The Market Pendulum

It is Dec 2020, and with some time on hand since I am on leave, I was able to spend time reading on top of spending time with the family.

In one of my previous post “Chill and Read“, I mentioned 3 books which I have read or which I will be reading. Today, I have read the 3 books about 3 incredibly talented and driven men:

The first man: A former English teacher. He failed his entrance exam twice before studying at a Teachers College. He graduated in 1988 and continued to teach English for several years. Subsequently, he got rejected from 30 jobs before he decided to band together with a group of friends at the age of 29 to create his internet start-up.

The second man: A computer science graduate who turned out to be a great businessman as well. His first job was with China Motion Telecom Development where he was in charge of developing software for pagers. He saw first-hand how the rise of the internet and the messenger services disrupted the pager services and within a few short years, many companies like his went out of business. Along with four other classmates, he went on to co-found his internet start-up and launched the Chinese version of ICQ (QICQ).

The third man: A private gay man who had big shoes to fill eg. Taking over the CEO job from who was at that time, probably the one of the world’s most inspirational & iconic (if not the most inspirational & iconic) tech founder, in one of the biggest tech firm at that time. Unlike his predecessor, he was never the chief product officer but was perhaps best known as a brilliant operations manager / chief operation officer (COO) with an unbelievable work ethic (and social ethic) at that time. He managed to bring the company to a new peak (which is today’s second most valuable company in the world).

I have just finished reading the book “Mastering the Market Cycle” written by Howard Marks.

I think reading this book “Mastering the Market Cycle” is timely. In the book, it talked about the different types of cycles eg. the Economic cycle, Government involvement with the economic cycle, companies’ cycle in profits, the Pendulum of Investor Psychology, the cycle in attitudes towards risk, the credit cycle, the distressed debt cycle, real estate cycle, etc.

Well, these are cycles we are all familiar with, but perhaps the more important cycle these days is the credit cycle. Howard Marks listed it as the top influence concerning the 2007-2008 Global Financial Crisis. At that time, the crash in the stock markets was due to the fear that the credit window was shutting which would lead to (or led to) the credit crunch witnessed by many big financial institutions and companies.

Many companies (esp. the top companies) made use of their reputation and credit ratings, to borrow via/take on short-term debts at favorable rates to issue out long-term bonds or loans/mortgages when times are good (to earn the spread). Basically to take advantage of the spread during good times and assume that they can always roll over the short-term debts (when the ‘money’ tap is on). This is hard to resist for companies, as they risk losing out to others if they do not follow suit. However, when the sub-prime crisis hit and liquidity dried up (eg. credit windows closed), they found themselves in trouble.. especially for the big banks.

If not for the swift unprecedented actions by the Federal Reserve then and fiscal measures by the US government to unfreeze liquidity and back the credits bringing back investors’ confidence, the crash would have lasted a lot longer and people’s faith might not be restored.

Many of the cycles I view are all inter-related in many ways, whereby typically the worst deals are made when times and future outlooks are good. Howard Marks called it the ‘race to the bottom’ when sellers of bonds or credit lower their requirements given the buoyant markets. Inversely, the best deals are made when there are hardly any buyers (who are often scarred by recent losses) and the interest offered for the bonds are sometimes at eye-popping juicy double digits, and in some odd cases, the interests itself can cover the shortfall in the liquidation value of the companies (eg. still make money when the companies go bust, since bond buyers are higher up the pecking order as compared to stock-holders). One simply ‘cannot lose’, but due to the situation then, many fund managers just could not get over their fear (and kept asking: ‘What if it gets worse?”).

Or to put it in another way, from the perspective of the investors: “What the wise do in the beginning, the fools do in the end’. To succumb to the urge to invest when everyone around you is boasting of the massive profits they made is a mistake that many people make.

Even Newton who once muttered that “‘he could calculate the motions of the heavenly bodies, but not the madness of the people”, made the mistake of buying back in the South Sea Company stocks, although he initially made a profit of £7,000. He ended up losing £20,000 (or more than USD 4.37 million in 2020’s money). For the rest of his life, he forbade anyone to speak the words ‘South Sea’ in his presence. Read here.

In the Chapter “Pendulum of Investor Psychology”, Howard mentioned that the swing between optimism and pessimism (euphoria vs depression) is ever-present in the markets. What is perhaps pertinent here that historically, the pendulum itself spends very little time at the midpoint (equilibrium) or normal range. For the past 47 years (from 1970 to 2016) the markets are either up more than 30% or down more than 10%, for 13 out of the 47 years (more than a quarter of the times). The annual returns on the S&P500 were within 2% of ‘normal’ (which is between 8% and 12%) for only 3 times! No wonder Benjamin Graham described Mr. Market as manic-depressive, randomly swinging from bouts of optimism to moods of pessimism.

Thinking about today, the credit windows in many countries are wide open. I reckon many countries are getting more knowledgeable and experienced (since 2007-2008 GFC) in managing the risk of having no liquidity when a crisis strike. This is probably why the crash this year recovered rather swiftly.

Currently, greed perhaps is more prevalent now as compared to the fear felt in Feb, March, or April 2020.

Besides, with the US presidential election over (results are known), and the vaccine for Covid-19 found, markets have largely priced in these known/positive news. Nevertheless, there are on-going US-China trade tensions and an anticipated slow global economic recovery.

We are now near the end of the year, and many people are showing their year-end portfolio results. The upswing in the US markets (esp. S&P500 and Nasdaq) has already erased the losses seen in the early part of the year. The tech-heavy Nasdaq has already far surpassed its previous peak in Feb 2020.

Somehow, the cycle duration (of the stock markets) has been getting shorter and shorter – when it comes to the US markets. For the Singapore market, on the other hand, the STI is still around 13% below its Jan 2020 level.

Still many people if they have bought during the March / April 2020 period, would have achieved gains. Also, if they have bought into Tech stocks, that gain would be even more. Even for many traditional recovery stocks (REITs, banks, consumer-related), there would be gains as well.

For me, there are always two opposing thoughts: The fear of losing (Fear) and the fear of missing out on opportunities (Greed). To embrace one in totality would mean forsaking the other.

In the book, Howard Marks mentioned that choosing good companies itself is not sufficient. This is probably stemmed from his early experience during his career, whereby many bid the stock prices of Nifty-Fifty stocks sky high (in the late 60s and the 70s). These are great companies during their time (Xerox, Coca Cola, IBM, Kodak, Polaroid, AIG, etc). People who invested in them during that period saw many years of under-performance subsequently (or did not make money at all).

Howard Marks: Lessons from the Nifty Fifty (read here)

“So, if you were smart enough to invest in Merck, Lily, Avon, Coke, Texas Instruments, Hewlett Packard, and that ilk of companies in ’68 and you were smart enough to hold those stocks for 5 years you lost 80-90% of your money. And I would be shocked, actually, to find that — I mean, I haven’t done the work. But I’d be surprised to find that you have an attractive rate of return to today…
And so, I was very fortunate to learn a painful lesson early. You invest in the best companies in America and you lose almost all your money…
So, what I learned from the combination of these two things is that investing is not a matter of what you buy, it’s what you pay. Investing is not a matter of buying good things, but buying things well. And you have to understand the difference between buying good things and buying things well. And I think that’s what we’ve been able to do.” Howard Marks

In his Oct 2020 memo titled – Coming Into Focus, Howard Marks included a great piece on comparing today’s tech goliaths with the Nifty Fifty. Marks makes the point that while the FAAMG’s may be larger, faster growing and have greater growth potential than the Nifty Fifty, no one’s valuing them on current income or intrinsic value, and perhaps not on an estimate of e.p.s. in any future year, but rather on their potential for growth and increased profitability in the far-off future. And herein lies the problem.

We can be choosing the best stocks, but can still screw up (leading to years of under-performance) if we don’t understand where we are in the cycle. Knowing when the tide is in favor would greatly increase our odds.

Having said that understanding where we are in the cycle is different from timing the market. Since nobody can accurately time the exact low and high of the markets. Nobody can be sure of the outcome, but there are times when the probability of success (or failure) is higher. Nobody knows when, since the markets are driven by people’s emotions. Nobody can predict emotions. We can only prepare for the inevitable.

I always feel that the window of opportunity is closing. Currently, it is probably left with two places that few would want to invest in now (see below). No, not the tech stocks.

1) The extreme recovery stocks. eg. Travel related, retail/commercial, hospitality stocks. Kind of like the ‘ground zero’ sectors in this pandemic. However, these companies have to be financially strong to be able to survive the prolonged crisis.

2) Hong Kong stocks. Again these have to be fundamentally sound companies able to outlast their competitors.

These 2 groups have been underperforming compared to other sectors / or their contemporaries in other exchanges, and for good reasons. Investors hate unknowns, and there is the ever-present potential for opportunity cost losses (heck… there are much better stocks with brighter prospects out there, why be stuck in the mud with these stocks). To some, these are the untouchables. However, I may be wrong – as always do your own due diligence, and diversify.

However, it is not that straight forward, as the euphoric US markets (historic low-interest rates and QE infinity) would also have an impact. As such, it might be more worthwhile to stay on the sidelines.

As mentioned by Howard Marks, it is really a very difficult task to understand the cycles as a whole. He was able to clearly distinguish the different cycles in his books, but in real life (to me at least), all cycles are inter-related, and not all are synchronized. Taken as a whole it is not so clearly defined.

Who knows, maybe a perfect storm will occur again for these stocks. After all, if I am unsure, I can always choose not to invest or sell some (eg. opt to be more defensive rather than being aggressive). Knowing myself and the much-limited level of my war-chest now, I would much rather wait and snowball my war-chest. As Howard Marks says, it is easy to make gains in a rising market. However, the distinction of a superior investor is that he can to make gains in good times with the risk under control (cause we never know when the tide will turn from favorable to unfavorable). To be prepared. eg. to make more in good times than what he gives back in the bad times.

Nevertheless, my inclination is towards being defensive at this stage, given what I have seen in the US markets, the tendency towards greed (psychologically), credit window being wide open (loose monetary policies / QE infinity), the on-going requests for further government fiscal stimulus in the US (and other parts of the world), and even the housing price indices in many parts of the world are higher than they have ever been.

Overall, my portfolio is still heavily towards equities. It is still aggressive. My current stock portfolio is more towards the defensive sectors, tech light. So perhaps moving slowly towards building my war-chest, and being less aggressive in my stock purchases. Just adjusting the allocations perhaps. Nothing extreme about it (eg. not selling out and going fully towards cash). I think the key word to use here is ‘calibrating’.

As I am more towards dividend investing, I will probably be invested for a long time, and to borrow Standard Charter’s tagline: “Here for good”. So it is a matter of building upon the proportion of cash/bond vs equities or more defensive or growth stocks etc. I don’t think Howard Marks has ever advocated going fully into cash and abandoning the markets altogether.