How to tell when the market's bottomed

Two years ago, I penned this piece based on Stephen Schwarzman's then-newly released book. A week later, the ASX went into a month-long tailspin. To paraphrase Howard Marks, being early is the same as being wrong. Hopefully, the timing is better on this occasion. 

If you’ve never heard of billionaire investor, Stephen A Schwarzman, you’re not alone. Despite being one of the founders of Blackstone Group, worth over $20 billion, and living in John D Rockefeller Jr’s old apartment in Manhattan, Schwarzman was not widely known outside the industry until quite recently. The release of his book, What It Takes: Lessons in the Pursuit of Excellence, late last year changed that, offering a rare glimpse into the mind of arguably the world’s most successful private equity investor.

Schwarzman is a keen observer of market cycles, having seen seven major recessions and market crashes in his career. Blackstone Group was one of the few Wall Street firms that did well through the financial crisis, with their strong position allowing them to make two of the largest real estate purchases in history in late 2007.

In his book, he discusses his simple rules for identifying market tops and bottoms. Given the relevance to today’s markets, I thought I’d take the opportunity to share some of his key points from the book, and relate them to observations in the local market

Look out below

Schwarzman believes that market tops are much easier to recognise than market bottoms. He believes that a surplus of cheap debt, relaxed loan covenants, and overconfident buyers are some of the best indicators a top is near. The first two conditions on that list appear to have met already, whether buyers are overconfident or not, we’ll have to leave that one to you to decide.

“Leverage levels escalate compared to historical averages, with borrowing sometimes reaching as high as ten times or more compared to equity.”

If you do a bit of searching, there are plenty of examples of companies with very high debt levels. For example, Virgin Australia Holdings has a balance sheet of over $6.5 billion following its large debt raising at the end of last year, compared to just $619 million of equity. If you subtract their $581 million of intangibles, that’s just $38 million of tangible equity, barely a fraction of their outstanding debt.

“Buyers will start accepting overoptimistic accounting adjustments and financial forecasts to justify taking on high levels of debt.”

This is another more subjective one, but ask yourself this; how many times have you seen “EBITDA” or “Adjusted EBITDA” in company accounts recently?

“Another indicator that a market is peaking is the number of people you know who start getting rich. The number of investors claiming outperformance grows with the market.”

Bitcoin, Tesla, Afterpay, Sezzle… It’s hard to miss the ‘life changing’ returns some investors have seen in recent times. Tell us what you’re seeing out there; are your friends and acquaintances suddenly stock market geniuses, offering stock tips to whoever will listen? Leave a comment to let us know.

The long grind higher

The hard part, according to Schwarzman, is picking the bottom. Most of us are not good at this.

“Most public and private investors buy too early and underestimate the severity of recessions. It’s important not to react too quickly. Most investors don’t have the confidence or discipline to wait until a cycle fully plays out. These investors suffer by not maximizing the profit they would have otherwise made from executing the same idea at a later point.”

The good news is you don’t have to pick an exact bottom. In fact, he says that “it’s often a bad idea to try.” He explains that asset prices can take a very long time to recover. Following the collapse of oil prices in the early 80s, Houston office buildings entered a severe downturn. The bottom of the market was in 1983, but it took a full 10 years for prices to recover. Instead, he suggests waiting until prices start to rally.

“The way to avoid this type of situation is to invest only when values have recovered at least 10 percent from their lows. Asset values tend to increase as economies gain momentum. It’s better to give up the first 10 to 15 percent of a market recovery to ensure that you are buying at the right time.”

One final note on following the herd

Have you ever wondered why so many investors follow the crowd, despite knowing that this is not a good way to make outsized returns? Schwarzman says that they’re deluding themselves. They think they want to make money, but in reality, they just want the psychological comfort of investing with the crowd.

“They would rather be part of the herd, even when the herd is losing money, than make the hard decisions that yield the greatest rewards. Doing what everyone else is doing seems like a way to avoid blame. These investors tend not to invest aggressively near market bottoms, but instead do it at market tops, where it makes little sense. They like the comfort and reassurance of watching assets go up. The higher prices go, the more investors convince themselves that they will continue appreciating.”

Read the book

If you enjoyed these excerpts, you can get the full book for Kindle and Audible, or try here if paper is more your style.