Of Cycles and Swings

“The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.” – Seth Klarman

I elucidate further. The story of the market is a story of two wave-cycles, one a cycle of Price and the other a cycle of Human Emotions. Both are joined at the hip, synced in time and direction, albeit with a slight lag. One begins and leads, then feeds the other and vice- versa, causing a mutually reciprocating and a reinforcing phenomenon with “Soros- reflexivity” type characteristics. Price and Emotion are also best analogous to two swings of pendulums. Both moving in parallel and each mutually “leading, feeding and causing” by and along with the other.

Emotions swing between euphoria and depression, between celebrating positive developments and obsessing over negatives. Prices swing between peaks and being overvalued at one end and depressed and undervalued at the other.

A typical cycle or swing could look as follows. The trigger is usually a market emotion, triggered perhaps by a macro-economic change event, either economic or regulatory. The most recent example is the lax real-estate lending policies in the US prior to 2008. Once triggered, the emotion and the corresponding behavior build in a direction, gradually at first. Then as the herd’s social-proof behavioral bias gathers momentum, the emotions compound in strength and do so exponentially, reaching their full intensity as the wave- cycle reaches an extreme.

With rising emotions (say greed), prices rise and rising prices lead to increased greed buying and increased risk-taking which in turn fuels mass-buying, in turn causing prices to rise higher yet, and the vicious vertigo begins, the bubble expands, until prices peak along with peaked optimism and exuberance. All rationality is temporarily abandoned at this stage. The fear of “losing out” is ridiculed. The only fear that market participants suffer is the fear of “missing out.”

Then the inevitable occurs. A catalyst event, often times seemingly innocuous, exposes the irrationality. The proverbial “clock at Cinderella’s ball strikes 12.” The child in the crowd yells the truth, “the emperor is naked.” Immediately, an emotional overreaction occurs in the opposite direction causing a switch in the wave-cycle’s direction. Then fear followed by rising fear takes over. Prices briefly decline first and then plummet precipitously as the herd rushes headlong towards the fire-exits fuelling a panic and leading the bubble to…burst. Prices trough, crash and burn. The pendulum begins to reverse the direction of its swing. In fact, its movement toward the extreme itself supplies the energy for its swing back.

This phenomenon of the market leading itself to extremes and its overreaction once at the extremes is termed by Benjamin Graham as “Mr Market’s Folly.”

Value Investors beware. It would be wonderful to be able to successfully predict the cycles and swings of prices and the market’s behavior and always move in the appropriate direction, but this is an unrealistic expectation. It is more reasonable to:

  1. Stay attuned to the market’s folly, anticipate it and patiently prepare well for its inevitable occurrence.
  2. When it does occur, adjust your behavior in response.
  3. Most importantly be careful that you resist and avoid participating in the folly. This is a feat which is more easily understood than achieved by most. You may underestimate the pull of its “gravitational force” and overestimate your ability to overcome and resist it at your own peril.

Value investors remain vigilant not only against participating in Mr Market’s folly but to fully profit from it. This is achieved by acting against the cycle’s direction particularly at its extremes. An important preparation is to have ready cash to BUY when markets burn and crash. And the only sane way of being in that position is to SELL and exit before prices peak.

A useful maxim for Value Investors then could be to: “Have Cash and Courage and wait for a Crisis.”

Howard Marks (Oaktree Capital): “For forty years I’ve seen the manic-depressive cycle of investor psychology swing crazily: between fear and greed – we all know the refrain – but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd – and swinging with the pendulum – will give you average performance in the long run and can get you killed at the extremes.”

 

– Husain Kothari
5th May, 2011

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