation.  Along the way, markets will ebb and flow, but true extremes are uncommon and largely unpredictable.

In our client portfolios, we believe disciplined rebalancing is the best strategy to take advantage of market cycles.  When stocks run higher and valuations become elevated, as we’ve witnessed throughout the last several years, it is prudent to marginally reduce equity exposure and add to high-quality bonds.  And vice versa, the next time markets fall precipitously, we will look to gradually rebalance back into equities at cheaper valuations.

During our current prolonged cycle, it is easy to lose sight of how important a truly long-term investment discipline is to investors.  As Howard Marks repeatedly reiterates in his book, we cannot understate the necessity of a repeatable, consistent and disciplined investment strategy.