Back to the Future- Howard Marks on Cycles

Howard Marks’ latest memo came out yesterday. It was insightful and objective.

The usual stuff.

In the memo, he mentioned that he was writing a book about cycles. I am eagerly waiting for that book to come out.

There was another Howard Marks’ memo that I re-read from time to time, which was also about cycles. It is titled “You Can’t Predict. You Can Prepare.” It was written in Nov 2001, when the US experienced its first recession since 1991.

In this post I will liberally take excerpts from the 2001 memo.

It’s mostly a reminder for myself the inevitability of cycles amidst the current environment.

What is the current environment you might ask?

Well from the eye of a microcap-focussed investor, I see it as an environment where:

  • Egregious valuations given to an increasing number of microcap stocks with limited revenue
  • Euphoria in a number of sectors including lithium, AI, crypto and blockchain and marijuana
  • Large influx of institutional money in microcap sectors. This is interesting because microcap performance tend to magnify the broader market’s performance- so it grows more when the broader market grows and drops steeper in a bear market

However, there are also real reasons to not be bearish about the market:

  • Synchronised global growth which can have a positive effect on commodity prices
  • Positive sentiment on mining services spend
  • Booming infrastructure spending in Australia
  • Historic lows in interest rate

If you are confused by this background, then join the club.

Macro predictions have always been difficult and will continue to be difficult. I will probably go broke if I have to bet on macro calls. This is the reason why I am a stock picker.

”I don’t think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand.” Charlie Munger

With that in mind, here is what Howard Marks have said about cycles:

“In my opinion, the key to dealing with the future lies in knowing where you are, even if you can’t know precisely where you’re going. Knowing where you are in a cycle and what that implies for the future is very different from predicting the timing, extent and shape of the next cyclical move. And so we’d better understand all we can about cycles and their behavior.”

On cycles in general:

  • Cycles are inevitable. Every once in a while, an up-or down-leg goes on for a long time and/or to a great extreme and people start to say “this time it’s different.” They cite the changes in geopolitics, institutions, technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend. And then it turns out that the old rules do still apply, and the cycle resumes. In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical.
  • Cycles’ clout is heightened by the inability of investors to remember the past. As John Kenneth Galbraith says, “extreme brevity of the financial memory” keeps market participants from recognizing the recurring nature of these patterns, and thus their inevitability.
  • Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. The reason they reverse (rather than going on forever) is that trends create the reasons for their own reversal. Thus I like to say success carries within itself the seeds of failure, and failure the seeds of success. “

On the economic cycle:

“Most of the time, the consensus forecast extrapolates current observations… Thus they’re close to right when nothing changes radically, which is the case most of the time, but no prediction can be counted on to foretell the important sea changes. And it’s in predicting radical changes that extraordinary profit potential exists. In other words, it’s the surprises that have profound market impact (and thus profound profit potential), but there’s a good reason why they’re called surprises: it’s hard to see them coming! “

On how to profit from the economic cycle:

“How can non-forecasters like Oaktree best cope with the ups and downs of the economic cycle? I think the answer lies in knowing where we are and leaning against the wind. For example, when the economy has fallen substantially, observers are depressed, capacity expansion has ceased and there begin to be signs of recovery, we are willing to invest in companies in cyclical industries. When growth is strong, capacity is being brought on stream to keep up with soaring demand and the market forgets these are cyclical companies whose peak earnings deserve trough valuations, we trim our holdings aggressively. We certainly might do so too early, but that beats the heck out of doing it too late.”

On the credit cycle:

“The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.”

 On why availability of credit is cyclical:

“At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.” This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.”

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.”

On the stages of a bull market:

“For decades – literally – I’ve been lugging around what I thought was a particularly apt enumeration of the three stages of a bull market:

  • the first, when a few forward-looking people begin to believe things will get better,
  • the second, when most investors realize improvement is actually underway, and
  • the third, when everyone concludes everything will get better forever. “

On stock market’s movement

“The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the position of a pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.”

On how to live with cycles

“No one knew when the tech bubble would burst, and no one knew what the extent of the correction could be or how long it would last. But it wasn’t impossible to get a sense that the market was euphoric and investors were behaving in an unquestioning, giddy manner. That was all it would have taken to avoid a great deal of the carnage.

Having said that, I want to point out emphatically that many of those who complained about the excessive market valuations – including me – started to do so years too soon. And for a long time, another of my old standards was proved true: “being too far ahead of your time is indistinguishable from being wrong.” Some of the cautious investors ran out of staying power, losing their jobs or their clients because of having missed the gains. Some capitulated and, having missed the gains, jumped in just in time to participate in the losses.

So I’m not trying to give the impression that coping with cycles is easy. But I do think it’s a necessary effort. We may never know where we’re going, or when the tide will turn, but we had better have a good idea where we are.”

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