Mastering the Market Cycle
Value investors strive to take advantage of discrepancies between price and value.
Investing is all about forming probability distributions.
Cycles oscillate around a midpoint (secular trend).
Markets rarely go from underpriced to fairly priced and stay there, meaning they overshoot in the opposite direction.
Cyclical developments in one area influence cycles in others.
Trends create the reasons for their own reversal.
The official technical definition of a recession is two consecutive quarters of negative GDP.
One of the main determinants of a year’s economic output is the number of hours worked, which is primarily driven by population growth (demographics).
Short-term investors are largely interested in the rate of change in GDP and that change’s duration.
The underlying secular trend of economic growth is primarily driven by hours worked (birth rates) and productivity.
One of the implicit duties of central banks is to manage the market (business) cycles.
A government’s best tool for managing the market cycles is fiscal policy (spending and taxes).
Keynesian economics focuses on the role of aggregate demand in determining the level of GDP and suggests governments should manage the economic cycle by influencing demand.
Elastic goods and services tend to be more influenced by market cycles. If economic booms and busts considerably influence a(n) industry’s/company’s revenue relative to other industries/companies, its performance is likely to be more cyclical.
Durable goods tend to be more expensive and longer lasting, meaning people can go without them in hard times. Durable goods, then, are largely cyclical.
In general, operating leverage is higher for companies whose costs are fixed and lower for those whose costs are variable.
Operating leverage can be good when sales are up, but it has an equal and opposite effect when sales are down.
Debt holders occupy a senior position relative to equity holders and have the first claim to any liquidated assets.
In business, financial, and market cycles, most excess to the upside and downside are driven by psychology.
In the long term, stocks should provide returns in line with the sum of their dividends plus the trend line growth in corporate profits.
Markets fluctuate between fear and greed because people fluctuate between fear and greed.
The risk of investing comes from the inherent challenge of predicting the future.
Investments that seem riskier must appear to offer higher returns, otherwise, nobody would invest in them.
Risk is high when investors feel that risk is low, and risk compensation is at a minimum just when risk is at a maximum.
The greatest risk is thinking there is none.
The totality of investors rarely reach an equilibrium with regard to where they fall on the fear-greed spectrum, rather, they tend to oscillate between the extremes.
Capital refers to all the money used to finance a company, while credit refers to the debt (not equity) portion of that capital used to finance the company.
The ability of companies and economies to grow usually depends on the availability of incremental capital.
Capital must be available in order for maturing debt to be refinanced.
The worst loans are made in the best of times. This eventually leads to capital destruction where the cost of capital for investments exceeds their return.
It’s hard to understand most phenomena in the investment world unless you’ve lived through them.
Superior investing doesn’t just come from buying high-quality assets, it comes from buying when prices are excessively low because of influences related to investor psychology and the market cycles.
A slammed-shut credit window in states of market panic probably does more to make investment bargains available than any other single factor.
Nothing will protect an investment made at too high a price.
Prices are primarily affected by fundamentals and psychology.
Every price is an amalgamation of past events, expected future events, and investor psychology.
What the wise man does in the beginning, the fool does in the end.
You can’t have intelligent investing in the absence of quantification of value and an insistence on an attractive purchase price. Any investment built on something other than price and value is irrational.
When current prices start to deviate from past valuation standards, the market will be testing the limits of its bullish or bearish excess.
The demand for “low-risk, high-return” CDOs filled with MBS drove demand for more and more mortgages leading up to the GFC, which is why banks slowly reduced their mortgage standards (to sell more mortgages and meet that demand).
Though you never want to be the investor catching falling knives in the market, you can’t wait for the bottom to be confirmed and sentiment to shift because, at that point, it will be too late. You have to just buy below intrinsic value and wait out the storm.
Investors have to deal with two possible sources of error:
- The risk of losing money.
- The risk of missing opportunity.
As an investor, you will be wrong more times than you expect. Your goal is to survive this by managing your risk, not to win every trade.
Don’t confuse brains for a bull market.
Everything that produces unusual profitability will attract incremental capital until it becomes crowded and the risk-adjusted returns move back toward the mean.
In investing, everything that is important is counterintuitive, and everything that is obvious to everyone is wrong.
Investing is all about the changing of attitudes and sentiments and how that change contributes to error.
Buying when others are despondent sellers and selling when others are eagerly buying requires the greatest fortitude and pays the greatest reward.