Everything in a world moves toward an extreme direction from average and come back to average. This is known as a regression to mean. Sometimes we get more happy or sad and as time passes, we start coming back to our normal feelings. We tend to be nice to other people when they please us and nasty when they do not, we are statistically punished for being nice and rewarded for being nasty.
Poor performance was typically followed by improvement and good performance by deterioration, without any help from either praise or punishment. Our performance has an average point, sometimes we perform very better than average and sometimes perform below average and sometimes reach back to mean performance. So that when performance is above or below average, then it has a higher probability to meet the average which is known as a regression to the mean.
Investment – The price of the companies sometimes go either extreme to fundamental points but as time passes stock prices start moving towards fundamental performance and at some point fundamental performance and stock prices marched. The stock price cannot be sustained at either extreme. We have seen various cyclical events, business cycle and many more are responsible for the regression to the mean. We have experienced that market always walk away from averages for a period but it comes near to mean by its self-correcting nature. So that when anything moves at the extreme side of the mean then we must have to be ready for self-correction of it. Value investing mainly focus on reversion to mean theory. It believes that if the stock price is well below its fundamental value then now or later it will catch up with its fundamental value.
We have seen that the best performance in equities has come after the worst performance and vice-versa. So that we should not focus on a smaller period of outcome to make any conclusion. Rather should focus on a decently long period to understand mean reversion. But when fundamental performance is improving then we should compare market price with improving fundamental performance rather should wait to fall in price as it has risen in past. Also, we need to study thoroughly about fundamental of any business, its prospects, challenges faced by the business. Rather believing that if the business has performed well in past then it will repeat it in future. It may or may not repeat the same performance but that we have to conclude from a detail study of business.
We have seen superior results with superior insights. But for getting these skills, we also need to know the limitations and how difficult it is to acquire them.
If we are going to identify what will be going to happen tomorrow or the day after tomorrow or next week, next month then we are not going to get success in identifying cycle. Identifying cycle is never easy, it requires a greater effort to capture a cycle in a better way which provides us with an advantage.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
It is always important to be defensive and aggressive over a different period of time. We cannot be defensive for every time or aggressive all the time. The most important is when we should become defensive and when we should become aggressive, it matters a lot. If we become defensive at the bottom of the cycle and aggressive at the top of the cycle then it will be dangerous for our wealth.
We require aggressiveness, timing and skills for achieving success. Aggressiveness at the right time creates a fortune.
For getting success, we have to focus on key elements mentioned by Mr Marks.
Risk in our portfolio in the cycle, which assets we are holding in the portfolio and among those which are overweight or underweight.
Aggressiveness such as holding second-grade assets, leverage, macro dependent investment, putting more capital at risk. Defensive investment such as holding cash than securities, safer assets, avoid leverage. Selection from above both depends on where we stand at the cycle and what can be a future market development.
The skill requires to make a balanced decision. Luck required when randomness has more effects on the events. Skills help us to make a decision in the portfolio but luck can fail our right decision or proven to succeed in our wrong decision in the short run. Skills win the battle in the long run.
When we found that we are positioned in the cycle where pessimism at lowest, the economy has better development, etc. and we have become aggressive towards portfolio positioning then it will reward us with greater profits while the market does well as per our assumption. And also incur losses if the market does not work as per our assumption.
Being right is not into the control of anyone due to the involvement of randomness and luck factors.
When we found that the economy started being optimistic, the psychology of investors started optimistic, good news started flowing then we need to cut position in our portfolio which we feel overpriced. This effort helps us to reduce risk when slowdown or recession occurs. But this decision requires a skill set otherwise we will underperform the market at whole.
We always have to keep in mind that when the market is low in the cycle then the probability of losses is low and the probability of making profits is higher. Reversely, when the market is high in the cycle then the probability of incurring losses is higher and the probability of making profits is lower. We cannot predict the outcome but we can take advantage of the cycle by making an assumption of it.
After identifying the market cycle, we need to make a selection of the assets. If the price of the asset is lower compared to its intrinsic value then it will do better than other assets. And if the price of the assets is higher compared to its intrinsic value then it will not do much better than other assets. We also should focus that whether the intrinsic value of the assets has scope for further growth or not.
Theoretically, it quoted that the market is efficient and all the information is available with everyone so that no one can make profits from it. But reality shows something different. It shows that few people can think differently from the crowd and get above average than all. This is called second-level thinking where we need to think wise and differently from the crowd. Those who use second-level thinking they can do above average than consensus. This is key to assets selection.
Winners have a tendency to fall less than the market and during the rising market, they meet the market. And those who do not have a skill, they fall more than the market and does not have a higher return when market raises.
Aggressive investors with superior insights, fall slightly more than market in falling time but raise more than market in good time. Whereas defensive investors with superior insights, outperform in the worst time and underperformed the market in good time. We need to keep a balance between both. The person who can make a balance between both aggressive and defensive with superior insights, that investors outperform the market at the worst time as well as in the good time also.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
We cannot predict the future and cannot see the future so that can we prepare for the future? How can we be positioning our investments? Answers to these questions lie in the understanding of the cycle and at where we stand at the current cycle.
It’s not always what we buy that matters but at what price we are buying that matters a lot.
These checklists help us to an understanding regarding cycle and where we stand at the cycle. That understanding helps us with what we should do and what can be the portfolio positioning. These checklists also help us to remove some mistakes such as buying little when risk is low so that capital allocation decision also can be improved. The capital allocation also one of the key elements to becoming a successful investor.
We all see the everyday events which were covered by the media but we also need to put effort to understand that what it is going to indicate to us. These efforts help a lot to us. I got saved in recent market turmoil due to understanding of the cycle which I have practised after reading “The Most Important Things”.
I want to quote my learning from the most important things here to explain this concept with a few additions.
The earlier scene in the year 2017-18
The current scenario in the year 2019-20
We need to focus on the current scenario what it is indicating to us, not to worry about the future. If the current scenario tells us to stay away and we are into the third phase of the bull market then we need to adjust our portfolio accordingly. And if the current scenario suggests the third phase of the bear market then we need to adjust our portfolio positioning accordingly. We cannot track each and every information flowing around the world but we need to understand which of them are important and help us to reach the conclusion.
When market and psychology of the investors flying then do not care for the valuations. People argue that old valuation techniques do not work in the current period. Another argument is that we should look at the business, not stock so that valuation does not matter. But what happens to this logic when bear take a charge?
Old technique again starts taking place. Higher P/E looks as an unhygienic for the health of the portfolio and low P/E tempted to the investors.
We can see that during the bull period even non-qualitative companies also traded at the multiple of quality companies.
There are qualitative and quantitative two phenomena which we can study to understand where we stand in the cycle. We always need to ask the question to ourselves how the assets priced and how the investors around us behave? That means the quantitative part refers to the valuation of the assets. And qualitative part refers to the behaviour of investors around us & understand it.
Example – one of the E-Commerce company of India
When the market is booming, the psychology of investors is positive, economy growing, people are eager to make an investment then low-quality securities also getting issued by providing a better rating.
We have to be contrarian, have to learn to go against the wind prevailing in the market.
When market falling, people tend to stay away from it. They argue that keep away from catching a falling knife. But when dust gets settled and we realize that the final bottom has made, a bargain will also be gone.
There is no way to know when and at what price exact bottom has made. We come to know about the bottom only after it has made.
We should avoid buying with leverage money because when pendulum moves towards extreme pessimism then we cannot able to know where it will stop and we get a margin call, due to the leverage. We get a disastrous outcome of such an act.
John Maynard Keynes is reputed to have said: “The market can remain irrational longer than you can remain solvent.”
When the economy is in a troublesome period and investors psychology also negative then only, we get a good asset at a bargain price.
We have a two-risk scenario – one is a risk of losing money and the other one is a risk of missing out an opportunity. Investors have to make a balance between the risk. When market moving higher in the cycle, we have to focus more on the risk of losing money and when market-moving lower in the cycle, we have to focus on the risk of losing the opportunity. When there is a high chance of losing money then we have to play defensively and when there is a chance of missing out an opportunity then we need to play aggressively.
The cycle is going to happen and how we respond to it is the key matter. Successful investors are those who have survived under the different market cycle and that cycle makes them more thoughtful.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
As an investor, we have to deal with the prices of assets and evaluate where currently its standing and what can be in the future. Prices of assets are getting affected by fundamental and psychology.
Psychology of the people does not remain the same forever. It will change for any of the reasons for millions of reasons.
Rising prices of the assets make investors’ psychology in the optimistic area and falling prices of the assets make investors’ psychology in the pessimistic area. The reason and result for the occurrence of the cycle do not remain the same with all the cycle but it is sure to a repetition of a cycle. Performance numbers are already recorded and sometimes, we require skill to understand it thoroughly. This is a past and we are not able to predict the future. It is essential to roughly think about the future to protect our investment. Second-level thinking also help us to understand the psychology of the market participants and act according to our conclusions.
There are few factors which influence and force cycle to occur.
Confirmation bias where investors seek for a piece of information or events which supports the thesis or not.
The tendency toward non-linear utility where we value a money loss is far greater than money made.
The gullibility is which influence the investors to swallow tales at good times which have the potential to gain at a good time and the excessive scepticism that makes them reject all possibility of gains in bad times.
Risk tolerance and risk aversion which investor ask for risk premium for the incremental risk.
Herd behaviour indicates to act with keep in mind that what the other people are doing.
One of the highly influential bias is to see other people making money with the idea which we have rejected initially. We do not resist such situations and left with the buying those assets which resulted in a boost to the asset bubble. Also, we generally do not select an unpopular idea and prefer to go with the herd.
All such biases lastly transform into the greed for more, envy of the money others is making, and fear of loss.
A bull market where prices of assets risen, rising or will raise and bear market where prices of assets fallen, falling or will going to fall.
But there are three-phase of the bull market –
In the first phase, growth and better improvement are invisible to most of the investors. Because it does not have a huge price appreciation, also occurs after the crash, wipeout of the prices has affected the psychology of investors.
In the last phase, prices of assets have risen, improvements are visible & started a long back. This improves the mood of the market and investors where they are ready to pay any price for the assets.
It is obvious that those who buy assets in the first phase, those got assets are at bargain prices and the probability of making money is huge. Whereas those who buy assets are at last phase then assets are available at costlier prices so that probability of losses are higher.
“What the wise man does in the beginning, the fool does in the end.”
Warren Buffett has said much the same thing even more concisely: “First the innovator, then the imitator, then the idiot.”
As we have seen three phases of a bull market, there is also a three phases bear market.
We have to see the problem behind the scene. Because an excess of good things always invites trouble. And an excess of pessimism gives birth to the new era of optimism. We need to focus on each little thing happening into the surrounding which helps us to recognize problem or opportunity earlier than others.
People always get pain when they see others are making money so that they fear continuing of trend and they will miss out on an opportunity. Thus, they also join the trend. Such influence affects the investors who have rightly enter at the first phase and by affecting the psychology, they again enter the last phase where they involve doing the wrong things. The most brilliant person also can fall under such psychological influences.
We also have to understand that the bubble is not always where the market raises and also not bust where the market falls.
If the company is good in quality then also it has taken around six years to reach the same price but if assets are not good quality then it gets disappear after the bubble get burst.
No assets are good enough that it will never be going to become overvalued. Price does not matter and borrowing money to make an investment are a sign of building a bubble. I have met a few of the people who take a loan on credit card, use credit period to trade in the market. Such is a sign of the bubble. This was an incident of late 2017 and starting of 2018.
We can see that good news, maximum availability of the credit, maximum optimism in psychology, maximum prices, minimum potential returns, etc. All come at the same time, which is a signal for the identification of the bubble.
Reversed to the top, the bottom has an inability to get credits, falling in the asset’s prices, maximum pessimism, bad news flows, minimum risk.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
We have seen the financial cycle in the post of the credit cycle. Similarly, Real Estate also follows the same cycle as all the financial cycles follow, except one that real estate having a higher lead time to development takes place. Generally, real estate projects take a huge time to get constructed to get commercializes.
When the economy is bad at that time credit will be unavailable for the construction work and when time is a good credit will available easily. This impact on the real estate cycle. Better economic time causes an increase in demand and bad economic conditions led to a fall in the demand. Due to the higher lead time, supply & demand mismatch takes place which causes the rise in the rent and the sale price.
When projects got halted due to the credit unavailability then these situations invite a bust in the Segment. That will cause a fall in the price of buildings. Investors can get land less than what developers have invested in. Also, here, lead time reduces as approval got finalised in good time. It hurts to the projects of which construction started in the boom period.
When there is a demand for home and financing options available, builders decide to build a home and all builders decide the same which creates a surplus of home. Also, due to long lead time, demand gets soften then builders left out with the inventories which he has to sell at lower than the expected value. But the reverse of it, when the economy is slow, availability of finance is low and pile-ups of unsold inventories so that builders stop building a new home. This helps to slowly getting sold out of inventories. Now, when the economy revives again, at that time supply will be lower than the demand which brings prices to the upper level. So that building a home during the slowdown is a better way to reap profits.
People tending that real estate investment beat the inflation (same for common stocks) but we need to understand that if the price which we pay are too high then it will not beat inflation and in result, it will beat us.
If we have bought real estate during a high price growth then we have to wait a little more while price growth has been slowing and many of the area it has been degrowth. So that not all price purchased of real estate result into the wealth creation.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
As we have seen that the economy moves in a cyclical way and if the economy moves in a cycle then the industry will get affected by the cycle and due to that corporates also getting affected. The profitability of corporate earnings has been affected by the economic cycle. But such effects vary from company to company as per the inherent capability of the company.
Corporate profits rise and fall more compared to the GDP growth and we need to focus on factors that cause such cyclical trends.
And when GDP shows weakness
So corporate profits also getting affected by the economic cycle. We can argue that food, beverages, pharmaceuticals do not have any impact on the economic cycle. Yes, not high but during a recessionary environment, people tend to save more than what they earlier used to. People prefer to eat at home rather than to go out to a restaurant. People prefer to cut costs while experiencing a tough time.
Durable products majorly affected by the economic downturn because such goods can last longer and people can defer spending on such goods.
We should not have to directly consider that increases in the sales will similarly result in the increase in profits. This is because of the operating leverage. Cost mainly remains fixed and few costs increase with the sales.
In general, it’s higher for companies for whom a larger percentage of costs are fixed and lower for the ones whose costs are more variable. Operating leverage helps the companies when the economy is in good shape and sales rising. But when the economy and sales are in bad shape, profits fall more than sales.
Other than these, there are few other factors which can also affect the profitability of the companies such as management’s decisions regarding inventories, production levels, and capital investment; technological advancements (on the part of a company, its industry competitors); changes in regulation and taxation; and even developments exogenous to the industry or war, weather, etc.
The technological disruption led cycle such as streaming has killed the DVDs culture so that those businesses which does not welcome technological changes, they all get out of the business. Nokia & Kodak are also the biggest examples of got the worst hit on business.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
The world is full of randomness and people behave differently at different times so that it is difficult to predict the exact future. If we study the science and mathematics cycles then those have predictable sets of rules and moves in a regular way. But economics, companies, and participants are relying on the psychological influences so that they do not behave in a regular way. When emotions have an involvement then things become more difficult to predict.
So that Greed and Fear of the investors remain regular in every cycle. This affects the prices of the assets.
As per the Cambridge dictionary, the definition of cycle “a group of events that happen in a particular order, one following the other, and are often repeated.”
We can see that many factors affect the occurrence of the events and that makes it difficult to predict the exact for the future. Current global scenario, we have an ample number of factors that can affect the cycle such as crude, the decision of the USA, domestic economic conditions, etc.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
Cycle changes for the different time period, details, extent but it will be ups and downs forever which changes the investment environment & behavior.
There are cycle moves in an identical phase such as a low to the middle point, middle point to a higher point, higher point to middle point with correction, middle point to lower point and then again to the middle to a new high. It is not necessary that the cycle starts from the low and ends at high or at again low, but it can start with any point and end up at any point.
Actually, the cycle never starts nor ends. We need to know why this upswing starts, where we are into the cycle, are we near the end of up/downturn, etc. Such answers need to be sought for the better judgment of the cycle.
Details of every cycle can change such as speed, time, reason, duration, etc. but cycle repeats.
Mr. Marks has quoted a story that blind persons touch the different parts of the elephant and make a story based on that touched part. Mr. Marks has explained that we are also similar to them, we also do not try to put things together and make a judgment. We must remember past events and keep in mind the cyclical nature of things. We also keep on thinking that the bull/bear run will continue forever but we need to focus on the previous cycles and understand the cycle that no phase-in cycle remains forever.
Cyclical development into one area also affects the other area of the cycle. That is if growth in an economy starts going down then the central bank will also work on reducing interest rates which involves a different cycle.
We must have to understand that cycles are interconnected and one affects others, others affect another. We can study individual cycles for the analysis purpose but for the conclusion, we need to combine all together. Without putting everything together, we cannot reach a conclusion that where we stand at the cycle.
We have seen that it takes time when we pump air into the balloon but it takes very little when air goes out from the balloon. Similarly, asset booms take time to occur but the majority of the time bust happens very rapidly.
Every boom and bust having a similar lesson that excessive optimism is a dangerous thing; that risk aversion is an essential ingredient for the market to be safe; that overly generous capital markets ultimately lead to unwise financing, and thus to danger for participants.
Generally, we do not learn lessons from past mistakes and doing the same things with the expectation of different results. This is never going to happen. Every time when asset prices start moving towards the bubble territory then people start running to take the asset with the missing feeling. And similarly, when asset prices are near to bust then all running away from the asset. This is a common and repeatedly occurred event. And every time, people keep believing that it’s different this time. But it’s never different but yes the majority of people are different in the different cycles which make them a force to think that it’s different this time. Those who have survived during the different cycles must know that every cycle having the same characteristics and it will always be going to occur.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
After the completion of the Bibliophile series on the book “The Intelligent Investors” by Mr. Benjamin Graham; I am hereby starting a series on the book “Mastering Market Cycle”by Mr. Howard Marks. I have already completed bibliophile series on his first book – “The Most Important Things”. He is one of the investors to whom I admire and learn about the cycle and always get to protect my wealth while nobody thinks about it.
As the cycle getting change, our odds also start getting change. It is mainly depending on our position to the cycle at where we stand to the cycle. If we are standing in a favorable position then we can increase our bets and reap the benefits of the cycle. Similarly, in unfavorable situations, we can protect ourselves from unfavorable changes in the cycle. If we are standing at unfavorable situations then we can adjust our position.
If we have the same information as others have and we analyze as similar to them then we cannot outperform the mass. Consistently outperform the mass is already a difficult task to perform.
Mr. Buffett has mentioned regarding the desirable piece of information – it has to be important, and it has to be knowable. Macro definitely affects the market so knowing it helps. But for consistently outperforming through knowing macro is difficult.
When we are constructing the portfolio then we generally look at the difference between price and value. Also, we bought the company which has the highest value I. E. Company available at a discount to its value.
So, does it not look at the quality of the company?
Yes, it is right that for successful investing, we need to identify the company which understates the value proposition. Higher the upside, we can take a position accordingly. But if we adjust our position as per the upcoming market storm then it can be more profitable and can add further value to our investment journey. This estimation of the upcoming market situation helps us with the decision making to remain aggressive or to be defensive in our portfolio. We only make an aggressive /defensive decision when we know the investment environment and where we stand in a cycle. When we get investment opportunity at cheaper, discounts to value then we should be aggressive and when getting expensive, then we should be defensive.
Similar we can do for the midcap and small-cap universe. And prepare ourselves from an upcoming cyclone.
We all talk about the risk but what actually risk mean? It can be loss of capital, academic says the risk is volatility in the price of assets. So, Mr. Marks has explained the types of risks in a good manner.
Opportunity loss, this is a missing out a potential gain, our investment has underperformed compared to what we missed and things do not happen the way we want it.
Risk means the occurrence of more things than we have predicted. If we know what is going to happen then there will be no uncertainty or not any risk. And if things are certain then we also get certain returns such as bank deposits. We cannot surely know the outcome of the events but we can assume the probability of the occurrence of the events. We assume the probability of the events that does not mean that we know the occurrence of the events. Anyone event can occur out of the many events. When we do not know the occurrence of the events, then we do not have an edge and we have to stay depended on luck. When we have the knowledge of the occurrence of the events then we have an edge and winning probability will increase with lower down losing probability.
Superior investors are attentive to cycles and they capture the cycle for reaping profits.
When a cycle is in our favor, we can earn good profits by taking benefits of it and visa Versa, when the cycle does not favorable to us then we can protect ourselves for loss of capital.
When cycle at extreme of Greed then we have to protect ourselves from capital loss. There will be a higher chance of incurring losses rather than earning profits.
If we look at the P/E of Midcap and Small Cap index during the year 2017-18 then on the closing basis it was 37.22x and 86.19x respectively and high P/E of both during the same period was ~47x and ~114x respectively. At such valuation, we are not ready to buy a few growing large caps but having a huge hope of getting a return at such high valuation and transformation of small-cap as a future large cap. So that such a scenario is for protecting capital rather than chasing high returns. I had parked ~73% of my portfolio in the liquid fund during the same period which has helped me to survive in such cyclone. We need to focus on the cycle, pendulum where it is moving and where we stand in the cycle.
When in a similar cycle economy, corporate profits and prospects remain the same but pessimism among the participants provides an excellent opportunity to make an investment, increase our position to be more aggressive. And when the economy, corporate profits, and prospects remain the same but having a huge optimism among the participants then we should adjust our position as a defensive investor.
When our position in the cycle changes, our odds also get change and if we do not change our investment accordingly then we miss the opportunity to enhance return or protect capital.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
Lucky Idiot 