“You Can’t Predict. You Can Prepare.”
To introduce his chapter on cycles and cyclicality, Howard Marks (Trades, Portfolio) borrowed that advertising tagline from the MassMutual Life Insurance company.
Chapter eight of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor” saw Marks making the point that while we cannot know the future, we can at least prepare for it by understanding there are a few constants.
Two such constants are:
- Rule No. 2: “Most things will prove to be cyclical.”
- Rule No. 2: Many great opportunities for gain and loss occur when other investors forget Rule No. 1.
Only machines go in straight lines. Anything involving people will be varied and cyclical. Why? Because humans are “emotional and inconsistent,” not “steady and clinical.” They overreact and underreact to events in the external world, including technological developments and corporate decisions.
When life seems to be going well, they become optimistic, spending more and saving less. They even begin borrowing to increase their enjoyment or profits. In addition, they are willing to pay more for those benefits. And so, an upward leg of the credit cycle begins:
- A period of prosperity begins.
- Banks and other financial institutions do very well and build up their capital bases.
- Little bad news leads to the belief risks have shrunk.
- Financial institutions expand by providing more capital.
- They also compete by lowering credit standards and making bigger loans.
Marks summed up with these words from The Economist magazine: “The worst loans are made at the best of times.”
As the cycle continues to move upward, capital destruction begins and returns lag, even to the point where the cost of capital exceeds the returns. Around this point, the cycle reverses and a downward leg begins:
- With accelerating losses, lenders become pessimistic.
- Their risk averseness increases, along with interest rates and restrictions on credit.
- Less capital becomes available, especially for poor credit risks.
- Many companies are thus starved of capital, including those who simply wanted to roll over their loans.
- A vicious cycle has been set in motion, and the economy keeps contracting.
Needless to say, this leg, too, will reverse itself. As Marks wrote in one of his memos to clients:
“Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal. Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.”
At some point along the downward leg of the credit cycle, contrarians see opportunities for high returns and commit their capital. As they are followed by other investors, a recovery begins. In Marks’ words, “I stated earlier that cycles are self-correcting. The credit cycle corrects itself through the processes described above.”
He also advised readers to look around when the next crisis occurs; they will likely find overly permissive lenders. These lenders contribute to financial bubbles and he saw their fingerprints on several collapses over the past 30 years. He also found investors guilty of the same practice — putting too much capital into overpriced assets — leading to “overexpansion and dramatic losses.”
Marks added that cycles will not stop coming, as consumers and companies shift from optimism to pessimism and back again, over and over. In the case of companies, they expand their facilities and their inventories to the point they become a liability rather than an asset.
Despite this, some commentators still see cyclicality fading away. One such period was in the mid- and late-1990s; in 1996, The Wall Street Journal reported, “From boardrooms to living rooms and from government offices to trading floors, a new consensus is emerging: The big, bad business cycle has been tamed.”
“This time it’s different” are the four words that get bandied around when such optimism is widespread. They should inspire fear among citizens, and optimism among value investors.
To show this propensity for believing cycles have been tamed is not new, Marks offered several quotations from a compilation of pre-Depression statements by business people and political leaders. Titled “Oh Yeah?” and published in 1932, the book included these gems:
- “There will be no interruption of our present prosperity,” from the head of the Pierce Arrow Motor Car Co. in 1928.
- “I cannot help but raise a dissenting voice to the statements that … prosperity in this country must necessarily diminish and recede in the future," from the president of the New York Stock Exchange in 1928.
- “We are only at the beginning of a period that will go down in history as the golden age,” from the president of the Bush Terminal Co. in 1928.
- “The fundamental business of the country … is on a sound and prosperous basis,” President Herbert Hoover on Oct. 25, 1929.
At times, a leg of the cycle may go on for longer than expected (consider our own 10-year up-leg) and the idea that “this time is different” will emerge again. It also happens when profound changes occur, as was the case in the 1990s. Watch for the extrapolation of trends whenever investors and others believe “this time is different.”
But, eventually, the “old rules” reassert themselves and the cycle begins again. “Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do,” Marks said.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
