[00:03:32] Clay Finck: That is episode number 497 on the We Study Billionaires Show. In that episode, one of the most important things for investors to understand, according to Howard, is being attentive to cycles. Marks states, “Good cycle timing combined with an effective investment approach and the involvement of exceptional people has accounted for the vast bulk of the success of my firm, Oaktree Capital Management. Understanding cycles makes our lives much easier.” I just think about my own life and how my family plans on going to the lake during July because that’s when it’s going to be hot outside. And we plan our trips around when we anticipate there to be nice weather because the lake is really just much less fun when it’s cold out.

[00:04:22] Clay Finck: Just like how the weather moves in cycles or moves in this pattern, economies, companies, and markets move in cycles too. Marks explains how cycles in the markets are largely driven by human psychology and human behavior. And because human behavior is the key driver in cycles, predicting exactly how the cycles play out really isn’t as predictable as something like the weather or predicting when the sun is going to rise and set.

[00:04:51] Clay Finck: Marks states here, “In order to do the best job of dealing with cycles, an investor has to learn to recognize cycles, assess them, look for the instructions they imply, and do what they tell ’em to do. If an investor listens in this sense, you’ll be able to convert cycles from a wild uncontrollable force that wreaks havoc into a phenomenon that can be understood and taken advantage of, a vein that can be mined for significant outperformance.”

[00:05:23] Clay Finck: Chapter one in Marks’s book is titled “Why Study Cycles?” and the reason we want to study cycles is because the odds of success in investing change as our position changes in the cycle. He argues that if you’re being passive about where you’re at in the cycle, then you’re ignoring the chance to tilt the odds in your favor.

[00:05:47] Clay Finck: He also mentions that we should be cautious about making macro forecasts about the economy, markets, or geopolitics because very few investors are able to achieve outperformance over the benchmark based on macro forecasts. It’s not that the macro environment doesn’t matter because it does matter a great deal, but we shouldn’t make macro forecasts because those who do often have unimpressive overall results, and very few are able to outperform based on macro forecasts.

[00:06:17] Clay Finck: So Marks focuses his time more generally on three areas. First is trying to know more than others in areas that are knowable, such as the fundamentals of industries, fundamentals of companies, and securities. Second is being disciplined as to the appropriate price to pay for participation in those fundamentals.

[00:06:37] Clay Finck: And third is understanding the investment environment we’re in and deciding how to strategically position our portfolios for it. The first two points, which involve fundamental analysis and understanding value, are core to what value investing is all about, and a lot has been written about it, as we’ve covered on the show.

[00:06:58] Clay Finck: This is why Marks, in his book, has focused on the last point, which is understanding cycles. Marks believes that the greatest way to optimize the positioning of a portfolio is by determining the right balance between aggressiveness and defensiveness. I interpret that as if you believe we’re at the top of a cycle, then you want to be more defensive, and if you believe we’re around the bottom of a cycle, then you want to be more aggressive.

[00:07:30] Clay Finck: Part of investing is that we don’t necessarily know what the future holds. Even legendary investors like Howard Marks can’t be 100% certain of what lies ahead, but superior investors have a better sense of the odds and which bets are and aren’t worth making.

[00:07:48] Clay Finck: So they understand the odds better than everyone else. Understanding cycles is important because the average investor doesn’t fully grasp the nature and importance of cycles, and they haven’t been around long enough to have lived through many of these cycles. The average investor falls victim to their own natural human psychology, rather than being a level-headed student of history who doesn’t succumb to things like greed and fear.

[00:08:15] Clay Finck: The superior investor is attentive to cycles. They make judgments about whether they’re at the beginning of an upswing or in the late stages of a bull market. They consider whether they’re operating in dangerous territory or not, and they’re mindful of how greedy and how fearful the current market is, and whether it’s time to be aggressive or defensive in their portfolio approach.

[00:08:41] Clay Finck: In Chapter Two titled “The Nature of Cycles,” Marks highlights the Mark Twain quote: “History doesn’t repeat itself, but it does rhyme.” Cycles will vary in terms of details, such as their extent, timing, and specific reasons, but the ups and downs and the underlying causes will always occur. Cycles oscillate around a central trend that generally moves upward and to the right due to increasing company profits, economic growth, and rising markets. Markets deviate above and below the trend line due to human psychology.

[00:09:15] Clay Finck: Marks recently mentioned on our show that humans tend to take things to extremes. It’s interesting that people acknowledge that markets move in cycles, but they often get caught up in those cycles and can get themselves into trouble when they reach extreme levels. Mark states that this oscillation bedevils those who don’t understand it, are surprised by it, or even contribute to it.

[00:09:40] Clay Finck: He breaks down this cyclical phenomenon into several phases: the recovery from a low point, the swing past the midpoint towards the peak, the high or peak itself, the downward correction towards the midpoint, the overcorrection and crossing below the midpoint, reaching a new low, and then the cycle starts again with a recovery. It’s important to note that there’s no defined beginning or end to a cycle, as each part of the cycle is influenced by what happened before it. When explaining how we reached the current point, one would have to decide how far back in history they want to go in their analysis.

[00:10:23] Clay Finck: While cycles often move above or below the trend line, a general rule is that they eventually gravitate back towards it. This is similar to the belief in value investing that companies tend to move towards their intrinsic value over the long run. This idea also relates to the concept of reversion to the mean.

[00:10:45] Clay Finck: The tricky part with cycles is that the details can vary widely when comparing one cycle to another. This includes factors like timing, duration, speed, the magnitude of market swings, and the reasons behind them. As mentioned earlier, history doesn’t repeat itself, but there are rhymes or similarities between cycles.

[00:11:05] Clay Finck: Marks also emphasizes a crucial point about the nature of cycles. People tend to think of cycles in terms of distinct phases, with upswings followed by downswings and vice versa. However, Marks highlights that one event causes the next event. During a bull market, the market’s upward movement fuels the bull market itself. As greed takes hold and more people join in, eventually the weight of the bull market becomes too much, and it reaches a peak. The energy that fueled the bull market then drives the bear market back towards the trend line.

[00:11:42] Clay Finck: And that energy and continued downward momentum is what carries it to a low below the trend line. I think understanding physical realities like gravity and momentum is really important here, and I believe it’s a good mental model for investing in the very best companies. There are times when they will trade well above and well below their general trend line, and patience is needed to enter these companies at the appropriate time in relation to the nature of cycles. He pulls in a few observations from his November 2001 memo titled “You Can’t Predict, You Can Prepare.”

[00:12:22] Clay Finck: The first observation is that cycles are inevitable. Every once in a while, you’ll see a new extreme where people start to say, “This time’s different” for whatever reason, and they make the mistake of extrapolating a new trend that ignores the time-tested ways of investing. But it turns out that the old rules still apply when the cycle resumes. Marks states, “In the end, trees do not grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical.”

[00:12:56] Clay Finck: The second observation is that cycles’ impact is heightened by the inability of investors to remember the past. In other words, people forget or simply don’t know that markets have a natural tendency to move in cycles.

[00:13:11] Clay Finck: The third observation is that cycles are self-correcting, and their reversal is not necessarily dependent on external events. The reason they reverse rather than persist indefinitely is that trends create the conditions for their own reversal. Thus, Howard likes to say that success carries within itself the seeds of failure, and failure carries the seeds of success.

[00:13:34] Clay Finck: The final observation about the nature of cycles is that, through the lens of human perception, cycles are often seen as less symmetrical than they actually are. Negative price fluctuations are referred to as volatility, while positive price fluctuations are called profits. Collapsing markets are labeled as selling panics, while surging markets receive more benign descriptions.

[00:13:56] Clay Finck: Marks believes that cycles are generally symmetrical based on his own experience. However, he clarifies that this symmetry applies reliably to the direction of the market but not necessarily to the extent, timing, or pace of the movement. As they say, the stock market takes the stairs up, climbing a wall of worry, and it takes the elevator down as it often falls more swiftly than it rises.

[00:14:24] Clay Finck: Marks argues that the details of each boom and each bust are not that important and are ultimately irrelevant. But understanding the underlying themes behind those booms and busts is essential. For example, during the Great Financial Crisis, the boom occurred largely due to the issuance of a number of unsound subprime mortgages, which in turn happened because of excess optimism, a lack of risk aversion, and an overly generous capital market, all of which led to risky behavior surrounding these subprime mortgages.

[00:14:57] Clay Finck: Then he says that the themes or warning signs that should be drawn from this are that excessive optimism is a very dangerous thing, that risk aversion is an essential ingredient for the market to be safe, and that overly generous capital markets ultimately lead to unwise financing and danger for participants.

[00:15:18] Clay Finck: Again, it is important to understand the overall common themes of a boom and bust, and the specific details of a particular event are not as important. At the end of this chapter, Marks includes one of my very favorite quotes: “Experience is what you got when you didn’t get what you wanted.” He states that the greatest lessons about cycles are learned through experience.

[00:15:44] Clay Finck: Chapter three is titled “The Regularity of Cycles.” One of the definitions of cycles that Marks likes is one that reflects how he thinks about cycles and oscillations. He refers to a definition from the Cambridge dictionary, which defines cycles as a group of events that happen in a particular order, one following the other, and are often repeated. Since cycles are driven by human psychology, and as many of us know, human psychology is not entirely predictable. How people react in one situation may not be exactly how they react in another situation.

[00:16:21] Clay Finck: Cycles in things like mathematics and physics are very predictable and regularly occurring, but in markets, it just isn’t the case. In markets, cycles play out in a somewhat random fashion, and they aren’t entirely predictable. To help explain the unpredictability of markets, Marks uses an analogy of baseball and how the result of any particular at-bat depends primarily on the player’s ability, but it also depends on the interplay of many other factors, such as the player’s health, the wind, the sun, the quality of the pitches he receives, the game situation, and countless other factors.

[00:17:00] Clay Finck: If it weren’t for all of those unpredictable factors, then a player would be able to hit a home run at every at-bat or fail to do so at every at-bat. The same unpredictability applies to the markets. A company may release positive earnings for the quarter, but whether the stock rises or falls may be a result of its competitors’ results, what central banks are doing at that time, or what the overall market is doing at that time as well.

[00:17:33] Clay Finck: So when someone proposes a very simple rule for doing well in the markets, they are probably oversimplifying how the world truly works. People will always have a thirst for simple rules rather than recognizing that markets are driven by a variety of different forces. Towards the end of this chapter, Marks states, “I’m firmly convinced that markets will continue to rise and fall, and I think I know why.”

[00:18:01] Clay Finck: And what makes these movements more or less imminent? I’m sure I’ll never know when they’re going to turn up or turn down, how far they’ll go when they do, how fast they’ll move, when they’ll turn back towards the midpoint, or how far they’ll continue on the opposite side. So there’s a great deal of uncertainty about.

[00:18:24] Clay Finck: I have found, however, that the little I do know about cycle timing gives me a great advantage relative to the majority of investors who understand even less about cycles and pay less heed to them and their implications for appropriate action. The advantage I’m talking about is probably all anyone can achieve, but it’s enough for me.

[00:18:47] Clay Finck: End quote. I love the humility that Marks shows here of just how much about cycles is unknown, but he does know enough to gain some sort of advantage in his investment approach. So while many get caught up in the excessive bull market, for example, Marks recognizes that he’s seen this story play out before and knows to be more defensive when people have become too euphoric.

[00:19:14] Clay Finck: Turning to chapter four, which is titled “The Economic Cycle,” Marks opens it up by stating the economic cycle, also known as the business cycle, provides much of the foundation for cyclical events in the business world and the markets. The more the economy rises, the more likely it is that companies will expand their profits and stock markets will rise, in quote.

[00:19:40] Clay Finck: Now the main measure of an economy’s output is GDP (Gross Domestic Product), and GDP is the total value of all goods and services produced and sold in an economy. On average, people typically assume two to 3% in growth in GDP in the US, while many emerging markets are growing at a rate faster than 3% for many years. When thinking about economic growth, we mainly want to consider what the long-term secular trends are rather than the oscillations around those trends.

[00:20:13] Clay Finck: The oscillations around the trend tend to cancel out in the long run, and the long-term secular trend is what’s really going to lift the economy. In January of 2009, Howard wrote a memo titled “The Long View,” where he outlined that security markets have risen over the previous decades due to a number of factors including the macro environment, corporate growth, the borrowing mentality of consumers, the popularization of investing, as well as investor psychology.

[00:20:43] Clay Finck: With these factors driving the secular uptrend in markets, of course, did not go up in a straight line. Another factor he mentions later in the chapter, which drives the economy, is population growth. Population growth can take a long time to change, and of course, if population growth were to turn negative and the population were shrinking, then of course GDP growth would be facing a headwind in addition to population growth.

[00:21:12] Clay Finck: The other important element of GDP is productivity. Higher productivity in an economy simply means that more can be produced in the same number of hours worked by a worker, like population growth. The change in productivity growth is very slow and gradual, which AI is certainly trying to accelerate in the years to come.

[00:21:34] Clay Finck: He states that economic growth appears to have slowed in the US, and I’ll note here that this book was originally published back in 2018. From 2010 through 2018, US GDP growth trended around two to 3%. In 2019, it was 2.3%. In 2020, it was -2.8%. In 2021, it was nearly 6%, and then in 2022, it was 2.6%. When I look back at the 1990s period, for example, I see many years where we had growth of over 4%.

[00:22:07] Clay Finck: So it does seem that, in general, economic growth has slowed, and Marks states that it’s yet to be seen whether this is a short-term cyclical change or a change in the long-term trend itself. Then Marks touches on short-term economic cycles and how, although many factors in the economy might not change too much, there are periods where consumer and investor behavior can change drastically.

[00:22:33] Clay Finck: For example, during the great financial crisis, consumers were spending less, even if they still had their jobs. The credit market just totally dried up, which meant less investment was happening, and companies generally were hesitant to expand their operations, and that led to a recessionary period from December 2007 through June 2009. To help paint a picture of how psychology plays into the economy and the short-term cycle, you can think about the wealth effect. When people feel wealthy and they feel that times are good, then they’re much more likely to spend more money. I know I’m personally much more likely to do things like go out for a nice dinner or buy something I don’t really need if my portfolio is doing really well.

[00:23:24] Clay Finck: The housing market also ties into this because people generally keep an eye on how much their house is worth relative to what they bought it for and how much equity they have after considering the mortgage. This makes the economy somewhat self-fulfilling. If consumers and businesses expect times to be good in the future, then they spend more and invest more, and this creates economic activity.

[00:23:51] Clay Finck: Marks says that it’s his belief that the crisis of 2008 was not a V-shaped recovery as it had been in past recessions because most companies were hesitant to do things like expand their operations. So their expectations, in a way, led to the reality of a more modest and gradual recovery. He then touches on how most economic forecasts are simply extrapolations of the past, and any deviations from the general trend are really hard to predict.

[00:24:22] Clay Finck: So he doesn’t really spend time trying to make economic forecasts, and he references this quote from John Galbraith. We have two classes of forecasters. Those who don’t know and those who don’t know, they don’t know. So the big takeaways from this chapter on economic cycles is I have five points here.

[00:24:41] Clay Finck: The output of an economy is the product of the hours worked and the output per hour, and that’s determined primarily by factors like the birth rate and the rate of gain and productivity. And those factors change relatively little from year to year. Second is, although the long-term secular growth is relatively steady, the year-to-year changes can drastically change due to things like wars, pandemic, economic crises, and other factors that really aren’t foreseeable.

[00:25:07] Clay Finck: Third is the long-term economic growth is steady over long periods of time, but is subject to change in the long-term cycle. Fourth, the short-term cycle oscillates around the trend line from year to year and over a long enough time period, it tends to follow the trend line. And then fifth and finally, people try really hard to predict economic growth, but very few are able to do it right consistently, and few do it much better than everyone else.

[00:25:33] Clay Finck: And few correctly predict the major deviations from the trend. So in order to understand market cycles, it’s also really important to understand the government’s role in cycles, which is what’s covered in chapter five. Free markets today are accepted as being the best system for allocating economic resources and encouraging economic output.

[00:25:53] Clay Finck: But markets today are rarely left to their own devices. Central banks in particular, play a big role in markets today. Today, central banks are primarily concerned with actually managing the economic cycle. One thing central bankers wanna do is try and control inflation. Because when inflation becomes high, then it’s interpreted by central banks as the economy running too hot and having too strong of an upward movement.

[00:26:18] Clay Finck: And central banks wanna prevent high inflation from spiraling outta control before it’s too late. So when inflation is high and the economy is too hot, then central banks will try to slow things down in the economy. And when the economy is too slow, they’ll try and stimulate it by doing things like QE and lowering interest rates.

[00:26:35] Clay Finck: Central banks also wanna support high employment because it helps stimulate the economy and then have continued economic growth. This is often referred to as the Federal Reserve’s dual mandate, which is low inflation and low unemployment, and the central bank also wants to help tamper the swings in the market cycles.

[00:26:53] Clay Finck: But just like how it’s really difficult for us as investors to spot where we’re at in the cycle, it’s also very difficult for central bankers to figure out where exactly we’re at in the cycle. Along with the central bankers, governments themselves also play a critical role through things like deficit spending and the level of taxation to stimulate their own country’s economy.

[00:27:13] Clay Finck: They can increase spending, lower taxes, and vice versa if they feel they need to slow the economy down. Left to their own devices, the free market can produce extreme levels of economic cyclicality, which is considered undesirable by governments. So the government, along with the central bank, wants to make an attempt to tamp down the cyclicality.

[00:27:36] Clay Finck: So, in a way, the job of these groups is to be countercyclical. When things get too hot, they try to cool things down. When things get too cold, they try to heat it up a little bit. Jumping to chapter seven, this is one of the longer chapters in the book titled “The Pendulum of Investor Psychology.” At the start of this chapter, he references a piece he wrote all the way back in 1991 that I’ll read here.

[00:28:08] Clay Finck: I quote, “The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum on average, it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc.”

[00:28:30] Clay Finck: But whenever the pendulum is near either extreme, it is inevitable that it will move back towards the midpoint sooner or later. In fact, it is the movement towards an extreme itself that supplies the energy for the swing back. Investment markets make the same pendulum-like swing. Between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced markets and underpriced markets.

[00:28:57] Clay Finck: This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at the “happy medium.” I find the pendulum analogy really useful here as the market continually fluctuates between greed and fear, optimism and pessimism, risk tolerance and risk aversion, and between urgency to buy and panic to sell.

[00:29:23] Clay Finck: The swings in the pendulum represent the psychological excesses. For example, Marks explains how it seems logical that the overall stock market should provide returns in line with the sum of their dividends, plus the trendline growth in corporate profits. And that really equates to a ballpark figure of around six to ten percent.

[00:29:45] Clay Finck: Now when stocks return much more than that for a while, Howard says that it’s likely to be excessive and people are getting too optimistic, and returns are essentially being borrowed from the future, which makes stocks risky in a downward correction. Howard has talked about this on our show recently, stating that stocks, on average, return around 10% a year, but the majority of years are not in the eight to 12% range.

[00:30:14] Clay Finck: People have a natural tendency to get carried away. From 1995 through 1999, for example, we had five straight years where stocks returned 19% or more. The S&P 500 entered 1995 at a price of $541, and it closed the year 1999 at 1469, representing an average annual return of over 22%, not including dividends.

[00:30:36] Clay Finck: Then we all know what happened next. The S&P 500 had three straight years of negative returns, with -10% in 2000, -13% in 2001, and -23% in 2002. From peak to trough, the index nearly got cut in half as it dropped by 49%. Now in hindsight, it seems that the market got way too optimistic and greedy in ’98 and ’99, and then it became way too pessimistic and fearful around 2002, as the market rebounded by 26% in 2003.

[00:31:09] Clay Finck: Howard points out that from 1970 through 2016, a period of 47 years, there were only three years where the market returned between eight and 12%. So the market very rarely delivers the average returns that investors generally expect from it. In this chapter, Marks is really emphasizing the idea of the pendulum and how the overall market swings between greed and optimism to fear and pessimism.

[00:31:35] Clay Finck: He says that the superior investor strikes an appropriate balance between greed and fear. Everyone feels these emotions, but the superior investor keeps these conflicting elements in balance. He writes, “The superior investor is mature, rational, analytical, objective, and unemotional. Thus, he performs a thorough analysis of investment fundamentals and the investment environment. He calculates the intrinsic value of each potential investment asset, and he buys at a discount to the price from the intrinsic value, plus any potential increases in the intrinsic value in the future. Together, this suggests that buying at the current price is a good idea.”

[00:32:15] Clay Finck: Mark says that few people are always even-keeled and unemotional, and thus few investors are capable of staking out a midpoint position between the balance of greed and fear. Most swing between greed when they’re optimistic and being fearful when they’re pessimistic, and they do so at the exact wrong times, which is just so ironic.

[00:32:38] Clay Finck: This reminds me of the classic bubble chart that oftentimes circulates on the internet or on Twitter. The smart money buys early before the trend becomes apparent to everyone else. Then there’s the awareness phase where the asset starts to appreciate in price and gains some momentum. Then it receives media attention, and investors start to become really enthusiastic as the price starts to go parabolic. Greed and delusion set in as many people FOMO in near the top before the bubble crashes.

[00:33:11] Clay Finck: And then we fall well below the trend line. So it’s a great example of taking things too far both to the upside and too far to the downside. When I think about these swings as a stock investor, it also reminds me that you need to look at your investments as objectively as possible. If a stock I’m holding has declined by, say, 20%, I have to ask myself questions like: Has the business’s intrinsic value been increasing or decreasing as of late? What is my assessment of the intrinsic value? Has the moat been impaired? Is the company gaining or losing market share? Is management deploying capital effectively? These are all questions that get to the core of where the business is trending and trying to ignore the stock price movements. If I can get a good sense of some of the answers to these questions and if the business is well-positioned to continue to grow, then drawdowns shouldn’t really faze investors who purchased at a reasonable price and are willing to hold it for the long term.

[00:34:23] Clay Finck: And since earlier I checked out the stock returns during the tech bubble and the crash to follow, I figured I’d also look at what things look like as of the time of this recording. In 2019, we saw stocks return 28% for the S&P 500. 2020 was 16%, 2021 was 26%, and you know, three really, really good years overall.

[00:34:47] Clay Finck: Then in 2022, it was -19%. Year to date, 2023, we have a positive 11%. So again, really volatile returns, typically straying pretty far away from the midpoint of around 10%. We’ll see where 2023 turns out in another six months to see whether greed or fear prevails in the markets. This brings us to Chapter Eight, titled “The Cycle in Attitudes Towards Risk.” Investing, at its core, is the art of bearing some level of risk in pursuit of a profit.

[00:35:20] Clay Finck: Investors generally try to position themselves to profit from future developments rather than being penalized by them, and the superior investor is someone who is able to do that better than others. Marks says that since risk and the uncertainty regarding future developments are the primary sources of the challenge in investing, the ability to understand, assess, and deal with risk is the mark of the superior investor and an essential requirement for investment success. Then, a bit later, my view that risk is the main moving piece in investment makes me conclude that at any given point in time, the way investors collectively view risk and behave with regard to it is of overwhelming importance in shaping the investment environment in which we find ourselves, and the state of the environment is key in determining how we should behave with regard to risk at that point.

[00:36:19] Clay Finck: Assessing where attitudes toward risk stand in their cycle is what this chapter is about, and perhaps the most important one in this book,” end quote. Howard outlines the trade-off between risk and return and how generally investors believe that in order to receive a higher return, they must take on more risk.

[00:36:40] Clay Finck: But he says this assumption can’t be correct because if riskier assets could be counted on to produce higher returns, then by definition, they wouldn’t be riskier. Instead, investments that seem riskier appear to offer the promise of higher returns. Again, investments that seem riskier appear to offer the promise of higher returns.

[00:37:01] Clay Finck: Otherwise, no one would make that investment. To better understand risk and return, you can think about your opportunity costs. Today, the yield on, say, a 10-year treasury is around 3.8%, and this is perceived to be one of the safest investments one can make because the US government is the one footing the bill on the yield associated with that asset.

[00:37:26] Clay Finck: If a stock gives an investor an expected return of 3.8% as well, then the theory in finance is that no one would be interested in making that bet. So they would need a return well above 3.8% to even consider taking that position because there’s a higher risk associated with investing in stocks. No rational investor wants to take on any extra risk than they need to, and people are naturally risk-averse.

[00:37:55] Clay Finck: If we assume that investors are rational and risk-averse, then once there are mispricings in the market, we would assume that investors would correct those mispricings by purchasing assets that offer high returns relative to their risk and selling assets that offer lower returns relative to their risk.

[00:38:15] Clay Finck: And this pretty much aligns with the efficient market hypothesis, and we all know that markets are not always efficient, and they’re more driven by human psychology, as Marks outlines in this book. In this chapter, Howard talks about how investor attitudes toward risk change over time, and this leads to changes in market prices.

[00:38:37] Clay Finck: Sometimes investors become too risk-averse, and sometimes they relax their risk aversion and become too risk-tolerant. This ties directly into the investor emotions of greed and fear that we’ve been talking about. When investors become too greedy, they become too risk-tolerant and too optimistic, and they reduce their level of caution in their investing process.

[00:38:59] Clay Finck: Since greedy and optimistic investors have more risk tolerance, they tend to chase returns and get pushed into riskier and riskier assets. This reminds me exactly of 2021. We saw crypto prices going through the roof, hyper-growth tech that had little or no profits trading at a hundred times sales, countless IPOs and SPAC offerings, and so on.

[00:39:22] Clay Finck: Overall, investors were very optimistic about the future while things were going really, really well. Ironically, risk is the highest when investors generally feel that risk is low, and risk is the lowest when investors feel that risk is high. This is because when investors feel risk is low, they overestimate future expectations and are too optimistic.

[00:39:45] Clay Finck: So future returns are low and the potential downside is high. Conversely, when stocks fall, investors are too cautious. This leads to higher than average future expected returns and lower than average potential downside risk. Howard writes, quote, “For me, the bottom line of all this is that the greatest source of investment risk is the belief that there is no risk.

[00:40:09] Clay Finck: Widespread risk tolerance or a high degree of investor comfort with risk is the greatest harbinger of subsequent market declines. But because most investors are following the progression described just above, this is rarely perceived at the time when perceiving it and turning cautious is most important.

[00:40:28] Clay Finck: Then a bit later, he writes, ‘What’s the greatest source of investment risk? Does it come from negative economic developments, corporate events that fall short of forecasts? No. It comes when asset prices attain excessively high levels as a result of some new intoxicating investment rationale that can’t be justified on the basis of fundamentals, and that causes unreasonably high valuations to be assigned.

[00:40:54] Clay Finck: When are these prices reached? When risk aversion and caution evaporate and risk tolerance and optimism take over. This condition is the investor’s greatest enemy,'” end quote. He points to the example of the great financial crisis as the greatest financial downswing of his lifetime, and I just love how he points out in this book that one of the most difficult periods of his career, he sees it as an opportunity, an opportunity to observe, to reflect, and learn, rather than a burden he has to endure.

[00:41:29] Clay Finck: To sum it up, investors overall became complacent and they lacked standards on risk assessment and quality. Banks started to lend to those who previously weren’t able to get loans. Wall Street packaged together new types of assets that were riskier than they were generally perceived, and it reminded Howard of Warren Buffett’s wise words that we need to adjust our financial actions based on the investor behavior playing out around us.

[00:41:58] Clay Finck: The Buffett quote he’s referring to here is, ‘The less prudence with which others conduct their affairs, the greater prudence we should conduct our own affairs,'” end quote. So Howard says, when others fail to worry about risk and fail to apply caution, we must be more cautious. And when investors become panicked or depressed and can’t imagine a condition under which risk would be worth taking, we should be more aggressive.

[00:42:27] Clay Finck: When times were good from 2005 to 2007, there was a high degree of confidence. But when fear struck the markets, it quickly eroded all confidence. Excessive risk aversion took the place of unrealistic risk tolerance. Once Lehman Brothers collapsed in 2008, people were very quick to sell everything they could with a high degree of urgency.

[00:42:49] Clay Finck: There were many more sellers than buyers, leading to a total collapse of all asset prices, and liquidity just dried up completely. I love that Howard shared this story of his own troubles. He personally had to endure the financial crisis, which inspired him to write a memo called “The Limits of Negativism.”

[00:43:11] Clay Finck: Preceding the great financial crisis, Oaktree started to participate in the use of leverage in some of their funds, but they used less leverage than most other companies. For example, they used leverage of four times equity in their European senior loan fund, versus the more conventional seven or eight times leverage.

[00:43:31] Clay Finck: And they tried to be more conservative about the assets they bought as well, but the crisis still managed to almost bring down their fund. Prior to the great financial crisis, senior leveraged loans rarely sold below 96 cents on the dollar. Oaktree believed that they were well positioned to never have to worry about a margin call as long as these prices didn’t fall to 88 cents on the dollar.

[00:44:00] Clay Finck: But after the bankruptcy of Lehman Brothers, loan prices fell to unprecedented levels, and margin calls were off the hook, which further exacerbated the issue of falling loan prices. Oaktree acted swiftly to raise more equity from their investors to lower the leverage in their fund. They wanted to lower it from four to one down to two to one.

[00:44:24] Clay Finck: They were able to raise more money from their investors, and now they were protected if the loans were to fall to 65 cents on the dollar. And then not too long after, Oaktree’s book value fell to 70 cents on the dollar, as there was a total absence of buyers, and margin calls continued, leading to more and more selling pressure.

[00:44:49] Clay Finck: Now Oaktree saw the need to go out and raise even more equity from investors. But getting a call from your investment manager twice isn’t exactly a good sign, and many people don’t always have a ton of cash laying around, especially when there’s a market panic, and they’ve already been called once, and you know, they see prices collapsing.

[00:45:13] Clay Finck: Some investors just didn’t have the cash on hand, and some didn’t have the willingness to make additional investments. Mark writes that at bottoms, it can be extremely hard to take actions that require conviction and staunchness, and that led to the event I’m going to describe in the quote. So Howard had approached a pension fund that was one of his investors to make the case to put up more capital, but they were worried about the possibility of a loan default on their positions.

[00:45:47] Clay Finck: They pushed Howard to explain how the fund would perform if the loans started to default. And even if they saw the worst default rate in the history of high-yield bonds, which was a 12.8% default rate, twelve times the average default rate in their portfolio, Oaktree would still make money.

[00:46:07] Clay Finck: Howard told them that since they were so fearful and had a doomsday outlook on the economy, they should be selling every single equity they own instantly. And that pension fund, of course, did own a lot of equities. Howard writes, “My point is that in a negative environment, excessive risk aversion can cause people to subject investments to unreasonable scrutiny and endlessly negative assumptions, just as they may have performed little or no scrutiny and applied rosy assumptions when they made investments in the preceding times. During panics, people spend one hundred percent of their time making sure there can be no losses, at just the time when they should be worrying instead about missing out on great opportunities. In times of extreme negativism, exaggerated risk aversion is likely to cause prices to already be as low as they can go, and further losses to be highly unlikely, thus the risk of loss is minimal.

[00:47:10] Clay Finck: As I’ve indicated earlier, the riskiest thing in the world is the belief that there’s no risk. By the same token, the safest and most rewarding time to buy usually comes when everyone is convinced there’s no hope. If I could only ask one question regarding each investment I had under consideration, it would be simple: How much optimism is factored into the price? A high level of optimism is likely to mean that the most favorable possible developments have been priced in. The price is high relative to the intrinsic value, and there’s no margin for error in case of disappointment. But if optimism is low or absent, it’s likely that the price is low, expectations are modest, negative surprises are unlikely, and the slightest turn for the better would result in appreciation. The pension fund meeting described above was important for the simple reason that it indicated that all optimism had been rung out of investors’ thinking.”

[00:48:13] Clay Finck: This event with the Pension Fund then led Howard to rush back to his office to write this piece titled “The Limits of Negativism.” And this is all a good reminder that we should always include a higher level of margin of safety than what our initial gut instinct might be, especially in the really good times. If your gut says that an emergency fund of, say, three months’ expenses is appropriate, then maybe it should really be five or six months. Maybe you should have a little bit less debt than your gut instinct tells you. Marks originally believed that the loans hitting 65 cents on the dollar was unimaginable, and they still managed to almost hit that, and they actually hit 70 cents on the dollar. So whatever you think isn’t likely is still potentially in the cards and is probably a good general rule of thumb to have in your life and in your investments, in that piece.

[00:49:18] Clay Finck: “The Limits of Negativism,” Howard writes, “Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive, but it also calls for optimism when pessimism is excessive—contrarianism, or doing the opposite of what others do.” Leaning against the wind is essential for investment success, but as the credit crisis reached a peak last week, people succumbed to the wind rather than resisting it.

[00:49:44] Clay Finck: I found very few who were optimistic. Most were pessimistic to some degree. Some became genuinely depressed. Even a few great investors I know increasingly exchanged negative tales of the coming meltdown via email. No one applied skepticism or said, “That horror story is unlikely to be true.”

[00:50:03] Clay Finck: I found this story to be very valuable since I myself was not an investor during the Great Financial Crisis. The story also gives a sense of what the market environment can look like in the extremes of far too much optimism and far too much pessimism. A few of Howard’s fund investors didn’t put up additional capital, including the one he visited that day.

[00:50:29] Clay Finck: In the story he told, and in order to keep his fund, Aflo, Howard put up the money himself to keep things going. This one investment into a levered portfolio of depressed senior loans at a time of maximum pessimism ended up being one of the best investments he has ever made because there was a massive unwillingness for anyone to participate in that market, which gave him absurdly cheap prices.

[00:50:57] Clay Finck: This brings us to Chapter Nine, the last chapter we’ll touch on here in today’s episode, titled “The Credit Cycle.” All the cycles discussed in the book vary to some degree. Stock market cycles can have big swings, whereas cycles in things like food or everyday needs really don’t change all that much. And then there’s GDP, which doesn’t fluctuate much either. Corporate profits fluctuate a little bit more than GDP.

[00:51:26] Clay Finck: When thinking about credit cycles, these are subject to massive swings. Howard actually believes that the credit cycle is the most volatile of the cycles and has the greatest impact on the economy. Sometimes the credit window is wide open, and then suddenly it can just slam shut. This is why it deserves a great deal of attention.

[00:51:49] Clay Finck: In order for the overall economy to continue to grow, it’s essential that businesses have access to credit because without credit, most businesses wouldn’t be able to finance future growth, at least to the same extent. Without credit, debt that is maturing on a company’s and a government’s balance sheets couldn’t be refinanced and rolled over. Generally, companies aren’t repaying their debts. Usually, these debts are rolled over and refinanced.

[00:52:17] Clay Finck: Another consideration with regards to credit is that financial institutions rely on credit to maintain their daily operations. For example, if a bank has an influx of depositors wanting their money, that bank is in trouble if they don’t have access to the credit markets to meet those depositors’ demands.

[00:52:37] Clay Finck: Finally, there’s a psychological impact when the credit market seizes up. It can quickly cause fear to spread, leading to things like forced selling and margin calls, which further exacerbate the issue and create a vicious cycle downward until relief is provided.

[00:52:54] Clay Finck: Now, why does the credit window open and close the way it does? Howard explains in his November 2001 memo, “You can’t predict, you can prepare.” When the economy enters a period of prosperity and bad news is relatively scarce, lenders are more willing to lend out more capital. Financial institutions then compete to expand their businesses, and the growing economy results in more capital being flushed into the economy.

[00:53:22] Clay Finck: This leads to some lenders lowering their returns by offering lower interest rates, lowering their credit standards, providing more capital in transactions, and easing their covenants. At the extreme end of this credit cycle, many borrowers end up getting loans they shouldn’t have been getting, and this, of course, leads to capital destruction.

[00:53:43] Clay Finck: The credit cycle reaches a tipping point when lenders have overextended themselves, and the cycle reverses the other way. Lenders start to see losses from their bad loans, and they begin to reign in their lending standards. Interest rates go up, and requirements to get a loan are now a higher bar for borrowers to reach.

[00:54:05] Clay Finck: At the trough of this cycle, on the downside, only the most creditworthy borrowers are able to get a loan, if anyone at all. Then companies begin to starve for capital. As some borrowers aren’t able to roll over their debts, there are defaults and bankruptcies, and then the cycle turns back.

[00:54:26] Clay Finck: Another way to sum up this process, Mark summarizes as “prosperity brings expanded lending, which leads to unwise lending standards, which produces large losses, which makes lenders stop lending, which ends prosperity, and so on.”

[00:54:40] Clay Finck: Howard believes that the credit market can be a great indicator for seeing where the market stands psychologically, and it’s a significant contributor to investment bargains. You can see we’re around the trough of a credit cycle when credit is tight in the economy, and if there’s a liquidity event like what happened in March 2020, then you can almost be certain that there are bargains out there to be found as many people have become forced sellers of assets. The Great Financial Crisis is another prime example of an extreme credit cycle.

[00:55:17] Clay Finck: Marks writes, “The developments that constituted the foundation for the crisis weren’t caused by a general economic boom or a widespread surge in corporate profits. The key events didn’t take place in the general business environment or the greater world beyond. Rather, the GFC was largely a financial phenomenon that resulted entirely from the behavior of financial players.”

[00:55:41] Clay Finck: The main forces that created this cycle were the easy availability of capital, a lack of experience and prudence sufficient to temper the unbridled enthusiasm that pervaded the process, unimaginative financial engineering, the separation of lending decisions from loan retention, and irresponsibility. Downright greed when the credit window slammed shut in 2008.

[00:56:01] Clay Finck: Howard believes that a financial catastrophe, similar to the Great Depression, was absolutely possible and in the cards, but the US government took the necessary steps to turn the tide. The final big shoe to drop was the collapse of Lehman Brothers. Before the government provided bailouts to the banks and put guarantees behind commercial paper and money market funds, Howard writes, “Market participants demonstrated that when negative psychology is universal and ‘thanks, quote, can’t get any worse,’ they won’t.”

[00:56:33] Clay Finck: When all optimism has been driven out and panicked risk aversion is everywhere, it becomes possible to reach a point where prices can’t go any lower. And when prices eventually stop going down, people tend to feel relief, and the potential for price recovery begins to rise. At the end of the chapter, Marks talks about how the best time to invest is when there is an uptight and cautious credit market.

[00:57:02] Clay Finck: When lenders generally are fearful of losing money and have high risk aversion, there’s an unwillingness to lend, a shortage of capital everywhere, an economic contraction taking place, and there are defaults, bankruptcies, and restructurings occurring. All of these create a market with low asset prices, high potential returns, low risk, and excessive risk premiums.

[00:57:24] Clay Finck: Ironically, when the market is very fearful in this way, it makes it very difficult for people to invest because it’s just so hard to psychologically be optimistic when the overall market is pessimistic. On the flip side, a generous capital market shows characteristics like investors showing fear of missing out on profitable opportunities, reduced risk aversion, and skepticism.

[00:57:48] Clay Finck: Too much money chasing too few deals. The willingness to buy securities of decreased quality, the willingness to buy securities in increased quantity, a willingness to buy securities of reduced quality—these all lead to high asset prices, low prospective returns, high risk, and skimpy risk premiums.

[00:58:06] Clay Finck: From Howard’s perspective, when the credit window is wide open, it’s best to proceed with caution as an investor and be more defensive. When the credit window is closed and sealed shut, it’s the best time to be aggressive because that’s when the bargain prices are likely available. Now, at the end of the chapter, he writes, “Superior investing doesn’t come from buying high-quality assets, but from buying when the deal is good, the price is low, the potential return is substantial, and the risk is limited. These conditions are much more the case when the credit markets are in the less euphoric, more stringent part of the cycle. The slammed-shut phase of this credit cycle probably does more to make bargains available than any other single factor.”

[00:58:57] Clay Finck: I just loved the first half of this book, so hopefully, you found value in this episode and learning how to think about cycles, how you can think about identifying and trying to figure out where we’re at in the cycle. This covers the first nine chapters of the book, which is roughly the first half of it.

[00:59:21] Clay Finck: I hope to see you again next time to cover the second half of the book, which I believe will be going out in two weeks from today. If you’re listening to this episode as it comes out, thank you so much for tuning in. I really hope you enjoyed it, and I hope to see you again next time.

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