The Perennial Philosophy in investing is to buy great companies and hold them for the long term. Buy right and sit tight. That is is how the big money is made in stocks.

In fact, you don’t even have to buy the best stocks to do well in markets because most stocks will do just fine as the result of what Warren Buffett has termed The American Tailwind. The American System of free enterprise and the rule of law has unleashed human entrepreneurialism like never before in human history and stock investors have come along for the ride. The most important thing is to stay invested.

Nevertheless, the upward trend of markets will be interrupted from time to time by nasty bear markets. For the most part, the average investors should not try to time the market and simply ride these out. For the professional investor who aspires to superior performance, however, some value can be added by an understanding of macro and cycles. The problem is that a lot of value can be subtracted by being overly bearish.

While a lot of great stuff has been written about buying great companies and allowing them to compound earnings over time, as well as valuation and other micro topics, most investors have determined that trying to time the market cycle based on macro considerations is too hard. While I am sympathetic to this perspective, I don’t think it’s the whole story.

The one legendary investor who has tried to tackle cycles and macro is Howard Marks in his book Mastering The Market Cycle: Getting The Odds On Your Side (2018). In fact, in Marks’s case timing the market has been responsible for much of his success: “Good cycle timing has accounted for the vast bulk of the success of my firm, Oaktree Capital Management” (p. 1-2).

But Marks makes no claim to being a second coming of Jesse Livermore. For Marks, it’s all about probabilities. Understanding if we are early or late in the cycle changes the probabilities for good returns from stocks. If it’s early, be fully invested and aggressive. If it’s late, take some chips off the table and be a bit more defensive. While you can never definitively call a top or a bottom, Marks believes there are many clues that help you determine where we are in the cycle. And just being able to do that can improve your returns.

While I used to think I was the second coming of Jesse Livermore after starting Top Gun in 2006 to short the impending housing bust and cleaning up in 2008, after many years of wrongly attempting to call the top again I have come around to Marks’s view of cycles and macro. Unless you’re Jesse, it’s just too hard and you will subtract from your overall return by trying. That said, an understanding of history can give you a rough idea of where we are in the cycle which can improve investment performance.

It’s like putting someone on a hand in poker. Sometimes you have a soul read and know exactly what they have. But the costs are high when you’re wrong. For the most part you’re better off thinking in terms of ranges: “He 3-bet preflop and he’s a straightforward player so he likely has a big pocket pair or AK”. Of course, you can always be wrong.
 

So how do we apply this to the current market? After a huge run off the April lows – and really since March 2009 – and now two significant down days, Is This The Top?

And the answer is of course: Nobody Knows.

But given the context I think it’s safe to say that we are late in the cycle. In fact, I think we are very late after an almost 10x move in the S&P 500 since March 2009 and almost 35% off the April lows. Valuation and sentiment corroborate my suspicions.

So what do you do? SELL EVERYTHING!!! NO!!!

The problem with selling everything is that while a top is surely coming since the cycle has not been eradicated and appears to be a permanent part of the economy and financial markets, this may very well prove not to be it. The probabilities are higher than usual that it is – but there is no certainty. And if you sell everything and the market keeps moving higher – which it usually does – you will have left money on the table. Potentially a lot. Further, The Perennial Philosophy still holds true so you don’t want to sell great stocks that may correct but will continue to go higher over the long term.

But you may want to start thinking about cutting here and there, reducing your position sizes and in general becoming more defensive. Don’t cut your best idea but maybe do sell your 20th best idea and stop speculating in third rate names.

The truth of the matter is that Bulls make money in this game and Bears for the most part don’t. But trees don’t grow to the sky and while there is a time for pushing the gas there is also a time for gently applying the brakes. Everything suggests to me that now is the latter.

More By This Author: