“The stock market is the story of cycles and of the human behaviour that is responsible for overreactions in both directions.” – Seth Klarman
We must never forget about the inevitability of cycles. Economies and world
affairs rise and fall in cycles. So does corporate performance. The reactions of
market participants to these developments also fluctuate cyclically. Thus price
swings usually overstate the swings in fundamentals. When developments are
positive and corporate profits are high, investors feel good and often bid assets to
prices that more than reflect their intrinsic value. When developments are
negative, on the other hand, panicky investors are prone to sell them down to
overly cheap levels. So prices sometimes represent high multiples of peak
prospects (as they did with technology stocks in the ‘90s), and sometimes low
multiples of trough prospects.- Howard Marks
“It’s so good it’s bad, it’s so bad it’s good.” – Anon
In every cycle there comes a point where fundamental conditions are so good that they are bad: economic growth is so strong that its causing inflation to rise and central banks to run ever tighter monetary policies; shares have become overvalued; and investors have piled in at such a rate that there is no one left to invest. This then sets up a market top and a new bear market. And the reverse applies during economic and market downturns. Which brings us to contrarian investing.
Ignoring cycles and extrapolating trends is one of the most dangerous things
an investor can do. People often act as if companies that are doing well will do
well forever, and investments that are outperforming will outperform forever, and
vice versa. Instead, it’s the opposite that’s more likely to be true.
“Markets are in a constant state of uncertainty and flux and money is to be made by discounting the obvious and betting on the unexpected.” – George Soros
There are two insights in this. First, markets are always bouncing around – minute by minute, day by day, year by year – because they are trying to discount the future. We just have to get used to it. Second, investment markets can be perverse. If the economy and profits are obviously bad then that is likely already reflected in the share prices and you are better off betting on what is not, eg an economic recovery. And vice versa when things are obviously good.
“When the facts change I change my mind. What do you do sir?” – John Maynard Keynes
This is the classic economists’ defence for when their forecasts don’t pan out! But it also highlights that any investment process needs to have a bit of flexibility for when the facts change.
“Markets go in cycles like all the other rhythms of life.”
You can’t do the same things others do and expect to outperform.-Howard Marks