The disclaimer every investor knows by heart — "past performance is no guarantee for future results" — is something Oaktree Capital co-chairman and co-founder Howard Marks puts to the test in his new book, Mastering the Market Cycle: Getting the Odds on Your Side.
In anecdote-packed chapters on investment strategy and market cycles, Marks decribes his theory of "The Pendulum of Investor Psychology" and explains how to anticipate market fluctuations by analyzing patterns and recognizing events that can have a psychological impact on the investment environment.
"If we pay attention to cycles, we can come out ahead," writes Marks. Since businesses and markets have patterns of behavior, he reasons, understanding events that have influenced markets in the past can help investors today.
Marks is a well-known analyst and investor. He began his career as an equity research analyst in 1969 and served as a portfolio manager for Citicorp for seven years. In 1985 he moved to The TCW Group, overseeing investments in distressed debt and high yield bonds while also serving as the firm's chief investment officer for domestic fixed income. Marks launched Oaktree Capital in 1995. The firm now manages $120 billion in assets.
For nearly three decades, the author has published "Memos from Howard Marks" — a series of wide-ranging, insightful, often lengthy musings on the markets that have burnished his reputation as a serious thinker on investment strategy. These provided some of the material for this book, and a previous title, The Most Important Thing. His February 2007 essay, "The Race to the Bottom," recounts why, during the fast-rising stock market in 2005-06, Oaktree adopted a number of defensive positions, while also raising funds to purchase distressed debt. When the market crashed in 2008, the fund had nearly $11 billion waiting to invest, he writes.
While the idea of "market cycles" seems to imply a set of events that repeat consistently, in Marks' framework, the elements that shape the market — corporations, economies, investors, external events — are not regular. In Mastering the Market Cycle, Marks acknowledges that unexpected, real-world events always influence each cycle.
As he notes, a company may issue a favorable earnings report, but the impact of that report may not lift its valuation if other competitors issue more positive reports, if the market has a bad week, or if the Fed raises interest rates. As a result, the cycles he's "concerned with certainly aren't regular and can't be reduced to reliable decision-making rules."
The reward for bearing incremental risk is greatest at just the moment when — no, rather, just because — people absolutely refuse to bear it.
Employing charts and graphs to illustrate the nature of market cycles, Marks points out that market returns may fluctuate widely from year to year, but historically move around a mean, or midpoint, which itself tends to rise over time. "Averaging out good years and bad years, the long-run return (of the S&P 500) is usually stated as 10% or so," he notes.
This circling of the mean is a cycle, and Marks delineates a number of its stages. Essentially a "what goes up, must come down" scenario, the cycle stages he lists — a stock recovering from a low, a swing past the midpoint; the attainment of a high; a downward correction toward the mean; a drop past the mean; a low, and then, a new upward swing — may seem obvious to some, but they are critical to investors. As Marks sees them, they are more than stages; they are indicators, or cues, for investment.
When valuations stray too far from the mean up or down, one of the major factors driving the movement is what Marks calls "psychological excess in action." In his view, investor attitudes, like market cycles themselves, swing back and forth, often propelled by two motivating factors — fear and greed — which, in turn, influence the runs and crashes.
"The behavior of people in the market changes the market. When their attitudes and behavior change, the market will change," Marks writes. Investors who recognize and resist psychological excess in the markets will have an advantage, he writes, adding "the vast majority of superior investors I know are unemotional by nature."
To help readers learn from history, Marks devotes much of Mastering the Market Cycle to case histories. He recounts the climate that caused the sub-prime mortgage bubble and explains how the proliferation of low-quality debt instruments raised an alarm at Oaktree. Along the way he gives a lively account of real estate cycles and explores the events and conditions that spur booms and busts in the sector.
But no chapter may be more thought-provoking than "The Cycle in Attitudes Toward Risk." Here, Marks studies the fundamental nature of investing — "bearing risk in pursuit of profit" — and assesses attitudes toward risk. "The reward for bearing incremental risk is greatest," he reminds readers, "at just the moment when — no, rather, just because — people absolutely refuse to bear it."
One of the strengths of the book is the way Marks encircles so many cycles and provides guidelines for timing risk and caution. Interpreting these cycles and investing successfully will remain no easy feat, given the vast number of cycles to gauge. With that in mind, it may be worth noting that Marks' most recent memo reveals Oaktree's current mantra: "Move forward, but with caution."