This winter, do you expect it to be warmer in Minneapolis or in Miami? This isn’t meant to be a trick question. We’d probably all agree it will be warmer in Miami. But what if I asked you to predict the precise temperature in either city on January 1st. This is a much more difficult question.
In his book Mastering the Market Cycle, investor Howard Marks uses illustrations like this to make an important point. When it comes to investment markets, the future is essentially unknowable. But just because we don’t know precisely what will happen, Marks says, “doesn’t mean we’re helpless in contemplating the future.”
Weather patterns are, of course, more predictable than investment markets, but Marks argues it’s still possible for investors to gain some sense of the future. How? By understanding the importance of market and economic cycles, Marks says, and by understanding where we stand within each cycle. We can use this cycle-based approach to evaluate where markets stand today.
Stocks. In judging the stock market, a typical starting point is to assess recent performance. This year, for example, the U.S. market is up about 12%, after losing 18% last year. That tells us something—but it doesn’t provide a lot of context. Other measures, however, such as the market’s price-to-earnings (P/E) ratio, tend to move in cycles and can thus provide more perspective. Today, the market’s P/E stands at about 18—a bit above its 25-year average of 16.8. That suggests the market is neither cheap nor expensive relative to the range of past cycles.
Investor sentiment also has significant bearing on markets, and it turns out there’s a sentiment cycle as well. In 2021, for example, investment manager Jeremy Grantham highlighted examples of “crazy behavior,” such as the cult following that developed, for no rational reason, around the stock of video game retailer GameStop. Sure enough, after the froth of 2021, a period of more negative market sentiment took hold. This cycle of investor sentiment repeats regularly.
Where does sentiment stand today? According to Ned Davis Research, investor sentiment is somewhat more positive than average but significantly less bullish than it was a few years ago, when “crazy behavior” was widespread. Like the market’s P/E, sentiment could be characterized as being at a neutral level.
What does this mean for your portfolio? If you’re a long-term investor, you shouldn’t worry too much about where the market stands at any given point. At the margin, however, I do think it’s relevant. Suppose, for example, you receive a bonus at year-end and want to decide how quickly to invest it. Having a sense of the market cycle could help you make that judgment.
Bonds. Normally a mundane topic, interest rates took the spotlight last year when the Fed raised rates 11 times, triggering a double-digit decline in bonds. Many are now asking when rates will stabilize, or better yet, decline. While we can’t know for sure, there’s a relevant cycle that offers some insight: where things stand with inflation. Since it was a spike in inflation that prompted the Fed to lift rates, it stands to reason that the Fed will feel comfortable reversing course only after inflation is under control. Fortunately, things have been heading in the right direction. After peaking at nearly 10% last year, the September inflation figures came in under 4%—a meaningful improvement. What does this mean for your portfolio, and specifically, for bond prices? Observers sketch out two possible scenarios.
Skeptics like to point to the 1970s, when on more than one occasion, inflation seemed to be on the decline, only to reappear. If we were to see a repeat of that pattern, interest rates would likely rise, and bond prices would fall further. On the other hand, if the current trend in inflation continues, the Fed would likely start lowering rates. That would cause bond yields to fall and prices to rally.
Since these are both plausible scenarios and we don’t know which way things will go, a reasonable approach at this point in the cycle would be to split the difference. With part of your portfolio, you could purchase a ladder of intermediate-term bonds. That would allow you to lock in some of today’s attractive yields even if rates drop. Then with the other part of your bond portfolio, you could buy a short-term bond fund, which would likely hold most of its value should rates rise further.
Income tax rates. Certain decisions require a judgment on the direction of tax rates. For example, if you’re trying to decide whether to direct 401(k) contributions to a tax-deferred or to a Roth account, you’d want to have a view on future tax rates. Since Congress controls tax rules, it’s tricky to make any kind of forecast, but the historical cycle of tax rates does provide a guide. Over the past 30 years, the top marginal tax rate has averaged just over 37%—very much in line with today’s top rate. Hard as it is to believe, though, the top rate has been as high as 94%, back in the 1940s, and the top rate was at 70% as recently as 1981.
What does that mean for future tax rates? There’s one change we can probably count on: In 2026, tax rates are scheduled to revert automatically to the higher rates that were in place prior to 2018. But beyond that, there’s another cycle that can provide some insight: the Federal government’s debt situation. That picture is sobering.
In the mid-1990s, the government actually ran surpluses for a time, and debt as a percentage of GDP was under 40%. Today, however, the government’s debt stands at 118% of GDP—nearly the highest level in history. As a result, the Federal government now spends more than $600 billion a year on interest alone, and with interest rates on newly-issued Treasury bonds now much higher, this figure will probably only climb. While it’s up to Congress—and thus to political considerations—it seems quite possible that tax rates will have to rise at some point down the road to help manage this debt. It’s anyone’s guess when, or by how much, but these debt figures suggest rates are more likely to rise than to fall.
Domestic vs. international stocks. Most investors agree that diversification is important. Nevertheless, over the past 15 years, investors have been punished for diversifying outside the United States. While the S&P 500 has returned more than 11% per year, on average, international markets have returned less than 5%. To avoid further pain, investors could decide to stay close to home. But this is where it’s important to consult past cycles. While international markets have lagged almost every year in recent memory, that hasn’t always been the case. Go back to the mid-2000s, and international markets outperformed for seven years in a row. There were also periods of multi-year outperformance in the mid-1990s and in the mid-1980s—in other words, about every 10 years.
What does this mean for your portfolio? There is, of course, no guarantee we’ll see a repeat of past cycles. But there’s also no reason to think we won’t. That’s why, despite years of unpleasant results, I still think it makes sense to maintain international exposure.
As you think about this decision, there’s another cycle worth consulting: Look at the top five holdings in the S&P 500 today, and you’ll see that they account for nearly 25% of the total value of the index. To put that in perspective, 10 years ago, the top five stocks accounted for little more than 10% of the S&P 500. And the last time the index saw a rapid increase in concentration was the late-1990s—just before the market dropped.
Nothing in the world of investing is guaranteed, but by consulting past cycles, we can at least gain a sense of which way the wind is blowing.
