I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Tuesday Book Club, I share an idea from a book.
In Mastering the Market Cycle, long-time investor Howard Marks writes:
The odds change as our position in the cycles changes. If we don’t change our investment stance as these things change, we’re being passive regarding cycles; in other words, we’re ignoring the chance to tilt the odds in our favor. But if we apply some insight regarding cycles, we can increase our bets and place them on more aggressive investments when the odds are in our favor, and we can take money off the table and increase our defensiveness when the odds are against us.
He suggests that deciding on a balance between aggressiveness and defensiveness at a given point in time is the best way to optimize a portfolio:
I believe the aggressiveness/defensiveness balance should be adjusted over time in response to changes in the state of the investment environment and where a number of elements stand in their cycles.
The key word is “calibrate.” The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive. When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back.
Right now, I would argue, the situation calls for a defensive stance, for these reasons:
- The oil, gas, and fertilizer shock in the Middle East is likely to both increase inflation and decrease corporate earnings in the next few months to a year. While inflation can nominally increase corporate earnings, it also drags on the economy as consumers must cut back on discretionary spending in order to pay higher gasoline and food prices.
- U.S. equities in particular are already very pricey. The current S&P 500 Shiller PE Ratio (a price-to-earnings ratio smoothed over time and adjusted for inflation) is almost 38, almost as high as it reached in October 2021 before the market fell in 2022 and 2023. Only in the run-up to the dotcom boom did it reach a higher level than 2022 and now. Around the world, equities are priced high, after a big international stock run-up at the beginning of this year.
- There’s evidence of previous investor euphoria and poor decision-making in the private credit sector as well as in AI capex spending that is draining big tech companies cash.
In general energy shocks like we are facing right now are not good for the stock market. Russia’s invasion of Ukraine in 2022 saw a fall in both stocks and bonds. The fall was erased by investing based on AI enthusiasm, but this may have just postponed an inevitable recession in the business cycle. The 1973 oil shock came along at a time when the stock market was already struggling. In 1973 and 1974, the S&P 500 declined by almost 50%. The decline lasted roughly 21 months, and didn’t recover its previous peak for more than seven years.
Trump’s TACO yesterday might have resulted in a day-long rally. But stock market corrections play out over months. Author Nassim Nicholas Taleb has been quoted as advising “If you must panic, panic early. Be scared when you can, not when you have to.”
As of right now, the S&P 500 is down about 6% from the peak it reached near 7000 during January. That’s not much at all. It could grind down much lower through 2026, as the effects of the Middle Eastern conflict play out, as central banks around the world hold off on rate cuts due to incoming inflation (or even hike rates), as consumers and businesses find their financial situations deteriorate due to rising energy, food, product, and material costs.
I’m about 75% in cash in my non-retirement account and 30% in my retirement account. I don’t see many good investments right here. Energy-related stocks have been doing well, but may have outrun themselves here.