[00:02:47] Clay Finck: And then fourth, eventually the upward reinforcement is unsustainable before the cycle reverses back the other way. Now, one important difference between real estate and other asset classes is the level of liquidity and then the long lead time for real estate development to take place. Before a building can come to the market and therefore increase the supply of real estate, economic analysis has to be performed by investors.

[00:03:15] Clay Finck: A site has to be found and purchased. The building has to be designed. You have to work through these regulatory hurdles and get permission to build. Financing has to be obtained, and construction has to be completed just to name a few. So as you probably know, there are many, many steps before new real estate can be put on the market for sale.

[00:03:41] Clay Finck: Sometimes, this whole process can take years, while the market conditions can change significantly from start to finish. Another consideration with cycles in real estate is that the players need to be well aware of what others in the space are doing. For example, when the real estate market is booming, it may appear that there’s a housing shortage and a need for new houses.

[00:04:07] Clay Finck: So, let’s say a real estate developer decides that there’s unmet demand for 100 houses, and they say, “Alright, we’re gonna go out and build 20 new homes to bring in some sort of margin of safety so they’re not flooding the market with new homes.” But if nine other home builders make the same assessment, then you may have 200 homes filling what was a hundred homes of demand.

[00:04:35] Clay Finck: And by the time the homes get built, the economy may have cooled down. People might not feel as prosperous and willing to buy, and the demand for homes, in turn, may be lower. Marks shows this chart to help illustrate the cyclicality. Here, the chart shows the number of new housing developments relative to the overall population because naturally population growth is a key driver in the demand for housing.

[00:05:03] Clay Finck: The chart showed that the ratio of new housing developments per million people after the Great Financial Crisis was at its lowest level in recorded history, dating all the way back to the 1940s. Most people after the Great Financial Crisis were totally convinced that the American dream of homeownership was really over.

[00:05:25] Clay Finck: The demand for houses would remain depressed forever, and thus, the overhang of unsold homes would be absorbed very slowly. So, in short, the market naturally extrapolated this negative sentiment into the future rather than understanding and believing in the cyclicality of markets. Marks understood that any material increase in demand for housing would lead to a strong recovery for housing prices.

[00:05:49] Clay Finck: And, since he’s a believer in cycles and with the support of data and analysis, Howard went ahead and invested heavily in non-performing home mortgages. He also purchased North America’s largest private home building company, both of which turned out very well for him and Oak Tree.

[00:06:08] Clay Finck: Then Howard turns to talk about the gross generalizations and sweeping statements that people make. Like I mentioned at the beginning, you know, “they aren’t making any more real estate.” “You can always live in it.” These sweeping statements usually highlight the positive because humans have a natural tendency towards greed.

[00:06:29] Clay Finck: In wishful thinking, Howard writes, “what people eventually learn is that regardless of the merit behind these statements, they won’t protect an investment that was made at a price too high” (end quote). These sorts of general beliefs are what lead asset prices to be lifted to levels that are extreme and unsustainable.

[00:06:50] Clay Finck: To help avoid these dangerous generalizations, Marks recommends removing a number of words and phrases from an intelligent investor’s vocabulary. Words like “never,” “always,” “forever,” “can’t,” “won’t,” “will,” and “has to.” Marks goes back to the Great Financial Crisis to talk about the bullish behavior in the real estate market and how many came to believe that real estate could be depended on to steadily appreciate and prove to not be cyclical and prone to corrections like all other markets.

[00:07:22] Clay Finck: He then references a Times article that highlights a study by Pete I. Colts. Colts found that from 1628 through 1973, real property values increased by just 0.2% per year, and that’s adjusted for inflation over that period. Now, many people would probably argue that real estate has generally performed really well since the Great Financial Crisis due to things like currency debasement and the use of policies like QE by the Federal Reserve.

[00:07:51] Clay Finck: And this is a really valid point because QE has fueled the growth in prices of scarce assets like real estate, stocks, etc. The bottom line is that real estate is subject to cyclical ups and downs, just like all other markets. And the real estate cycles can be amplified by high financial leverage, like it was during the Great Financial Crisis.

[00:08:16] Clay Finck: And it can be amplified by the fact that the supply is inflexible, and it takes a lot of time to adjust to the market dynamics. In Chapter 12, Howard ties everything together here that we’ve learned thus far. He says, “Our job as investors is simple. It’s to deal with the prices of assets, assess where they stand today, and make judgments regarding how they will change in the future.”

[00:08:45] Clay Finck: Prices are primarily affected by two things: fundamentals and psychology. Fundamentals can relate to many things depending on the asset you’re talking about. For stocks, it might be earnings, cash flow, and the outlook for the two. And these are all influenced by the trends in the economy, profitability levels, and the availability of capital.

[00:09:07] Clay Finck: And then the other side is psychology. This relates to how investors feel about the fundamentals and how they’re valuing these assets. If the market valued, say, a stock based primarily on the company’s current earnings and the outlook for future earnings, then the stock really wouldn’t fluctuate that much more than the company’s earnings.

[00:09:29] Clay Finck: But since the market is also highly influenced by market psychology, the reality is that generally stock prices move much more than earnings, and they move much more than the general fundamentals of the business. Like I explained in the previous episode, a company doing well and the stock price increasing really feeds on itself.

[00:09:51] Clay Finck: So, a rising stock price feeds into that investor psychology, and they want to get in on that action. Positive and negative events really feed on themselves either way, and humans, whether it’s going up or going down, tend to take it too far. We’re all familiar with examples where bubbles form, such as the tech bubble in ’99, where these profitless.com companies just soared through the roof regardless of the underlying fundamentals.

[00:10:20] Clay Finck: A more recent example of the market taking things too far down is Meta. Given that Meta is now today worth over $270 per share, when Meta was trading for under $90 like six months ago, it seems like the market became way too pessimistic on that company’s future. You know, it started out as bad news, and then the falling stock really just fed on itself as investor psychology just fed on it.

[00:10:49] Clay Finck: They sold out, they capitulated, and they just lost all belief in the company. To summarize the way a cycle works here briefly again, events in the economy turn positive, and higher corporate profits lead to higher asset prices. Higher asset prices feed investor psychology and trigger the animal spirits, increasing tolerance for risk because more people are optimistic. They’re less demanding in terms of risk protection and perspective returns, and this causes asset prices to rise further. Eventually, things fail to meet expectations, and the market tops out and moves in the other direction, reversing its trend. Asset prices start going down, and this causes investors to be less positive, down to the point where the market sets a new stage for recovery.

[00:11:39] Clay Finck: Now, this process sounds basic and it seems to make a lot of sense, but in reality, it’s really quite messy. The speed and duration of one cycle versus another can really vary by quite a lot. As Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” There are a number of reasons that Howard lists here that cycles come into play time and time again.

[00:12:06] Clay Finck: A few that I’ll mention here are that first, investors’ natural instinct is to want a profit, and they don’t want to miss out on the bull markets, and they’re skeptical and don’t want to lose anything during the bear markets. The second reason that cycles occur is that herd behavior results from pressure to fall in line with what other people are doing, rather than people really thinking for themselves and thinking independently.

[00:12:36] Clay Finck: Third is the extreme discomfort that comes from watching others make money doing something you’ve previously rejected. Fourth is the tendency to give up on investments that are unpopular or unsuccessful, no matter how intellectually sound they are. And then Howard has a couple of sections here that cover bull markets, bear markets, as well as stock market bubbles and crashes, starting with bull markets.

[00:13:02] Clay Finck: Howard, early in his career, was taught about the three stages of a bull market, which I’ll list here. The first stage is when only a few unusually prospective people believe things will get better. The second stage is when investors realize that improvement is actually taking place, and then the third stage is when everyone concludes that things will get better forever.

[00:13:27] Clay Finck: In the first stage, the possibility of improvement is really invisible to most investors, and thus the asset is underappreciated and reflects little to no optimism. In the third stage, events have gone well for so long, and they’ve been reflected powerfully in asset prices. So, instead of little to no optimism, there’s excessive optimism.

[00:13:49] Clay Finck: Trees generally don’t grow to the sky, but in the third stage of a bull market, investors act as if they will, and they’re willing to bet money on it. Howard states few things are as costly as paying for potential that turns out to be overrated. End quote. This description of a bull market also brings in the brilliant quote by Warren Buffett, “What a wise man does in the beginning, the fool does in the end.”

[00:14:20] Clay Finck: In the end, Howard says that this quote alone tells 80% of what you need to know about market cycles and their impacts. Buffett also has a similar quote that points out the three stages of a bull market: first the innovator, then the imitator, then the idiot. And another one of Howard’s favorite quotes on FOMO is from Charles Kindleberger.

[00:14:45] Clay Finck: “There is nothing as disturbing to one’s wellbeing and judgment as to see a friend get rich.” Howard writes, market participants are pained by the money that others have made and they’ve missed out on, and they’re afraid the trend and the pain will continue forever. They conclude that joining the herd will stop the pain, so they surrender.

[00:15:08] Clay Finck: Eventually, they buy the asset well into its rise or sell after it’s fallen a great deal. End quote. Now, the three stages of a bear market are essentially the inverse of the bull market. The first stage is when a few thoughtful investors recognize that despite the prevailing bullishness, things won’t always be rosy.

[00:15:30] Clay Finck: The second stage is when investors recognize that things are deteriorating. And then the third stage is when everyone’s convinced that things can only get worse. Then Howard tells a story of the South Sea bubble to illustrate how even the most brilliant people can fall prey to capitulation. Isaac Newton, along with many other wealthy Englishmen, joined in on the South Sea investment as it started at 128 pounds per share in January and rose to 1050 pounds in June, and this was in the year 1720, by the way.

[00:16:07] Clay Finck: Newton was smart, though, and he realized the speculative nature of the rise of this bubble. And before he got to the euphoric heights, he sold out and gained his 7,000 pounds early on in the bubble. When asked about the South Sea market, he said, “I can calculate the motions of heavenly bodies, but not the madness of people.”

[00:16:31] Clay Finck: But even Newton couldn’t keep himself from watching all of his friends get incredibly rich off the price of their shares continuously rising day by day. Newton bought back in near the top at around 1000 pounds a share, and by September of that year, the bubble had popped, and the price of shares had already fallen to 200 pounds, which was down 80% from the highs.

[00:16:57] Clay Finck: Newton had then exited his position at prices he had originally bought in at earlier on that year, and he lost 20,000 pounds, which equates to over 5 million today. Even with the chance to learn from history and learn from things like the South Sea bubble, people are still prone to create bubbles. They buy into them through FOMO, and they suffer from the crash that follows.

[00:17:25] Clay Finck: People are naturally hardwired to have a very hard time overcoming FOMO and watching all of their friends get rich on paper in a bubble. Because bubbles are all too common when looking at the bigger picture, as people seem to create a bubble every decade. Marks is often asked if today’s market resembles a bubble.

[00:17:47] Clay Finck: Since we’ve seen the massive rise in the stock market since the great financial crisis, any cautions that any big market rise doesn’t necessarily mean it’s a bubble. The first big market bubble that Howard Marks lived through was the Nifty 50. In the late 1960s, investors believed that these high-flying companies had no price too high that investors could pay for them because of the prosperous growth that was certain to lie ahead, and this led to shares in the Nifty 50 rising to 80 to 90 times earnings in 1968.

[00:18:24] Clay Finck: Mark’s writes, “The result was predictable. Whenever people are willing to invest, regardless of the price, they’re obviously doing so based on emotion and popularity rather than cold-blooded analysis.” End quote. What came next was a massive correction. As many of these stocks saw their PE multiples go to eight to nine times, so that’s an 80 to 90% drop, which is a good reminder that many of the greatest companies today may cease to exist over time, as many of those companies did, and no asset or company is so good that it can’t become overpriced.

[00:19:03] Clay Finck: The hallmark of a bubble is when investors stop believing that price does not matter. Since investors believed that the underlying bubble will only continue to go up, they oftentimes double down using leverage because they’re so certain that the prices will continue to rise. Mark’s writes, “No Price Too High” is the ultimate ingredient in a bubble, and thus a foolproof sign that a market has gone too far.

[00:19:31] Clay Finck: There is no safe way to participate in a bubble, only danger. It should be noted, however, that overpriced is far from synonymous with going down tomorrow. Many fads roll on well past the time they’ve reached bubble territory. End quote. Then he has a long list of events and inputs that can form a bubble, which are all items I’ve been discussing during this episode and the previous episode.

[00:19:59] Clay Finck: When you have people getting really greedy, they’re getting overconfident. The credit window of easy money is wide open. The media is celebrating new highs, and risk is at its highest. Prospective returns are at their lowest, and it’s time for investors to act with caution. And then you see the opposite when it swings back the other way.

[00:20:22] Clay Finck: As bad things start to happen, the economy slows. The media emphasizes price drops, and it causes panic and prices to drop further. Defaults occur, credit dries up, prices fall well below the intrinsic value, which leads to minimal risk, higher perspective returns as even the optimists start to throw in the towel.

[00:20:43] Clay Finck: This brings us to chapter 13, which is one of the longest chapters in the book titled “How to Cope with Cycles.” Now that we understand the underlying dynamics of cycles, we need to better understand how to deal with them so we know when to be more aggressive and when to be more defensive. Some investors believe in economic and market forecasting, but Howard Marks certainly isn’t one of them.

[00:21:12] Clay Finck: He rightly mentions that very few people can consistently rely on economic and market forecasts in order to achieve superior investment results. So we may not know where we’re going, but we can try and get an idea of where we’re at today. So far, Marks has covered the basic nature of cycles and the elements that influence market cycles.

[00:21:36] Clay Finck: Things like the tendency of themes within cycles to repeat throughout history, the role of psychology and human behavior within cycles causing markets to continually rise and fall, the tendency of cycles to reach extremes, and their tendency to eventually head back to the midpoint and overcorrect the other way.

[00:21:56] Clay Finck: Using these insights, Marks wants to try and get an accurate picture of where we’re at today in the cycle and act counter to the crowd. Sir John Templeton stated, “Buy when others are despondently selling and sell when others are greedily buying. Buying requires the greatest fortitude and it pays the greatest reward.”

[00:22:17] Clay Finck: One way to get a sense of how optimistic or pessimistic the market is, is to simply look at various valuation metrics, such as the PE ratio on stocks, the yields on bonds, and the cap rates in real estate. The good thing about these metrics is that they’re actual numbers and they’re based on something that’s quantified, rather than just going off your gut feeling.

[00:22:44] Clay Finck: The qualitative aspect of figuring out where you’re at in the cycle is being aware of what’s going on around you and taking note of how other investors are behaving. Here’s an excerpt from Howard in his book: “The most important thing, I quote, if we are alert and perceptive, we can gauge the behavior of those around us, and from that judge what we should do.”

[00:23:11] Clay Finck: The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day as reported in the media, but how many people make an effort to understand what those everyday events say about the psyches of the market participants, the investment climate, and thus what should be done in response.

[00:23:32] Clay Finck: Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident in buying aggressively, we should be highly cautious. When others are frightened into inaction and panic selling, we should become more aggressive. So look around and ask yourself, “Are investors optimistic or pessimistic?”

[00:23:53] Clay Finck: Do the media talking heads say markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are our security offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Are our PE ratios high or low in the context of history, and are our yield spreads tight or generous?

[00:24:18] Clay Finck: All of these factors are important, and yet none of them entails forecasting. We can make excellent investment decisions based on present observations with no need to make guesses about the future. The key is to take note of things like these and let them tell you what to do. While the markets don’t cry out for action along these lines every day, they do at the extremes when their pronouncements are highly important.

[00:24:47] Clay Finck: End quote. So, as mentioned before, to gauge the temperature of the market, Howard looks at both the quantitative and the qualitative. The quantitative aspect is the valuation metrics of whatever asset class he’s looking at, and the qualitative aspect is being aware of his environment and how other investors are behaving.

[00:25:08] Clay Finck: And again, he isn’t forecasting. No matter where you’re at in the cycle, the market is fully capable of moving in any direction, whether that be up, down, or sideways. But that doesn’t mean that all three are equally likely. Assessing the position in the cycle accurately doesn’t tell you what will happen next, but it does tell you what’s more and less likely, which can be really powerful for investors.

[00:25:37] Clay Finck: Then Howard outlines how cool-headed investors were easily able to recognize the euphoria and extremes that were happening during the tech bubble in the 2006-2007 housing bubble. For example, during the tech bubble, WebVan Group was a business that started in 1999. They had $3.8 million in sales, $350,000 in profit in the September quarter, and the stock was valued at $7.3 billion.

[00:26:02] Clay Finck: Another company called VA Linux went public on December 9th at $30 a share, and it soared by 698% on the first day of trading to $239 per share, which is really just laughable considering that in 1999, the company had $17 million in sales and its earnings were negative $14 million. Another company named Red Hat traded at a thousand times annualized revenues.

[00:26:27] Clay Finck: The list really goes on of these obvious excesses in greed and the euphoria that was present in the market. Howard writes, “The bottom line is that in an extreme bubble like this one, the rational investor doesn’t have to make fine distinctions. All you have to be able to do is identify nutty behavior when you see it.”

[00:26:51] Clay Finck: To me, as an observer viewing it in a detached fashion from the sidelines rather than someone with skin in the tech investing game, the events of the tech/internet craze had the appearance of a Hans Christian Anderson tale. Those who participated in it wanted it to roll on forever, so no one would step forward to say that the Emperor had no clothes.

[00:27:17] Clay Finck: Developments like those just described were signs of mass hysteria that is present in every bubble. End quote. As I mentioned in part one of these episodes, the stock market declined for three straight years after the tech bubble. From 2000 to 2002, the stock market went down, and that was the first three-year decline of the overall market since 1929 through 1931.

[00:27:42] Clay Finck: One would think that after the market experienced such a dramatic rise and fall, market participants would be hesitant to allow it to happen for quite some time. But a new one emerged just a few years later. Kenneth Galbraith wrote about how a new one could emerge so quickly.

[00:28:02] Clay Finck: Contributing to the euphoria are two further factors, little noted in our time or in pastimes. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world.

[00:28:32] Clay Finck: End quote. So, a different segment of the economy, especially a different segment within Wall Street, led to the bubble in subprime mortgages through financial engineering and the packaging of these bad loans. And this, together, was all falsely deemed as safe because it was believed that there could never be a nationwide default on mortgages.

[00:28:55] Clay Finck: And when I read this piece, the key word that stands out is the word “never.” In a very uncertain and fragile world, you have to be very, very careful with using words like “never” and “always.” There’s another lesson that Marks drew out of the financial crisis as well because many investors were shying away from equities and bonds.

[00:29:19] Clay Finck: They were easily drawn into buying mortgage-backed securities. They shied away from equities because of terrible recent performance and shied away from bonds because of historically low interest rates. So they were drawn to mortgage-backed securities because they offered higher returns with what was sold as a similar or maybe even a lower amount of risk.

[00:29:41] Clay Finck: Mark says that he has never seen what he calls a silver bullet play out well, which is something that is pitched as offering superior returns with no additional risk. If it were true that there wasn’t additional risk, then the market should, in theory, drive the price up to the point that the mispricing no longer exists.

[00:30:04] Clay Finck: He says, no investment strategy or tactic will ever deliver a high return without risk, especially to buyers lacking a high level of investing skill. Outstanding investment results can only come from exceptional skill (or perhaps, in isolated moments, from good luck). So Oaktree took risk off the table before it was too late, and the prices of essentially all assets collapsed in 2008.

[00:30:30] Clay Finck: Shortly after the collapse of Lehman in 2008, Howard and co-chairman of Oaktree, Bruce Kah, came to the conclusion that one, no one knew how far the financial meltdown would go, and two, negativity was certainly rampant and very possibly excessive. And then three, assets looked very, very cheap. So they came to the conclusion that if the financial world did collapse to the ground, then it really didn’t matter if they bought into the fear or not because they’d have much bigger issues to worry about.

[00:31:05] Clay Finck: And if the financial world did not end, then they would profit tremendously, just like they did. So they bought debt aggressively as they invested over half a billion dollars each week for 15 weeks straight from mid-September 2008 through the end of the year. Taking note of investors’ attitudes ended up working out perfectly for them.

[00:31:27] Clay Finck: They didn’t know how bad it would get, but judging investor psychology at that time, they knew that market pessimism was about as bad as they could imagine. Now when markets are crashing and pessimism is high, it can be really easy to say to yourself, “The market keeps going down. Why would I jump in now and catch a falling knife?”

[00:31:52] Clay Finck: And this is a totally normal reaction to have. If you expected that the market was going to go down by a few percentage points tomorrow, then why would you want to buy today? Even the greatest investors, like Howard Marks, can’t reliably time every bottom. So it’s easy for investors to say they’re going to wait it out and wait until the market environment looks clearer and more optimistic.

[00:32:20] Clay Finck: But by that time, the market will be way up, and it will have rebounded from where you could have originally bought it. When things get really bad, sometimes the window of opportunity in hindsight is really, really small. If the coast is clear and markets don’t look as risky, you can be pretty certain that most of the biggest bargains have already passed.

[00:32:46] Clay Finck: Oaktree strongly rejects the idea of trying to time the bottom. The first reason is that you never know what the bottom is until you have the benefit of hindsight. There’s no big flashing sign that tells you what day the bottom is going to be. By definition, a bottom can only be declared after the passage of time.

[00:33:09] Clay Finck: The second reason they don’t try to time the bottom is that during a sharp drawdown, you have massive selling pressure due to things like margin calls, and those waiting on the sidelines don’t want to catch a falling knife. So you have big selling pressure relative to the number of buyers, which leads to falling prices.

[00:33:32] Clay Finck: Once a bottom is found, selling pressure has found relief. So by definition, there aren’t as many sellers as there were before. Oaktree would rather be buying when there is overwhelming selling pressure rather than jumping in when buyers have come back to dominate the market and push prices back up. Oaktree’s guideline for investing isn’t speculating on where prices will move from day to day or week to week. Rather, they purchase when the price is trading well below its intrinsic value, and if the price keeps dropping, then they prefer to keep buying because it’s an even bigger bargain.

[00:34:13] Clay Finck: Howard writes that all you need for investment success in this regard is an estimate of intrinsic value, the emotional fortitude to persevere, and eventually, to have your estimate of value be proven correct. To round out this lengthy chapter, Howard gives some final thoughts regarding positioning yourself during various points in the cycle.

[00:34:34] Clay Finck: Investors generally take on two kinds of risks, which he outlines here. The first risk is the risk of losing money, and the second risk is more subtle—the risk of missing opportunities. You can eliminate either risk, but doing so exposes you to the other. So investors should decide on some sort of normal stance to balance out the two, depending on their goals, circumstances, personality, and ability to withstand risk.

[00:35:03] Clay Finck: And then the stance or normal posture can be adjusted based on where you’re at in the cycle. If you feel like you’ve gained insight and can bear the possibility of being wrong by acting on that insight, ideally, when the market is high, you want to limit your potential to lose money, and when the market is low, you want to limit your risk of missing opportunities.

[00:35:30] Clay Finck: One thought experiment he proposes here is to put yourself, say, five years into the future. So today, I’m recording this in June 2023. Think five years ahead to June 2028 and ask yourself, is it more likely that you wished you had been more aggressive or more defensive during this time period? So think about what you might say a few years down the road when you’re at extreme points of a market cycle, and that’ll help you determine what you think is the best action.

[00:36:05] Clay Finck: I think this is a good reminder to think about the big picture and think long-term rather than getting caught up in what’s happening day-to-day. That may cause some people to act based on their emotions and how they’re feeling in that moment. In chapter 15, Howard touches more on how we can position ourselves during cycles since making superior investment decisions can be really difficult.

[00:36:31] Clay Finck: We want to be careful to try to make decisions that tilt the odds heavily in our favor. When you consider this in the context of cycles, a lot of the time we’re in a fairly normal part of the cycle, which I would say is somewhere close to the trend line or generally close. When you get to the extreme points like where we were for some asset classes in 1999, 2007, and 2021, you know, these were the high points in an extreme cycle.

[00:37:05] Clay Finck: And then in 2002, 2008/2009, and 2020, these were on the opposite side, and they were sort of the capitulation at the bottoms in the markets. And this is when Marks is looking to make some major or larger changes in his portfolio because he is often able to recognize when we’re somewhere close to or around an extreme point in the cycle.

[00:37:31] Clay Finck: This is when he’s able to tilt the odds heavily in his favor. The reason it’s important to take action at the extremes is that is when he’s most able to heavily tilt the odds in his favor. When you’re somewhere around the trend line, the odds really aren’t heavily tilted either way, and there may be a higher likelihood of you being wrong in your assessment based on where you’re at in the cycle.

[00:38:01] Clay Finck: If you’re close to the trend line, it reminds me of Charlie Munger talking about how truly great opportunities are rare, and you need to be able to recognize these opportunities when they come along and act in size when they do. The market extremes might come maybe only once in a decade, but when they do, they are highly profitable.

[00:38:25] Clay Finck: For superior investors who recognize the cycle, they’re able to accurately assess the intrinsic value of an asset and they buy it when it’s trading at a large discount to that intrinsic value. Howard mentions that positioning Oaktree’s portfolio based on the major cycles has been a big contributor to the firm’s success.

[00:38:46] Clay Finck: They became aggressive in the early nineties, in 2002, and in 2008, and they became defensive in ’94, ’95, 2005, 2006, and they’ve been largely right in recognizing the extremes, but he rightly points out that it’s by no means easy, and he doesn’t want to give the impression that it is easy. Interestingly, Howard has a chapter here on the Cycle of Success as well, chapter 16.

[00:39:13] Clay Finck: I love this because he links the concept of market cycles to other walks of life because cycles are really everywhere. Even with the best investors, they see their success come and go as they won’t be successful all the time. As Howard mentioned earlier in the book, success carries within itself the seeds of failure, and failure carries with it the seeds of success.

[00:39:39] Clay Finck: Another way he puts it is that success isn’t good for most people. Success can actually change people and usually change them in a way that isn’t good for them or not for the better. You can think about how someone reaches some level of success in their life. They start a business, and then the business makes them financially independent.

[00:40:04] Clay Finck: Well, now that person may have a really difficult time coming up with motivation to take that success to new heights and new levels. When you think about a business like Blockbuster, this business took off and it saw tremendous success, but they failed to adapt to the changing times with the rise of the internet.

[00:40:26] Clay Finck: Jeff Booth has this line that instead of adapting to the rise of Netflix, Blockbuster decided to add candy to their aisles to try and increase their sales. It’s human nature to not want to make drastic changes, but that’s what’s required in the fiercely competitive and fiercely capitalistic world that we live in.

[00:40:48] Clay Finck: When Howard says that success carries within itself the seeds of failure, it’s because when people become successful, they can be tricked into thinking that it’s easy and they take it for granted. For example, people tend to confuse brains with the bull market and don’t consider the way luck played into that success, and they might even think that they no longer need to do proper risk management.

[00:41:15] Clay Finck: It’s a good reminder to be humble. You never know when your success or luck may turn against you, whether that be because of poor decision-making or things simply totally outside of your control. Always remain humble. We can also think about how different segments or areas of the market become really popular and they get a lot of people’s attention.

[00:41:40] Clay Finck: No sector or asset class can outperform the market into perpetuity, and no investment strategy is likely to continue to work well all the time. During the late nineties, people were enthusiastic about tech stocks. In the mid-2000s, it was real estate. In the 2010s, we saw the rise of the FANG stocks, and in 2021, we saw the rise of things like cryptocurrencies and other up-and-coming tech companies.

[00:42:07] Clay Finck: Howard writes that one essential truth about investing is that, generally speaking, good results will bring more money to hot money managers and strategies, and if allowed to grow unchecked, more money will bring actually bad performance. Once a certain segment produces unusual profitability, it’s going to attract incremental capital until it becomes overcrowded and fully institutionalized.

[00:42:30] Clay Finck: And this will push down prospective returns towards the mean to correct that mispricing. On the flip side, assets that perform poorly for a while, they’ll become so cheap and due to their depressed prices and lack of investor enthusiasm, they will be primed to outperform on a relative basis. The bottom line, Howard states, is that nothing works forever.

[00:42:54] Clay Finck: When people start truly believing that a strategy will keep working forever, that’s the very time that it’ll become certain not to. He has this wonderful quote that in investing, everything that’s important is counterintuitive, and everything that’s obvious to everyone is wrong. One famous example was the Business Week magazine publishing the story titled “The Death of Equities” in 1979.

[00:43:19] Clay Finck: After a decade of poor performance, the symbolic logic was that stocks weren’t popular and interest was low. Thus, they would remain low because institutions and pension funds were much more interested in hard assets like gold. First-level thinking says that stocks haven’t done well and they aren’t popular, so they’ll continue to not do well.

[00:43:41] Clay Finck: Second-level thinking says that stocks haven’t done well and no one cares to touch them. Thus, there must be some good bargains available somewhere in the equity markets. At the time the article was published, the S&P 500 traded at $107, and it rose to 1527 by March of 2000, which is an average annual return of 13.7% over that 21-year period.

[00:44:06] Clay Finck: The lesson is to be leery of popular assets because unpopularity is a buyer’s friend. He has a section here talking about the tendency of companies rising and falling, and he talks about Xerox, which I won’t go directly into here, the story. When a company rises to unprecedented heights, the natural tendency is to become complacent, bureaucratic, and slow-moving.

[00:44:30] Clay Finck: Innovation is lost, and thus they aren’t able to release new breakthrough products to push for continued growth. And these giants tend to also assume that they can venture into any industry because they think they’re special. But just like how success carries the seeds of failure, failure can also carry the seeds of success.

[00:44:52] Clay Finck: Once a company realizes that they’re under attack from competition, then that can stem motivation and a sense of purpose can be regained. They can make changes. They can shed out the bureaucratic excess, and they can cut unprofitable business units and get serious about regaining that market share.

[00:45:11] Clay Finck: When reading about a company like Xerox and looking at their stock chart, it’s another good reminder to remain humble. One of your biggest stock winners today may eventually see its downfall because for every great company seeing their profits increase year after year, there are many other companies out there working really, really hard to try and get their piece of the pie and create a product or service that’s better.

[00:45:40] Clay Finck: And you can think about as investors, once we realize one or two big investment successes in choosing the right stock or the right investment, it’s really easy to think we’ve got the game figured out and we can be willy-nilly in choosing our next investments or becoming overconfident and doubling down on something that has gotten really popular.

[00:46:04] Clay Finck: Nothing has made me personally more humble than experiencing a giant boom and bust for myself and watching what felt like easy gains turn into fast losses, and it makes you realize that you probably aren’t as smart as you maybe think you are. Good times counterintuitively can produce bad times, and with anything in life, don’t ignore the cyclical nature of things, whether you’re currently at the upswing or currently in the midst of a downswing.

[00:46:35] Clay Finck: Nature tends to bring things back the other way, and you want the general direction, of course, to be up at least when you’re talking about your investments. The final two chapters here cover the future of cycles and the essence of cycles. Before we wrap up the book, Mark speaks of pastimes in history.

[00:46:57] Clay Finck: When leaders believed that we’ve entered a new era, cycles of the past weren’t expected to be repeated, but it’s the belief that cycles don’t matter or cycles won’t ever happen again that helps create the bubble and the crash to follow. In Howard’s piece titled “Will it Be Different This Time?” he writes, “Of course, what these observations signaled wasn’t that cycles wouldn’t repeat, but rather that the onlookers had grown too overconfident. Cycles in economies, companies, and markets will continue to occur at least as long as people are involved in making the decisions, which I believe means forever. There is a right time to argue that things will be better, and that’s when the market is on its backside and everyone else is selling things at giveaway prices.

[00:47:49] Clay Finck: It’s dangerous when the market’s at record levels to reach for a positive rationalization that has never held true in the past, but it’s been done before and it’ll be done again.” End quote. The main reason that cycles will continue as they have is because humans, as we’ve mentioned many times here, humans are a key component of markets.

[00:48:13] Clay Finck: Scientists can predict the movement of atoms, but they can’t precisely predict the actions of human beings, who are highly influenced by their own personal emotions. Human emotion and psychology drive bull and bear markets, and that aspect cannot be removed from the equation, no matter how much we’d like it to.

[00:48:34] Clay Finck: Humans are emotional, inconsistent, unsteady, and nonclinical. In Howard’s last chapter, he brings everything together and summarizes the most important points from the book. I loved the connection he made here, relating the stock market to a lottery or a parlayed betting system.

[00:48:51] Clay Finck: I quote, “Investment success is like choosing a lottery winner. Both are determined by one ticket, which is the outcome, and it’s being pulled from a bowl full of tickets, representing the range of possible outcomes. In each case, one outcome is chosen from among the many possibilities. Superior investors are people who have a better sense of what tickets are in the bowl and whether it’s worth participating in that lottery.”

[00:49:20] Clay Finck: In other words, while superior investors, like everyone else, don’t know exactly what the future holds, they have an above-average understanding of future tendencies. I find this to be such an interesting way to view the world, and it’s a good reminder that not every investment will turn out as desired. Diversification across different investments is crucial to prevent the risk of ruin.

[00:49:45] Clay Finck: Regarding cycles, your odds change as your position in the cycle changes. As valuations rise, your odds aren’t as good, and as valuation multiples drop, your odds tend to improve when people become too pessimistic. This last chapter covers much of what I’ve already discussed in this two-part series.

[00:50:05] Clay Finck: Now, I’d like to transition to a clip from Howard’s recent interview on our channel with Trey Lockerbie, released in mid-April 2023, episode number 545. It’s a really great episode, and I want to play a few clips from that chat with Howard. Having read this book, I find it really interesting to contemplate where we stand in today’s market, which is a burning question for everyone.

[00:50:31] Clay Finck: Since our economy is largely driven by credit and lending, one might generally expect, as I did, that interest rates moving from near zero to 5% would cause massive ripple effects throughout the economy. However, as of today, surprisingly, the S&P 500 is only 7% off its all-time high. I can’t believe I’m really saying that, and I can’t believe the chart, but it’s only 7% off its all-time high.

[00:50:59] Clay Finck: I wanted to play a clip here with Howard’s assessment of the current market cycle from that interview.

[00:51:28] Trey Lockerbie: I know that you’re not one to make market forecasts, and in your 54 years of investing, you’ve only made five real market calls, all of which have come to pass. In your latest memo, “Sea Change,” you list two major sea changes you’ve experienced along the way and make a prediction that a third is currently underway.

[00:51:51] Trey Lockerbie: You are a master of market cycles, and Ray Dalio has recently been out there saying, “We’re in the 12th major market cycle.” I’d love it if you could outline for us how a sea change differs from normal market cyclicality, which two prior events qualified in the past as a sea change, and what you’re seeing today that’s giving you this level of conviction.

[00:52:45] Howard Marks: Sure. You know, back in 2017, I was writing a book called “Mastering the Market Cycle,” which I’m happy to see on your shelf. And, you know, I’ve been a student of cycles, an observer and user of cycles, for a long time as you cite. And yet, when I got two-thirds of the way through writing that book, I said to myself, “Myself, I wonder why we have cycles.” Why don’t things just go in a straight line? If the economy grows 2% every year on average, why doesn’t it just grow 2% every year? Why sometimes three and sometimes one, and sometimes four, and sometimes negative? The stock market, the S&P 500, has risen by about 10% a year on average for the last hundred years. Why doesn’t it just go up 10% every year? And in fact, Trey, why does it almost never return between eight and 12? If the average is 10, why don’t we see some eights, nines, elevens, and twelves? The answer is that cycles, in my opinion, occur because people take things too far.

[00:53:30] Howard Marks: When things are going well, they turn optimistic, and then they become too optimistic. And then they do things that are unsustainable. And so eventually, the events become less optimistic. The people become less optimistic, and they kind of reverse their prior actions, whether it be the decision to build a factory or the decision to buy a stock, or whatever it might be. And when the overly optimistic actions are reversed, very often the actions are too pessimistic.

[00:54:01] Howard Marks: So, I concluded that we have a trend line, let’s say it’s 2% of the economy, but then optimism takes over and we go above the trend. But then people say, “No, that’s unsustainable,” and it corrects back toward the trend. But through the trend, because psychology goes too far to an excess on the negative side, and that corrects back toward the trend, but goes through it toward an excess on the positive side.

[00:54:31] Howard Marks: So, I think that cycles are very useful in thinking about excesses and corrections. They are, for the most part, the operation of the traditional machine, be it the economy or the market, with some novel events thrown in from exogenous territory, but just going too far and then correcting in both directions.

[00:54:53] Howard Marks: Normal operation with normal excesses and normal corrections. A sea change in my way of thinking is a change in the machine, in the fundamentals of the machine. People are going to do things differently post the sea change than how they did it before. So, in the memo, I talk about the two important sea changes that I feel I’ve lived through and worked through.

[00:55:19] Howard Marks: The first occurred in the late seventies. I started this business in the late sixties. At that time, a fiduciary was somebody who would buy high-quality assets for the beneficiaries’ trust, whatever it is, and you could not be criticized for buying quality that was too high. You could be criticized for buying quality that was too low. And in fact, under the right circumstances, if a fiduciary bought 10 risky assets, and if nine of them were up 10x and the 10th one lost 5%, the fiduciary could be surcharged for having bought a risky asset and made to pay. So, the job of the fiduciary was to avoid low quality.

[00:56:04] Howard Marks: Then around ’77, ’78, Michael Milken and others had the idea that the prohibition on issuing below investment-grade debt was excessive, and rather than consist of a blanket prohibition, there should be an understanding that they’re risky. Because they’re risky, they have to appear to offer a higher return as an inducement. But if the promised return seems adequate for the risk, then that’s a reasonable thing for a fiduciary to do. So, this was a big change. This was a sea change. You know, you go from “there are good assets and bad assets, and you can’t buy bad assets” to “you can buy any asset.”

[00:56:47] Howard Marks: No matter how risky it is, as long as a prudent professional would say that the prospective return compensates for the risk. Big change. Risk-return thinking. And I dare say that it’s risk-return thinking that governs everything we do today. And nobody declines to buy anything just because it’s low quality, but because it’s too risky for the return that seems to be offered. Big change. Big change. And we wouldn’t have hedge funds, venture capital, private equity, and all the derivatives at the institutional level if the old fiduciary rules were still in force. So shifting to thinking about risk and return together really has made the investment universe of today unrecognizable from 50 years ago.

[00:57:33] Howard Marks: The other sea change I lived through came right around the same time, not connected, I don’t think, by anything underlined, but in 1980, I had a loan outstanding from a bank in Chicago, and they sent me a slip of paper as they did when rates changed. And they said the rate on your loan is now 22 and a quarter percent. 1980. December. 40 years later, I was able to borrow at two and a quarter percent fixed for 15 years. Well, this is a major change. And first of all, declining interest rates have a number of very strong impacts. They stimulate the economy, they make it easier for companies to make money, they make assets worth more, and of course, they reduce the cost of borrowing. So these events of those 40 years made it very, very attractive for asset owners and for borrowers. And people who borrowed money to buy assets got a double bonus, and this was the overwhelming condition over this period. And it’s not a coincidence that this is when private equity, in particular, had its great success because that’s what it does. You borrow money to buy assets. The assets, as it happened, turned out to be worth more than you thought they would, and the cost of borrowing to buy them turned out to be less than you thought it would be. What a great combination.

[00:59:08] Howard Marks: So, I believe there are a couple of things worth noting. Number one, I think that this decline in interest rates was the biggest single event of the last 45 years in the financial world. Most people wouldn’t say that. Why? Because it was very gradual over a long period of time. Kind of like the frog in the pot of water. You know, you put a frog in a pot of boiling water, he’ll jump right out. But if you put him in cool water and you turn on the heat, he’ll just sit there while it gets hot. And eventually, he’ll come because he doesn’t notice that it’s taking place. So gradually, and I think that’s what happened with rates, they changed so gradually that people… I mean, if you sent out a questionnaire asking what was the most important event in the last 45 years in the world of finance, I don’t think anybody would say, they would say derivatives, high-yield bonds, private equity. Very few, I think, would say the decline in interest rates.

[01:00:19] Howard Marks: A couple of other things worth noting: number one, that means that in order to have seen a more normal period, you had to be working in the seventies or maybe in the sixties. In the seventies, of course, we had the battle against inflation, so that wasn’t a typical period.

[01:00:39] Howard Marks: The sixties may have been something we would call normal, but that was obviously the sixties, 53 years ago. So not too many people who worked in the sixties are still working today. And I believe that the declining interest rates were responsible for the majority of all the money that’s been made in the last 45 years. So that’s pretty important. Those are my candidates for sea changes. Obviously, not just a normal cyclical up and down, not just an excess and a correction, but a replumbing of the whole environment.

[01:01:16] Clay Finck: So a couple of things stick out here. As someone myself who wants to find high-quality businesses to invest in at a reasonable price, his remarks are a good reminder that prudent investors should still be very mindful of the prices that they’re paying. If the prospective return doesn’t compensate for the level of risk, then the odds are not in your favor, and it’s not a bet worth making.

[01:01:44] Clay Finck: Also, Howard’s piece on the sea change relates to the change in the level of interest rates, meaning that we may have a tougher time receiving similar returns to what we’ve seen in the past decade because companies will generally have a harder time growing without having that tailwind of ultra-low interest rates, which is almost like having free money at your disposal.

[01:02:09] Clay Finck: Apple is one example of a company that became a massive business. They were able to take on a bunch of debt at low interest rates and buy back shares in their own company. Economically, it made so much sense for them to do that, given how robust their business is and how attractive the interest rates were at the time to take on that debt.

[01:02:36] Clay Finck: And since we, as investors, naturally have some recency bias, Howard also talks about how the era of ultra-low interest rates is over, and what worked so well during that era likely won’t be what works in the era we’re entering. This is why we need to use some level of caution and account for a margin of error or margin of safety in our investing approach. Because the world today, as much as ever, is fundamentally uncertain, and the future may not unfold as we expect.

[01:03:11] Clay Finck: And this is the type of thing I talked about in my interview with Scott Patterson on episode 558. Next, I wanted to play a clip here of Howard’s view on the level of caution investors should have today in light of where we’re at in the current cycle.

[01:03:30] Trey Lockerbie: I’m curious about how your opinion on investing with caution has changed in recent months. Is it the new definition of caution to a degree or a different type of caution that you’re now investing with?

[01:03:45] Howard Marks: Well, there are various kinds of caution, and for me, caution means insisting on a margin of safety. Not many of us are foolish enough to make investments that would suffer if things remain as they are. However, a cautious investor seeks a margin of safety or margin of error, whatever you want to call it, to ensure that they will be okay if things worsen, as they anticipate. It’s an essential aspect of being a cautious investor because occasionally things do turn out worse than expected. How will you fare in such circumstances? That’s a pivotal question.

[01:04:24] Howard Marks: When the market is soaring and valuations are stretched, and optimism permeates all opinions, caution becomes crucial because there is a high potential for outcomes to be worse than anticipated. On the other hand, when the market is at its low point in the cycle, there is little risk of that happening. Prices lack optimism, and no one believes in favorable prospects, so the risk of overestimating the situation and experiencing the same level of disappointment is minimal.

[01:04:55] Howard Marks: The thesis of “Mastering the Market Cycle” is that your actions should be guided by the market’s position in its cycle. To the extent that you can discern it, when the market is high, caution should prevail, and when it’s low, you should be more aggressive. I still hold the same belief in this regard. At Oaktree, we maintain a cautious bias. Every investor and investment portfolio embody a combination of aggressiveness and defensiveness. You may want to be defensive to mitigate potential losses in adverse scenarios, but you also don’t want to miss out on all the opportunities, so some level of aggressiveness is necessary.

[01:05:37] Howard Marks: Striking the right balance between aggressiveness and defensiveness is paramount to me in the short and intermediate term. Currently, I believe the market is in moderate territory, so I aim to maintain the same balanced approach, which, for Oaktree, means a cautious stance. We charted our course many years ago, focusing on delivering numerous good years, perhaps the occasional exceptional year, but never a terrible one. If we can achieve this combination, as we have thus far, over a span of 40 or 50 years, I believe we will have truly accomplished something significant.

[01:06:15] Clay Finck: And then to round out this episode, I wanted to play one more clip from Howard that I think is a really good one to leave our audience with. Here it goes.

[01:06:23] Trey Lockerbie: What is the least important thing when it comes to investing?

[01:06:28] Howard Marks: I’m glad you asked that. Very few people asked that, and, uh, I happened to have written a memo in November, I believe, entitled “What Really Matters.” And first, I talk about a bunch of things that, in my opinion, don’t matter: short-term events, short-term trading, short-term performance, volatility, hyperactivity. These are things that don’t matter, that don’t add to your long-term success, and that you shouldn’t emphasize. But of course, these are the things that most people spend all their time on.

[01:07:01] Howard Marks: You go into a committee, you know, I’ve been on a lot of investment committees for nonprofits, and you go into the meeting, and they spend the first 45 minutes discussing the performance in the last quarter. Why? It’s over. Nothing you can do about it. Well, you might say, “There, there’s stuff you can figure out to do in the future.”

[01:07:26] Howard Marks: Yeah, but you almost never see anybody taking any strong action based on what happened last quarter, changing their portfolio. Most people never change their portfolio wholesale. And you know, they spend 45 minutes because they think it’s their job. Well, why is it your job? Well, I’m a fiduciary. You gotta care.

[01:07:47] Howard Marks: Well, yeah, but it’s over. You know, and there was a great quote from a guy named Ian Wilson, who was head of GE, one of my favorites nowadays. He said something like, “There is no degree of sophistication that you will get around the fact that all your knowledge is with regards to the past, and all your decisions are with regards to the future.”

[01:08:13] Howard Marks: So studying the past as a way of figuring out what you could do in the future has severe limitations, and I would rather go with fundamentals. I’d rather say, “Which companies can I buy a piece of that will become more valuable over the years and decades, and which companies can I lend money to that have the highest probability of paying you back?”

[01:08:39] Howard Marks: And those things have nothing to do with GDP forecasts, interest rates, recession, and inflation. So, you know, I wrote that memo. Almost nobody said a word about it. I think it’s one of the most important ones I’ve written. And, uh, I hope the readers will take a look. By the way, all the memos are available on the Oaktree website, Oaktree Capital website, under the heading of something called “Insights.”

[01:09:08] Howard Marks: Hopefully, they have insight. Uh, but the great thing is that the price is right because they’re all free, and I hope people will take a look.

[01:09:19] Clay Finck: All right. Well, that wraps up today’s episode covering Howard Marks’ book, “Mastering the Market Cycle.” I hope you enjoyed this two-part series as much as I enjoyed putting it together for you.

[01:09:32] Clay Finck: If you happened to miss part one, you can check that out in our podcast feed here. That is episode number 559. And by the way, if you’ve been enjoying the show, if you’d leave us a rating or review on the podcast app you’re on, that will really help us continue to deliver this great content to you for free.

[01:09:56] Clay Finck: Thanks again for tuning in, and I really hope to see you again next week.

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