We often talk about cycles when discussing our investment philosophy and tactical asset allocation approach. This is because financial market and economic history is a series of multiyear cycles—albeit in the case of most stock markets and economies it is cycles within a very-long-term (secular) growth trend. These cycles, we believe, are driven by natural human group or herd behavior. And since we don’t think human behavior is going to evolve much over the next few decades, we expect markets will also continue to behave cyclically.
The existence of market cycles creates significant risks for investors who ignore them (i.e., the “this time is different” syndrome) and great opportunities for disciplined long-term investors. But while this time is rarely different when it comes to investing, neither do history and cycles repeat exactly in terms of timing, duration, or magnitude.
Howard Marks, co-founder of the hugely successful investment firm Oaktree Capital and the author of many insightful investment memos over the past 25 years, often emphasizes the importance of understanding cycles. He uses the metaphor of a pendulum to describe market behavior, as summarized in the following excerpt from his 2011 book, The Most Important Thing.
Investment markets follow a pendulum-like swing:
- between euphoria and depression [greed and fear],
- between celebrating positive events and obsessing over negatives, and thus
- between overpriced and underpriced.
This oscillation is one of the most dependable features of the investment world.
Marks notes that the oscillation of the investor pendulum is similar to the up-and-down fluctuation of economic and market cycles in that while the occurrence of the pendulum-like pattern is extremely dependable in most markets, one never knows exactly how far the pendulum will swing, how long it will stay at one extreme or another, or what might cause it to reverse.
It is impossible to consistently and accurately predict exactly when a cycle will turn or when the pendulum will start to swing back the other way or how far it will go at the extremes. But with our longer-term analytical framework and forward-looking assessments that are informed by and grounded in market history, we believe we can position our portfolios to benefit from the cyclic swings of the pendulum. This requires having a long-term perspective and the discipline to stick to your process and consistently execute it over time, especially when the cycle and pendulum are swinging to extremes.
Recent Market Cycles
In recent years, our portfolios have been positioned for a turn in some market cycles that haven’t yet changed course, namely our tactical underweight to U.S. stocks versus foreign stocks, and our exposure to value or cyclical stocks (i.e., businesses that are more sensitive to the broader economic cycle). While this has impacted our short-term performance, we remain confident the current market cycle will turn. The charts below show the relative performance cycles for both of these markets.
U.S. Versus Foreign Stocks—Our portfolios are positioned with the view that over our five-year tactical investment horizon, U.S. stocks are likely to deliver underwhelming returns (low single digit), while developed international and emerging-markets stocks are poised to produce much higher returns. This has been a headwind to our portfolio performance as the current cycle of U.S. stock outperformance versus foreign stocks now ranks as the longest relative performance streak for U.S. stocks since the inception of the international stock index in 1970.