By Dr. Hamik Martirosyan, Guest Writer
Incorporating this feature of markets in the construction of your portfolio may help to improve results. However, we have to be cautious so that this strategy does not morph into market timing. Instead, we should use it as a tool to supplement your investment plan.
In his book, Mastering the Market Cycle, Howard Marks discusses the cyclical nature of markets and how to utilize this tendency to position your portfolio for outperformance. He provides valuable insights which might be helpful to us white coat investors.
Nature of Cycles
Cyclicality is a constant feature of the markets. History shows markets fluctuate between greed and fear, optimism and pessimism, risk-tolerant and risk-averse, overpriced and bargain-priced, etc.
Cycling from one extreme to the opposite is a given. It is impossible for prices to increase to infinity, and conversely, it is unlikely that all asset values will go to zero. They must reverse course and progress in the opposite direction.
Just as important as the inevitability of cycles is the unpredictability of cycles. We know that cycles will happen, but we do not know:
- When it will happen (time)
- How rapidly it will happen (rapidity)
- How severe the reversal will be in the opposite direction (scale)
As a result, utilizing the cycle dynamics may not be as simple as it may seem. Putting these components together shows market return cycles as you would see for the S&P 500, for example.
The cyclicality of S&P 500 prices, via the JP Morgan Guide to the Markets
Cycles are self-correcting, and they do not necessarily rely on exogenous factors. The factors responsible for one portion of a cycle will sow the seeds for the next portion. Success will sow the seeds for failure and vice versa. Optimism will sow the seeds for pessimism and vice versa. Overpriced valuations will lock in lower future returns and future disappointment, eventually leading to bargain-priced valuations.
Cycles spend more time at the extremes and less time in the middle/average. Just like a pendulum has the highest velocity at the midpoint and spends the least amount of time there, the forces leading to cycle turnovers peak around the midpoint and cause rapid swings rather than stability at the center. The S&P 500 average annual return since inception has been around 10%. The chart below shows its annual return since the 1920s. It is a rare year when the S&P returns are at or close to 10%; most years see significantly higher or lower returns from this average.
Annual S&P 500 returns, via Macrotrends.net
One of the most, if not the most, important factors to cycles is investor behavior and psychology. The cycle is set by investor behavior rather than financial performance. We do not make decisions scientifically, solely based on financial performance. Instead, we are bound by our emotions. People are emotional and inconsistent, not steady and clinical. This is what leads to the cycles.
Different types of cycles, to name a few, include economic, business (profit cycle), investor psychology, risk, credit, and real estate.
More information here:
Optimists Are the Best Investors, Even If the Pessimists Sound Smarter
Stop Playing When You Win the Game
Typical Cycle Roundtrip
Upswing
An investment or strategy will start at an intrinsic value based on investment fundamentals, like revenue, income, and debt ratios. If there is a perceived benefit, there will be net buyers bidding up the price. Its success will elicit more buying, driving up the price even further. In some scenarios, we may see the formation of a bubble in which buying would continue as some may fear missing out. Continued success will lead to the belief that the investment can only go up and the old rules do not apply. Risk is minimized or ignored even though it is higher since the price being paid locks in lower future returns. Inevitably, since trees don’t grow to the moon, the price will peak, and the reversal will begin.
Downswing
Then, the next part of the cycle—the descent—will start. The catalyst may be a less hospitable economic environment or a black swan event, or it may simply be due to unrealistic expectations set by investors that cannot be achieved or maintained. Net selling will ensue. Prices will fall. Continued selling will feed on itself. No one will want to catch a falling knife. If severe enough, there will be minimal buyers, as most people will be tired of losing capital and will only care about preserving principal. All the negativity will be priced in.
The risk is lowest here when everyone is afraid. At a certain point, the sentiment is too bad to be true, and enterprising investors will jump in and begin the reversal to the upside.
The tech boom and bust of the late 1990s and early 2000s is a good example of a cycle. The euphoria of the tech innovations of the day created a tech bubble. Risk aversiveness was ignored, and fear of missing out was the prevailing emotion. The NASDAQ PE ratio was bid up to 200. Eventually, the unrealistic expectations became apparent as earnings and sales (as some did not even have positive earnings) disappointed. Overpriced valuations became apparent, and the selling began. The bust followed since the boom was not based on any inherent structural fundamentals. During the bust, the NASDAQ PE settled at a low of 10. That's 1/20th of the peak value.
Fundamentals could not have changed by a factor of 20 over a few years. The ups and downs were due to investor behavior.
Real Estate Cycles
Commercial Real Estate (CRE) shares the same characteristics as a typical market cycle, but it also has some additional important factors: development time and leverage.
Development Time
Ground-up construction is an important part of the real estate cycle. With buildings, you can't just turn the inventory up or down instantaneously. With how long it takes to build new properties, there is a lead time of 2-3 years. This may exacerbate cycles as the building will be started during boom times and avoided during busts. This may lead to a mismatch with market conditions when the construction is completed 2-3 years later and hits the market, exacerbating prevailing market conditions of the time.
Leverage
Credit is used in CRE, leading to leverage as acquiring real properties requires some debt. The credit cycle has its own characteristics. It is either open or shut, without an in-between. During booms, credit is openly available, even to those with poor capital structures. During busts, lenders stop lending or only lend with onerous terms. This leads to further exacerbation of the prevailing market conditions in both extremes.
We are seeing the current CRE cycle play out. Post-COVID, CRE went on a tear. During late 2020 to early 2022, multiple CRE investments popped up, and equity was easily raised with subscriptions. We started seeing unsustainable rent growths with some places growing at 20%. Some cap rates (valuation ratio for CRE, equal to Net Operating Income/Purchase Price) went down to historically low levels of around 3% (lower means more expensive purchase prices). Since it was so easy to raise money in both the equity and debt markets, poor capital structures were formed, including those with variable financing and high LTVs (loan to value).
Eventually, inflation caused rates to rise and exposed the unrealistic expectations with which investments were made. Variable rates started rising. Rent growth softened as new construction (started 2-3 years ago during the boom) added more supply to the market. This led to increased defaults and capital losses for investors. Cap rates have since increased to 5%. Though going from 3% to 5% does not sound like much, this, if all else is kept equal, would mean a price drop of 40%.
More information here:
The 60+ Worst Mistakes You Can Make in Real Estate Investing
Positioning Your Portfolio in Cycles
Marks recommends positioning your portfolio in cycles by assessing quantitative and qualitative factors of where we stand in the cycle.
Quantitatively, you would assess valuation measures—such as PE and CAPE ratios, capitalization rate (in CRE), and equity risk premium. Marks then gives a list of factors you would qualitatively assess to get a temperature check of how hot or cold the market is. Some include the economy, recent returns, the outlook, access to credit, risk premiums, investor psychology, and investor risk tolerance/aversion. This is not an exact science, but with enough diligence, it will provide utility.
Taken together, this will provide an estimate of where we stand in the cycle and help you decide if you should position in a defensive, offensive, or neutral position.
However, even the best assessment will not guarantee what will happen next. It will only show you the tendency of what may happen. It does not tell us what will happen with certainty. Instead, it tells you which is the most probable next step that will occur. Overpriced valuations can continue to rise temporarily (and vice versa) as markets can remain irrational longer than expected.
Practical Applications and Insights
Despite its utility, assessing the cycle is not a silver bullet. It might only be helpful during the extremes and not helpful during most years. Some examples of utilizing the market cycles are included below. To be clear, I am not advocating for market timing. I do not believe in market timing. The historical data shows that no one can reliably predict future performance.
But understanding the concept of cycles and assessing the market periodically may help you make fewer mistakes. This is done by identifying the extremes and avoiding buying during bubbles and selling low during panics. I think this is the most beneficial aspect of understanding cycles for us retail investors. We are playing a game of amateur tennis in which the winner is not who makes the best shots but who makes the least mistakes. This has hurt me when I have bought cryptocurrency due to the fear of missing out. And it has helped me recently in avoiding buying Tesla at a peak and avoiding buying NVDA currently.
Tilting
Rather than using it as a timing tool, it might be best to tilt your portfolio within the confines of your investment plan during the extreme years. For example, investors commonly use a range for asset allocation. During the COVID selloff when valuations tanked, I tilted my stock allocation to the higher end of my range. And during the end of 2021, when valuations seemed too high, I tilted my portfolio toward the lower range for stocks. At this time, I was not trying to time the market, but I wanted to take some risk off the table since I was progressing toward financial independence faster than I had anticipated. Risk de-escalation is in my investment plan and is based on aging and asset growth. I just accelerated this risk de-escalation as valuations appeared to be rich at the time.
Buying During Downturns
Marks mentions that it is more beneficial to buy when prices are falling and the bottom is unknown rather than during the upswing. Though it may feel like you are trying to catch a falling knife, continued buying will be beneficial in the long run. No one can perfectly time the bottom, and continued buying is important. Those who continued dollar cost averaging during prior bear cycles have been rewarded handsomely. As Dr. William Bernstein has said: if you are young, you should get on your knees and beg for a prolonged, painful recession. Your future self will thank you for it.
Investor Behavior
How investors behave may give you critical information, even though you might not be an expert in the asset class. Marks uses the Global Financial Crisis of 2008 and the subprime market as an example. He was not an expert with CDOs (collateralized debt obligations) and other exotic financial instruments, but based on how investors were behaving, he was led to believe that the US was in a housing bubble. This included home loans being made to people without verifiable income, negative amortization loans, people quitting their jobs to flip houses for a living, and the continued expectations of high price growth in housing.
Study and weigh investor behavior just as much, if not more, than the asset’s strategy and performance, and it will help your decision-making. This has helped me formulate my current plan around cryptocurrency. My decision on buying and selling crypto is based on how investors are behaving toward this asset class rather than the fundamentals of it. This most likely means that I will only buy when it is hated and left for dead. I might miss out on large gains if it succeeds, but I accept that, given its uncertainty and speculative nature. As Warren Buffett has said, “There are no called strikes in investing.” You do not have to pick every successful investment.
More information here:
How to Think About Risk and Why It’s So Hard to Quantify
A Tale of 2 Sponsors: How My Real Estate Investments Have Had Vastly Different Results
The Bottom Line
Cycles are an inherent feature of healthy markets. Investor psychology is perhaps the most important factor in dictating the cycle characteristics. Though cycles are an inherent feature of markets, they are unpredictable in that we don’t know when the tide will turn, how rapidly it will turn, how severe the turn will be, or how long it will last.
Estimating quantitatively and qualitatively where we stand in the cycle may help us tilt our portfolio so that we can achieve improved investment outcomes. This requires time, effort, and skill, and it is not a magic bullet. At a minimum, it may help us make less mistakes at extremes.
[FOUNDER'S NOTE BY DR. JIM DAHLE: One of the reasons we have guest posts at WCI is simply to provide a different perspective than my own, and that is why this post was selected to run. Those who have been reading this blog for many years know that I prefer a static asset allocation approach. It isn't that cycles don't exist or that if you could time the market well it wouldn't be super profitable. It's just that trying to take advantage of these cycles by tinkering with your portfolio in any way is just really hard. So hard that it probably isn't worth trying to do, especially after the costs (time and money) of doing so. Effective, long-term investing is so simple that it is hard to believe it even works. People figure it MUST be possible to add some value to the process by doing something else besides blindly buying, holding, and rebalancing a reasonable, low-cost, broadly diversified static asset allocation of index funds or similar investments.
Nobody wants to be that guy who put a bunch of money into the market in March 2000, July 2008, or February 2020 only to see it dramatically drop in value for a while. It's psychologically painful. But there's a reason all investment approaches are compared to this basic approach of just investing any time you have the money and staying the course with your plan. It's because everybody knows it works. It'll work for you, no matter how many market cycles you have to invest through. Nobody wants to admit tactical asset allocation (allocation changes made due to valuations or thoughts on the market cycle) is market timing, but that is exactly what it is. And a little market timing has the same issues as a lot of market timing—just to a lesser degree.]
Have you studied the market in depth to help you figure out when you should buy and sell? Or do you prefer more of a set-it-and-forget-it philosophy?
Thought I was going crazy until I got to the Founder’s note at the end. Despite the author’s protestations, his suggestions on how to apply the theory of market cycles to investment without engaging in market timing are all examples of market timing. He apparently speculates in individual stocks on top of this. Although I appreciate the author’s interest and effort, the read feels disingenuous as a result, and although I appreciate the variety of perspectives in WCI guest posts, this particular article feels more like a throwaway I’d read on a sold-off FIRE blog than the insightful content typical of WCI. Just my 2 cents.
This comes up in the Bogleheads forum regularly, and one of the posters Nisiprius has mentioned a Vanguard fund in the past that used strategic asset allocation based on the description above. The fund didn’t do so well and I don’t think it exists anymore. Wish I could remember the name. If professional fund managers can’t do it, I’d wager that someone who does this as a side hobby, on average, isn’t going to do any better.
I thought it was called the Vanguard Asset Allocation Fund but it might have been called the Vanguard Managed Allocation Fund: https://investor.vanguard.com/investment-products/mutual-funds/profile/vpgdx#overview
Eh. This one doesn’t add much for me. Nothing actionable here. More like a review article. Though I appreciate the author’s time and interest.
I felt similarly as you can probably tell from my note at the end, but we do publish most well-written guest posts from regular readers and this qualified as that.
Probably the most important point I was trying to make was that, it’s important to understand the market cycle so that you don’t rush into bubbles or hysteria.
Regarding market timing, I’m a boglehead as well. I think what I was describing is akin to what was described in Jim’s article yesterday regarding, Bernstein. Straight quote from yesterday:
“While this approach smacks of market timing, it’s entirely based on past performance—not future performance—and requires no predictive ability. He’s just suggesting that your gradual transition from a 75% stock portfolio to a 25% stock portfolio doesn’t have to occur in an even manner. It’s OK to reduce the risk level using broad strokes, especially after a good year or two. Seems wise to me.”
And no, I don’t buy individual stocks. NVDA was just an example of performance chasing and hysteria.
I think part of the issue with your post was that it didn’t really recommend anything. It was mostly just informational and kind of vague about what to do with that information. And that’s really the problem with trying to do anything with cycles. Looking in the past, you can see that bailing out of stocks in early 2000 would have been smart. But valuations would have also suggested you bail out of them at the end of 1996 when Greenspan was talking about irrational exuberance. And that would have been a mistake. We can all see that cycles exist. The problem is what to do about them.
Now if you have to make a portfolio change like dropping your AA from 70/30 to 50/50 or whatever over 5 years, you’re stuck with a dilemma. Do you do it all at once now. Do you do it all at once in 5 years. Do you do 20% a year. Do you do it at the end of the first year of the next 5 where the market goes up at least 10%? I don’t think anyone really knows without a functional crystal ball. Probably best to just write down what you’re doing to do and then follow that instead of spending the next 5 years watching the market and giving yourself an ulcer trying to figure it out.
In order to fully play the devils advocate, let’s set a possible scenario here.
John has some cash he’s had in a money market account making 2% nominal. He’s financially in a good job, let’s say tenured professor at Muckity-Muck U. or some other job that’s more or less unassailable. Suddenly, Trump tweets he hates Hostess snack cakes because the hostess at the restaurant last week put him on a lower table than Nancy Pelosi. John sees TWNK (that’s funny right there) drop 30%, and he starts eyeballing his money market fund. He knows that it doesn’t matter if Donald John Trump tweets TWNK into oblivion, there’s no way that sugar-addicted Americans and Europeans
(https://www.candylandsweets.uk/product-category/candy/hostess/ – you’re welcome)
will ever give up cream filled sponge cake delights. Are you going to tell me it’s patently impractical for John to time this Trump Tizzy Mini Market Cycle (TM) and load up on TWNK? You’d be crazy not to.
I don’t because I don’t have time to follow individual stocks, but if that were a hobby of mine, I could absolutely see me doing it.
P.S. In case anyone is wondering, twinkies are indeed a healthy food as indicated here
https://www.acsh.org/news/2010/11/09/food-for-thought-twinkie-diet-helps-nutrition-professor-lose-weight
If you think it’s easy to time the market and pick stocks, I suggest you try it for a while and carefully track your returns. If you’re good at it, you have a rare gift and should exploit. But just about everyone who does this exercise will learn just the opposite.
To be clear, I would not because I lack the time, but there are those with the inclination and time to do so. You must admit that the market values, which Bogleheads implicitly believe by virtue of being passive investors, must be set by a group of active investors. Thus, the majority of active investors are the ones who “correctly” set the market price. They can’t all be wrong all the time
On average I think they’re mostly right most of the time. But there’s a wide range around the average.
1. You can’t make definitive recommendations because people have different time horizons, risk tolerance, and financial goals.
2. Even if you sold in 1996, if it still got you to your financial goals (financial independence with less future risk), I’m not sure you can call that a mistake. We only in retrospect know that the market did well after 1996.
3. We just had a cycle where a lot of doctors bid up real estate; just looking at the WCI forum and other social media accounts suggests that. Some of the concepts described might help prevent future runups, including those specific to the RE cycle.
Respectfully, I still don’t see it. Do I need to understand anything about the theory of market cycles to consistently buy and hold in a fixed asset allocation? It seems to me that it doesn’t matter if I believe the underlying trend is a sine wave or a martingale if I don’t make decisions to buy (or not) based on the market but instead based on my available cash for investing. If I don’t need to assess market conditions to decide whether and what to buy, I don’t need to understand or pay attention to valuations.
Regarding the quote from Jim re: Bernstein: I don’t think that motivates in the way you’re implying. To illustrate the difference imagine hitting a winning streak of blackjack hands at a casino and finding yourself with a large stash of chips. You might (a) recognize that your winnings are within your tolerance for risk and entertainment value, and keep placing big bets seeking further extreme returns, (b) realize you realize you have enough winnings to now reach financially independence, and prudently cash out because your need and willingness to take risk have changed (a la Bernstein), or (c) surmise that you should stop and cash out simply because your winning streak indicates you are due for a loss (the gambler’s fallacy, a la market timing). Two of those options are rational, one is not.
My mistake on the individual stocks, but your references to market cycle understanding informing your non-purchase of Tesla and Nvidia suggested otherwise.
Hey Hamik nice post man. Yeah, I have to agree with others that I am not gonna use tactical asset allocation to help boost my returns. However, there is kind of a tactical asset allocation when you are rebalancing using a band based methodology. I’ve read some evidence for having a band-based rebalancing strategy be better in terms of return overall than time-based.
I think though recognizing market cycles are more important in terms of behavior and making sure you don’t freak out and sell at the bottom.