Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 298

Review: Howard Marks on the market cycle

Howard Marks has long been regarded as one of the great investment communicators; wise enough to understand how investment markets work and witty enough to explain it in an interesting way. His ad-hoc memos always receive broad coverage and are considered essential reading by many including Warren Buffett.

Marks' recently released book, 'Mastering the Market Cycle', combines new material with passages from some of his historical memos. The subtitle, 'Getting the odds on your side' explains the reason for the book. He regularly asks the question, "Where are we at in the market cycle"?

It's not about knowing the future

From the outset, Marks is explicit that no one can know the future, particularly regarding market timing. Those who are given credit for calling the top of one cycle almost never repeat that feat again. However, investors should plan and invest with the market position in mind. Whilst the probabilities are never certain, they are often slanted towards above- or below- average future returns. The pendulum of market cycles often swings well past the mid-point, creating opportunities for patient investors to buy assets cheaply and sell them richly.

Marks is pragmatic in his advice. Even if an institutional investor could perfectly predict the peak or trough, it would be impossible to trade everything near that level given the relative illiquidity in markets for large portfolios. Marks notes how his firm, Oaktree Capital, was raising capital in 2007 and 2008, then started buying heavily in late 2008, all ahead of the market’s nadir in March 2009. If Oaktree had waited, it simply would not have been able to deploy its capital in meaningful size before the bargains were grabbed by others.

Structure of the book

Marks explains the characteristics of market cycles and the frequency with which they occur. Readers are then taken through chapters on the economic cycle and its impacts on the cycle of company profits, followed by investment psychology and attitudes to risk as the market cycle evolves. The book flows onto an analysis of the credit cycle, distressed debt cycle and property cycle, with the three interlinked as the boom and bust of credit cycles creates the other two. Marks finishes off with chapters on coping and positioning for market cycles, and a reminder that human behaviour isn’t always rational.

Marks’ book has the potential to either engage readers or frustrate them, over two types of repetition: reusing slabs of his memos, and repeating points from previous chapters before progressing. I was fine with this method but I’ve spoken to others who found it annoying.

The final chapter is a 22-page summary, a quick review which might be helpful for a professional before an asset allocation meeting.

Key risk lessons in market timing and asset allocation

Three key components of investment returns are market timing, asset allocation and security selection. Marks focusses on the first two.

Evaluating what the crowd is doing is partly art and partly science. The art is judging whether investors are seeing risk everywhere or ignoring risk everywhere, an ability enhanced by experience but never really definable. It often comes back to the anecdotes of stock tips from amateurs and people investing with expectations of rapid gains. The science aspect is more definable, for example P/E ratios for stocks and credit spreads on debt instruments. Marks notes that perceived risk dictates future long-term returns, in that when everyone is fearful long-term returns are likely to be above average and when optimism abounds, below-average returns lie ahead.

The impact of credit on economic and market cycles in chapters nine to eleven are compulsory reading. Marks sums up the impact of bad lending with: “look around the next time there’s a crisis; you’ll probably find a lender”. Excessive risk taking in lending inflates asset prices, particularly in sectors like property and infrastructure that use large amounts of leverage. The widespread withdrawal of credit, as lenders switch from being risk embracing to risk averse, leads to bankruptcies and fire sales of assets.

Market timing and asset allocation are highly interlinked. Market timing is not as simple as increasing cash and reducing risk assets or vice versa, it is nuanced across and within asset classes. For instance, a late cycle view on credit points to owing higher-rated securities and having lower credit duration across a portfolio. But it also has implications for bank equity, with the likelihood that credit losses will increase from their current low levels, reducing future bank profits.

An Oaktree crisis story

For portfolio managers, Marks inclusion of an Oaktree crisis story on pages 129-134 is a standout. He details how Oaktree had started managing geared funds of leveraged (sub-investment grade) loans in the years before the crisis. As loan prices declined and margin calls were imminent, Marks had to visit clients and plead with them to add more equity to their position in one fund. He could not convince all investors to add to their positions but saved the fund by adding either his own or Oaktree’s capital and reaping a great return as a result. Marks uses the story as an illustration of an investor’s irrational risk avoidance, but there are far deeper lessons for portfolio managers which he leaves out.

First, Oaktree should never have been in a situation where it was facing margin calls on its funds. When leverage is used, it should be locked in for a long enough period for the underlying assets to materially paydown the debt from normal cashflows. Strategies that include borrowing short to lend long (e.g. structured investment vehicles in 2007/2008) or giving lenders control via mark to market triggers (e.g. LTCM in 1998), have a long history of blowing portfolio managers out of their positions.

Second, using leverage creates the wrong conversation at the wrong time. Margin calls always occur at the most inconvenient time and will almost always be seen by clients as mismanagement on the part of the portfolio manager. Rather than pleading for more equity for a precariously placed fund, Oaktree should have been pointing to the good management on its existing funds and asking for additional capital for a new distressed debt fund.

Going beyond the book

Howard Marks sticks to high level commentary and strategy in his writing and interviews. This is understandable given his role as Chairman and face of Oaktree, which would involve far more time on marketing and client engagement than 'on the tools' investment analysis. However, I like to give more detail on what I’m doing with the capital I’m entrusted with.

I’m in hearty agreement with Marks that we are late in the cycle but simply cannot know how long it will be before there is a meaningful downturn. Sell-offs in late 2015 and late 2018 turned out to be blips rather than busts. Holding cash and hoping that the next major downturn will arrive soon is both unprofitable and unnecessary for credit investors.

I’m finding plenty of opportunities to invest in low risk, short duration securities. What I’m typically giving up is immediate liquidity, instead getting liquidity from a portfolio of securities that predominantly matures or amortises over the next 6-24 months. It’s a case of fishing in a different pond, rather than fighting with the crowd who are seeking higher returns from subordinated securities, by extending duration and by giving up covenants.

This delivers on almost all of what clients are looking for. They have below average risk, they receive good returns (often equivalent to the long-term average returns of listed equities) and they will have cash available when asset prices fall and the bargains are there. The portfolios have also been surprisingly stable month to month, experiencing little of the losses seen through the sell-off late last year.

One final point on the value of market timing. Using basic estimates of long-term returns, inflation and asset prices through the cycle, 15 years of alpha can be made in 5 years from buying crossover (BBB/BB) credit securities towards the bottom of the credit cycle. This demonstrates the optionality from having near-term maturities in a credit portfolio during buoyant times. There may be underperformance of 1-2% per year for two to three years before a downturn occurs, but this can be recouped many times over through buying bargain securities in the downturn.

 

Jonathan Rochford, CFA, is Portfolio Manager for Narrow Road Capital. This article is for general information purposes only and does not consider the circumstances of any investor.

RELATED ARTICLES

How are high net worths investing and thinking now?

Howard Marks and his 'Latest Thinking'

Howard Marks: move forward with caution

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.