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Key Takeaway #5 – understand “Tendencies”
Brian has been investing in the stock market for a few years now. Ultimately, he wants to be able to live on his investment income, so that he can spend more time with family and friends and less on his tedious 9-5.
Lately, it seems like he will have to work forever though, as his timing in the stock market has been well, let’s say, less than optimal.
His portfolio took a serious hit in late 2018, apparently due to some trade war between the US and China, which made him sell most of his stocks.
He just couldn’t stand looking at those red figures every morning – watching his hard-earned money just slip away.
But apparently, he should have stayed with his stocks, or even invested more money because just a few months later, the market was hitting new highs.
Brian is now investing again but he feels confused about whether to put more of savings into the market or to take some of it out.
What if his portfolio loses 20% again? Or worse, what if something like the financial crisis is knocking on the door, but he doesn’t know about it?
Brian wants to be able to tell with certainty if we are heading for a bull or bear market and act accordingly. In other words, he wants to “Master the Market Cycle.
Luckily for Brian, there is a way. When market swings can become friend rather than foe.
But first and foremost, some of his wording must be examined. In investing, no one can ever tell with certainty “what will happen”
But it is possible to talk about what is “more likely to happen”. And that makes all the difference
Let me show an example:
Brian gets the opportunity to participate in one of three different lotteries. The three lotteries follow the same rules – at the cost of $1,000, he gets to draw one marble from a bag filled with ten marbles. If he draws a green one, he gets $3,000. If he draws a yellow one, he gets his money back (or $1,000) and if he draws a red one he gets nothing.
Which lottery should he participate in?
Lottery A has an expected payoff of $500 per marble drawn. Lottery B is a zero-sum game and lottery C has a -$500 payoff.
So picking lottery A would be the correct answer. However, notice that even if Brian identifies that lottery A is the superior one is in no way guaranteed to win money, but there is a “tendency” for it. He could draw a red marble, but it’s not very likely.
It’s the same in investing. The superior investor is able to tell which stock that has a higher probability of returning a profit, or in other words, he is able to tell which marbles the bags hold. The mediocre investor, on the other hand, just picks a bag at random.
There are times when choosing a bag becomes quite simple though, when even stocks of mediocre companies can be expected to yield high returns.
And then there are times when pretty much all bags should be avoided – when even stocks of superior companies are expected to yield negative returns.
Brian must now learn when the tendencies are in his favor, and when they are turned against him.
Key Takeaway #4: Cycles
When Brian saw his portfolio crash by 20% in late 2018, only for it to regain more than that in the coming months (well, hadn’t he sold that is) he witnessed a stock market cycle in action. But thinking back, he has seen this behavior before. He has a vague memory about how a friend of his father made millions of dollars in dot-com companies, only to lose it all in a later market crash. And he remembers the boom of new homeowners that was later followed by newspaper headlines about how the financial system might implode.
The stock market isn’t the only system that shows this type of cyclical behavior. Seasonality and the weather work like this, many phenomena in physics behave this way, and even success in one’s life can be argued to follow this pattern.
A cycle oscillates around a so-called “secular trend”, a “midpoint” or something which can be viewed as “reasonable”. In the stock market, the secular trend is rising, and it’s made up of the underlying growth in profits of businesses plus their dividends.
Most cycles show the following behavior:
A: a reversion to the mean from an excessive low
B: the continuation past midpoint towards an extreme high
C: reaching a high
D: a reversion to the mean again, this time from an excessive high
E: The continuation past the midpoint towards an extreme low
F: reaching a low
G: and then, once again, a reversion to the mean
An important remark here is that these events aren’t just following each other. They are causing each other.The stock market is like a pendulum. It swings from optimism, greed and high prices,to pessimism, fear and low prices – and then back againGreed and optimism cannot continue ad infinitum. It cannot deviate forever from the secular trend.
Stocks become too expensive relative to their earnings and when investors turn more risk-averse, the next crash or correction comes knocking.
Warren Buffett, probably the greatest investor of all time, concludes that: “What the wise do in the beginning, fools do in the end”.
It won’t always look as neat as in the illustration I’ve made here, but, to keep stealing from others who know how to express themselves better than me, Mark Twain said:
“History doesn’t repeat itself, but it does rhyme”
At the extreme highs, most stocks are represented by bags of marbles like these.
While, at the extreme lows, most are represented by bags like these.
Brian wants to learn how to identify these excessive highs and excessive lows in the market cycle, but first, he must learn that the stock market does not function in isolation
Key Takeaway #3: What influences the market cycle?
The pattern of ups and downs in the stock market is a very dependable one, much like another cyclical phenomenon. But it does not work in isolation. Rather, it’s influenced by four other major cycles.
The economic cycle
The main measurement here is the GDP, or gross domestic product of a country. It can be determined by multiplying two variables: number of hours worked and productivity per hour.
The GDP of the USA has been growing by about 2% per year during the last decade, and, as an investor Brian should be particularly aware of deviations from this. Swings in the economic cycle are caused by: demographic movements, the unemployment rate, and globalization, among other things.
The cycle in profits
The profits of businesses are one of the main components determining prices in the stock market.
Brian knows about the most commonly used indicator to determine if prices are high or low – the price-earnings ratio (P/E).
The total sales of all companies in a country is per definition equal to the GDP of that same country, but profits fluctuate more than sales. The reason for this is because of leverage – both in operations and in the financing of a company.
The credit cycle
Why is credit so important to companies in the stock market?
A: because it could be used to speed up growth, and
B: because it is necessary to roll over old credit
Not having access to new debt can cause some companies to default, when they are required to fulfill their old obligations. I think it is both a bit funny and bit frightening that most people and companies don’t plan to repay their debts. I was at a lecture with one of Sweden’s greatest real estate investors, Erik Selin, when he said:
“28 years ago, I borrowed two million dollars from the bank to pay for my first real estate property. Little did they know that, 28 years later, not only would the loan not have been repaid – but increased – to about a billion dollars instead.”
At times, it’s easy for companies to get financing. But at other times, the credit doors are slammed shut.
Howard Marks explains:
“Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity and on and on”
The cycle in psychology/attitude towards risk
“Buy before you miss out!” is replaced by “Sell before it goes to zero!” and vice versa
Psychology is the main reason for swings in the stock market. When the financial community is euphoric, it becomes risk-tolerant and overlooks bad news. When it is depressed, it becomes risk-averse and expects that the world could end. Assessing where attitudes towards risk currently are is probably the most important part for Brian to recognize where we currently stand in the market cycle.
Okay, so prices in the market cycle are determined by two:
First – fundamentals – such as the swings in the economic profit and credit cycles
Second – psychology – through the cycle in attitude towards risk
[Brian:] “But how does this help me in identifying the excessive highs and lows of the market?” Let’s check it out.
Key Takeaway #2: Taking the temperature of the market
The key steps in determining where in the market cycle we stand can be divided into two:
First, Brian should look at the valuations of the stock market and see if they are out of line compared to what they’ve been historically.
This is a pre-requisite – if there are no deviations, the market is probably not excessively high or low. And in that case, there’s no need for the second step.
Second, Brian must establish an awareness of what goes on around him in the investing community. How do other investors feel about risk?
The first step is quite simple: The most commonly used metric for valuations in the stock market is the price-earnings ratio, or, how much investors currently are willing to pay for $1 in yearly earnings.
Brian finds this information at multpl.com and recognizes that the p/e of today is at 22.9, which could be argued to be in the excessive territory.
Next, he examines this table:
For each pair, he checks the one which he thinks best describes the current market.
If most of his checks are in the left-hand column, we are probably at an excessive high and vice-versa.
These points are nonquantifiable and non-scientific, which is a good thing because otherwise the skill to identify highs and lows wouldn’t be as profitable as it is.
A key insight here is that Bryan needs no forecasting to do this. No guesses about the future, only observations of the here and now.
Now that Bryan knows how to identify highs and lows, it’s time for him to learn how to respond properly to that information.
Key Takeaway #1: Aggressiveness vs defensiveness
This graph shows quite well what the stock market is typically expected to return.
If Brain has a good reason to believe that we are currently in an excessively low market, he could tilt his portfolio to be more aggressive.
- Risk more of his capital
- Hold lower quality companies
- Make investments that are highly dependable on a good macroeconomic outcome; or
- Use financial leverage
With an aggressive portfolio like this, he has made both very profitable swings and very costly swings more likely.
Luckily, as he now knows how to take the temperature of the market, he’s assured that there’s a tendency for positive outcome.
The difference between the two curves is how much extra Brian can make by favoring this aggressive play, rather than a passive one, should he turn out to be right.
But what if Brian believes that we are currently in an excessively high market?
Then he could tilt this portfolio to be more defensive instead. He could:
- Hold cash instead of stocks
- Invest in safer assets, such as high-quality corporate bonds and Treasury bills
- Buy strong companies that aren’t cyclical; and
- Stay away from financial leverage
With this defensive portfolio, he has made both very profitable swings and very costly swings less likely.
As he knows that there’s a tendency for a negative development, this is how much he can earn (or perhaps save is the better word?) should he turn out to be proven right.
Brian now knows how to master the market cycle, and, going forward, he will be able to profit from market swings, rather than crashing and quitting from them.
But mastering the market cycle is only one of the most important things when fishing for stocks, according to Howard Marks
Check out our summary of Marks’ other book, The Most Important Thing, to learn about other ones, that are just as important
Like … contrarianism, for instance
Credit: Hats off to the Swedish Investor.
What did you learn from this book? What was your favorite takeaway? Is there an important insight that we missed? What do you disagree with? Comment below or tweet to us @storyshots.
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