Next month, the respected investor Howard Marks is coming out with a new book, "Mastering the Market Cycle," whose title might inspire many readers to scour it for evidence that short-term market timing can work.
They will look in vain. You should scale back or crank up the level of risk you take in the markets, says Mr. Marks—but only when signs of euphoria or despair become extreme. The more often you do change your stance, the less likely you are to be relying on valid indicators.
To be sure, Mr. Marks warned in early 2007 that the mortgage market was overheating. In October 2008, with the stock and bond markets in free-fall, he wrote: "When others conduct their affairs with excessive negativism, it's worth being positive." As a result, Oaktree Capital Management, the Los Angeles-based investment firm that Mr. Marks co-founded and co-chairs, largely avoided the buy-high-sell-low behavior that devastated so many other investors during the financial crisis a decade ago.
As Mr. Marks explains in his book, markets typically move in big, multi-year cycles. The turning points can be recognizable, but they are surprisingly rare and far apart. So investors who react to what they perceive as short-term signals are likely, most of the time, to be basing their moves on little more than noise.
Worse, many investors—individuals and professionals alike—take their own current emotions as indicators of the market's future moves.
In an interview, Mr. Marks, 72 years old, grabs a piece of paper. With a practiced hand, he draws a long, swooping series of ups and downs that slope up the page from lower left to upper right. With three swift pen-strokes he draws a diagonal and two parallel lines that bisect all the curves. He scribbles "FAIR" on the central line, to mark the normal zone of decent value. Below it he writes "CHEAP"; above, he writes "RICH," to show when assets are overpriced.
In the top right, as the curve of the market sweeps up and into the zone of RICH, Mr. Marks draws a little box to show the short-term fluctuation of prices. So what will happen next? He scribbles a fan of three dotted lines: one going up, one flattening out, one falling.
Mr. Marks admits his book is a kind of tug of war between his certainty that "we don't know what the future holds" and his belief that "we can identify where the market stands in its cycle."
By studying how the economy, the markets and the psychology of investors all move in long cycles of expansion and contraction, Mr. Marks and Oaktree have been better able to cut back risk near market peaks and ramp it up near market bottoms, he says.
But Mr. Marks doesn't think you can use that sort of understanding to go all in or all out of markets again and again. He likes the book's subtitle—"Getting the Odds on Your Side"—better than its title, he quips.
"Recent performance doesn't tell us anything we can rely on about the short-term future," he says, "but it does tell us something about the longer-term probabilities or tendencies."
He pokes a finger again at the sketch he has made.
"Everything about our human makeup conspires to make us do the wrong thing," he says. "Most people get excited at the highs and depressed at the lows instead of being able to buy low and sell high. That's the human failing."
In his book, Mr. Marks describes a conversation he had with a pension-fund client in the fall of 2008. Trying to get the pension fund to invest more, Mr. Marks emphasized how the crisis was creating current bargain prices and, thus, high potential future returns.
As Mr. Marks demonstrated that Oaktree's investors would still make money in one doomsday scenario after another, each more dire than the last, the pension officer kept interjecting, "But what if it's worse than that?"
That was an epiphany, Mr. Marks tells me: "When there's no assumption you can make that the onlookers consider bad enough, things must be too bad to be true."
Today, neither stocks nor bonds are cheap overall, but they aren't so drastically overvalued "that this is the time for maximum defense," says Mr. Marks. "Nor are prices so low and the outlook so good that you should be aggressive." You should expect returns over the next five years or so to be "low or negative in most asset classes."
Imagine a continuum from 0 to 100, he says, with 0 being completely out of the market and 100 being completely in using aggressive techniques like investing with borrowed money.
"Each of us, based on our understanding of ourselves, should have a normal position between 0 and 100. So, vis-à-vis our normal position, where should we be now? I think today we should be moderately tilted toward defense."
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