Michael Mauboussin is out with a new piece. In it, he lays out the ingredients that drive market cycles, both normally and to extremes, and how to cope with it.
The normal fundamentals that drive market cycles, when combined with our own biases, can lead to extreme asset prices.
Procyclical feedback loops commonly start with fundamental economic strenght taht becomes virtuously self-reforcing. For example, an increase in consumer demand leads to greater business investment, which leads to higher employment, which spurs additional demand. The process also works in the opposite direction.
Whether up or down, a trend in fundamentals can morph into a feedback loop that pushes asset prices to an extreme. While it is difficult to isolate the exact cause of a procyclical extreme, we can offer a taxonomy that captures much of the behavior we observe. The boundaries between these categories are blurred, but they reflect most of what we see in markets.
This is a normal part of the cycle. It’s only when irrational thought permeates that you see extremes like the Dotcom and the housing bubble and busts.
There is a mix of drivers Mauboussin identifies that can fuel procyclical extremes:
- Debt and Leverage – Debt and innovation are the leading forces behind asset bubbles, debt being the more harmful of the two. The counterintuitive nature of accessing debt is that lending standards are tighter at the bottom of a cycle than the top. So it’s easier to borrow when the economy is strong than when it’s weak. Not only is it easier to borrow, but it’s easier to borrow a higher amount. And higher asset prices, help that effort. So accessibility, the ease with which one can borrow, is a primary indicator of potential excess in the cycle. Think back to the housing bubble — where someone only needed a pulse to get a mortgage — as an extreme example.
- The Madness of Crowds – In general, the crowd is fairly wise, except for the brief bouts of crazy. The wisdom of crowds is due to a multitude of opinions. The madness of crowds is due to singular thinking. A lack of diverse thinking can lead to excess in markets.
- Recency Bias – It’s the tendency to put more weight on recent events. In other words, whatever’s been happening lately, will continue to happen. If the market has performed great, it will continue to perform great. If it’s performing poorly, it will only get worse.
- Complacency – We take more risks when things seem stable. Stability brings a sense of certainty, leads to less caution or careless behavior, and more risk-taking. Riskier behavior sows the seeds of eventual instability.
- Confirmation Bias – It’s the overwhelming tendency to search for information that confirms beliefs. So bullish investors look for bullish information. Bearish investors seek out bearish opinions. So investors end up with a rosier or dimmer view of reality.
- Desperation – When investors need to earn a certain return to meet goals, desperation drives them to take exceptional risks in the hope of achieving it. Low expected returns can lead to higher desperation and more risk-taking.
- Institutional Policies – The people behind the institutional rules used for asset allocation, portfolio construction, and risk are not immune to recency bias, complacency, confirmation bias, or desperation.
- Government Policy – The people behind government policy have the same lack of immunity to bias, desperation, and complacency — on top of the shortsightedness and short-termism prevalent in government thinking.
Not only should investors be aware of these drivers, they should know that almost everyone is influenced by it. CEOs and businesses, in general, are more cautious at the bottom of a cycle, then the top. Consumers are too. The so-called “wealth effect” shows that consumers spend more as markets strengthen and asset prices rise. And investors are hardly immune.
It’s the nature of the beast. It’s easy to get caught up in the prevailing attitude of the cycle. Philip Carret actually laid it out quite plainly in The Art of Speculation:
As simple and perhaps as good an explanation as any is the inability of the majority of mankind to maintain a regimen of hard work in the face of easy living conditions. Just as in the realm of pugilism a few years of soft living will make a Dempsey easy prey for a Tunney so a period of prosperity contains the seeds of its own destrution. Effort slackens, wages obtained with relative ease are spent for luxuries, business men forget the painstaking care by which they have built up their enterprises and commit themselves to reckless plans of expansion, others curtail their office hours, increase their golf hours. The sik-shirt era of 1919 and 1920 was followed by the painful depression of 1921. So it has been throughout the history of the world.
Mauboussin suggests the best way to defend against it to be aware of it and have a process in place to offset the behavioral aspects and ways to recognize the extremes — extreme asset prices and ease of debt access. Obviously, he gets more specific on how to do that. So go read the whole thing.
Source:
Mauboussin: Procyclicality and Its Extremes (PDF)
Last Call
- The Dunning-Kruger Effect: We are All Confident Idiots – Kottke
- The Shortcut Crowd – S. Godin
- Proof Negative – Above the Market
- Three Ways to Shift the Bell Curve to the Right – Evidence-Based Investor
- Factor Investors Don’t Believe in Global Warming – Mindfully Investing
- Where’s the Value in Value Investing (PDF) – Schroders
- Mohnish Pabrai’s Advice for Value Investors – Sumzero
- Billionaires (Gates & Buffett) in Cars Getting Candy – GatesNotes
- The Strange Brain of the World’s Greatest Solo Climber – Nautilus
- The Nutella Billionaires: Inside The Ferrero Family’s Secret Empire – Forbes
- Ways to Think About Machine Learning – Benedict Evans
- Disney Imagineering Has Created Autonomous Robot Stunt Doubles – TechCrunch
