The cycle of optimism and pessimism drives markets. Ben Graham understood this well enough to point it out whenever he saw an excessive amount of either one in the market.
One of those times was 1958, where Graham warned of the risks inherent in the bull market of the time. According to Graham, the big risk was how optimism slowly creeps into an investor’s thought process (the same thing happens with pessimism during a bear market). He noticed that people were projecting lofty expectations around earnings growth (of course, optimism isn’t limited to just earnings).
Future assumptions plugged into in math formulas, infect investment decisions with an optimistic viewpoint. And when everyone thinks that way, it gets reflected in prices. When optimism is priced in, investors end up paying a high price for lofty expectations.
Eventually, the market turns and the pendulum swings the opposite way – pessimism – and the cycle rolls on. But not before it does some damage to the average investor’s psyche.
Here’s Graham on the error of speculating too much on the future:
But in revenge, a new and major element of speculation has been introduced into the common stock arena from outside the companies. It comes from the attitude and viewpoint of the stock-buying public and their advisers – chiefly us security analysts. This attitude may be described in a phrase: primary emphasis upon future expectations.
Nothing will appear more logical and natural to this audience than the idea that a common stock should be valued and priced primarily on the basis of the company’s expected future performance. Yet this simple-appearing concept carries with it a number of paradoxes and pitfalls. For one thing, it obliterates a good part of the older, well-established distinctions between investment and speculation…
Secondly, we find that, for the most part, companies with the best investment characteristics – i.e., the best credit rating – are the ones which are likely to attract the largest speculative interest in their common stocks, since everyone assumes they are guaranteed a brilliant future. Thirdly, the concept of future prospects, and particularly of continued growth in the future, invites the application of formulae out of higher mathematics to establish the present value of the favored issues. But the combination of precise formulae with highly imprecise assumptions can be used to establish, or rather to justify, practically any value one wishes, however high, for a really outstanding issue. But, paradoxically, that very fact on close examination will be seen to imply that no one value, or reasonably narrow range of values, can be counted on to establish and maintain itself for a given growth company; hence at times the market may conceivably value the growth component at a strikingly low figure.
On assumptions that become too optimistic (especially in bull markets):
But more important than the foregoing is the general relationship between mathematics and the newer approach to stock values. Given the three ingredients of (a) optimistic assumptions as to the rate of earnings growth, (b) a sufficiently long projection of this growth into the future, and (c) the miraculous workings of compound interest and the security analyst is supplied with a new kind of Philosopher’s Stone which can produce or justify any desired valuation for a really “good stock.”
On the paradox between math and bull market optimism:
The point I want to make here is that there is a special paradox in the relationship between mathematics and investment attitudes on common stocks, which is this: Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom. In 44 years of Wall Street experience and study I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever excalculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.
On making assumptions everyone else is making, then it’s likely already priced in:
Yet one might argue, perversely, that precisely because the old-time investor did not concentrate on future capital appreciation he was virtually guaranteeing to himself that he would have it, at least in the field of industrial stocks. And, conversely, today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss.
The New Speculation in Common Stocks – Ben Graham