Investors can gainfully spend their time researching three areas:
- Knowing the knowable, the fundamentals of an investment.
- Understanding value and being disciplined on the price they pay.
- Studying the investment environment we are in and appropriately positioning portfolios for it.
This book focuses on the third. It is harder to gain an edge over investors in judging the environment — where we are in the market cycle — than in the first two areas. But it is not impossible.
Cycles are largely driven by human psychology and behavior. Successful investors can learn to analyze the psychological state of the market, but it requires a level of emotional detachment that few investors have. Successful investors must aim to be unemotional in order to exploit the emotional swings of the average investor.
Small swings in the economy lead to big swings in profits, bigger swings in markets, and changes in the credit window. The credit window can go from “wide open” to “slammed shut” in an instant. Small changes in fundamentals can trigger big shifts in markets, with a turn in investor sentiment providing the catalyst. Howard Marks, CFA, a co-founder of Oaktree Capital Management and a pioneer of distressed debt investing, has made his career by stepping in to provide capital when the credit window slams shut.
Cycles are inevitable. The stages of a cycle do not just follow one after the other; each stage is caused by what happened before. Marks uses the rise and fall of the distressed debt cycle to illustrate:
- “Risk-averse investors limit quantities issued and demand high quality.
- “High-quality issuance leads to low default rates.
- “Low default rates cause investors to become complacent and risk-tolerant.
- “Risk tolerance opens investors to increased issuance and lower quality.
- “Lower-quality issuance eventually is tested by economic difficulty and gives rise to increased defaults.
- “Increased defaults have a chilling effect, making investors risk-averse once more.
- “And so it resumes.”
Indeed, because this process is continuous, it is wrong to talk about a start or end of the cycle.
Investors cannot accurately predict when the cycle will reach a top or bottom, but they will be better prepared if they know where the cycle stands today. Nor can investors sit on their hands and wait for the cycle to become extended in one direction or the other. Regression to the mean is a powerful and very reasonable tendency. But investors should remember that just as much time is spent moving from the mean toward an extreme as from an extreme toward the mean. And markets spend very little time at fair value.
According to Marks, market cycles are not entirely dependable or predictable because people are involved in them, “and people don’t make their decisions scientifically.”
Maximum psychology, maximum availability of credit, maximum price, minimum potential return, and maximum risk are all reached at the same time. At extremes, overly optimistic or pessimistic investors can mistake a cyclical process for a virtuous cycle or a vicious circle. Extremes in markets always involve extremes in valuations.
“Normal” investment returns are not normal in any one year. In his 48-year career, Marks has experienced significantly more years with strong gains or losses in markets than years when returns are close to the average.
Marks’s successful positioning of portfolios over long cycles — shifting between aggressive and defensive at the five major turning points in markets that he has experienced during his career — has been a big contributor to Oaktree’s success. He provides real-life examples to illustrate his thinking.
Oaktree formed its first fund for distressed debt investing in 1988. “Often conditions are exacerbated by exogenous events that sap confidence and damage the economy and the financial markets,” Marks explains. In 1990, the Gulf War, the bankruptcy of many prominent and highly leveraged buyouts, and the imprisonment of Michael Milken (the principal investment banker behind high-yield bonds) provided the ideal opportunity for putting capital to work.
A conversation with a client during the depths of the 2008–2009 global financial crisis provides a clear demonstration of maximum fear. The client was — understandably — worried about defaults. After Marks presented a scenario for the possible default rate, the client asked, “But what if it’s worse than that?” After five iterations of increasing doom, Marks asked, “Do you have any equities?” If this client really believed in the doomsday scenario, Marks believed the client should rush out of the room and sell them all.
Readers should be aware that this book is not a comprehensive guide to market cycles. There is no analysis of the economic cycle, no mention of the commodity cycle or the role of rising oil prices in so many economic downturns, and no discussion of the political cycle.
Nor is there an analysis of our current environment. The consensus (including me) believes we have entered a “new normal” — that is, a prolonged period of low interest rates and low investment returns. This omission is a shame because the market is essentially saying that “this time is different” — a phrase often associated with collective myopia, as Marks points out.
“Writing makes you tighten up your thinking,” Marks told market commentator Barry Ritholtz in a discussion of the book. Readers should approach this book with the same attitude. There is no big reveal of the secrets of investment success. Much of the content feels like common sense rather than the wisdom of an acknowledged expert. The book can be repetitive at times; the psychological drivers are the same whether Marks is discussing the credit cycle, the distressed debt cycle, or the real estate cycle. But when I pulled together the lessons learned to write this review, I realized that the book had succeeded in sharpening my thinking too.
The bottom line: “Risk is high when investors feel risk is low.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Robert N. Farago, ASIP, is head of thought leadership at Aberdeen Standard Investments. He was previously head of asset allocation at Schroders Private Bank. Robert has over 30 years of investment experience, including portfolio management roles at Schroders and Bankers Trust. He is an active member of the CFA Society of the UK.