Mastering the Market Cycle
The odds change as our position in the cycle changes. If we don’t change our investment stance as these things change, we are being passive regarding cycles, in other words, we are ignoring the chance to tilt the odds in our favor.
But if we apply some insights regarding market cycles then we can increase our bets and place them on more aggressive investments when the odds are in our favor, and we can take money off the table and increase our defensiveness when the odds are against us.
Warren Buffet once told his two criteria for information: it has to be important and it has to be knowable.
Everyone knows that macro developments play an important role in determining the performance of markets, very few macro investors make impressive returns. It’s not that macro doesn’t matter, but rather that very few people can master it. For most, it’s just not knowable or not knowable well enough and consistently enough for it to lead to outperformance.
Thus macro prediction can’t bring investment success to the majority of investors. So, trying to time the market is a futile exercise.
Instead, investors should spend significant time on something that can be knowable.
Spend time on these three areas which can be knowable:
(1) Try to know more about the fundamentals of industries, companies, and securities
(2) Being disciplined as to the appropriate price to pay for participation in those fundamentals, and
(3) Understanding the investment environment we’re in and deciding how to strategically position our portfolios for it.
This chapter is all about how to understand the investment environment and take advantage of it.
A sensible investor should know how to optimize his portfolio returns by balancing it between aggressiveness and defensiveness. This balancing should be done based on his understanding of the market cycle.
One should position his portfolio based on his understanding of most likely future possibilities.
Even a sensible investor doesn’t know exactly what the future holds, they do have an above-average understanding of future tendencies.
A sensible investor understands the significance of cycles and pays significant attention to cycles. The outlook for returns will be better when investors are depressed and fearful since we can buy stocks at low prices and worse when they’re euphoric and greedy since investors have to pay high prices.
If we apply some insight regarding cycles, we can increase our bets and place them on more aggressive investments when the odds are in our favor, and we can take money off the table and increase our defensiveness when the odds are against us.
Investors can achieve superior returns by understanding cycles and most importantly where we stand in the cycle at a point in time.
Markets rarely go from underpriced to fairly priced and stop there. Usually, the fundamental improvement and rising optimism that cause markets to recover from depressed levels remain in force, causing them to continue right through fairly priced and on to overpriced.
Success carries within itself the seeds of failure and failure the seeds of success. It can take years for a boom to grow to its full extent. But the bust that follows may seem like a fast-moving train. Because the air goes out of the balloon much faster than it went in.
Everything else being equal, the bigger the boom, the greater the excesses of the stock market in the upward direction, the greatest the bust.
The Three Stages of a Bull Market:
(1) In the first stage, only a few unusually perceptive people believe things will get better
(2) In the second stage, most investors realize that improvement is actually taking place, and
(3) In the third stage, everyone concludes that things will get better forever.
In the first stage, because the possibility of improvement is invisible to most investors and thus unappreciated, stock prices incorporate little or no optimism.
Often the first stage occurs after the stock prices have been dropped in a crash. The sinking of stock prices would turn members of the crowd against the market and cause them to swear off investing forever.
In the last stage, on the other hand, events have gone well for so long and have been reflected so powerfully in stock prices, further lifting the mood of the market, that investors extrapolate improvement to infinity and big up prices to reflect their optimism.
Trees generally don’t grow to the sky, but in the last stage investors act as if they will, and pay up hefty prices.
A sensible investor is someone who invests in the first stage, when almost no one can see the reason for optimism, buys stocks at bargain prices when substantial appreciation is possible. But someone who buys in the third stage pays a high price for the market’s excessive enthusiasm and loses money as a result.
So remember, what the wise man does in the beginning, the fool does in the end. Warren Buffett said, First the innovator, then the imitator, then the idiot.
The Three Stages of a Bear Market:
(1) In the first stage, just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy,
(2) In the second stage, when most investors recognize that things are deteriorating, and
(3) In the third stage, when everyone’s convinced things can only get worse.
It’s a fascinating phenomenon. In the first stage of either bull or bear market, most investors refrain from joining in on the thing that only a tiny minority does. This may be because they lack the special insight that underlies that action, lack the ability to act before the case has been proved, and others have flocked to it ( by this time the stock prices would rise, and the opportunity for substantial gain might no longer available), or the spine needed to take a different path than the herd and to be a contrarian.
Having missed the opportunity to be early, investors may continue to resist as the movement takes hold and gathers steam. They refused to buy into a market that has been lifted by bullish buyers and to sell when the price of the market is beaten down by bearish sellers. They don’t want to join the trend late.
But once the asset price doubled or tripled in price, or halved on the way down, many people feel so stupid and wrong and are envious of those who profited from the fad or side-stepped from the decline, that they lose will to resist further.
There is a quote to explain this behavior,
“There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich”, by Charles Kindleberger.
Market participants are pained by the money that others have made and they’ve missed out on, and they’re afraid the trend will continue further. They conclude that joining the herd will stop the pain, so they surrender. Eventually, they buy at the peak of the bull market and sell after the crash, losing significant money.
We may never know where we’re going, but we’d better have a good idea where we are right now.
Some characteristic of the bull market:
a. The economy is growing and the economic reports are positive
b. Corporate earnings are rising and beating expectations
c. The media carries the only good news
d. Stock market strengthens and rises beyond the intrinsic value
e. Buyers outnumber sellers
f. Investors would be happy to buy if the market dips
g. Prices reach new highs
Some characteristics of the bear market:
a. The economy is slowing, reports are negative
b. Corporate earnings are flat or declining and falling short of projections.
c. Media reports only bad news
d. Stock market weakens and prices fall below intrinsic value
e. Sellers outnumber buyers
f. Don’t try to catch a falling knife, takes the place of, buy on the dips.
g. Prices reach new lows
An investment activity that is built around a concept other than the relationship between price and value is irrational. Actually, when you hear investors saying price doesn’t matter, it is the hallmark of a bubble.
We have discussed earlier that timing the market is not easy and one can’t predict the direction of the market consistently. Thus,
when should one begin to buy? Maybe we should be waiting for the market bottom, to start buying? No, that’s a bad idea, because
1. There is absolutely no way to know when the bottom has been reached. The bottom can be recognized only after it has passed. So, you can figure out the bottom only in hindsight.
2. Usually, it is during the market crash that you can buy the largest quantities of the stocks you want, from the sellers who are throwing in the towel. But once the bottom is reached, that means few sellers are left to sell. Thus the selling dries up and potential buyers would face growing competition.
So, if targeting the bottom is wrong, when should you buy?
The answer is simple: when the price is below the intrinsic value.
What if the price continues downward?
Again the answer is simple: Buy more, as now it’s probably an even greater bargain.
So, all you need for ultimate success in this regard is:
a. An estimate of intrinsic value,
b. The emotional strength to be a contrarian
c. Eventually to have your estimate of intrinsic value proved correct.
Lastly, an investor has to deal with two possible risks.
(1) The risk of losing money
(2) The risk of missing opportunity
Most investors are scared of missing opportunities during the bull market and scared of losing money during the bear market.
In contrast, when the market is high in its cycle, they should emphasize limiting the potential for losing money, and when the market is low in its cycle, they should emphasize reducing the risk of missing opportunity.
So, a sensible investor should be scared of losing money in the bull market and scared of missing opportunity in the bear market.