We are facing an extremely confusing investing landscape.
Both the bears’ and the bulls’ arguments are persuasive.
The former are saying that stocks are significantly overvalued and that the economy will take years to recover.
The latter argue that the trillions of dollars being pumped into the economy by the Fed and the government will be enough to keep the stock market momentum going.
So how do you decide whether to be aggressive or defensive with your investing?
One tool that’s helped me over the years in answering that question is looking at where we stand in the market cycle.
If we are in the early or middle stages, then it’s a good time to invest aggressively. If we are in the late stage, however, it’s better to have a defensive posture.
The way I like to determine where we stand is by using a methodology developed by the great investor Howard Marks in his book Mastering The Market Cycle.
In it, Marks outlines ten criteriums that show whether the market is near its highs or near the lows.
Depending on how many of them point to one way or the other determines how aggressive or defensive you should be with your investing.
This tool is also a great way to eliminate biases since it forces you to look at all the criteriums that move the market, not just the one that favors your belief.
Moreover, what you’ll notice, is that Marks believes one should sell when the stock market is booming, and buy when it’s depressed—precisely how you should think if you want to be a successful investor.
Let’s use this methodology today and see what it can tell us about our current situation.
The Bears Vs The Bulls
Criterium #1 is the Economy.
When it’s vibrant, chances are we’re near the highs. When it’s sluggish, we’re more likely near the lows.
Right now, we’re in a recession, which is about as sluggish as you can get, indicating it’s better to be aggressive.
Criterium #2 is Outlook.
It’s typically positive near the highs, and negative near the lows.
There’s no unified consensus on this topic at the moment, with some saying economic recovery will take years, and others arguing we’ll be back to normal by the end of 2020.
So, the score on this criterium is neutral.
Criterium #3 is Capital Markets.
These are venues where those in need of capital, like businesses, and those with capital, the investors, meet.
The biggest ones are the stock market and the bond market.
Near market peaks, there’s plenty of capital to go around, so it’s easy for businesses to raise it through new stock or bond issuance. In this case, we say that capital markets are loose. When they are tight, the reverse is true. The latter typically occurs near market bottoms.
Right now, capital markets are loose, and it’s easy for companies to raise funds, indicating it’s better to be defensive.
Criterium #4 is Interest Rates.
When they’re declining, loans become cheaper. Therefore, companies are more likely to borrow money and expand their operations. That’s when you want to be bullish. And when they’re on the rise, and loans are getting expensive, you should become bearish.
With the Fed lowering interest rates to zero in March, this criterium indicates it’s better to be aggressive.
Criterium #5 is Yield Spreads.
There are different ways to measure the yield spreads, but most commonly, it includes comparing bonds of shorter maturities—less than a year—with those of longer maturities—more than five years.
In the later stages of the market cycle, investors will move into bonds to protect from a possible downturn. Long-term bonds offer higher yields than those of shorter durations, and so they attract more buyers at such times. But the more popular they become, the further their yields drop, and the more the spread between long-term and short-term bonds narrows.
That’s why a narrow yield spread indicates that the stock market is near the highs, and a wide yield spread indicates that it’s near the lows.
At present, the yield spreads are narrow, and there’s little indication of them widening anytime soon. In which case, it’s better to be defensive.
At the halftime of this analysis, the score is 2:2, with one criterium being neutral.
Meaning, it’s going to be up to criteriums #6-10 to tell us how we should position our investment portfolios.
The good news is that all of them point in one direction, making the final score 7:2.
Well, that’s the bad news. You’ll have to wait until Tuesday and my next essay to get the answer.
In the meantime, I invite you to read my analysis on the asset class I’m the most bullish about in 2020.