Investors are always experiencing different phases or cycles. Those who fail to consider the current stage of the cycle may face serious consequences. This book teaches investors how to identify cycles, evaluate them, follow their guidelines, and take the appropriate actions.
Three Key Areas
There are three key areas that investors should focus on:
- Gaining a deeper understanding of the “knowable” elements of industries, companies, and securities, such as their fundamental characteristics.
- Being disciplined in terms of the appropriate price to pay for the underlying fundamentals.
- Understanding the current investment environment.
The State Involvement: Banks and Government
Central bankers have dual responsibilities that are in opposition to each other:
Limit Inflation: This requires restraining the growth of the economy.
Support Employment: which calls for stimulating economic growth.
Governments
Investor Psychology and Emotion
The mood swings of the securities markets resemble the swing of a pendulum. They swing between the following:
- Between euphoria and depression
- Between celebrating positive developments and obsessing over negatives
- Between overpriced and underpriced
- Between greed and fear
- Between optimism and pessimism
- Between risk tolerance and risk aversion
- Between urgency to buy and panic to sell
The Market Cycle
If the market were a disciplined calculator of value based exclusively on company fundamentals, the price of a security wouldn’t fluctuate much more than the issuer’s current earnings and the outlook for earnings in the future.
Three stages of a bull market:
- A few forward-looking people begin to believe things will get better.
- Most investors realize improvement is taking place.
- Everyone concludes things will get better forever.
Three stages of a bear market:
- A few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy.
- Most investors realize things are deteriorating.
- Everyone is convinced things can only get worse.
Cycle Phases
A: Recovery from an excessively depressed lower extreme, toward the midpoint.
B: The continued swing past the midpoint, toward an upper extreme or high.
C: The attainment of a high.
D: The downward correction from the high back toward the midpoint.
E: A continuation of the downward movement past the midpoint, toward the new low.
F: Reaching low.
G: Recovery from the low back toward the midpoint.
Coping With Market Cycles
The investor’s goal is to position capital so as to benefit from future development. The Key to accomplishing this goal is:
- To know where the pendulum of psychology and the cycle in valuation stand in their swings.
- To refuse to buy when too positive psychology and the willingness to assign too high valuations causes prices to soar to peak levels.
- To buy when downcast psychology and the desertion of valuation standards cause panicky investors to create bargains by selling despite the low prices that result.
The Economics Of Cycles
The output of an economy is the product of hours worked and output per hour. Thus the long-term growth of the economy is determined by fundamental factors like birth rate and the rate of gain in productivity.
Long-term trends have given the economy and stock market a strong uptrend over several decades:
- Macro Environment
- Corporate Growth
- The Borrowing Mentality
- Popularization of Investing
- Investor Psychology
Stimulating The Economy
When governments want to stimulate their country’s economy, they can:
- Cut Taxes
- Increase Government Spending
- Distribute Stimulus Checks
When governments want to slow their country’s economy, they can:
- Increase Taxes
- Decrease Government Spending
The Pair Of Threes
There are three ingredients for success:
- Aggressiveness
- Timing
- Skill
If you have enough aggression at the right time, you don’t need that much skill. Good timing in investing can come from diligently assessing where we are in a cycle and then doing the right thing as a result.
There are three components to the formula for investment success:
Pair 1: Cycle Positioning and Asset Selection
Pair 2: Aggressiveness and Defensiveness
Pair 3: Skill and Luck
The Two Risks
There are two main risks to consider:
The risk of permanent capital loss.
The risk of missing out on potential gains, also known as “opportunity risk.”
Risk is ultimately about uncertainty, as many possible outcomes may exist, but only one will ultimately occur.
The Right Attitude Towards Risk
Investing is basically “bearing risk in pursuit of profit.”
The ability to understand, assess, and deal with risk is the mark of the superior investor and an essential requirement for investment success.
The way investors are collectively viewing risk, and behaving toward risk is of overwhelming importance in shaping the investment environment in which we find ourselves.
The state of the environment is key in determining how we should behave with regard to risk at that point.
The rational investor is diligent, sceptical, and appropriately risk-averse at all times.
The Credit Cycle
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 prevalent when the credit markets are in the less euphoric, more stringent part of their cycle.
Capital: all the money used to finance a business.
Credit: the portion of a company’s capital that is made up of debt rather than equity.
